Term Deposits: Are reports of their death greatly exaggerated?

As increasing regulation is implemented across the Australian banking sector ‘safe havens’ such as term deposits are starting to lose their luster.

“The reports of my death have been greatly exaggerated”.
Mark Twain

The global financial crisis of 2008 brought home to regulators the inherent risks within the existing regulatory framework, especially with respect to large financial institutions, which were basically viewed as being ‘too big’ for governments to allow to fail. This provided a wake-up call after the more liberal regulatory and supervisory framework of the 2000’s. The process of addressing the limitations of existing regulations has taken time but the results have been a series of material changes in the regulatory framework applying to major Authorised Deposit Taking Institutions (ADIs)¹.

These material regulatory changes were designed to both reduce the risk of bank failures and to more clearly impose losses on wholesale funders of the financial institutions rather than the government. Such regulatory changes are consistent with the entire aim of limiting, to the greatest extent possible, the contingent liability of governments to support major banks. Some of the more important regulatory changes are set out in Figure 1.

Figure 1: Australian banking sector regulatory change

The Liquidity Coverage Ratio (“LCR”)

For investors in Term Deposits (TDs), the greatest potential impact from regulatory change is the Liquidity Coverage Ratio (“LCR”)² which came into effect in 2015 and has resulted in banks applying an increasingly inflexible approach to TD issuance. At its most basic, the LCR requires that (a) 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 (b) 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:

1. There is an increased divergence in deposit rates offered by financial institutions based on the type of organisation they are as:
   • 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).
   • Branches of foreign banks that operate in Australia (such as Bank of China Limited) are only required to meet 40% of the LCR.
   • Credit unions, building societies and other mutual banks (technically termed ‘minimum liquidity holding’ or MLH ADIs) are not required to comply with the specific LCR.
2. 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)³.

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). 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.
• Looking to invest in TDs issued by the quality branches of foreign banks or credit unions who from time to time may offer more competitive rates given the LCR does not fully apply to these financial institutions.
• Considering the stability of your balances held in these products. Banks may tend to increasingly monitor the behaviour of depositors and may 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 in the position whereby multiple needs could be satisfied by using securities such as TDs. Increasingly regulators are requiring that the funding sources of banks be “true to label”. Despite these regulatory changes, while the ability of the TD to provide both liquidity and high returns simultaneously is becoming increasingly problematic, TDs will still have a role to play in portfolios. However, to get the most out of TDs, investors will need to be more selective about how they are used.

Investors will need to take a closer look at their investment needs: considering the level of very low risk liquidity needed and its associated lower returns versus the desire for more return on the portfolio in total. Increasingly investors will need to consider what their investment horizon is and whether the level of liquidity incorporated within a portfolio is consistent with that investment horizon. As part of the review process, investors should look to use a broad range of fixed income investments to optimise the returns and characteristics of their fixed income portfolios.

¹ While the term ADI refers to a wide range of financial institutions in Australia, for simplicity, Russell Investments will often simply refer to banks in this paper.

² The LCR focusses on ensuring that in the event of a future liquidity crisis, a bank can survive for a period of at least 30 days using its own resources without any need for extraordinary public sector intervention.

³ This increase in differential pricing doesn’t have a direct impact on institutional investors except where they may be offering products which compete against TDs for retail funds. Post 2015 Institutional investors will increasingly face the risk of materially less attractive rates when investing in TDs compared to retail investors. Given the increasing differential in pricing applied to institutional versus retail investors, institutions may increasingly need to look at other sources of return enhancement to lure retail investors away from their investments in TDs.