Reducing bail-in risk with money market funds

Recent bank turmoil and bank deposits

The recent collapse of Silicon Valley and Credit Suisse failure sparked turmoil in the banking sector, and uncertainly over bank solvency and the security of bank deposits. The speed at which Silicon Valley deteriorated to the point of collapse highlighted how quickly bank runs can occur, and how quickly banks can find themselves in severe difficulty.

In the UK, the Financial Services Compensation Scheme (FSCS) insures deposits up to £85,000 per individual. In the event that a financial institution gets into difficulty, deposits above this amount would mean bail-in rules override the FSCS and those uninsured deposits would be eligible in providing financial relief to a failing institution.

Rationale and objectives of bail in

The purpose of a ‘bail-in’ is to rescue a failing bank. The 2008 global financial crisis showed that some banks could not be unwound under a conventional liquidation process without a substantial and adverse effect on the economy. As such they were bailed out by the UK government who were forced to provide billions of pounds in support which subsequently prompted the bank liability structure to come under scrutiny, and new legislation to be passed. Whilst bail-in ensures financial stability, it forces creditors to bear the cost of recapitalisation should the institution find themselves in financial difficulty, which will undoubtedly lead to investor uncertainty and unease.

The Creditor Hierachy

Bail-in would be applied in accordance with the insolvency creditor hierarchy which sets out the order in which creditors and depositors would receive reclamation should a bank become insolvent. There are exemptions however: Covered bonds, government debt, mortgage-backed securities and Canadian debt with a maturity of less than 400 days are all exempt from bail-in.

Source: RLAM.

Money market funds vs Fixed bank deposits

Cash investors often balance the need for capital preservation, liquidity and yield. However, it is more often the case that not all of those goals can be achieved at any one time. Money market funds offer liquidity and diversification of high-quality assets. They invest not only in bank deposits and money market instruments, but also in longer duration assets offering higher yields.

Due to a money market fund’s short duration, the yield should keep pace with rising rates as proceeds from maturing assets can be reinvested in higher yielding assets. By contrast, rates on fixed deposits are determined by the bank itself and will depend on its balance sheet and funding requirements at the time of issue. Depositors are exposed to a single bank’s creditworthiness which represents a sustained risk throughout the life of the deposit. Fixed deposits do not offer the same liquidity that money market funds offer, and the bank may impose penalties should an investor wish to redeem their funds prior to maturity.

Recent events have highlighted the risks associated with single bank deposits and how quickly contagion risk can spread. Whilst bank failures and bail-ins are not an everyday occurrence, they are a consideration which needs to be made by cash investors who are considering a single bank deposit against a money market fund.

Our most liquid strategies invest predominantly in traditional money market instruments, with typically a little over half of their assets eligible for bail-in. Our short-term fixed income strategies for investors with a slightly longer investment horizon include a range of short-term credit instruments, but our use of and bias towards covered bonds means that these strategies usually have a slightly lower weighting, with around half of these typically invested in bail-inable assets.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.