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It’s Not You, It’s Me: Finding Investment Alternatives for Bank Deposit Investors

Garret Sloan, CFA

Director, Fixed Income Market Strategy

[email protected]

Vanessa Hubbard

Associate, Fixed Income Market Strategy

[email protected]

mailto:[email protected]

mailto:[email protected]

Bank Deposits Growing in Corporate Portfolios

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Growing Deposit Allocations in Corporate Portfolios

Bank deposits have grown on an outright basis and in terms of

proportional share of institutional cash investments

since the financial crisis of 2008 in which a number of global

banks failed. 0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2009 2010 2011 2012 2013 2014

Other

Variable rate demand notes

Auction rate securities

Municipal notes

Asset-backed securities

Enhanced cash funds

Separately managed accounts

Eurodollar deposits

Repurchase agreements

Agency securities

Commercial paper

Treasury bills

Diversified MMMFs

Treasury-only MMMFs

Bank Deposits

Source: Wells Fargo Securities, LLC, AFP

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Deposit growth can be attributed to four primary drivers:

Bank Deposits

Source: Wells Fargo Securities, LLC

Potential Reasons Behind Deposit Growth

• Lack of business reinvestment has resulted in cash accumulation

• Unlimited FDIC insurance encouraged companies to park cash1

• Attractive ECR relative to money market rates

• Government support (TARP) and regulatory reform has reduced perceived bank risk

1 Unlimited FDIC deposit insurance ended December 31, 2012

Liquidity Coverage Ratio (LCR)

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Liquidity Coverage Ratio

According to the rule set forth by the Federal Reserve, a bank’s LCR must be greater than 100

percent at ALL times or the bank becomes subject to

regulatory restriction.

The LCR rule has been finalized by the Federal Reserve

The rule requires U.S .bank holding companies with more than $250 billion in consolidated assets, or more than $10 billion in on-balance sheet foreign exposure, to hold enough High Quality Liquid Assets (HQLA) to withstand severe deposit outflows over a 30-day period

A modified version for bank’s with assets below the above thresholds have also been introduced

Liquidity Coverage Ratio 100% <

Total HQLA

Net Cash Outflows over Stress Horizon

Liquidity Coverage Ratio Equation

Banks are now more likely to (all else equal):

Purchase assets that provide the best funding efficiency under the LCR and,

Reduce yields on certain deposit products to compensate for the increased cost of institutional demand deposit offerings.

Banks (as investors) may become more competitive in buying high quality assets, but banks (as deposit takers) may become less competitive when compared to similar money market investment products.

Source: Wells Fargo Securities, LLC, U.S. Federal Register

Liquidity Coverage Ratio (LCR)

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An analysis of expected deposit outflows is required, based on a deposit’s purpose and depositor type

Deposits are first distinguished as either retail or wholesale

If a deposit is classified as wholesale, it is further broken down as either operational or non-operational

Numerator: High Quality Liquid Assets (HQLA)

Denominator: Deposit Outflows

HQLA’s are separated into two categories, Level 1 and Level 2 with haircuts assigned to each category based on the perceived liquidity characteristics of the securities

Level 1 Assets – 0 percent haircut

Level 2 Assets – 15 to 50 percent haircut


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LCR – HQLA Breakdown

A more detailed breakdown of the haircuts assigned to securities under the LCR rules, is listed in the table below:

Level 2 assets are further broken down by either a 2A or 2B category. The haircuts ranging from 15 percent to 50 percent can be interpreted that only 85 percent to 50 percent of the security’s value may be used for purposes of calculating the security’s contribution to HQLA.

The purpose of the haircuts is to direct banks to use longer-term sources of funding or equity capital to finance less liquid assets.

We expect banks may be more likely to bid up the value of Level 1 assets versus Level 2 assets subject to HQLA haircuts in order to minimize the impact of haircuts on bank balance sheets

Liquidity Coverage Ratio (LCR) - HQLA

HQLA Description Haircut % HQLA

Level 1 (1) Federal Reserve Balances; (2) foreign reserves; (3) Treasury securities; (4) sovereign debt

0% Min. 60%

Level 2A Certain securities issued or fully guaranteed by U.S. GSEs 15% Max. 40%

Level 2B (1) Liquid investment-grade non-financial corporate bonds; (2) Certain exchange- traded non-financial equities

50% Max. 15%


U.S. Bank Investment Portfolio Allocations

7

Banks, especially those with >$250B in assets, have been increasing their holdings of U.S. Treasuries in their investment portfolios due to LCR requirements.

Source: BLS , Boston Federal Reserve Bank and Wells Fargo Securities, LLC

U.S. Bank Holdings of U.S. Treasuries U.S. Treasuries as a % of Total Portfolio

-

50,000

100,000

150,000

200,000

250,000

300,000

350,000

400,000

450,000

Q4 2013 Q4 2014

U.S

. Tre

asury

Hold

ings (

$M

M)

Total Industry >250B in Assets

$211,0

03

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

Q4 2013 Q4 2014

Tre

asuries a

s a

% o

f Tota

l

Total Industry >250B in Assets

10.7

%

6.2

%

$188,5

36

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LCR – Deposit Outflows

Focusing on wholesale deposits, operational deposits can be characterized as those deposits that:

Reflect a deep relationship with the customer

Are linked to bank services like payments or payrolls, and

Are considered stable

An operational deposit must be linked to an operational service and can be defined as “necessary for the provision of operational services”

The twelve services listed in the table below may qualify a deposit for operational treatment

Liquidity Coverage Ratio (LCR) – Deposit Outflows


LCR- Defined Operational Services that may be Linked to an Operational Deposit

Payment remittance Payroll administration Transmission, reconciliation and confirmation of payment orders

Daylight overdraft Determination of intra-day and final settlement positions

Settlement of securities transactions

Transfer of recurring contractual payments Client subscriptions and redemptions Scheduled distribution of client funds

Escrow, funds transfer, stock transfer, and agency services, etc.

Collection and aggregation of funds Capital distributions

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In addition to the operational services listed on the preceding slide, additional criteria are required to meet the operational deposit definition as listed in the table below:

The table above highlights that a bank may not use economic incentives to maintain excess funds if it classifies the deposit as operational.

Economic incentives are highlighted in the table above because of its importance to investors that use above-market deposit rates to maintain excess balances.



Additional Criteria for Operational Deposits

Services held pursuant to an agreement subject to high termination or switching costs

Deposits must be held in an operational account

Account must be for the primary purpose of obtaining operational services

Prohibition of economic incentives to maintain excess funds

Banks must separate “operating” from “excess” deposit balances, taking into account average balance volatility

Exclusion of prime brokerage services-related deposits

Exclusion of “excess” deposits from banking organizations

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The table below illustrates the outflow assumptions for various wholesale depositor categories:



Wholesale Depositor Operational Non-Operational

Insured Uninsured Insured Uninsured

Non-Financial Corporate 5% 25% 20% 40%

Mortgage Escrow N/A 25% N/A N/A

Public Entity 5% 25% 20% 40%

U.S. GSEs 5% 25% 20% 40%

Sovereigns 5% 25% 20% 40%

Multilaterals 5% 25% 20% 40%

Non-Bank Regulated Financial 5% 25% N/A 100%

Pension Fund 5% 25% N/A 100%

Investment Advisor N/A N/A N/A 100%

Investment Company N/A N/A N/A 100%

Non-Regulated Fund (Hedge, PE) N/A N/A N/A 100%

Other Legal Entity 5% 25% N/A 100%

Bank 5% 25% N/A 100%

Special Purpose Entity 5% 25% N/A 100%

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The table below illustrates that more than 40 percent of corporate investors use ECR/deposit rates as a major determinant in choosing a bank deposit provider.

Investors may also have a higher propensity to look at non-bank investment alternatives if the yield differential between bank deposits and short-term investments is sufficiently wide.

Non-Financial Corporate


Source: Wells Fargo Securities, LLC, AFP Liquidity Survey

Major Determinants for Which Banks to Use When Investing in Bank Deposits

All Respondents Net Investors

Overall bank relationship 72% 71%

Credit quality 65% 69%

Earnings credit rates 41% 41%

Compelling rates on offered deposits 36% 41%

Simplicity of working with bank 36% 36%

Ability to determine how to apply ECR 10% 10%

Basel III considerations 6% 6%

Other 3% 4%

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Dollar Amount of HQLA

The table below illustrates the dollar amount of HQLA that a bank may be required to hold for certain deposit types.

Banks will be under pressure to reduce the costs associated with the various deposit categories. It may be the case that banks will be interested in divesting out of certain deposit types and others will be re-priced significantly


Bank Deposits


Estimated HQLA for $50 Million Sample Deposit

HQLA Category Financial Non-Operational

Financial Operational

Non-Financial Non-Operational

Non-Financial Operational

30-Day Outflow Assumption $50,000,000 $12,500,000 $20,000,000 $12,500,000

Level 1 $50,000,000 $12,500,000 $20,000,000 $12,500,000

Level 2A (Maximum 40%)2 $53,529,412 $13,382,353 $21,411,765 $13,382,353

Level 2B (Maximum 15%)3 $55,625,000 $13,906,250 $22,250,000 $13,906,250

2 Assumes that HQLA is 40% allocated to Level 2A assets, using a 15% haircut, with 60% invested in Level 1 3 Assumes that HQLA is 40% allocated to Level 2B assets using a 50% haircut, 25% allocated to level 2A assets, using a 15% haircut, with 60% allocated to Level 1 assets

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Public Entity Collateralized Deposits

Collateralized public entity deposits are treated similar to uncollateralized public entity deposits for outflow assumption purposes.

Consequently, deposits that are fully collateralized by Treasuries should fare well from a pricing standpoint as the securities held for collateral purposes may also satisfy the HQLA requirement under LCR.

There are instances whereby public entity deposits may reflect those of other uncollateralized deposits and banks will be required to increase their HQLA to meet LCR requirements. The table below lists the number of U.S. state statutes that accept collateral types and their status under current LCR rules:


Public Entity Collateralized Deposits


Collateral Type Number of States Accepting Collateral

HQLA Eligibility

Treasuries 484 Level 1

Agencies 48 Level 2A

Agency MBS 48 Level 2A

Municipal Bonds 43 Non-Eligible (possible change)

ABS/CMO 6 Non-Eligible

4 Note: Not all states require collateral to support public entity deposits

Alternatives for Short-Term Investors

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We do not anticipate that traditional corporate cash investors will move a significant amount of cash into short-term bond funds

Expect short-term bond funds to remain a very small component of overall cash strategies

Overall fixed income supply, bank demand for government assets, deposit flows out of banks and outflows from prime funds to government funds will likely impact short-term yields going forward

The yield differential between various asset classes will likely become more pronounced, proving a more attractive investment environment for direct investments

Money Market Funds

Short-Term Bond Funds

Direct Investments

Expect money market fund balances to remain an attractive alternative in both floating-rate and fixed-rate options

Money market funds are a strong alternative for short-term operating cash balances and are a close cousin to bank deposit products


Tactical Liquidity

• Portfolio Segmentation to Optimize Investment Objectives

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Positioning Corporate Cash Portfolios

Curve steepening in the current environment is causing investors to look at their strategic cash allocations to see if there are opportunities to extend or introduce new asset classes.

Source: ICI, Wells Fargo Securities, LLC

Segmentation of the Corporate/Public Cash Portfolio (for illustrative purposes only)

Operating Cash (Horizon - daily)

Reserve Cash (Horizon - Quarterly)

Restricted Cash (Horizon - longer-term)

Strategic Cash (Horizon - longer-term)

Liquidity,

Stability

of Principal

Less liquidity,

higher yields,

more price

volatility

Q1 Q2 Q3 Q4

Liquidity, stability of principal

Less liquidity, higher yields, more price volatility

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Corporate Cash Portfolio Segments have different Durations, Objectives, Strategies and Return Expectations

Operating Cash

Reserve/Core Cash Strategic Cash

Investment Horizon 0 – 6 months 6 months – 2 years 1 – 5 years

Portfolio Duration 30 - 90 Days 6 – 18 months 2 – 3 years

Cash Flow Volatility High Low/Maturity Matched Very Low/Maturity

Matched

Strategy Money Market/Cash

Equivalents Incremental Duration and

Credit Risk Incremental Duration

and Credit Risk

Benchmark N/A Treasury-based

LIBOR “+” -based Index-based

(strategy-specific)


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Products can be placed in multiple buckets. However,

certain products are more suited to certain investment styles

based on relative liquidity and duration profiles.



Duration

Yie

ld

Bank Deposits Sweep Accounts

Money Market Funds Treasury Bills

Discount Notes Repo

Commercial Paper Certificates of Deposit

TE/Taxable VRDNs

Operational Cash

Commercial Paper Certificates of Deposit Short Corporate Bonds Treasury Bills/Notes

Agency Discos/Bullets Agency

Municipal Securities Floaters

Certificates of Deposit Brokered CDs

Corporate Bonds Treasury Notes

Agency Callables Agency Bullets

Municipal Securities Asset-backed Securities

Reserve Cash

Restricted/Strategic Cash

S/T Investments > 12M Money Markets < 12M

Product Segmentation Across Liquidity Buckets

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Portfolio Construction Approaches

The Basic Approach manages all expected cash outflows through

existing cash balances, represented by the grey area.

The cash balances represented by the light and dark blue areas are not anticipated to be used

and can be invested further out on the curve to augment yield.


$0

$5

$10

$15

$20

$25

$30

$0

$5

$10

$15

$20

$25

$30

7-Jan 7-Feb 7-Mar 7-Apr 7-May 7-Jun 7-Jul 7-Aug 7-Sep 7-Oct 7-Nov 7-Dec

$9M Short-term inv. (1-3Y)

$4M Short-term inv. (6 – 12M)

MMFs,

LGIP, O/N Inv.

Cash Balance Forecast

Basic Approach

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Portfolio Construction Approaches

The Maturity Matching Approach identifies the size and

dates of known cash outflows and invests an equivalent

amount of cash to those dates. Liquidity is partially managed through maturity matching,

allowing short-term investments to constitute a larger part of the

overall portfolio.


$0

$5

$10

$15

$20

$25

$30

$0

$5

$10

$15

$20

$25

$30

Short-term inv. (1-3Y)

Short-term inv. (6-12M).

MMFs, LGIP, O/N Inv.

Cash Balance Forecast

Maturity Matching Approach

Preparing for the Changes in the Short-Term Investment Environment

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Maximize Liquidity and Outperform LCR-Pressured Bank Deposits

We suggest investors consider three options to efficiently

allocate short-term investments into categories that maximize

liquidity and outperform LCR-pressured bank deposits

Ensure investment policy is up to date and flexible

Have a clear picture of cash flows over multiple investment horizons

Develop an investment strategy to aid in fulfilling the objectives outlined in your investment policy


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Disclaimer

This publication is intended for institutional accounts only (as defined in FINRA Rule 4512), please do not forward. Strategist Commentary is a product of Wells Fargo Securities Fixed Income Sales and Trading and is not a product of Wells Fargo Securities, LLC’s Research, Economics and Strategy. The views expressed herein might differ from those of Research, Economics and Strategy. Important Information for Non-U.S. Recipients This report is prepared by Wells Fargo Securities, LLC in accordance with U.S. law and applicable rules and regulations for use by institutional investors. The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors. This report is not intended for, and should not be relied upon, by retail investors. Please consult your Investment Representative for additional information. U.S. residents are directed to wellsfargo.com for investment and related services. Important Information for Australian Recipients Wells Fargo Securities, LLC is exempt from the requirements to hold an Australian financial services license in respect of the financial services it provides to wholesale clients in Australia. Wells Fargo Securities LLC is a U.S. broker dealer registered with the U.S. Securities and Exchange Commission and a member of FINRA and SIPC. Wells Fargo Securities, LLC is regulated under U.S. laws which differ from Australian laws. Any offer or documentation provided to you by Wells Fargo Securities, LLC in the course of providing the financial services will be prepared in accordance with the laws of the United States and not Australian laws. Important Disclosures Relating to Conflicts of Interest and Potential Conflicts of Interest Wells Fargo Securities, LLC may sell or buy the subject securities to/from customers on a principal basis. Wells Fargo Securities, LLC has or may have proprietary positions in the securities mentioned herein. The trading desk has or may have proprietary positions in the securities mentioned herein. The author's compensation is based on, among other things, Wells Fargo Securities, LLC's overall performance, the profitability of Wells Fargo Securities, LLC's Markets Division and the profitability of the trading desk. This report is for your information only and is not an offer to sell or a solicitation of an offer to buy the securities or instruments named or described in this report. Interested parties are advised to contact the entity with which they deal, or the entity that provided this report to them, if they desire further information. The information in this report has been obtained or derived from sources believed by Wells Fargo Securities, LLC to be reliable, but Wells Fargo Securities, LLC does not represent that this information is accurate or complete. Any opinions or estimates contained in this report represent the judgment of Wells Fargo Securities, LLC at this time and are subject to change without notice. Wells Fargo Securities, LLC and its affiliates may from time to time provide advice with respect to, acquire, hold or sell a position in, the securities or instruments named or described in this report. About Wells Fargo Securities Wells Fargo Securities is the trade name for the capital markets and investment banking services of Wells Fargo & Company and its subsidiaries, including but not limited to Wells Fargo Securities, LLC, a member of NYSE, FINRA, NFA and SIPC, Wells Fargo Prime Services, LLC, a member of FINRA, NFA and SIPC, and Wells Fargo Bank, N.A. Wells Fargo Securities, LLC and Wells Fargo Prime Services, LLC are distinct entities from affiliated banks and thrifts. Copyright© 2015 Wells Fargo & Company SECURITIES: NOT FDIC:-INSURED/NOT BANK-GUARANTEED/MAY LOSE VALUE

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