Banks are having a hard time investing their money. Loan demand remains slack, and securities portfolios are already bulging. Besides, a lot of these securities, have been "gapped" - long-term instruments bought with short-term money (federal funds).
But maybe banks can still accumulate bonds at a positive spread without taking on more rate risk.
No Spread on Treasuries
A bank should calculate the return on any asset by assuming that the instrument has to be "match-funded" with purchased money. Thus, the cost of financing a bond with a seven-year duration is roughly what it would cost the bank to borrow at wholesale for the same period.
Since most banks have credit ratings no higher than single A, that cost is relitively steep - steep enough to rule out the match-funded (read: safe) purchase of most bonds and certainly all Treasuries and agencies.
But why use the wholesale funding rate' The obvious answer is that any solvent bank should be able to borrow at wholesale whenever it wishes.
But the same institution may not be able to generate the required additional retail monies quite so readily. So the cost of retail deposits is not relevant to marginal investment opportunities.
Changed Ground Rules
That's a fair assumption in an inflationary period when the public is shopping for plusher yields than are obtainable from deposits. But it may no longer be valid in today's rate environment.
In periods of low rates, the money supply is growing rapidly and. in addition, people are content to keep more money in core and even no-interest checkable and savings deposits. That's because, in so doing, they don't sacrifice much interest income.
It should be noted that last year the total of bank demand deposits surged from $290 billion to $340 billion. By way of contrast, in 1981, a year of strongly. rising rates, bank DDAs fell from $261 billion to $231 billion.
As long as deposit categories like DDAs, NOWs, and passbook savings are essentially on a growth path (with only an occasional downward blip), one can argue that banks are justified in treating a high proportion of them as bona fide long-term monies. Indeed, some banks now view a portion of consumer DDAs and NOWs as at least five-year and perhaps as long as 10-year money.
If that's the case, it may no longer be reasonable to argue that the yield on all new investments must be compared with the cost of borrowed money.
It may be more reasonable to view the funding pool for incremental investments as consisting of a weighted average of retail core deposits as well as long-term borrowings (actually, for most banks, short-term borrowed funds that have been swapped into longer durations).
The results of such a change in the funding mix might be significant. Obviously a bank that is rated single A can't earn a positive spread matching-funding bonds rated higher than, say, BAA.
But suppose that this bank included in its funding mix a gob of deposits "purchased" by its treasury from the branch system. Many branch systems raise money at an all-cost that approximates the Treasury rate, and bank treasury departments will frequently "buy" these funds from their branches at the very low triple-A rate.
The addition of this low-cost retail money to the funding mix cannot fail to lower appreciably the bank's composite funding rate, enabling it to earn a positive spread on at least A-rated corporate bonds and perhaps also on double-A rated ones.
A New Risk Weighting
Bear in mind, moreover, that an adequately diversified portfolio of double-A corporates has minimal credit risk.
So, by legitimately reclassifying many of its demand deposits and passbook accounts as long-term funds, the bank is able to book a new category of profitable asset that adds comparatively little to both its interest rate and credit exposures.
That being the case, the new portfolio should not require the full 4% Tier I equity. As the regulators acclimate themselves to this new situation, they may see their way clear to creating the same risk weighting for a portfolio of matched-funded double-A corporates as for, say, mortgages, which are equivalent to a double-A-rated security. That risk weighting is, of course, 50% or 2% Tier 1 capital.
Such a step would greatly increase the asset category's attractiveness. (Obviously, as banks begin putting money into double-A bonds, they will reduce their riskiness, causing the market place to upgrade their credit ratings and lower their required rates of return).
This idea requires a very serious word of caution. Since the concept is based on the current low cost of retail deposits, if inflation returns and retail rates rise significantly, the benefits are reversed. Therefore timing is critical, and any bank employing this tactic must be aware of the need to reverse its position quite quickly.
Nevertheless, we believe that the growth in the money supply could be neutralized for some considerable period by the ongoing increase in money demand.
If that happens, the very circumstances (a slow-growth economy and low interest rates) that now constrain one area of asset allocation (commercial loans) will create the preconditions for the safe and yet sufficiently profitable employment of bank funds in more novel asset categories.
Mr. Wyman is managing partner of the New York based consulting firm of Oliver, Wyman & Co.
