The Federal Reserve is expected to begin shrinking its $4.5 trillion-asset balance sheet later this year, a move that could halt deposit growth and disrupt other parts of the banking business.

Exactly how much of a toll the unwinding process will take on banks is anyone’s guess as the central bank has never attempted to shrink its balance sheet like this. Predictions range from there being little to no effect on banks, to a mad scramble for deposits to replace the lost liquidity.

Why are core banking and the undoing of the Fed's historic, crisis-era quantitative easing program — a market-oriented activity that involved the Fed buying up Treasuries and mortgage-backed securities from private interests — so inextricably linked? Because banks were key middlemen in many of those transactions.

As insurance companies, institutional investors and other private interests sold securities to the Fed, the money ultimately was deposited in their bank accounts, and a lot of it stayed there.

Total deposits at U.S. banks rose from $6.7 trillion in March 2007 to $11.8 trillion in March of this year, according to the Federal Deposit Insurance Corp.’s Quarterly Banking Profile. The Fed's QE program generated between $1.6 trillion and $2.5 trillion of that deposit growth, estimates Gerard Cassidy, an analyst at RBC Capital Markets.

Now that it is time for the Fed to sell assets, many of the former sellers — mostly commercial interests whose deposits at banks swelled — are going to spend those same deposits on what amounts to a massive buyback.

Investors, analysts and bankers themselves paint different pictures of how banks’ liquidity and deposit levels will be affected.

Many analysts have projected that banks with a large proportion of consumer deposits — Bank of America, Capital One Financial and Regions Financial, to name a few — will perform better during the great unwinding than banks that rely more on corporate business, Cassidy and others say.

Kelly King, chairman and CEO of the $221 billion-asset BB&T, was asked during a July 20 conference call about the potential impact on his Winston-Salem, N.C., company. King responded that BB&T will be safe because of its focus on small towns and local businesses.

“The Fed’s balance sheet restructuring has nothing to do with Main Street, and then it has nothing to do with BB&T,” King said.

On the other hand, banks with high levels of commercial deposits may not fare as well, especially banks with large concentrations from financial institutions, Cassidy said. If bank deposits diminish markedly as commercial customers use the funds to buy assets from the Fed, many bankers and investors could be caught off guard if a significant amount of deposits leave the system, said Richard Magrann-Wells, an executive vice president at Willis Towers Watson’s financial institutions group.

“Banks have become used to this source of deposits from the Fed, but it’s going away,” said Magrann-Wells, who advises banks insurance and risk management issues.

The banks most affected by the Fed’s unwinding could respond in a number of ways. Some smaller banks may race to find brokered deposits or other types of wholesale funding to fuel their loan growth. However, “regulators have said that brokered deposits are no longer safe, or that they’re no longer be tolerated in the way they were in the past,” Magrann-Wells said.

“They don’t want banks relying on sources of deposits that might disappear overnight,” he said.

Many banks will engage in deposit pricing wars to win new customers or to simply prevent existing customers from leaving for a higher rate elsewhere.

The deposit competition has already started, thanks to the Fed’s series of rate hikes. Deposit costs have increased for more than 90% of the banks that had reported second-quarter financial data through Friday, FIG Partners analyst Chris Marinac wrote in a research note Monday.

Banks could see their profit margins squeezed if they raise rates too soon, said Marty Mosby, an analyst at Vining Sparks.

The Fed’s unwinding could also lead to bidding wars in mergers and acquisitions, as buyers chase sources of cheap deposits. Banks with higher loan-to-deposit ratios might become active buyers, and those with fewer loans to deposits might become prime M&A targets, Cassidy said.

For the time being, many bankers are downplaying the potential effects of the Fed’s balance sheet moves, citing Fed leaders' assurances that they will strive to minimize disruption to the economy and markets.

“I do believe that just because it’s going to be very gradual, it’s going to also be very manageable, and the market’s going to respond accordingly,” Terry Dolan, chief financial officer at the $450 billion-asset U.S. Bancorp, said during a July 19 conference call.

Jay Hooley, chairman and CEO of the $238 billion-asset State Street in Boston, agreed with Dolan’s assessment.

“The Fed is going to be very careful,” Hooley said in an interview. “Their plan is to go at a very slow pace.”

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Andy Peters

Andy Peters

Andy Peters writes about regional banks, consumer finance and debt collections for American Banker.