Deposits Flight Reflects Quantitative Tightening, Not Confidence

Summary

• While quantitative easing (QE) expanded deposits during the pandemic, quantitative tightening (QT) is now contracting them.
• The deposit flight has been mainly from large banks because institutional investors involved in QT hold their deposits at large rather than small banks.
• The deposit flight out of large banks has been matched by decreasing cash and securities holdings, while loans have continued expanding.
• By contrast, small banks’ deposits have been stable, except for the week of 15 March when Silicon Valley Bank (SVB) failed. Small bank lending is growing fast.
• The Federal Reserve (Fed) policy response suggests bank lending will expand further.

Market Implications

• Markets overestimate the risks of 2023 Federal Funds Rate (FFR) cuts.

Pre-Pandemic Deposits Surged on QE

The ongoing deposit flight started well before the SVB failure and was preceded by a surge during the pandemic (Chart 1). Moreover, changes in the stock of bank deposits closely match changes in the Fed’s security portfolio. This is not a coincidence, but rather reflects the relationship between QE/QT and deposits creation/destruction.

Table 1 shows how QE creates deposits:

1. The Fed pays for the bonds it purchases by issuing reserves.
2. The bank of the bond seller sees an increase in its reserves and credits the account of the bond seller by an equivalent amount.
3. The bond seller sees an increase in its deposits matched by a decrease in its bond holdings.

Note that if the Fed had purchased bonds from a bank instead of from a non-bank, the quantity of deposits would not have changed. Rather the composition of bank assets would have changed, with bond holdings falling and reserves increasing by an equivalent amount. In practice, the Fed counterparts in QE/QT operations tend to be non-banks, which explains the tight fit between the Fed portfolio and bank deposits.

QT Is Causing the Deposit Fall

Bank deposits have been falling since Q1 2022, which reflects:

• Since Q1 2022: higher returns on Money Market Funds (MMF) relative to deposits, as banks did not feel the need to pass on the FFR increases to their depositors. This suggests banks have more than enough deposits (Chart 2).

• Since Q2 2022: QT, that works in reverse from QE and destroys deposits.

• Since 10 March (SVB failure): concerns over bank safety, though recent Fed and commercial bank balance sheets suggest those flows have ended (Dom’s Quick Take: Commercial Banks’ Balance Sheet Confirmed Stabilization).

Small Banks’ Deposits Are Stickier

As Chart 1 shows, bank deposits on aggregate have been falling. In reality, small bank deposits have been much stickier than those of large banks (i.e., the largest 25 – Chart 3). 

This difference in deposit stickiness reflects a difference in business models between large and small banks. Loans are a larger, and cash a smaller, share of assets at small versus large banks (Chart 4). This reveals a smaller involvement in QE, maybe reflecting institutional investors involved in QE/QT tend to hold their accounts at larger banks. In addition, smaller banks could be more agile lenders than larger and more bureaucratic banks.

Traditionally, a bank creates deposits by extending credit: when a bank extends a loan, it creates an asset and a liability, a deposit in the borrower’s name, in the same amount. The deposit gets typically destroyed when the loan is repaid (See the Bank of England’s Money creation in the modern economy). Deposits created through credit extension therefore tend to be independent of the Fed’s QE/QT, hence the greater stickiness of small banks deposits.

The data shows that fears of deposit flight at small banks are overblown. To the contrary, deposits are more stable at small rather than large banks.

Simultaneously, despite the outflow of deposits, bank credit has kept expanding.

Bank Loans Increasing Despite Deposits Falling

Because the ongoing deposit outflows from large banks reflect QT, it has been matched on the asset side by a decline in cash, and to a lesser extent, a decline in securities, rather than a decline in loans (Chart 5). That banks would reduce securities holdings rather than loans reflects that the business of a bank is to lend rather than to hold securities. Finally, the increase in cash holdings during the week of 15 March reflects the SVB bankruptcy and the Fed’s lending to banks (Table 1). 

As mentioned above, small banks’ deposits are much stickier than large banks. In addition, despite the outflow of deposits the week of 5 March, loan growth has so far continued apace (Chart 6). Overall, small banks have been expanding their loan book faster than large banks. 

Market Consequences

This article shows that deposits have been stable at small banks and falling at large banks because of QT, not because of a loss of confidence. 

Since the week of 15 March, Fed lending to banks has been falling, despite continued increases in MMF assets that in turn suggest continued deposit outflows (while the Fed and MMF balance sheets are published with a one-day lag, bank balance sheets are published with a one-week lag).

I am not saying that long-term bank profitability is assured. I believe that instant payments and social media render the traditional bank business model obsolete by greatly increasing the risk of runs. Also, non-bank financial institutions are increasingly taking market share from banks. This could be what bank equity prices indicate (Chart 7).

But with the Fed ready to provide liquidity with zero haircut on collateral, and with banking regulators assuring the public that no deposits are at risk, a banking crisis appears a tail risk.

Furthermore, those Fed assurances will also limit the impact of the SVB bankruptcy on banks’ willingness to lend. 

The three 2023 FFR cuts currently priced in therefore appear unlikely.

Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed, the IMF, and the World Bank. She joined Macro Hive soon after its inception.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)