Falling household deposits are a growing worry for banks
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Falling household deposits are a growing worry for banks

Net interest margins are shrinking. Banks may need to find new sources to fund customer loans, perhaps even by lending to each other.

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In a free-market economy, who should set the short-term price of money that underpins all other financial markets: state-sponsored central authorities answerable to governments, or private market lenders and borrowers?

On November 2, Scope Ratings published a report on how rising interest rates and shrinking liquidity – the two most visible effects of the ECB’s tighter monetary policy – are impacting European banks’ balance sheets, including retail funding.

Household deposits have reached a tipping point, Scope suggests. For the first time in 20 years, they are contracting.

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This is a fundamental change. Cheap retail funding is key to European banks’ business models and profitability. Household deposits represent the bulk of deposits used to fund loans and accounted for 30.3% of European banks’ total funding as of June 2023.

Corporate deposits accounted for just 16.2%.

Nicolas Hardy, Scope’s deputy head of financial institutions, says: “There is very little banks can do to prevent an exodus of deposits. What characterizes the current trend is the growing customer focus on pricing.”

Banks were so slow to improve what little they pay for deposits when central banks started to hike rates that politicians in some countries justified taxing their windfall profits.

Now, “banks may be forced to look for alternative sources of funding, which will likely be more expensive”, Hardy points out.

Banking is going back to the future.

Money markets

For the best part of 15 years after the global financial system implosion that began in 2007, central banks did not so much support the money markets: they became the money markets.

Their balance sheets inflated not just because they bought vast quantities of government bonds from banks to repress the cost of debt service for grossly over-leveraged sovereigns.

That was just one side of the trade. There was another too.

Nicolas Hardy, Scope Ratings

When the banks couldn’t find any creditworthy borrowers to lend out the vast cash surpluses injected into them by quantitative easing, the central banks took those excess funds back as deposits.

At least, so the banks reasoned, their money would be safe even if the central banks didn’t pay much for those deposits. And the central banks wouldn’t charge banks a negative rate for holding those excess reserves, even when policy rates hit zero or turned negative.

The US Federal Reserve led the way in all this. Its balance sheet stood at around $870 billion in August 2007. By March 2022, it was $8.94 trillion.

It was the same story at the ECB, whose balance sheet rose from roughly €1.5 trillion in mid 2007 to €8.5 trillion in early 2022, or from the equivalent of about 12% of eurozone GDP up to 70%.

If European banks ever did struggle to fund loans to businesses, the ECB would lend to them at a favourable rate through targeted long-term refinancing operations (TLTROs).

But then years of monetary financing to profligate sovereign borrowers let inflation out of the bag. Twelve to 18 months of 10% inflation may have been a good thing for over-indebted sovereigns, but it was a humiliation for central banks who are supposed to keep inflation at around 2%.

Switching accounts

Rising rates and inflation change everything.

At first, banks were a big beneficiary through fatter net interest margins. Government support and lockdowns boosted savings in the first years of the Covid pandemic. Even when inflation picked up and rates started to rise, so devaluing those savings, retail savers did not have the means or inclination to withdraw money from instant access savings accounts paying nothing and put it into sovereign bills paying 5% instead.

But corporate treasurers made that switch. And people learn. In a cost-of-living crisis anyone lucky enough to have any savings left in the bank – which have rundown as household bills rise – needs to earn something.

So even retail savers have been switching money kept at their banks into higher-paying term deposit accounts. Wealthier savers have been withdrawing funds and turning to money market mutual funds or buying government bills in their own names.

NIMs are now falling, and banks are increasingly anxious to reassure their shareholders that they can find fee earnings to replace interest income: from wealth management, transaction services or, maybe one day, even from investment banking.

As for funding, banks must be wary of becoming reliant once again – as many were before the global financial crisis – on the wholesale markets to fund loan books that grow beyond 100% of deposits.

Deposits, even retail deposits, may be flighty but can probably be held at a price. Capital markets will periodically slam shut in this new era of extreme rate and credit-spread volatility, and may not be there when most needed.

Central banks want to shrink their balance sheets and reduce the amounts they pay to banks for holding their excess reserves, as part of quantitative tightening.

Banks have to repay TLTROs.

The strange logic of banks charging a margin on loans to better rated corporations that do carry bankruptcy risk, makes some kind of sense

Austrian central bank governor Robert Holzmann has argued that banks were the main beneficiaries of extraordinary monetary policy after the global financial crisis and that, if central banks are ever to provide it again, they would be well advised to bolster their reserves ahead of time and have the banks pay for this insurance.

Holzmann has floated the idea of the ECB raising the level of minimum reserve requirements on which the ECB pays zero – as distinct from excess reserves on which it does pay a deposit rate – from 1% of banks deposits up to 5% or even as high as 10%.

Is there another source of funding for banks?

In olden times – before the global financial crisis, rates repression and monetary financing of government debt – banks with an excess of deposits used to lend money out unsecured to other banks for short periods: overnight, one week.

Deposit brokers used to make a living matching up banks that wanted to earn something on their excess liquidity with those that had a short-term need of it.

There are signs of that market reviving. If it grows, that might show a banking system sturdy enough to fund itself. The short-term interbank funding cost could even become a base price for lending to the real economy.

We have seen, after all, that banks are still contingent liabilities of the sovereign. Depositors were protected in the US regional banking crisis and in the state-supported rescue of Credit Suisse.

So, the strange logic of banks charging a margin on loans to better rated corporations that do carry bankruptcy risk, makes some kind of sense.

But then, the banks would be setting a market price for money that transmits to the price of credit.

The big question now is whether or not central banks are willing give up their complete control of that price.

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