We keep on hearing stories about the trouble hedge funds are having in finding a home for their cash. What is going on here?
The banks are flush with cash, but does that fully explain why they would turn down institutional cash deposits? It goes back to LCR. Those rules are designed to protect banks from when “hot money” flees and institutions have liquidity problems as a result. In LCR, banks need to cover 30 days of outflows with HQLA (or other assets, subject to haircuts and concentration rules).
However some outflows are assumed to be “sticky”. That is to say, they won’t necessarily leave the bank at the first sign of trouble. Insured deposits would be the best example. Mom and Pop won’t put their cash in the mattress when a bank is under stress since they know the FDIC will cover any losses.
LCR rules will assign a low factor to retail deposits. For example, an insured deposit is multiplied by 3% to calculate its contribution to a bank’s outflows. The lower the factor, the less HQLA has to be held against it. Factors for retail deposits go up to 10% depending on several considerations including if the deposit is “stable” or not. A stable deposit is a.) insured and b.) from a client with other relationships with the bank that would make it unlikely they pull the cash or if in a transactional account.
If a deposit is assumed to be “hot” then more of it will be included in the outflows. The drivers are the nature of the deposit and who the depositor is. Insured is good. Cash from a nonfinancial is good. Cash in support of an operational relationship is also good. Wholesale funding from financials — not so good.
From a piece from Morrison & Foerster, “Liquidity Coverage Ratio: New Basel Measurement Published”:
“…Deposits by nonfinancial corporates, sovereigns, central banks, multilateral development banks, and PSEs have a 20 percent runoff rate if the amount of such a deposit is fully insured by a program that meets certain requirements and a 40 percent runoff rate otherwise…”
Operational deposits in support of clearing, custody and cash management activity is considered reasonably stable and has a cash outflow factor of 25%. But banks aren’t jumping up and down to take that money either.
“…Certain activities lead to financial and non-financial customers needing to place, or leave, deposits with a bank in order to facilitate their access and ability to use payment and settlement systems and otherwise make payments. These funds may receive a 25% run-off factor only if the customer has a substantive dependency with the bank and the deposit is required for such activities…”
But the kicker is how non-operational deposits from most financials are treated: 100%
“…Unsecured wholesale funding provided by other legal entity customers: 100%…This category consists of all deposits and other funding from other institutions (including banks, securities firms, insurance companies, etc), fiduciaries, beneficiaries, conduits and special purpose vehicles, affiliated entities of the bank and other entities that are not specifically held for operational purposes (as defined above) and not included in the prior three categories. The run-off factor for these funds is 100%…”
So cash taken from say, a hedge fund, needs to be 100% covered by HQLA (or certain other types of assets, subject to haircut and concentration limitations) either owned outright or repo’ed in for more than 30 days. It is no surprise that cash from these kinds of institutions are shunned. The irony is that hedge funds are holding the cash, for among other reasons, to manage their ability to make margin calls.
It isn’t just the hedge funds that are having trouble placing cash. We recently heard a story about a multilateral development bank having their money turned away too — and they look to be a 40% factor for uninsured deposits.
This is only going to get worse when NSFR kicks in. Funding from non-financials will be more valuable than cash from financials. The Available Stable Funding (ASF) factor applied to cash from a non-financial is 50% for trades 1 year or less. To get that same 50% factor for funding from a financial institution, the maturity has to be at least 6 months. Funding from a financial shorter than 6 months has a 0% ASF factor.
And it goes without saying that paying a couple basis points for a deposit and letting the money sit at the Fed as excess reserves (which, by the way, are considered HQLA) still absorbs capital and expands the balance sheet. How much is an appropriate spread for this kind of business to generate a respectable ROE? It will be interesting to see the elasticity of deposit rates when rates eventually do go up. But we digress….
It is hard to know if this was intentional or not. We understand the purpose behind the LCR and NSFR and respect its objective. But doesn’t it seem like something went off the rails here?
For more on the Hot Cash problem, see our recent posts:
Hedge funds not getting much love from LCR or NSFR, April 23, 2014