Near-Zero Short-Term Interest Rates May Go Lower Under FDIC Rule

Friday, 07 Jan 2011 12:34 PM

 

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A planned change in deposit insurance fees for U.S. banks may lower already near-zero short-term interest rates, according to strategists at Barclays Plc, Bank of America Merrill Lynch and the Royal Bank of Canada.

The Federal Deposit Insurance Corp. proposed broadening the base for deposit insurance fees to banks’ liabilities, rather than domestic deposits. The plan is designed to fund depositor protection while shifting the burden to larger lenders whose reliance on riskier funding may pose greater threats to the financial system.

Increased FDIC fees may cut into banks’ interest income and drive money market rates lower, the strategists said. The volume weighted average for overnight fed funds, the so-called effective rate, may slide by as much as 0.1 percentage point if the FDIC change is implemented, according to Wrightson ICAP LLC, a Jersey City, New Jersey research unit of ICAP Plc.

“The FDIC’s actions would have the same effect as a cut in the interest rate the Federal Reserve pays banks on excess reserves,” said Joseph Abate, money-market strategist at Barclays in New York. “This will drive repurchase agreement and Treasury bill rates lower.”

Rate Catalysts

Even lower short-term interest rates will potentially make it even harder for the $2.8 trillion money-market fund industry to retain customer assets. The FDIC changes will add to catalysts for lower money-market rates, chiefly the Fed siphoning of about $1 trillion in Treasuries from the market through its debt purchases by June, according to New-York based Brian Smedley, a strategist at Bank of America Merrill Lynch, a unit of Bank of America Corp.

“The Fed will likely achieve lower short-term rates even without lowering the 25 basis points it currently pays on banks’ excess reserve balances,” said Smedley, a former senior trader at the Federal Reserve Bank of New York. With short-term interest rates likely to decline this year, “it will make money- market mutual fund managers lives more difficult and could lead to further consolidation of the industry.”

Deborah Cunningham, chief investment officer in Pittsburgh for taxable money markets at Federated Investors Inc., which manages more than $336 billion in money-market investments, said a fall in overnight rates would at most be only about five basis points and wouldn’t be sufficient to speed any consolidation of the money-fund industry.

Consolidation Happened

“There will be pressure on short-term rates depending upon how this plays out, but a 10 basis points fall is pretty draconian and we don’t expect that,” Cunningham said in a telephone interview. “Most of the consolidation of the industry has happened, is happening and will continue to happen, but this wouldn’t push it any faster. This isn’t like a nail in the coffin or anything that really pushes people over the edge.”

FDIC-member banks pay quarterly assessments to the insurance fund, which fell into deficit as bank closings soared in the wake of the 2008 credit crisis. The Nov. 9 FDIC proposal, a response to the Dodd-Frank financial-regulation law, is in a 45- day comment period. If adopted, it would be implemented April 1.

Record-low interest rates during the past two years have made it difficult for the money market fund industry, which saw assets fall by $491 billion, or 15 percent, in 2010, according to the Investment Company Institute. Fund yields average 0.07 percent for the biggest 100 taxable funds, according to Crane Data, down from 1.16 percent two years ago.

Excess Reserves

Banks’ excess reserves held with the Fed above required amounts total about $991 billion, compared with $2.2 billion at the start of 2007. The Fed began paying interest on these reserves in October 2008 to keep the benchmark U.S. overnight interest rate traded in the market close to the target set by policy makers. The Fed’s deposit rate is 0.25 percent.

The central bank’s official target for overnight funds has been held in a range of zero to 0.25 percent since December 2008.

“Now that all banks’ assets, including short-term liquid assets, are included in the FDIC’s assessment base, it means that every bank faces its own interest rate on excess reserves,” said Lou Crandall, chief economist at Wrightson ICAP. “For a large number of custodial banks, at the margin, the benefit to them to keeping an extra dollar of reserves at the Fed will be about 15 basis points or some number in the mid teens rather than the 25 basis points the Fed is now actually paying. That will lower overall the structure of overnight rates.”

Overnight Lending

Overnight Treasury general collateral repurchase rates, which typically move in the same direction as the fed funds rate, may fall this year to as low as “single digits” from about 0.22 percent at present, according to Bank of America, as the Fed’s quantitative easing drains securities from the marketplace.

The Fed in November began buying $600 billion of Treasuries in a second round of debt purchases, expanding its stimulus measures in an attempt to reduce 9.8 percent unemployment and avoid deflation. The Fed also plans to reinvest $250 billion to $300 billion of proceeds from mortgage-backed debt and agency securities into Treasuries in the same time period.

Fewer securities available for borrowing and lending in the repurchase markets typically causes rates to fall as investors are willing to take lower interest rates on loans in order to get needed securities.

Another $200 billion in Treasury bills will be removed from the market by late February, as the Treasury’s Supplementary Financing Program is forecast to expire as the government reaches the federal debt limit and Republicans won’t likely allow an increase, according to Barclays and Bank of America. Through the program the Treasury sells bills at the Fed’s behest.

The FDIC fee assessment change “should have a pronounced effect on the fed funds effective rate,” Michael Cloherty, head of U.S. rates strategy for fixed income and currencies at Royal Bank of Canada in New York, wrote in an e-mail. “The banks subject to the new insurance fees should only be willing to borrow fed funds at rates more than 10 basis points below where they are currently borrowing.”

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