Banks' Treasury Holdings Continue to Rise

Increases in U.S. banks’ holdings of Treasury securities continue to put downward pressure on long-term U.S. interest rates. Banks’ demand should continue, as suggested by recent FDIC data.

Treasury Holdings at All-Time High

In last week’s Interest Rate Weekly, we discussed how increased demand for Treasury securities by large financial institutions was helping to maintain downward pressure on U.S. interest rates and should lead to a flatter yield curve moving forward. Recent data from the Federal Deposit Insurance Corporation (FDIC) show demand from banks remained strong in Q1. Whether it is because of regulatory requirements or changing riskpreferences from FDIC-insured banks, we can clearly see these firms’ holdings of Treasury securities surge higher beginning in early 2014 (top chart).

Looking at a historical perspective, however, we can see that Treasury securities relative to total assets at banks are not currently accounting for an unprecedented share of banks’ balance sheets (top chart). Treasuries as a share of total assets trended downward steadily until the financial crisis. Following the crisis, Treasury holdings increased rapidly, in part because of the factors mentioned earlier.

Although banks’ holdings of Treasury securities have certainly spiked, and increased capital holding requirements are likely one reason for the increase, it is difficult to say that this is the only cause. Deposit liabilities on banks’ balance sheets have continued to trend higher, leaving banks with additional cash to put to work. In addition, the net interest margin, at 3.02 percent, is at a historically low level (middle chart). This implies that lending is relatively less profitable in the aggregate, although less risk taking could be another cause for the low net interest margin. Recall, the net interest margin is net interest income divided by the average earning assets, so a less risky mix of assets, all else equal, would imply a lower net interest margin.

When we combine all these factors with the low Treasury issuance that we have seen recently and the increased size of the Fed’s balance sheet, we are left with continued downward pressure on U.S. Treasury rates.

Treasury Demand and the Yield Curve

We do not expect many of these factors depressing yields to lessen in the coming months. Demand for Treasury securities by banks should continue, as increased regulatory requirements will make holding Treasuries more attractive relative to other assets and types of lending. Although we expect interest rates to migrate modestly upward over time, we are looking for the yield curve to flatten over the coming years. This should keep downward pressure on the net interest margin, as banks’ cost of funding increases relative to their revenues. However, we maintain the view that yields, particularly at the long end of the curve, will continue to experience greater volatility.