Savers flee banks for money funds

Assets in US money market funds (MMFs) rose past $5.1 trillion in March 2023, a record, after taking in more than $300 billion in a few weeks. As worries about regional bank solvency spread and Silicon Valley Bank's uninsured depositors ran for cover, it was one of the fastest shifts of savings on record. Pundits called it a panicked flight to safety. Fund managers see something more lasting. Fear set it off, but depositors are finally giving up on bank accounts that pay next to nothing and going where the yield is.

For more than twelve months, banks took advantage of customer inertia, holding savings rates near 0.2 per cent while the Federal Reserve lifted policy rates above 4.5 per cent. Deposit rates barely moved as the policy rate climbed, and few customers complained while the banking system looked safe.

A gap too wide to ignore

That gap gave banks bumper net interest margins. The banking scare ended the apathy that made it possible. Depositors realised their money was earning nothing and might not even be insured, and they found money market funds paying 4.5 to 4.8 per cent, backed by short-dated government paper and the Fed's Reverse Repo Facility.

The convenience of a current account no longer justified giving up 450 basis points of yield. Corporate treasurers and household savers moved together, and sensibly, toward risk-free returns.

The gap has just widened again. On 22 March the Fed raised its target range by a quarter-point to 4.75 to 5.00 per cent, despite the banking turmoil, and the rate it pays on overnight reverse repos rose to 4.8 per cent. Money funds pass such increases on to their investors within days, because their holdings are so short. Banks, by contrast, adjust deposit rates slowly and partially, which is what made the business so profitable while nobody was looking.

How the switch drains banks

The plumbing explains why regulators care. When a company moves spare cash from its bank account into a government money fund, the fund must put that cash somewhere. If it buys Treasury bills from a dealer or another investor, the deposit simply moves to the seller's bank, and the banking system as a whole keeps it. If the fund lends the money to the Fed through the overnight reverse repo facility, the deposit and the matching bank reserves leave the system entirely.

At present the second route dominates. The federal government hit its debt ceiling on 19 January and has been running down its stock of bills while it uses extraordinary measures, so there are fewer bills for funds to buy. That pushes more of the inflow into the Fed's facility, which has held more than $2 trillion for months. Each dollar that goes there is a dollar of deposits and reserves that no bank can lend.

Money that will not come back

The shift pulls funding away from traditional banks. Cash that goes into a government money market fund ends up in Treasury bills or parked at the Fed's ON RRP. It does not flow back to regional banks to finance commercial mortgages or loans for small-business payrolls.

To stop the outflow, banks must either pay much more for deposits, which eats into their margins, or let their balance sheets shrink. Both options hurt earnings. Paying depositors more raises what economists call the deposit beta, the share of each rate rise passed on to savers, and a bank whose loans were written at fixed rates cannot raise its income to match. Shrinking the balance sheet means selling assets, some of which carry unrealised losses, or letting loans run off without replacing them. The squeeze falls hardest on mid-sized banks whose depositors are sophisticated enough to move and small enough to be uninsured.

This has happened before

Money market funds were born out of exactly this gap. In the 1970s, Regulation Q capped the interest banks could pay on deposits while inflation and Treasury yields climbed, and the first money funds appeared early in that decade to offer savers market rates. When Treasury bill yields rose into double digits at the end of the 1970s, money poured out of banks and thrifts into the funds. Congress responded with the deregulation of deposit rates in 1980 and, in 1982, allowed banks to offer money market deposit accounts to compete.

The lesson from that episode is that once savers learn to move, many stay moved. Banks won back some of the money only by paying rates close to the market, which permanently raised their cost of funds. There is no cap on deposit rates today, but inertia played the same role, and inertia, once broken, is hard to restore.

The limits of the flight

Money funds are not free of risk, and the argument for leaving banks has limits. In September 2008 the Reserve Primary Fund broke the buck after losses on Lehman Brothers debt, and the Treasury had to guarantee money fund balances to stop a run. In March 2020 prime funds, which hold commercial paper, suffered heavy outflows until the Fed set up an emergency lending facility for them. Government funds, which hold only Treasuries and repo, have been the safer home, and it is they that are taking most of the current inflows.

The strongest case against a lasting shift is that most household deposits are small, insured and used for payments. People do not pay their rent from a money fund, and banks can win back savers with certificates of deposit and higher savings rates, as several large lenders have begun to do. The shift could also slow once the Fed stops raising rates and the yield advantage narrows. None of that changes the fact that the cheapest part of bank funding has become more expensive.

What will show the trend

The Investment Company Institute publishes fund flows every Thursday, and the Fed's weekly H.8 release shows deposits at large and small banks separately. First-quarter bank results, due from mid-April, will show how much lenders have had to raise deposit rates and how far their margins have narrowed. A resolution of the debt ceiling would bring a flood of new bills, which would give money funds somewhere to put cash other than the Fed and ease the drain on reserves.

The move into money funds is unlikely to reverse when the panic fades. Savers have noticed what their banks were paying them, and regional lenders will probably be short of cheap funding for the rest of this credit cycle.