Banks are borrowing unsecured cash at a record pace while deposits are disappearing

In the past two years, banks have chased deposits away. Now, some are paying higher rates to shore up cash.

On Jan. 27, the Federal Reserve recorded its highest one-day borrowing total dating back to 2016. In recent years, activity in fed funds-used by banks and government-backed lenders to exchange cash reserves parked at the Fed-has surged as the central bank raised interest rates at the fastest rate in decades.

Customers are pulling cash from savings accounts to invest in higher-yielding products as some banks scramble to borrow to meet regulatory requirements.

Fed-funds trading usually involves a Federal Home Loan Bank lending overnight cash to a commercial bank. Government-sponsored entities designed to support mortgage lending during the Great Depression cannot earn interest by leaving funds at the Fed, so they lend their excess cash to banks without requiring collateral.

Bank identities aren't publicly available. Many foreign banks borrow cheaply in fed funds to make a few extra bucks, then leave that cash at the Fed to earn interest. U.S. banks are now dipping in, according to Bank of America, likely because regulators view such borrowing favorably. 

The New York Fed found that aggressive bidding by a subset of commercial banks has raised the cost of the priciest fed-funds transactions. The highest borrowing rates are 0.15 percentage points above the Fed's target range-now between 4.5% and 4.75%-and more than 0.3 points above the median. Prior to October, no measurable portion of trades had breached the target range since March 2020.

Fed-funds rates are used as a benchmark for borrowing costs across the economy. The Fed sets a target range for the rate to trade within, but daily trading determines the rate. The rate could rise if liquidity dries up substantially, putting stress on banks and companies.

"Banks don't want to compete for funding," said Mark Cabana, head of U.S. rates strategy at Bank of America Global Research. The Fed wants to tighten financial conditions, and this is one way to do that."

In the second and third quarters of last year, U.S. banks lost deposits at the fastest rate on record, according to the most recent FDIC data. In the third quarter, deposits fell by $206 billion to $19.357 trillion, continuing a decline of $370 billion in the second quarter. It was the first time since 2010 that the economy declined for two consecutive quarters.

Most community banks are unable to match the higher rates offered by Treasury's and money-market funds, losing customers to those products. In order to get cash on their balance sheets, many lenders rely on FHLB advances, longer-term borrowings backed by high-quality securities, and in some cases, the Fed's emergency lending facility-the discount window. 

According to Blake Gwinn, head of U.S. rates strategy at RBC Capital Markets, the increase in fed-funds borrowing may be due to home-loan banks having cash readily available for advances. 

According to him, FHLBs would rather keep their cash in daily products than lock it away in harder-to-access securities because banks are demanding longer-term loans at the highest rate since early 2020.

"I don't think we are seeing flashing red lights that things are getting tight," Mr. Gwinn said, even if a few banks are paying up for funding.

The ability of Canada’s five biggest banks, which are among the largest foreign banks, to handle a potential bank run is hovering around pre-pandemic levels, based on their liquidity-coverage ratios. As of June 2022, no European bank had failed to meet regulators' liquidity measures, according to a study by the European Banking Authority. 

In spite of significant declines in deposits and liquidity in the first half of 2022, banks were able to withstand potential turmoil, according to the study.

As recently as last year, banks were swamped with deposits. The solution was to push clients into money-market funds. As a result, banks compete with those funds for customers' business.

"This is a feature, not a bug," he said.

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