Euro Crisis May Pack U.S. Banks With Deposits They Can’t Use

The European debt crisis is poised to flood U.S. banks with something they don’t want and can’t use: more money.

Cash held by U.S. banks surged 8.4 percent to a record $981 billion during the week ending July 27, the Federal Reserve said in an Aug. 5 report. That’s more than triple the amount firms had in July 2008, before the collapse of Lehman Brothers Holdings Inc. almost froze bank-to-bank lending.

Even more money may be deposited with U.S. lenders if investors pull away from European banks amid concern the Greek debt crisis may spread to Italy or beyond, said Brian Smedley, a strategist at Bank of America Merrill Lynch in New York. Those funds may not be so welcome: With few opportunities to lend them out profitably, U.S. firms may have to slap fees on depositors to keep returns from eroding.

“It becomes a loser to hold these excess deposits,” said Bert Ely, a bank-industry consultant in Alexandria, Virginia. “At the margin they have to think, ‘What can we do with $50 million of deposits?’ The answer is not much.”

Bank of New York Mellon Corp. (BK), the world’s largest custody bank, announced plans last week to charge institutional clients for unusually high balances above $50 million. In a letter to customers, the New York-based firm said it’s “taking steps to pass on costs incurred from sudden and significant increases in U.S. dollar deposits” linked to events including the Greek crisis and the uncertainty over the U.S. debt-ceiling debate.

‘Getting More Worrisome’

The increasing reluctance of European banks to lend to each other has been on display since early last week. The so-called Euribor-to-Overnight-Indexed-Swap spread, which reflects the comparatively higher risk of lending euros for three months versus overnight, widened to 0.57 percentage point today. The rate compares with 0.36 percentage point at the start of last week and 0.32 percentage point a year ago.

The European Central Bank today started buying Italian and Spanish assets in an attempt to halt the region’s sovereign debt crisis. The ECB bought Italian and Spanish bonds this morning, according to five people with knowledge of the transactions, driving their 10-year yields down to 5.39 percent and 5.3 percent respectively from above 6 percent on Friday. Both reached euro-era records last week.

“Things in the European interbank market have gotten very slow, and it’s only getting more worrisome by the day,” said Carl Lantz, the New York-based head of interest-rate strategy at Credit Suisse Group AG. “It’s safe to say it feels like 2008 in the European funding markets.”

Credit-Default Swaps

By contrast, the U.S. Libor-OIS spread -- a stress barometer for dollar-based bank-to-bank lending markets -- stood at 0.19 percentage point today, down from 0.24 percentage point a year ago.

“For U.S. banks, the liquidity profile and the interbank market is in a much stronger position than what is going on in Europe,” said Jonathan Hatcher, a Jefferies Group Inc. credit strategist specializing in banks.

Among the world’s biggest banks, nine of the 10 perceived as the most likely to default are European, data compiled by Bloomberg show.

Credit-default swaps on Milan-based UniCredit SpA (UCG) surged 23 percent last week to 360 basis points, indicating an investor would have to pay $360,000 a year to insure $10 million of debt. For Bilbao, Spain-based Banco Bilbao Vizcaya Argentaria SA (BBVA), such swaps climbed 13 percent to 314 basis points. Among the largest U.S. banks, Bank of America Corp. (BAC) had the highest price at 207 basis points, followed by Morgan Stanley at 200 basis points, Goldman Sachs Group Inc. (GS) at 166 basis points and Citigroup Inc. (C) at 162 basis points.

‘Enormous’ Liquidity

The relative ease in dollar interbank markets stems partly from the $2.3 trillion the Fed has pumped into global financial markets since November 2008 through its purchases of Treasuries, mortgage bonds and agency debt. Fed balances stood at $1.62 trillion as of Aug. 3, up from $1.05 trillion a year ago, $718 billion in August 2009 and $10.3 billion in August 2008, before the U.S. mortgage crisis.

“There’s an enormous amount of dollar liquidity because of what the Fed has done in recent years,” said Raymond Stone, who tracks U.S. money markets as a managing partner at Stone & McCarthy Research Associates in Princeton, New Jersey. “That certainly helps.”

JPMorgan Deposits

Most of the largest U.S. banks have increased their deposits. JPMorgan Chase & Co.’s deposits rose almost 13 percent to $1.05 trillion at the end of June, from $930 billion at the end of December. Bank of America’s deposits climbed 3 percent to $1.04 trillion from $1.01 trillion.

Since late 2008, the Fed has been paying interest on deposits placed with the central bank, known as interest on excess reserves, or IOER. That rate is currently set at 25 basis points, or 0.25 percent.

At that rate, banks may struggle to profit from even non- interest-paying deposits, because the companies must pay premiums to the Federal Deposit Insurance Corp. when they route the money to the Fed. On April 1, the FDIC changed its methodology for assessing premiums, resulting in an increased cost for most large banks. Because a deposit at the Fed is technically an asset, taking the money may stretch banks’ capital-to-asset ratios, which are watched by regulators, Joseph Abate, a money-market analyst at Barclays Capital in New York, wrote in an Aug. 5 report.

‘Hot Potato’

“The higher deposit cost, the potential need for additional capital and the flight-prone nature of these balances clearly outweigh the 25-basis-point return from IOER that they would earn depositing the money at the Fed,” Abate wrote. Any reduction in IOER -- a move Fed Chairman Ben S. Bernanke told Congress in July might be possible -- may create a “serial round of deposit fees” since banks would try to “push cash from their balance sheets” like a game of “hot potato.”

In hot potato, players toss a beanbag to each other, trying to get rid of it as quickly as possible so they aren’t holding it when the music stops.

“Domestic banks will work very hard to shed those surplus reserves,” said Lou Crandall, chief economist at Wrightson, a Jersey City, New Jersey-based unit of London-based ICAP Plc, the world’s largest inter-dealer broker. “They’re not eager to expand their balance sheets with low-yielding assets even when they earn a small positive spread.”

Economic Slowdown

Slowing economic growth has capped demand for new loans, the biggest category of investments for most banks. Deposits held at U.S. domestically chartered commercial banks climbed 16 percent in the past 31 months to $7.38 trillion, while loans fell 6.4 percent, according to the Fed.

Yields on securities and loans have been dragged down by the Fed’s keeping benchmark rates near zero since December 2008, said Nancy Bush, contributing editor at SNL Financial, a bank research firm in Charlottesville, Virginia. That means new investments will bring lower yields than those already on bank balance sheets, eroding profitability, she said.

“The one thing I’ve learned over the years is that banks lead us into recessions and they lead us out,” Bush said. “They were in the process of leading us out. They were liquid and recapitalized, and they had the willingness to lend to that marginal creditworthy borrower. Now that entire thesis is thrown into question.”

Deposit growth may accelerate if money-market funds that lend to European banks redirect their investments to U.S. banks, said Bank of America’s Smedley, a former senior trader and analyst in the Federal Reserve Bank of New York’s markets group.

‘Very Connected’

Prime U.S. money funds had about $800 billion, or half their assets as of May 31, in securities issued by European banks, according to Fitch Ratings. A Greek default could threaten European banks that have lent to Greece and other heavily indebted European countries.

During the week of July 27, cash held by U.S. branches and agencies of foreign banks fell by $65.7 billion, the second straight weekly decline, according to the Aug. 5 Fed report. At domestically chartered U.S. banks, cash swelled by $76.2 billion.

“The global banks around the world are all very connected, and they’re connected through the funding markets,” Smedley said. “There’s no doubt that if there is an escalation in concerns about Spain and Italy at the sovereign level, and that spills over to the broader European banking system, it would most likely lead to an increase in funding costs in the markets where those banks are active.”

To contact the reporters on this story: Bradley Keoun in New York at bkeoun@bloomberg.net; Dakin Campbell in New York at dcampbell27@bloomberg.net

To contact the editor responsible for this story: David Scheer at dscheer@bloomberg.net

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