By Randy Schwimmer

For some time, US regulators have been discouraging banks from making “risky loans”. Now we’re learning of their concerns about banks taking “risky deposits” as well. There’s no mention yet of any plans to clamp down on giving away free toasters.

It seems the Fed and other agencies are worried about two related scenarios. First, when interest rates rise, individual depositors take cash out of non-interest bearing accounts in search of higher yields. JP Morgan’s CFO has predicted banks could lose $1 trillion in liquidity.

Some may be less well-equipped than others to deal with this. American Banker highlighted 14 institutions ranked by percentage of non-interest bearing deposits. Three regionals topped the list: Comerica (44%), Zions (41%) and M&T (36%). If that cheap funding goes away, its replacement will be more costly.

The other scenario involves corporate cash. For the same reason consumers have been indifferent about leaving large balances in zero or near-zero yield accounts, big businesses have accumulated billions of dollars in their house banks. But regulations kicking in this month say that banks must hold greater reserves for these kinds of accounts and customers, in order to cover for any swift exit of deposits. There is about $4 trillion in uninsured deposits at US banks involving more than 3.5 million accounts, according to the Federal Deposit Insurance Corporation.

As a result, banks including JP Morgan, Citibank and Bank of America are quietly suggesting to corporations, hedge funds, insurance and finance companies, that they find alternative parking for their excess balances, or pay fees.

OK, this is very interesting for bankers. But why should we care?

Banks historically have benefited from the cheap capital free deposits represent. They lend out that money and earn a nice spread on the difference. If those deposits go elsewhere, banks must raise their minimum lending yields. But with regulators also clamping down on higher yield opportunities, there are fewer places for the industry to go.

So let’s see. Banks can’t take deposits, and can’t lend them out. What’s left?

One interesting avenue, featured in a recent piece by Lincoln International’s Ron Kahn, is in providing liquidity for alternative lenders. For all the diligence regulators have shown in putting fences around risky loans, they seem to have ignored banks’ moves to extend leverage to BDCs, hedge funds and credit opportunity funds, which all invest in leveraged loans.

The middle market is particularly fertile ground for non-bank lenders, as the broadly syndicated market remains dominated by institutional investors, such as CLOs and retail loan funds. For BDCs the ability to obtain leverage from banks allows these vehicles to migrate up the borrower’s capital structure.

Instead of buying mostly junior debt, such as second lien term loans and mezzanine tranches to meet their higher return hurdles, BDCs with leverage can invest profitably in senior debt as well. Two times leverage, for example, means the yield on senior debt can match that of junior debt, with less risk.

Capital, like water, finds its own level. The unremitting pressure on banks to eschew risky loans and deposits will shift cheap and easy money to the non-regulated sector. Only the regulators know whether this consequence was intended.

Randy Schwimmer is a former member of senior management and investment committees for two leading mid-market debt platforms. He is also founder and publisher of The Lead Left (theleadleft.com), a weekly newsletter about trends and deals in the capital markets.

This column first appeared in the weekly newsletter of Creditflux, a leading global information source for the credit trading and investment market.