Navigating liquidity strategies: the role of deposits

We shed light on the fundamental concept of deposits, explore their relevance to liquidity management, and discuss how base rate fluctuations may influence the landscape.

But with the recent hikes in interest rates, the landscape has shifted and whereas in the past deposits may not have been considered as part of the investment mix, a more disciplined approach to funding could now be beneficial.

After a protracted period of overlooking deposits, fund managers may want a refresher on the subject. We asked Lee Wilson, Liquidity Lead Institutional Banking at RBS International and the bank’s Head of Markets, Dave Ramasawmy, about the types of deposits available on the market today, their value in liquidity management, and how to factor in the potential impacts of interest rate rises.

Deposits 101

A ‘deposit’ describes funds placed with a bank or other financial institution for safekeeping – and ideally for generating returns. In the context of investment funds, we will look at two main types of deposits: money market deposits (also referred to as fixed term deposits) and notice deposits. 

"In a money market deposit, funds are placed for a fixed period of time” explains Lee. “Typically, this could range from one week to one year. The longer funds are placed out on deposit, generally the higher the interest rate. Those funds are locked up for the chosen period, but this allows customers to capture where the market is on that particular day, offering stability if interest rates come down.”

“A notice deposit provides more flexibility,” he adds, “as it allows funds to select a suitable notice period. It does what it says on the tin. Money is put on deposit, the customer provides notice to the bank based on an agreed time period, and then after that they receive the funds back. A notice deposit allows you to earn higher returns on your funds without committing to a longer term deposit.”

How deposits benefit liquidity risk management

Liquidity management is a crucial strategy for funds to ensure there is sufficient cash or easily convertible assets to meet financial obligations without incurring significant losses. Deposits can also be used as a tool to help mitigate inflation, by reducing the erosive effect of inflation on cash. “Liquidity needs to be a priority because it helps investment funds to make decisions and move quicker,” adds Lee. “It’s also important to keep capital aside for any obligations or debts they have coming up.” 

Deposits can play a pivotal role in liquidity strategy by enabling:

  • Immediate access to funds: By holding funds in money market deposits, investors can access the required cash as investment opportunities or other needs arise. “It’s important to keep some funds on instant access for your liquidity management,” says Lee. “The key is understanding how much.”
  • Risk mitigation: Deposits provide a secure means of preserving capital, especially during volatile market conditions, by offering a lower-risk alternative to investments. “With a money market deposit, your capital is protected, and it gives you a guaranteed return,” points out Lee.
  • Diversification: A liquidity strategy may include diversifying deposits across multiple banks and deposit types to reduce counterparty risk. “Segregation is something clients should think about; so not putting it all on a money market deposit, but looking at different types of deposits and keeping some on instant access,” advises Lee. “Then if interest rates come back down, you’ve hedged yourself by placing a portion of your funds on a longer-term deposit.”
  • Yield enhancement: As base rates increase, so should interest rates offered on money market or notice deposit accounts, enhancing the yield on cash holdings and contributing to the overall fund performance. “When interest rates are high, deposits are going to give a stronger yield – and those returns can go back into the fund,” says Lee.

The impact of base rate hikes on liquidity

The arguments for deposits in liquidity risk management are compelling, as long as fund managers monitor rate changes to balance maximum returns against sufficient liquidity. Any further spikes in inflation and subsequent interest rates hikes will have implications for their strategy.

“Interest rates have gone from near zero to 5.25% in about 2 years, which is a different equation for funds to solve,” says Dave. “These funds are not necessarily targeted to put cash on deposit, they’re targeted to deploy capital in line with their investment objectives. However if capital won’t be deployed for a known period of time, there is now a credible alternative use for those funds rather than leaving them in a low or zero per cent interest account as in the past. Investments now have to work harder to achieve a better return than deposits, so it’s a very different dynamic that could well lead to a change in investment behaviour.” 

This change might see investors reassessing their portfolios, and investment funds could experience capital inflows or outflows as they seek higher returns in other asset classes with potentially increased interest rates. “If they can achieve 5% from deposits, it may be that investors start looking for much higher returns from the funds. For example they might think differently about holding riskier investments that might not get that 5% return,” points out Dave. 

Hiked interest rates also mean increased borrowing costs so “evaluating and renegotiating financing arrangements therefore becomes crucial to managing both expenses and liquidity effectively” says Dave.

In a volatile, high-inflation, high-interest rate environment, funds with a flexible mindset in their approach to deposits will be well placed to both protect liquidity and offer solid returns to investors.

With the right strategy, there is an opportunity to place available funds where they can get an enhanced return, believes Lee. ”Funds that don’t consider it may feel they’ve missed out, as and when rates start coming back down.”

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