Meyrick Chapman is the principal of Hedge Analytics and a former portfolio manager at Elliott Management.
So far, so good! The US banking system problems don’t seem to have popped up elsewhere. Credit Suisse had idiosyncratic, long-standing problems etc etc.
Europeans are therefore feeling a degree of Schadenfreude. Proud claims have been made that the UK and European banking systems more closely follow the Basel III/IV rules and regulators are more diligent than Les Americains. Are non-US banks more resilient though? Truly, we don’t know.
We do know (or think we know) that extraordinary monetary policy of the Fed at least contributed to current problems. Where Fed policy led, all developed economy central banks eventually followed. So we should be wary of claims that all is fine. For instance, some features of US banking fragility that seem to stem from QE are also evident in the UK.
According to a new paper written by among others Raghuram Rajan, a primary cause of US bank fragility was the shift from time to sight deposits (or demand deposits as they are known in the US) as a result of QE. The same shift happened in the UK.
Here is the abstract of “Liquidity Dependence and the Waxing and Waning of Central Bank Balance Sheets”:
When the Federal Reserve (Fed) expanded its balance sheet via quantitative easing (QE), commercial banks financed reserve holdings with deposits and reduced their average maturity. They also issued lines of credit to corporations. However, when the Fed halted its balance-sheet expansion in 2014 and even reversed it during quantitative tightening (QT) starting in 2017, there was no commensurate shrinkage of these claims on liquidity. Consequently, the financial sector was left more sensitive to potential liquidity shocks, with weaker-capitalized banks most exposed. This necessitated Fed liquidity provision in September 2019 and again in March 2020. Liquidity risk-exposed banks suffered the most drawdowns and the largest stock price declines at the onset of the Covid crisis in March 2020. The evidence suggests that the expansion and shrinkage of central bank balance sheets involves tradeoffs between monetary policy and financial stability.
Why would this shift happen? From a bank perspective, sight deposits are a cheaper source of funding than time deposits. But they are stickier, so they’re generally worth paying for as a funding source.
From 2008, all developed economy central banks relied heavily on “non-conventional” policies to indicate that interest rates across the curve would remain low for a long time. It therefore made sense – at the time – for banks to shift to the cheaper source of funding that sight deposits represented.
Using data from the Bank of England, there has been an obvious similar shift from time to sight deposits – at least from 2010, when this data series began.
Quantitative easing began in March 2009. So there’s some data missing from the beginning of the QE era. There is some data available to fill the gap between 2009 and 2010 in a slightly more complex form at quarterly intervals. Still, the monthly dataset nicely paints the picture of the shift to sight deposits.
If we normalise the data it shows that what happened in domestic deposits was more-or-less exactly repeated in non-resident deposits.
The US data shows that the shift from time to sight deposits there began immediately after the first bout of QE began by the Fed. That’s not true in the UK, where the shift seems to have begun only with the second round of BoE QE, which began in mid-2011. Why the delay? Hard to say. Perhaps inertia on the part of customers or the banks.
The paper’s authors – Viral Acharya, Rahul Chauhan, Rajan and Sascha Steffen – show how Fed QE matched the increase in deposits almost exactly one-for-one. So much for the “portfolio rebalancing” theory.
A similar (though slightly lower) translation of QE into deposits appears to have occurred in the UK, but with a more pronounced switch from time deposits into sight.
A feature of the US experience is the ‘ratchet’ effect of the shift in deposits – deposits migrate from time to sight during QE, but didn’t shift back during the bout of quantitative tightening in 2018-19. More recent UK data shows there’s been a slight shift back to time deposits since the beginning of Bank of England’s QT, though the effect so far is small.
The fragility of the US banking system remains a concern. Yet no-one seems to worry too much in the UK. Are we right to be sanguine?
True, interest rates are lower, and the UK yield curve is not as inverted. Both mean that profit pressures are lower than in the US. And there haven’ been the egregious exemptions from oversight that was permitted in the US. Perhaps the UK public shows greater inertia – possibly because there are a limited number of alternative destinations for deposits.
Still, the data suggests at least some of the problems identified in the US system are also present in the UK.
