The key to understanding the current crisis is to understand that this is no longer a funding crisis, but rather a deposit crisis.
Yes, there are funding issues in peripheral European banks. But don’t let that distract you from the main point.
As we’ve stated on multiple occasions on FT Alphaville before, there’s much to the argument that the Fed hasn’t been keeping rates low all this time, but rather supported — largely through mechanisms like interest on reserves (IOR). All because top quality collateral is simply in such huge demand, that there is a collateral squeeze going on.
Thursday’s move from Bank of New York Mellon only sees market forces finally instituting it for themselves.
After all, if not for things like the penalty introduced by the Treasury Market Practices Group (TPMG) for Treasuries in May 2009, repo rates would have been negative for some time.
Custodian banks are hurting because it’s near impossible for them to return even a zero rate on large deposits of cash. There’s simply not enough Treasury bills out there, which is why they are trading at negative rates causing all sorts of dysfunction at money market funds. It’s natural, therefore, that they would eventually start charging for a service that is costing them — as Bank of New York Mellon announced it would start doing on Thursday.
After all, what a lot of non-millionaires might not know, it’s always been near impossible to keep more than $1m in cash on deposit in a standard single bank account — exactly for this reason. Money has to be put to work, or else the system breaks down.
Indeed, funding is not the problem. It can’t be! You’re getting paid to take on debt at the moment everywhere apart from peripheral Europe.
Morgan Stanley’s Jim Caron made the point best on Thursday:
I have gotten several calls asking if the drop in equity prices is being driven by funding stresses in the bond market, as so often has been the case in the past. The answer is NO. In fact, quite the opposite, funding costs have sharply dropped.
If anything, the bond US bond market is following equities and events in Europe. The drop in risky asset prices are more likely repricing to lower growth expectations, this time it’s not the bond market’s fault. From Tighter to Easier Funding Costs. In an interesting turn of events some banks today are discouraging clients from depositing extra cash by charging additional fees for those deposits.
What prompted this was the desire from short-term money mangers to hold high levels of cash instead investing it due to all the recent uncertainties with the debt ceiling debate, the European sovereign crisis and now the fall in equity prices – which tightened funding costs.
As a result, many investors have opted to deposit money in banks where it is fully FDIC insured. But this creates a problem for the banks because cash that is maintained in a demand deposit account and cash in trust and custody accounts, which is not invested in short-term funds, is required to be held on the bank’s balance sheet and is subject to regulatory ratios and deposit insurance which is a cost for banks.
Banks are seeing these cash deposits as ‘hot-money’ inflows as investors de-risk in the market. But this tends to be a transient flow, and when market conditions improve, the money leaves and prevents banks from investing their balance sheet to cover costs from regulatory ratios and deposit insurance. As a result, some banks are now starting to charge a fee on excess deposits.
The result is that this is pushing clients to invest in short term investments such as repos, which in turn is pushing Treasury repo rates lower (a good thing). Overnight treasury financing is now back to the lows of ~2bps after being as high as 30bps on Monday prior to the debt ceiling resolution. This has even impacted Libor-OIS levels as spreads have started to narrow, which is typically a sign of less stress in the system (see chart below).
Which suggests the next obvious step for the Fed is to declare an official negative interest rate policy, or a national imposed tax on deposits of a certain sum.
It’s what Switzerland has already been hinting heavily it will do if the Swiss franc remains “massively overvalued”.
And yes, if you think that’s effectively nothing more than a wealth tax on the extremely rich, you’d be extremely right. Unfortunately, it might just be the incentive needed to get hoarded cash circulating through the economy once again.
If not, welcome to an eternal and global “liquidity trap“.