Since the financial crisis in 2008 regulators globally have systematically been tightening banking regulations in a reversal of the more liberal framework of the 2000s. In Australia one of the new regulations introduced, the Liquidity Coverage Ratio, is having a material impact on the way investors should view term deposits.
The Liquidity Coverage Ratio (LCR)
For investors in Term Deposits (TDs), the greatest potential impact from regulatory change is the Liquidity Coverage Ratio (LCR) which came into effect in 2015 and has resulted in banks applying, over time, an increasingly inflexible approach to TD issuance. At its most basic, the LCR requires that:
- Internationally active banks hold high-quality liquid assets in sufficient quantity to cover potential outflows from their operation over a 30-day period during a market-wide and idiosyncratic stress event; and
- Securities which can be repaid within 30 days need to be capital backed.
This makes the issuance of products with terms less than 30 days relatively expensive for banks. The implications of the LCR for banks include:
- There is an increased divergence in deposit rates offered by financial institutions based on the type of organisation they are as the LCR only applies to the major and regional Australian banks and locally incorporated foreign subsidiary banks (such as HSBC Bank Australia Limited and Rabobank Australia Limited).
- Banks will increasingly favour retail investors with such investors remaining in high demand, and hence commanding higher rates, given the difference in run-off assumptions (5% applied to retail and 100% to institutional investors).
In addition, with the LCR imposed by APRA being a 30-day liquidity requirement, ASIC (Dec 2014) has signalled that TDs that require 31 days’ notice for withdrawal will receive favourable liquidity treatment. This signal from ASIC further encourages the evolution of deposit products with 31+ day break or notice clauses.
What this means for investors using Term Deposits
Prior to the introduction of the LCR, investors were in the position of being able to ‘have their cake and eat it’. More specifically investing in TDs meant that an investor could, in practice, often earn a liquidity premium while still having liquidity (an investor was being paid a premium for illiquidity but was not being penalised materially, if at all, for breaking the TD early – in effect, the TD was being treated as fully liquid). Though the behavior of issuing banks has changed relatively slowly, in a post LCR world, the ability to do this is significantly reduced but the impact from this should not be exaggerated. TDs will still have a place within a portfolio but the rules have shifted and as such investors need to consider a broader range of factors when deciding how much to invest in TDs. Key factors to consider include:
- Using other sources of liquidity within a portfolio as the ease and low cost of breaking TDs has become increasingly problematic.
- Assessing what the real need for very low risk liquid funds is, as liquidity may now cost more money; i.e. illiquidity is now more appropriately priced as a risk premium. This will involve making an accurate and realistic assessment of absolute low risk liquidity needs and minimising the amount placed at-call or in short dated term deposits if the rates on offer are materially below those available with 31+ day break or notice clauses.
- Maximising the investment in products with 31+ day break or notice clause where these types of deposits provide the opportunity to earn higher returns.
- Watching for special rates which are often offered to attract deposits at both different points in time and to different points on the yield curve.
- Look to invest in TDs issued by the quality branches of foreign banks or credit unions who, on occasion, may offer more competitive rates given the LCR does not fully apply to these financial institutions.
- Reviewing the stability of your balances held in these products. Banks may increasingly monitor the behaviour of depositors and over time develop a bias to reward deposits that remain in place and penalise those that are seen to be ‘hot’ money.
Your total portfolio: determining where Term Deposits fit
Prior to the recent regulatory changes, many investors were able to satisfy multiple needs by using TDs. Increasingly regulators are requiring that the funding sources of banks be “true to label”. Despite these regulatory changes, TDs will still have a role to play in portfolios. However, to get the most out of TDs, investors will need to take a closer look at their investment needs and be more selective about how TDs are used.