Banks are paying up to protect their cash holdings from sinking further and to safeguard against future runs on deposits, according to Bank of America. 

Big and small institutions alike started doing this even before the turmoil in the US banking system in March, said strategists Mark Cabana and Katie Craig. Data show large time deposits – or certificates of deposit issued in amounts greater than US$100,000 – have risen by about US$675 billion since the beginning of the Federal Reserve’s balance sheet unwind in June 2022. 

“It is expensive to maintain deposits but banks appear willing to pay the price,” the strategists wrote in a note to clients on Friday (Sep 22). “Banks likely want an extra buffer of cash due to rapid deposit outflows and to manage shareholder perception about their overall liquidity.”

In the 18 months since the central bank started hiking interest rates, cash has been flowing out of the banking system in search of higher-yielding alternatives. With the Fed pledged to keep interest rates at current levels for longer and deposits continuing to leave, the risk that bank reserves will deplete is increasing. That could force the monetary authority to halt its quantitative tightening earlier than intended.

With lenders still jittery following the failures of Silicon Valley Bank and Signature Bank, the Fed’s most recent survey of financial offers published in August showed that roughly 79 per cent of respondents said their institutions preferred to hold additional reserves above the lowest comfortable level. Nearly half of those respondents also reported increased borrowing from Federal Home Loan Banks as the result of the stress in March.

Scarcity has also caused problems in the past, most notably in September 2019, when the Treasury increased borrowing and the Fed stopped buying as many Treasuries for its balance sheet. Balances dropped by nearly US$166 billion to US$3.14 trillion in the week through Sep 20, Fed data show. Wall Street strategists have estimated the banking system’s aggregate lowest comfortable level of reserves is somewhere around US$2.5 trillion.

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Fed policymakers have said the banking system’s lowest comfortable level of reserves is roughly 8 per cent to gross domestic product, which is a small buffer above the level in September 2019. Yet, the BOA strategists say, recent bank liquidity preferences may imply scarcity closer to when reserves are roughly 10 per cent of GDP – which means quantitative tightening might end once balances at the overnight reverse repo facility, or RRP, reach zero near the end of 2024.

There’s also a risk that bank liquidity preferences spur a more rapid increase in funding costs than market participants anticipate, especially after the RRP is depleted. That’s because liquidity strained commercial banks might be unwilling to backstop the overnight repo market amid rising rates as it’s not seen as the equivalent to reserve cash holdings.

“We are uncertain of the macro conditions that will prevail when overnight RRP depletes to zero,” Cabana and Craig wrote. “A higher for longer rate environment and continued bank deposit outflows could contribute to banks remaining liquidity strained towards end 2024, which risks funding pressure.”  BLOOMBERG