The first quarter of 2023 will be remembered by bankers as a tumultuous one — probably the most destabilizing episode in the banking industry since Washington Mutual’s collapse in September of 2008 – almost 15 years ago.

After over a decade of low interest rates and deposit abundance since the COVID stimulus program, banks have again been reminded that deposits cannot be taken for granted. In fact, if you lose too many too quickly, you could be in serious trouble. Retaining existing deposits and finding additional sources of funds has become the highest priority for banks nationwide. 

The total deposits held at banks as reported by the FDIC has decreased for a third consecutive quarter after peaking in Q1 2022. 

These decreases, however, must be put into perspective. The generous stimulus measures that the US government enacted to avert an economic crisis during the Covid-19 pandemic, resulted in unprecedented deposit growth in 2020 and 2021. In other words, a good portion of the money that individuals and businesses received from the government landed on the balance sheets of banks, just as the economy stalled and lending activity decreased. 

With the pandemic and stimulus money behind us, those excess deposits have been spent, the economy has been humming along, and lending activity has been brisk. That means banks are now looking for liquidity again.

In the past, banks have been able to rely on their securities portfolio to access liquidity, if needed, by selling these securities in the market. For decades the interest rate environment has been relatively benign, and banks were able to easily liquidate securities without much impact to their balance sheets. This time around it’s different.

With a massive increase in deposits and limited profitable opportunities for loan growth, a significant portion of COVID deposits was used by banks to purchase long-term securities in an attempt to earn a positive yield. These securities, usually government-backed, had been purchased at a time when interest rates were at all-time lows, yielding, depending on the tenure, a meager 1%–3%.

Then, things changed. 

All of this excess liquidity in the system, compounded by supply chain disruptions, produced the highest inflation rates since the late 70s and early 80s, and in March of 2022, the Federal Reserve started to increase rates. And those security portfolios started to lose value. The speed and size of the policy rate increases exacerbated the loss in value of these securities, putting banks in a catch-22.

It is estimated that a quarter of total bank assets are now in investment portfolios, which comes to roughly $6 trillion. Needless to say, that’s a lot of “trapped” liquidity that now needs to come from somewhere else. 

The total amount of money invested in Money Market Funds (MMFs) is now at a historical high of $5.2 trillion. While inflows into these types of investment vehicles accelerated after the FDIC’s receivership of Silicon Valley Bank, total assets had been growing since the Fed started to increase rates in March last year. After years of anemic returns (and fee waivers for fund managers), yields on money market funds are mounting a compelling challenge to bank deposits.

While MMFs and bank deposits are not identical, individuals and companies often view these instruments as comparable investments, and they have turned to MMFs (especially Government MMFs, which make up 82% of all MMF assets) to the detriment of bank deposits. 

Because MMF assets are comprised of capital market instruments, yield on MMFs adjust to FOMC rate hikes much more closely and much faster than the interest rate on a bank deposits, which are determined at the discretion of each bank. In addition, for those investors concerned about safety, Treasury or Government MMFs theoretically provide much higher protection than what is available for FDIC insured deposits. While Prime Institutional Money Market Funds have the potential risk of a floating NAV and gates and fees which could cause a loss or illiquidity, retail investors are not subject to floating NAV or gates and fees so money funds, and Treasury/Government funds in particular, provide a robust safe haven for cash.

A recent report published by the Federal Reserve Bank of New York shows how much more the net yield of MMFs reacts to the Effective Federal Fund Rate (MMF Beta) than a benchmark 3-month CD. This is true for the current period of monetary tightening as well as past periods.

With this, it is not surprising that uninsured depositors at banks are shifting to MMFs. 

Until the 90s, Time Deposits (Certificates of Deposits) represented a meaningful percentage of total deposits for banks. Today, only 5% of total domestic deposits are Time Deposits. Reasons for this are varied, but include consumer preference for liquidity, prolonged low returns discouraging depositors to extend out the curve, and the relatively higher cost for banks. Nonetheless, early withdrawal penalties associated with Time Deposits provide inherent stability vis-à-vis demand deposit accounts.

With SVB’s record-breaking twitter-bank run (just like a classic bank run, only faster), deposit stability has come to the forefront again and the deposit mix (demand vs. time) is being reassessed. Although still relatively negligible, the percentage of Time Deposits on banks’ balance sheets has increased from 6 to 9% since the start of the tightening cycle in March of 2022 initiating a reversal of the long term trend.

To compete with MMFs, all banks except perhaps the too-big-to-fail, must increase the competitiveness of their deposit product to retain and attract new depositors. The dilemma they face is that increasing rates compresses the Net Interest Margin that analysts so closely monitor. 

With this backdrop, it is more important than ever for banks to have access to as many diverse sources of liquidity as possible. In fact, the more sources, the better, as each can be leveraged when most efficient.

From brokered deposits to FHLB advances and even the Fed discount window, each type of liquidity tool plays an important role in a bank’s funding plan; however, deposits (and especially now, insured retail deposits) will always remain the most important funding source for banks. Advances in financial technology, such as online account opening or biometric identity verification have allowed banks to expand beyond their geographic boundaries and acquire depositors that will most likely never step foot in a branch.

Internet deposits have given banks natural reach and a way to engage younger, tech-savvy consumers, but the costs of building and maintaining a national online branch should not be underestimated. Even some of the most sophisticated and prominent financial institutions have struggled, if not failed, to stand up digital models that are economically viable.

As more competitors enter the digital deposit space, the cost of acquiring a new customer has steadily increased and the ability to monetize that customer relationship has become harder and harder. In many cases, leveraging advances in financial technology is the most efficient alternative to entering the digital deposit gathering space, especially as the tumult of the past couple of months have shown that sticky deposits are now more important than ever.

Fortunately, banks no longer need to be experts in digital banking or make huge investments in order to bring in new, insured deposits. They just need to be innovative and be able to tap into the right financial technology partners.

For example, with a partner like Raisin, banks are able to focus fully on what they do best, while allowing its digital funding platform to do the rest. They handle the end-to-end infrastructure, eliminating costly operational and build investments, and raise retail deposits nationwide with institutional simplicity. The entire value chain from marketing and KYC down to reporting and customer service is included, allowing banks to tap into a deep pool of incremental funding, thus growing those vital retail deposits — all with lower overall funding costs.