The last five years have seen funding in the senior unsecured market grow increasingly expensive, with European banks, especially smaller ones, seeing limited access to the debt capital markets. At the same time regulation has encouraged banks to increase their deposit bases, with such funding seen as high quality. Many have concluded that the best and cheapest, and in some cases the only way to fund, is now via deposits.
Not everyone is cheering this trend, and some see the drive towards retail deposits as the ultimate source of funding for long term loans as nonsensical. If you want to fund a 25 year mortgage, short term bank deposits give you a bigger mismatch than five year bonds, says David Soanes, global head of FIG at UBS.
The problems experienced by Cyprus illustrate another downside of having a high proportion of deposits relative to other forms of creditor. Because there were few junior creditors to absorb losses, senior creditors were wiped out. The absence of any significant buffer of shareholders or creditors left depositors facing the possibility of significant losses of their own, sparking a Europe-wide debate about the level of protection that should be expected by depositors. Should savers be entitled to protection, even when other creditors are taking losses? Or should it be taxpayers that enjoy the ultimate protection?
New EU bail-in rules have reaffirmed that a significant proportion of depositors are protected from losses in the event of bank failure, along with collateralised funding, covered bonds and short term funding. This leaves senior unsecured looking very exposed. To give such creditors a little more comfort banks will have to hold considerable buffers of equity tier one and tier two capital.
There is no single answer to the question of how much buffer capital is needed, says Chris Hittmair, head of European FIG DCM at HSBC. For a bank with a retail banking profile a total capital ratio of 15% could be sufficient, whereas for a larger bank with large wholesale operations, 20% or more could be more appropriate.
Deposit protection means the impact of bail-in should be muted among smaller depositors. The current draft of the Bank Recovery and Resolution Directive offers protection to small depositors with less than €100,000 per institution, and there is some debate about expanding this to include medium size depositors and SMEs.
Even larger depositors can spread their assets among institutions so that €100,000 is insured at each. But for high net worth individuals with millions in the bank it may become unwieldy depositing assets in so many institutions. More likely, larger sums will be deposited but people will be quicker to withdraw it at the first sign of trouble.
Although the public and politicians display little sympathy for the largest depositors, it is the movement of larger blocks of capital that will prove the most systemically destabilising. And these large depositors are not only rich individuals but also local authorities, government bodies and companies.
“Any corporate treasurer would be failing in their fiduciary responsibility if they failed to move money out of those kinds of dangerous situations,” says Adrian Docherty, head of FIG advisory at BNP Paribas.
There is some question whether policymakers in Europe have fully considered the implications of such large sums of capital being moved around at any sign of a crisis. Such a situation would certainly be systemically destabilising. It is therefore debatable what justification there is for changing the current insurance threshold, or where it should be moved to if a change is needed.
The new bail-in rules could also lead to a new market in term deposits. In Australia, government guarantees of deposits led to a thriving market in transferable certificates of deposit (TCD), with creditors trading ownership of the money held on deposit at the bank. “If senior debt holders are not ranked pari passu with depositors, as appears to be the case, the logical response is for liquidity to move to tradeable deposits,” says one banker. Investors could then make sure they never hold TCD-type instruments in excess of the level set for the guarantee with any one institution.
A bank eat bank world
Although a strong case can be made that retail deposits are inferior to long term bonds and the bank’s own equity base, which are more stable in times of crisis, banks have been ramping up their efforts to attract new depositors.
“In Spain, Italy, even France, competition for retail deposits is fierce,” says Alexandre Trulli, head of FIG syndicate at Natixis. “In Italy we have seen banks proposing a pick-up of up to 3.5% on the base rate to attract depositors. That has helped some to increase their deposits but they need to attract more.”
The question then becomes how banks justify paying such returns on deposits in such a low interest rate environment. The margins being made on deposits are being squeezed. “Higher rates will be unsustainable if deposits are not put to work to generate similarly generous returns on the asset side,” says Arno Kratky, head of liquidity risk at Commerzbank.
Meanwhile, regulators may be mistaken in thinking that retail deposits are inherently more stable in times of crisis.
Banks must now demonstrate the stickiness of their deposits and the regulator may consider less sticky deposits as lower quality. Regulators have some discretion to make this determination, although Basel does offer guidance: “Buckets of less stable deposits could include deposits that are not covered by an effective deposit insurance scheme or sovereign deposit guarantee, high value deposits, deposits from sophisticated or high net worth individuals, deposits that can be withdrawn quickly (eg internet deposits) and foreign currency deposits, as determined by each jurisdiction.”
At the far end of the spectrum, funds that are borrowed from other banks are considered flighty and of the lowest quality.
Some European governments, such as the UK’s, have explicitly stated they wish to encourage greater competition among banks. This is likely to encourage more people to hold multiple accounts, and to move money between them according to where they receive the best rates. In time, deposits may come to be seen more like assets under management within a fund, a far more transient number that can be expected to rise and fall according to performance and investor expectations.
“Retail funding is definitely less stable than it was,” says Soanes. “Depositors have learned how to flee which has undermined the stickiness of the business. This has far bigger implications for liquidity than whether an institution scores 90% or 110% in its liquidity coverage ratio.”
There is no doubt technology has played a part in this change. A person sitting on a train reading his newspaper who comes across a negative story about their bank could clear the entire balance before reaching their destination. “Technology has allowed people to be more impulsive which is the opposite of stickiness,” says Soanes. “Money is more manoeuvrable now than ever.”
At the extreme this opens the door to the possibility of greater incidence of bank runs. The Bank Recovery and Resolution Directive is intended to deal with this threat, but it does not alter the fact that future bank runs are likely to accelerate faster than they have in the past.
Even if more bank runs do not materialise, greater fluidity between accounts deprives deposits of the very characteristic that made them desirable in the first place.
Tempering the rush
Some believe the current forces pushing greater competition for retail deposits will ease over time. Following the next round of stress tests there will be more clarity about the health of individual banks and this could temper the rush for deposits, says Kratky. “Once the good banks have been sorted from the bad, rates should level off,” he says.
National regulators could also take the heat out of competition. If regulators clamp down on banks using deposits gathered in foreign subsidiaries to lend to clients in their home markets, the trend for local deposit gathering may no longer be so prevalent. Germany’s financial supervisory authority BaFin has already stepped in to prevent UniCredit borrowing from its German subsidiary.
And even if deposits do come to be seen as less sticky, this does not necessarily mean the system is less stable. Banks will look to increase deposits to improve their capital positions and enable them to lend more, but it may prove to be those with the most opportunities to lend that take in most deposits.
The consequences of the changes therefore look likely to favour the incumbents, reinforcing the status quo. People are likely to gravitate towards the big institutions, where they will be safest, predicts Trulli. “Depositors seem to be better protected in the large banks,” he says. “The larger banks have been the real winners in this crisis. Relatively speaking, credit risk and reputational risk are much higher among smaller banks, and government support is likelier for the big banks.”
The big deposit banks with retail networks are therefore likely to maintain a stable market share, he says. “People will move between banks but overall the proportion doing that will be quite low.”
“I think we will see the market polarise increasingly between the super-safe institutions versus everybody else,” says Docherty. “Those in the latter category are going to struggle to attract deposits and we will see more failures.”
Smaller banks may have no option but to merge to give them more scale to compete, leading to even more systemically important, too-big-to-fail banks in Europe.