Why Banks Are Paying So Little Interest
From December 2015 through June 2017, the Federal Reserve raised the short-term benchmark interest rate four times, each time in an increment of 25 basis points. But according to national average deposit rates published by the Federal Deposit Insurance Corp., the interest rates banks are paying depositors have barely budged.
This has occurred even though yields on short-term marketable securities, such as commercial paper (CP), have risen in tandem with the fed funds rate’s cumulative 1% increase, says Lance Pan, director of investment research for Capital Advisors Group.
In a new research note, Pan investigates why “while deposits generally lag the market when rates are rising, this lagging effect is more pronounced today than in the past.”
His evidence: Among jumbo deposits (greater than $100,000), the money market rate has risen only 0.01%, to 0.12%, since December 2015. The one-month certificate of deposit (CD) rate was unchanged, at 0.07%, during the same period. The three-month CD rate rose only 0.02%, to 0.11%.
“Historically, these rates tended to rise with the fed funds rate, sometimes exceeding the benchmark rate increases,” writes Pan.
He details four contributors to the still-low deposit rates being offered in the current cycle:
Abundant bank reserves. The Federal Reserve’s asset purchases following the financial crisis resulted in a huge increase in bank reserves, which reached a peak of $2.8 trillion in late 2014, Pan says. The reserves stood at $2.2 trillion as of June 20, “[providing sufficient liquidity in the banking system and [lessening] the need for banks to pay higher rates on deposits.”
Restrictive banking regulations. With higher capital adequacy and balance-sheet liquidity requirements, “banks need to optimize the use of deposits for high-margin lending and capital markets activities to justify the costs of holding deposits on their balance sheets,” writes Pan.
Banks keeping the first cut. “After nearly a decade of compressing net interest margins (NIMs), or spreads between lending and deposit rates, banks appear to be paying themselves before awarding depositors,” says Pan. Investor inertia may also be a factor. Corporate treasurers have “endured a decade of zero interest rates,” so many have yet to adjust their expectations for “higher income returns” from deposits.
Money market fund (MMF) reform. “In past cycles, yield on MMFs tended to trend higher with fed funds, which would in turn led to some asset migration from bank deposits,” points out Pan. That would result in banks offering higher rates to to retain depositors. However, the situation is different today. MMF regulatory reforms “have greatly reduced institutional cash investors’ appetite for prime funds and the absence of competition from prime funds has allowed the banks to keep returns low despite rate increases.”
Are higher deposit rates coming back? Probably, but it will be a slow process.
Pan says that “based on information that we have obtained from banking executives and investors, we expect banks to begin to raise deposit rates, although the increases are likely to remain less competitive than market rates until reserves are drained and lending picks up substantially.” As the market adjusts, Pan says, depositors may receive differential treatment based on the size and type of their deposits.
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