From 1 January 2015 an important change to banking regulation commenced with significant implications for term deposits, with the use of 31+ day break or notice clause becoming more common and a large divergence in deposit rates expected.
In December 2013, the Australian Prudential Regulation Authority (APRA) released a revised liquidity standard (APS 210) for all Australian Authorised Deposit-taking Institutions (ADIs). This standard encapsulated APRA’s views of the Basel III regulatory changes for global banks.
A centrepiece of Basel III and APS 210 is the liquidity coverage ratio (LCR). While other countries have transitional arrangements over a number of years for adoption of the LCR, APRA requires the larger Australian ADIs to comply with it from 1 January 2015.
The LCR aims to ensure that an ADI can meet its liquidity requirements in a severe stress or ‘bank run’ scenario. The regulation requires an ADI to hold sufficient unencumbered high quality liquid assets (HQLA) that can be converted into cash within a day to meet the ADI’s liquidity needs for a 30-day stress scenario. The ratio of HQLA to the ADI’s expected net cash outflows must exceed 100%.
The three key features (and implications for depositors) of the LCR are as follows:
1. 30 day horizon
The LCR looks at a 30-day liquidity period and any product or deposit with a 31+ day break or notice period intact will not be included in the calculation of liquidity required. ADIs must to hold low-yielding HQLA for any deposit (or at-call money) which can be repaid or matures within 30 days. This makes these deposits more ‘expensive’ for the ADI.
Conversely, a deposit that has a 31+ day break or notice period requires no HQLA backing. As such, ADIs will place a higher value on the latter and will pay higher rates to attract those funds. Traditional at-call and short-dated term deposits, particularly from financial institutions, will receive the opposite treatment with rates expected to be significantly lower come 1 January 2015. Corporates will receive slightly better treatment especially where money on deposit can be proven to be ‘operational’.
Since 1 January 2015, the ability to break term deposits has become significantly harder with Product Disclosure Statements and terms and conditions needing to change to prevent the breaking of term deposits, with very few exceptions, the main one being personal hardship.
2. Depositor classification and ‘run off’ assumptions
There are vastly different ‘run off’ assumptions for various categories of depositors which will have a significant impact on the rates the ADIs will offer. At one extreme are ‘sticky’ retail deposits that APRA assumes will withdraw just 5% of funds in a crisis scenario. At the other end are ‘hot’ wholesale deposits from financial institutions that are assumed to see 100% of funds withdrawn at the first sign of a crisis. For the purpose of the LCR calculation, this represents a differential of 20 times between the higher and lower deposit categories.
Again, the implications are clear. Mum and dad ‘retail’ deposits will continue to be in high demand and hence command higher rates. This typically covers deposits up to the $250,000 government guarantee amount. Self Managed Superannuation Funds up to this limit also attract positive treatment.
However, for wholesale deposits and at-call money from larger institutions, particularly those classified as financial institutions, the traditional deposit looks like a dying breed, to be replaced by 31+ day break or notice period deposit products. Corporations that can demonstrate a long term operational relationship will receive a 40% run-off assumption placing them in the middle of sticky retail and hot wholesale money. The focus here will be for corporate and potentially some financial institutions to prove the operational nature of portions of their funds on deposit and to argue for higher rates.
Another clear implication is that all wholesale depositors will have an incentive to do an accurate assessment of their real requirement for very liquid funds such as at-call or short dated term deposits, given the lower rates expected. This low returning portion of a portfolio should be minimised and as much as possible locked away for a minimum of 31 days.
3. The LCR does not apply to many other ADIs
Compliance with the 100% LCR is only required by what APRA terms the ‘scenario analysis’ ADIs. This essentially refers 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.
We expect the deposit rates from the branches of foreign banks and the MLH ADIs to be more competitive at certain points in time, especially for corporate and wholesale deposits. However, this will still be a function of demand and supply with many MLH ADIs currently very liquid and not in need of extra funding from the wholesale sector.
What to watch for when investing in TDs
The impending changes have already been occurring in the market, with many ADIs releasing 31+ day break or notice period products over recent months. Investors should consider the following when assessing term deposit investments:
- Make an accurate and realistic assessment of absolute liquidity needs and minimise 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
- Maximise the amount with 31+ day break or notice clause. Possibly combine this with other sources of liquidity such as an allocation to high quality, liquid bonds that can be sold at short notice if emergency liquidity is required
- Maximise the amount on deposit through personal/retail or SMSF accounts and minimise the amount through deemed corporate or financial institution accounts. Likewise maximise the amount that can be classified as ‘operational’
- Watch for special rates in the early stages to attract investors. Typically, the early adopters receive the best rates and this product is here to stay. It is not a fad.
- Don’t discount the branches of foreign banks or MLH ADIs who from time to time may offer competitive rates for the traditional deposit products, given the LCR does not fully apply to those ADIs. There are now over 10 credit unions and building societies that are rated investment grade and considered safe places to invest deposit or at-call money.
- The ease and low cost of breaking term deposits that has prevailed for many years has come to an abrupt halt since 1 January 2015, so be sure to have other sources of liquidity if this is a possibility.
- Be aware that ADIs will monitor the behaviour of depositors and over time (later in 2015 and beyond) will reward deposits that remain in place and penalise those that are seen to be ‘hot’ money. Where the difference in rate is small, it may pay to remain loyal in the long run.
Justin McCarthy is Director Financial Institutions and Corporate Research at FIIG Securities Limited. This article is general information and readers should seek their own professional advice.