In March of 2023 we almost had a bank crisis. Lots of money was quickly pulled out of banks and suddenly everyone realized 1) bank deposit interest rates are ridiculous when compared to other alternatives like money market funds and CDs and treasury bills, 2) banks might actually be in trouble because they have so much money tied up in low interest rate investments and loans, and 3) lots of bank deposits aren’t covered by federal deposit insurance and could be lost if the bank goes under.
Traditional banks take in deposits and use those deposits to make loans. For several years now banks have been making loans at very low interest rates, and many of those loans are long term, fixed rate loans. That money is tied up until it matures unless the customer decides to pay it off early. But nobody is going to pay a low interest rate loan off early if they would have to replace it at the current high interest rates. So many of those outstanding bank loans aren’t going anywhere.
When the pandemic hit, banks got even more deposits. When the Fed was doing “Quantitative Easing” they added multiple millions of dollars of deposits to commercial banks. Banks didn’t loan that money out for various reasons but they had to do something with it, so they invested it in long term treasury bonds and mortgage backed securities, which are more long term, fixed rate investments.
So most bank assets are tied up long term at very low interest rates. Now they can’t pay high interest rates on deposits or they’d be broke and out of business. But customers can do much better than those interest rates so customers are pulling deposits out of banks.
Deposits leaving banks often go to one of two places, money market funds and CDs. The government measures something called M2, which is what they call “money supply”. CDs could be at the same bank or some other bank, but they don’t count as deposits, and they don’t count in M2 as “money supply” since they are tied up and can’t be spent. And banks can’t make loans against money in CDs.
Money market funds are part of what is called “the shadow banking system”, things that look a little bit like banks but are not banks. They don’t have deposit insurance, and they don’t make loans and they aren’t subject to the same regulations or rules that banks are. Money market funds are not banks, so money in money markets does not count as deposits or “money supply”. Money that goes into money market funds is also money that won’t available for bank loans.
There are two things to potentially worry about with about the big drain out of bank deposits. One is whether it means consumers are feeling poorer or that they might spend less money. Those are things that might portend a recession. There are some gloomy headlines about the recent reduction in “money supply”, but a big part of this is the transfer from bank deposits to money markets. I don’t think more money in money markets vs bank deposits is any indication that consumers are more broke, so that doesn’t concern me much.
But the other implication of the deposit drain is that banks can’t lend money out, and that is something to pay attention to.
Banks can only make loans up to a certain percentage of their deposits, so when they have more deposits they can make more loans and when they lose deposits they have to stop making loans. In a worst case, if they lose enough deposits, they might even need to call in loans they already made to stay within their prescribed ratios.
Most of the deposit drain is coming out of medium to small banks, big banks have seen an increase in deposits. So the biggest banks will be able to make loans and the rest of the banks won’t.
Large banks make large loans, and are not necessarily interested in or good at small loans. Small and medium size banks mostly make home loans, auto loans, commercial real estate loans, small business loans, and agriculture loans, so those are the type of loans that may be at risk.
Home mortgage loans are also provided by another part of the shadow banking system, online-only companies that do home mortgage lending but don’t take deposits, so mortgages may continue to be available. And car companies and other shadow banks will continue to finance auto loans.
But agriculture loans are almost exclusively made by small banks. And a significant percentage of commercial real estate loans and small business loans are made by small to medium size banks.
So for agriculture, commercial real estate, and small businesses who need loans, the flight of deposits from banks could be a harbinger of trouble ahead.