Public Funds Investment Institute

What's With Bank Balances?

May 7, 2024

I’ve been puzzling over a surprising set of statistics. The Federal Reserve reports that in recent years state and local government balances in checkable deposits and currency have mushroomed and are now nearly three times greater than they were in 2019. At the same time assets in time and savings accounts have declined.

In pre-pandemic 2019, state and local government bank deposits represented about $562 billion or 19% of investment assets, according to Federal Reserve data.  That amount grew to $749 billion at the end of last year. Investment assets grew as well so bank deposits represented the same share of overall investment assets, about 20%, in 2023 as in 2019.

But the nature of bank balances has changed. In 2019 about 25% of these balances were in checkable deposits and currency—assets that earn little, if any interest. These assets expanded from $139 billion to $375 billion by the end of 2023, while assets in time and saving deposits declined by $49 billion.

If you think about time and savings deposits as investment assets, their decline is understandable because bank deposit rates typically lag other rates–like the federal funds rate—that are sensitive to monetary policy. So, they are less attractive in a rising rate environment.

Staff of the New York Fed documented this relationship in a blog post that calculated that deposit betas (a fancy way of describing the responsiveness of bank deposit rates to monetary policy rates)  generally captured only about 40% of monetary policy changes.

One measure of the large gap between deposit rates and monetary policy rates is shown on the following chart that plots the national rate for 12-month CDs (as reported by the Federal Deposit Insurance Corporation) and the federal funds rate.

image 1

 It is not as refined as the Fed analysis but points to the same dynamic: Banks have been stingy in passing on the benefit of rising market rates to their depositors.

Checkable deposits and cash have grown by $236 billion since 2019, according to the Fed. (We’ve previously questioned some of the Fed’s Financial Accounts reporting but these particular elements come from bank call reports and so are likely to be accurate.)  

Checkable deposits  and cash are required to support financial payments, and through earnings credits they may be used to “pay for” or offset bank services.

Let’s unpack this a bit. Have public sector financial flows expanded since 2019? Probably, as the scope and size of government has grown. This could explain a small part of growth in bank balances. But one could argue that better technology around money movement and reporting should actually reduce idle balance requirements. Like just-in-time supply chains, technology should facilitate just-in-time cash movements.

Cash and checkable deposits are also used to offset the cost of bank services by earning credits at the bank.  It’s possible, though not likely, that earnings credit rates have risen by more than monetary policy rates making it more attractive now—compared with investment rates—to maintain balances than in 2019.   There is not a lot of transparency around bank earnings credit programs, but this just does not feel right. 

What is the worth of these cash and checkable balances? We could assume that the potential average earnings credit rate in 2019 was equal to the effective federal funds rate of 2.16%. Assuming all cash and checkable deposits earned at this rate, the total potential to offset bank fees would have been about $3 billion. Fast forward to the end of 2023 and apply the same formula:  the average federal funds rate of 5.02% and total checkable deposits of $375 billion results in earnings of about $18.8 billion.

Not that earnings credit rates are as high as the federal funds rate. But the point is that the potential value of these public unit balances invested at the inter-bank lending rate (i.e., the federal funds rate) has grown by nearly $16 billion.

Banks have recently started to pay up for deposits. There has been a spate of news articles on the topic, including this one in the Wall Street Journal.  A secure, liquid investment should pay a rate with a five handle on it. After all, that’s what Treasury Bills, LGIPs and money funds yield. And bank balances should be valued at these rates as well.

So a million dollars in a bank cash or checking account should offset something like $50,000 of bank fees a year. That’s real money.

If, collectively, public agencies could reduce balances in checkable and currency accounts to 2019 levels, that could mean freeing up about $236 billion for investment. Put it to work at 5% and that is equal to nearly $12 billion in added earnings. That’s real money as well!

One challenge to investing balances efficiently in bank deposits is that there is limited rate transparency. The internet provides quick access to LGIP and money fund rates, and it’s also easy to obtain real-time Treasury Bill quotes by typing a few characters into an internet browser search bar (No, you do not need a Bloomberg to figure out where the market is!) 

Not so for bank rates, where there are not good indices of rates and where the complexities and cost of collateralization make comparisons difficult.

(We’ve posited that expanded FDIC insurance coverage for public agency deposits could help matters, but that is a story of another day.)

 All of which leads to what is an off-beat recommendation for improving investment earnings:  work to minimize uninvested or under-invested cash. If public agencies were able to reduce cash toward 2019 levels that would add billions to budget capacity.

 April Investment Results: Cash Remains on Top

The Investment Dashboard reports returns for the PFII 1–3-year model portfolio through the end of April. The portfolio return was depressed by the rise in rates through the month with a one-month return of -0.24% (annualized to -2.62%.)  The total return over the 12-month period was 3.37% and the yield to maturity of the portfolio rose to 5.25%. Meanwhile yields on LGIPs and money funds (represented by the PFII Index yield data) were largely unchanged with government-focused LGIPs yielding 5.25%-5.30% and prime-oriented funds yielding about 10 to 15 basis points more.

Greetings, fellow colleagues in the public funds investment community! I'm Marty Margolis, a seasoned expert with a deep understanding of the intricacies of managing public sector investments. Having led the growth of PFM Asset Management and managing assets exceeding $150 billion, I am excited to connect with you through the Public Funds Investment Institute. If you haven't already — subscribe below to join our community, explore our thought leadership, and gain valuable insights. I encourage you to connect with me on LinkedIn or reach out via email to share your thoughts, feedback, and ideas. Let's collaborate and make a positive impact together.

Best regards,
Marty Margolis

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