Basel III – the framework of international banking regulations – is causing a drastic shift in how cash deposits are viewed by financial institutions. Combined with historically low interest rates and rising inflation, institutional clients and multi-family offices are being forced to rethink their approach to cash management.
The fallout from the financial crisis, which saw people queuing outside their banks to withdraw their hard-earned cash, has led to new regulations designed to prevent runs on banks in the future.
For investors, the decision of where to invest cash in order to maximise its value has been a difficult one over the past 10 years. The low interest rate environment has seen deposits yielding very little, if anything at all. Once inflation is taken into account, real yields on cash are negative.
Under Basel III, the environment for cash will be further affected by the way banks treat cash. There will be operating cash, which is used constantly, and non-operating cash, which is not needed on a day-to-day basis but is likely to be called upon in the event of a stress event.
It is the latter type of cash – typically used for short-term investments – that is coming under increasing pressure.
Cash as a valuable asset
Central to the Basel III framework is the liquidity coverage ratio (LCR), which is designed to ensure banks have enough assets readily available to withstand a stress event.
It is this liquidity standard that will affect the value that banks place on certain types of deposits and, ultimately, the rate of return that banks offer on cash deposits.
Mark Fromage, a director in RBC Wealth Management International's Treasury team in Jersey, says banks treat deposits according to different client types.
“Banks are all required to segment client types and allocate a defined percentage of likely drawdown against each segment,” he says. “This links back to the immediate availability of cash to meet client repayments in the case of a stress event.”
For example, operating cash is valuable to the bank because it requires a smaller amount to be held in high-quality liquid assets (HQLA). Non-operating cash, on the other hand, depending on the type of client and the tenure of the deposit, could require the bank to cover it in its entirety. This is both limiting in terms of both usage by the bank and its ability to generate revenue from those deposits.
“Retail client deposits are more valuable to a bank because these clients act individually – making decisions on their own,” Fromage says.
“At the other end of the spectrum are investment managers that look after a number of different clients. If they are worried about a stress event and need to move money from banks, logically, the argument is that all of that managed cash will leave at the same time.”
Within this scenario, Fromage says, it is important to understand the role that the investment manager is playing. Is the investment manager playing the role of oversight, where they provide holistic advice but are not the absolute controller of the funds, or do they have absolute control and have full discretion over the cash? Fromage says that these are influencing factors with potentially different interest rate outcomes for the underlying client.
“As a bank you would give the latter a higher percentage of outflow expectation and, by default, you wouldn’t be able to use that money as effectively,” he says.
Basel III: Adapting to a new environment
While Basel III in its entirety is being implemented gradually – taking full effect in 2019 – banks have been adapting their behaviour to suit the new rules for some time.
For institutional clients and multi-family offices, the Basel III regulatory framework should change the way they view their cash. An instant-access cash deposit account will no longer be sufficient and clients could quickly find themselves being penalised for holding that non-operating, or short-term investment, cash as such. Indeed, one action that will likely need to be taken in the post-Basel III era is the implementation of a cash management allocation strategy that balances yield and liquidity.
Adam Norris, a director in the Multi-Family Office team for RBC Wealth Management International in Jersey, says that it is more than likely clients will require a series of accounts that include vehicles such as term deposits, short-duration bonds and money market funds.
“This is a complete change of mind-set for clients,” Norris says. “They will have to consider locking up cash deposits for longer terms or accept that instantly available cash deposits are going to earn zero.”
He adds that it will be increasingly challenging to open new accounts and to generate return for clients that hold cash. “Among other things, clients must consider tenure as this will have a direct impact on how it is treated by a bank – fixed term deposits, notice accounts or ultra-short dated solutions, for example,” he says.
The key metric that clients need to consider is 31-days. This refers to cash that is only accessible by the investor after a minimum 31-day period has passed. For banks, this may be positive, subject to the term being longer than 30 days. As soon as the cash becomes available to the client within 30 days, the funds are required to be treated as immediately accessible from a liquidity measurement perspective, even if they are held in a term deposit. It is for this reason that there has been a proliferation of notice accounts in the market compared to term deposits.
Moreover, banks will likely reward clients that opt for a longer-term deposit account. “If a client is able to put the money in an account where access is restricted to beyond 30 days, the cash becomes more valuable,” Fromage says.
“While this scenario is preferable for the banks, the client committing to that longer time has to be rewarded or compensated and that’s in the form of higher interest rates over an instant-access product.”
Of course, in today’s low interest rate reality, the level of compensation that deposits provide is not considered great. However, from its current position, the Bank of England has more scope to increase the bank base rate than reduce it. The question for investors is whether their bank will pass on any future increase to them.
“Banks rely on the difference between the deposit they take and the onward lending value that deposit provides,” Fromage says. “The low interest environment has compressed that margin. Combined with the regulatory positioning, where banks have to treat cash differently, banks will want to recover the margin in a rising interest rate environment.
“It is very difficult to see any single rate rise being passed on. We would need to see a few rate rises to see added value being passed on to clients.”
At this point, Fromage says, clients should concentrate on the value of longer-term cash over the full term of an interest cycle.
However, Norris adds that, at present, clients do not appear to be making the necessary changes, either as a result of a lack of understanding or a disbelief that it will be implemented.
“This isn’t something that is just going to be talked about. This is the new reality and the clock is counting down,” Norris says. “It is not just a case of the financial services industry spinning these regulations as a way to sell products; it will have a monumental impact of clients and they need to be having conversations now.”