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20 Apr 2012
What Does the Bank Do With Your Money? Alternatives Beyond Term Deposits

When debating whether to invest in a diversified New Zealand fixed interest portfolio or put your money in the bank, one question worth asking is, “What does the bank do with your term deposits?”

The bank can’t simply hold on to the term deposit and continue to pay interest.

What do they do with the money?

Simple, the bank invests in a diversified portfolio of fixed interest. They issue loans backed by property to mortgagees. They lend to large corporations and small businesses and receive interest in return. To control their risk the bank pays close attention to the credit worthiness of the borrowers and the length of the loans. Importantly, the bank issues many loans and is careful not to put all its money in one basket.

Alternatively, investors could consider investing in a diversified portfolio of fixed interest similar to the bank’s own portfolio. To provide a diversified portfolio of fixed interest there will be an advice fee plus a management fee, say 1.20% combined. However, I’d contend that fee is much smaller than the bank’s implied fee of what they earn on investors deposits versus what they give depositors in terms of guaranteed returns.

I acknowledge that the diversified portfolio of fixed interest bears more risk than the banks guaranteed deposit. However, if such a portfolio fails over the long term to provide positive returns, you can be sure the bank is also going to be in trouble. Why? Because the bank and the diversified fixed interest portfolio are investing in the same thing.

Now a diversified portfolio of fixed interest is liquid. The client can convert it to cash money in one week.  But how safe is it?

Looking at New Zealand Fixed Interest over the past 21 years, the worst:

  • 1 year return was 2.35% per annum (best was 16.34%)
  • 3 year return was 4.89% per annum (best was 9.37%)
  • 5 year return was 4.94% per annum (best was 8.11%
  • 10 year return was 5.71% per annum (best was 7.51%)

In other words it’s very unlikely to lose money over periods more than a year.

In some ways a diversified fixed interest portfolio is more secure than the bank. How so? Well, for one, many of the securities in the diversified fixed interest portfolio are bonds issued by banks. If the bank is borrowing from investors it must be lending to less credit-worthy borrowers at a premium. Note that most often a bank will borrow from investors at premium compared to what they pay depositors.  Beyond banks, the diversified fixed interest portfolio consists of large corporates like Fonterra and Auckland International Airport as well as the New Zealand Government.

What about the bank’s portfolio? Well in order to make larger returns the bank will often invest in small businesses. Almost every small business has a banking relationship. Small businesses pay big premiums to borrow money. The bank loves it. Remember they are still paying depositors 5% while they can charge small businesses, say, 15%. However, these businesses are much more likely to default than Fonterra or the NZ Government.

Now it doesn’t matter to a depositor if a single small business fails to return the money they borrow from the bank because the bank guarantees the deposit. And the bank protects itself by being widely diversified. But I’d argue that the bank’s fixed interest portfolio is riskier than the one we have on offer.

In other words, the diversified fixed interest portfolio has outperformed short term bank deposits. This is exactly what we expect to occur (especially over 3 or 5 year periods) into the future. Month by month, or even year by year, who knows, but over the long-term this advantage is almost required to occur. If it doesn’t, how can a bank offer those fat deposit rates? If the bank can’t get a high return on its fixed interest portfolio, how are they going to pay big deposit rates to investors? Thus the diversified fixed interest portfolio over the long term is almost destined to outperform deposits. Over the long-term it’s just about inevitable.

By the way, it’s the same principle for foreign diversified fixed interest, but the story is even better because you get much better diversification overseas than you get in New Zealand.

By Ben Brinkerhoff