NEW YORK--(BUSINESS WIRE)--Wider differences between the yields on US banks' interest-bearing deposits and money market funds (MMF) could drive deposit outflows after the Fed begins hiking rates, according to Fitch Ratings. Recent MMF reforms may also affect deposit flow changes as rates rise.
The tiny rate differences across short-dated rate products are currently not significant enough to offer a yield advantage of one product over another. However, as rates eventually rise, Fitch expects money market funds to be more reactive to increases in the Fed's short-term policy rates than deposits. Many observers expect money market funds will attract deposit cash away from banks into higher yielding assets after a meaningful (yet difficult to gauge) rate differential is reached. The magnitude of deposit outflows is mostly expected to be driven by institutional money managers that control billions of dollars of institutional liquidity.
<a href="https://www.fitchratings.com/web_content/images/fw/fw-chart-201408.htm"> Click here to view related chart.</a>
US banks currently sit on record levels of deposits, fueled by the Federal Reserve's quantitative easing program. As of July 1, checking deposits in the US banking system stood at $1.6 trillion, and rising. Deposits have risen at nearly a 15% compounded annual growth rate since the end of 2008, pushing loan-to-deposit levels well below historical norms. Institutional share classes of MMFs (including prime, government and tax-exempt) have stood just above a level of about $1.7 trillion for nearly three years, according to Fed data.
High balances of non-interest bearing deposits are mostly favorable for banks, but can be a headache for others, as even non-interest bearing deposits contribute some expense. Most traditional banks in the US consider themselves well positioned for rising interest rates, as excess deposits can be put to work in loans, boosting net interest margins.
Even though the Fed's rate increases are not anticipated until sometime in 2015, deposit balance forecasting is important now for larger banks (with assets greater than $50 billion) for stress test reporting and liquidity coverage ratio (LCR) disclosures that begin starting January 1, 2015.
When benchmark interest rates finally lift, banks will face important decisions about where to set offer yields for interest bearing bank products. Banks will have opportunities to hold onto rate sensitive depositors by offering higher yielding products to customers such as certificates of deposit or by boosting rates on savings products.
Slow rate increases by the Fed, which Fitch believes is a base case scenario, would allow for excess deposits to leak out of the banking system without any concern. However, rapid rate increases could draw deposits from banks at a faster rate, which Fitch believes would be a less favorable scenario for banks.
Recent MMF reforms will likely influence this balancing act with some degree of outflows from MMFs into banks. New requirements for prime money funds - including floating NAV, liquidity fees, and potential redemption gates, may make money funds a less attractive cash management product for investors. Consequently, Fitch expects that some investors will gradually take some assets out of money funds over the two-year implementation period for the reforms.
Fitch believes that banks could capture at least some of the money currently invested in prime MMFs if institutional investors do not feel adequately compensated for the added risks.
Money market reforms mostly impact the $956 billion of institutional prime and municipal money market funds that will no longer enjoy constant net asset value pricing. The new rules represent a dramatic overhaul for the liquidity management industry, which has relied upon stable-NAV money funds and no gating restrictions for decades. Money funds investing in government issued or backed securities face no changes. However, because many bank products tend to be more rate competitive with government money market funds, there is a greater likelihood that some investors could stick with bank products.
The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.