Regional Bank Stress Puts Spotlight on Cash Management

The challenges roiling some regional banks in recent days have stressed financial markets as investors and depositors have been forced to consider the basic safety of bank accounts. As in past crises, U.S. policymakers are stepping in to provide solutions for those banks suddenly facing an unexpected wave of withdrawals.

The situation will likely complicate the U.S. Federal Reserve’s fight against inflation. Officials must now balance any plans for continued policy tightening against efforts to quell market volatility and preserve investor confidence. The Fed will be aiming to shore up liquidity, both in terms of individual accounts and broader financial conditions.

The rapid developments have led to a change in investor sentiment. Previously, signs of persistent inflation had caused markets to reprice higher their expectations for the Fed’s terminal policy rate. As risks related to regional banks have moved to the fore, markets have recalibrated those interest rate expectations amid a flight into safer assets. Short-term markets have rapidly repriced, with the two-year U.S. Treasury yield falling from more than 5% late last week to below 4% early this week before retracing part of that move.

The good news is that markets appear to be functioning well despite the volatility. Yet this episode may constrain the credit creation process for banks at a time when broader credit growth was already slowing (for more, see our recent blog post, “Bank Failures and the Fed”). That could accelerate the timing of a potential U.S. recession, in our view.

The past week’s events have also put a renewed focus on a keystone of the financial ecosystem: the importance that corporations, individuals, and investors should place on understanding and navigating risks associated with cash management. As with the global financial crisis (GFC) in 2008, recent events are a fresh reminder of those risks.

Since the GFC, the global financial system has undoubtedly become more resilient, thanks to new central banking facilities and regulations such as mandatory capital requirements. Thus under normal conditions, a bank can run a mismatched asset/liability maturity plan and lend its deposits out profitably. It’s when depositors demand their funds back en masse that problems arise. Such is the inherent risk of our “fractional reserve” banking system, where banks need keep only a fraction of their deposits on hand to create loans in excess of the size of those deposits.

For individuals and corporate leaders charged with managing cash and navigating the recent market recalibrations, here are a few points to consider:

Yields on cash investments will remain greatly divergent. Although benchmark rates in the U.S. have risen by more than 400 basis points over the past year, not all cash yields have risen in sympathy with the central bank’s moves higher. Specifically, depository rates have languished well below yields offered in repurchase agreements, T-bills, and short-term strategies. Typically, investors need to take more risk to earn higher yields, but current market conditions – particularly the shape of the U.S. Treasury yield curve – may offer lower-risk opportunities to enhance returns.

Commercial paper and certificates of deposit are not entirely risk-free. The Federal Deposit Insurance Corporation (FDIC) covers up to $250,000 in depository insurance, a backstop that has been further complemented by the Federal Reserve’s weekend announcement of the Bank Term Funding Program. Yet investors who place cash on deposit above prescribed thresholds may be effectively taking a view on the creditworthiness of the underlying financial institution.

Counterparty risk remains a necessary focus. As highlighted by the most recent bank failures, many non-financial companies appear to have been blindsided by the risk that their bank could pose in the event that operational cash (i.e., money used to pay employees or vendors) is frozen or lost in the event of a bank insolvency.

Risks remain in prime money market funds. Despite the regulatory urgency to ensure that the failures of prime money funds in 2008 and the near-failures of 2020 are not revisited, prime money funds remain a significant component of the liquidity management landscape. Given past performance of those credit-oriented funds, investors may want to consider alternatives that acknowledge the credit risk being taken, in terms of liquidity and price, or look to higher-quality government fund strategies.

Recent headlines have been unsettling to individual and institutional investors alike. Though the immediate stress from this latest banking problem may have been alleviated by the quick response by the FDIC and regulators, cash investors may want to take the opportunity to review their current protocols for potential fault lines of weakness.