The Market And Policy Impact Of Reduced Custody Banks Deposit Capacity

The Market And Policy Impact Of Reduced Custody Banks Deposit Capacity

Where The Money Goes and Why it Matters: The Market And Policy Impact Of Reduced Custody Banks Deposit Capacity by Federal Financial Analytics

Get The Full Ray Dalio Series in PDF

Get the entire 10-part series on Ray Dalio in PDF. Save it to your desktop, read it on your tablet, or email to your colleagues

Key Points

  • The cumulative impact of geopolitical risk, market volatility, monetary policy, and new rules for banks, investment companies, asset managers, and trading companies has created a strong, secular influx of large cash deposits at U.S. custody banks. These have risen 34% since 2011, growing to increasingly higher levels despite spikes up and down due to large crisis-driven inflows and outflows. There is thus a clear pattern of growing cash-liability demand. Substantiating this, investment funds now hold sustained volumes of cash and cash-equivalents 205% greater than those held at the depth of the crisis.
  • Most excess deposits at custody banks are held at central banks, particularly the Federal Reserve, making them riskless to the bank and financial system. The leverage capital charge nonetheless applies. If it did not, then at least an additional $182 billion in cash-deposit capacity would result, creating a safety net for flight-to-quality deposits under stress scenarios.
  • Pricing flexibility is unlikely to offset regulatory costs due to U.S. price inelasticity, statutory deposit drivers, and other market factors in the current interest rate environment.
  • Current market conditions are particularly volatile and illiquid, posing systemic risk. Suggestions that regulations may be waived to permit custody banks to absorb sudden deposit inflows cannot be counted upon in advance by banks or customers. Sudden unavailability of cash-deposit facilities poses operational and even systemic risk because investment companies and other entities could face a choice between violating applicable law or suddenly ceasing critical operations in the absence of cash depositories.
  • Alternative deposit options pose more risk than higher custody deposit capacity because funds will likely flow outside the U.S., outside the banking system into “shadow liabilities,” or into attempts to hold larger amounts of high-quality assets at a time when market shortfalls are creating significant volatility. Structural and regulatory factors suggest these shortfalls will not quickly reverse.
  • Central-bank facilities to counter liquidity transfers outside custody or other banks may force creation of market-maker-of-last-resort facilities. Absent regulation that offsets arbitrage and moral hazard, additional risk not only to the financial system, but also to taxpayers may ensue.
  • The transfer of large liability balances outside the banking system could complicate monetary-policy transmission at a time when accommodative-policy tapering already poses significant challenges. Liquidity shocks exacerbated by securities “fails” or other market disruptions resulting from low cash holdings at custody banks could also adversely affect fiscal-policy execution, especially under stress scenarios.

This paper represents the views of Federal Financial Analytics, Inc. Funding for this research was provided by State Street Corporation, which was not granted editorial authority over the paper’s content, methodology, and findings. These are solely the responsibility of Federal Financial Analytics, Inc.

The Market And Policy Impact Of Reduced Custody Banks Deposit Capacity - Introduction

This paper continues a series of analyses Federal Financial Analytics has undertaken in the wake of the financial crisis to assess the body of new rules and their impact on financial-market structure and stability. This work does not argue for the relaxation of any of the new rules. Beginning in 2011,1 we instead analyzed the body of new rules to identify cumulative implications and potential perverse and unintended results. Our most recent white paper2 brings this body of work current to the first quarter of 2015, validating our forecast four years before that the combined effect of complex new rules could increase risk by creating pockets of illiquidity, reducing the ability of very large banks to provide financial-market infrastructure services, and driving products and services on which markets and macroeconomic stability depend to “shadow” financial institutions largely exempt from the post-crisis regulation and resolution framework.

Hedge fund managers present their best ideas at Robinhood [In-Depth]

investThe latest Robinhood Investors Conference is in the books, and some hedge funds made an appearance at the conference. In a panel on hedge funds moderated by Maverick Capital's Lee Ainslie, Ricky Sandler of Eminence Capital, Gaurav Kapadia of XN and Glen Kacher of Light Street discussed their own hedge funds and various aspects of Read More

In the wake of recent episodes of market illiquidity and growing fears about its consequences, U.S. and global regulators have begun to recognize this challenge.3 Most recently, a report from global central bankers concluded that:

[D]ifferent regulations, considered in isolation, can have consequences that go in opposite directions. Moreover, the interaction of these regulations could add to the difficulties in predicting their overall impact. As a result, central banks will need to monitor these changes and respond to them as they manifest themselves.

In this paper, we seek to support this central-bank review by focusing on a specific activity with systemic, monetary-policy, and fiscal-policy consequences: cash placed on deposit with custody banks. Although little noticed in the post-crisis debate, this activity is critical to the infrastructure of the global financial system. As shall be described in more detail below, the term “custody bank” clearly expresses the function these banks fulfill: safekeeping of assets and funds for investors, pensioners, municipalities, endowments, and other asset owners. Reflecting the very safe nature of custody banking, central banks often rely on custody banks in the implementation of their own market operations.

This paper will address:

  • The structure and function of custody banking under both normal and stress conditions. Data shall be provided to demonstrate a significant change in the manner in which customers use custody banks and the ability of custody banks to provide traditional safekeeping and administrative services;
  • regulatory factors that constrain the ability of custody banks to accept cash and cash-equivalent funds;
  • long-term changes in markets resulting from current restructuring in custody banking, and likely outcomes if this continues for the structure and stability of global financial markets;
  • the macroeconomic impact of the changing configuration of liability holdings and potential implications for the ability of central banks to conduct monetary policy; and
  • the implications for the U.S. Treasury Department regarding fiscal policy.

What is Custody Banking?

A. Products and Services

Custody banks provide an array of safekeeping, settlement, and asset-administration services on behalf of their customers. As a result, they enhance market efficiency and allow institutional investors to hold assets in a highly complex global market. Custody banks are registered as the securities holder and hold the securities instrument for the beneficial owner. This permits efficient transfers by an asset fund or pension plan on behalf of beneficial owners without the risk of holding securities in institutions that might themselves trade on information related to these securities, as well as reducing the complexity of re-registration that can slow trading.

Custody Banks Deposit Capacity

See full PDF below.

No posts to display