A Cash Conundrum: Money funds or Bank Deposits?

Despite nearly 18 months passing since the collapse of Silicon Valley Bank (SVB) and Credit Suisse’s acquisition by UBS, counterparty risk remains top of mind. Bank deposits expose investors directly to the financial health of a single bank in which funds are deposited. Should a bank face financial instability, the liquidity and safety of funds deposited at that institution can be in serious jeopardy. Additionally, efforts to enhance yield by terming out deposits further increase implicit counterparty risk – the longer you are exposed to a given counterparty, the more time there is for something to go wrong and for you not to get your money back. High profile, and undoubtedly high consequence, bankruptcies and restructurings dominate headlines and institutional memory. In reality, a treasury team’s counterparty risk challenges are ever present. Credit rating migration (where a bank’s rating is downgraded below thresholds specified in treasury investment policy) can lead to intensive additional due diligence, increased resource requirements across the organisation and, ultimately, financial opportunity loss should a decision be made to attempt to break a deposit at an institution a treasury department no longer sees as safe.

MMFs mitigate counterparty risk thorough portfolio diversification. Prime MMFs invest in commercial paper, permitting for a broader diversification across issuers and potentially enhancing yield while adhering to stringent credit quality standards. Prime MMFs employ dedicated in-house credit research teams to continuously monitor and assess the creditworthiness of their holdings, which, in turn, adds an additional layer of oversight.

Liquidity is a crucial consideration for cash management decisions. Bank deposits present both benefits and drawbacks in this area. While bank deposits generally offer overnight liquidity, this can be subject to change in times of financial stress where access to funds may be delayed, potentially leaving cash managers in a vulnerable position. Additionally, term deposits (deposits that are held for a pre-specified period of time) often come with breakage fees that penalise depositors for making early withdrawals, even in normal market conditions.

MMFs, on the other hand, offer much more robust liquidity to cash investors. They offer same-day liquidity (T+0) with funds available shortly following a redemption request. This rapid access to cash provides for more flexible cash management that does not involve the risks of unexpected delays and/or a bank not being able to meet its liabilities.

Bank deposits often require managing relationships with multiple banks to diversify large cash balances, which can complicate cash management operations. This diversification strategy is necessary to minimise exposure to any single bank, especially given the collapse of SVB, the fate of Credit Suisse and the concurrent regional bank crisis experienced during 2023. Counterparty risk due diligence adds another layer of complexity, requiring ongoing monitoring and assessments of each bank’s financial health. Additionally, executing specific instructions across several banks can lead to increased operational workload and risk of errors.

MMFs on the other hand, offer a more streamlined implementation. MMFs require only a single transaction to gain exposure to a diversified portfolio of investments, significantly reducing operational burden. Multiple methods for implementation such as sweep accounts and online portals provide flexibility and convenience, allowing cash managers to easily integrate MMFs into their existing systems. This not only saves time and reduces operational risk but also simplifies the management of large cash balances that would have to be spread out across banks were they to be deposited. With MMFs, ongoing maintenance is minimal. The money fund managers handle investment decisions and diversification that in turn frees up cash management professionals to focus on other important aspects of their firm’s broader financial strategy.

The fee structure for bank deposits can often be opaque and relationship dependent, varying widely based on the terms negotiated between bank and client. These fees may include service charges, account maintenance fees, breakage fees and other costs that are not always transparent. This can make it challenging to gauge the true costs and benefits of placing a deposit.

In contrast, MMFs offer a more straightforward fee structure, usually charging a single management fee embedded into the net yield of a fund. This allows cash managers to more clearly understand the costs associated with investing in a MMF versus a bank deposit. MMFs also do not charge separate fees for subscriptions or redemptions.* Lastly, since MMFs are professionally managed by large asset management companies, fees charged reflect the value of active management, credit due diligence and ongoing oversight. Overall, from a fee perspective MMF’s transparent and static fee structure make them a more attractive option compared to bank deposits.

The difference in pricing dynamics between bank deposits and MMFs is very important to understand. Deposit yields are normally driven by individual bank’s funding needs which varies from bank to bank. To this point, large banks that are well funded (and theoretically safer) probably don’t need to pay up on their deposits as much as a mid-to-small sized bank that needs funding and might be in a weaker financial position than larger counterparts. Generally, in aggregate banks lack the incentive to fully pass on prevailing short-term rates to depositors in an effort to maintain healthy net interest margins. The relationship between changes in deposit rates and changes in market-based short-term interest rates is commonly referred to as ‘deposit beta’ and illustrated above. You can see that in aggregate, deposit rates have lagged the Fed funds rate during tightening cycles. Furthermore, during past easing regimes, many times deposit rates haven’t caught up with the Fed funds rate by the time the Fed begins to cut.

MMFs provide a much more highly correlated yield profile to prevailing interest rates when compared to bank deposits and also have the benefit of being actively managed. During tightening episodes, MMFs are able to quickly pass on higher rates to investors. During easing episodes, MMFs can strategically term out maturities to preserve yield prior to rates falling. In most market regimes, MMFs have tended to outperform bank deposits with arguably a considerably lower risk profile.