Jake Miller
The 2007-2009 financial crisis highlighted the importance of depositor discipline and its impact on banks' liquidity. The study of depositor discipline focuses on the relationship between depository institutions' risk and the pricing and growth of uninsured deposits. This relationship is particularly evident in the auctions of unsecured money market deposits, where firms observe banks' interest rate bids and make decisions on where to deposit their funds. The selection of firms where deposits are made is influenced by the notion of credit rationing, with risky banks potentially exiting the market temporarily. This dynamic has significant implications for banks' access to corporate funding and the overall understanding of deposit markets and Fintech.
| Characteristics | Values |
|---|---|
| Deposit interest rate bids | Increase with banks' risk |
| Corporate depositor preference | Higher deposit interest rates |
| Firm selection | Concave in bid interest rate |
| Risky banks | Exit the market when interest rates increase above the central bank's rate |
| Bank re-entry | Risk decreases in the long term |
| Liquidity provision | Banks honored credit lines during the 2007-2009 crisis |
| Loan spreads | Repeated borrowing lowers loan spreads by 10-17 bps |
| Depositor discipline | Examined through the effect of depository institutions' risk on uninsured deposits |
| Demandable-debt finance | Entails costs of bank suspension, liquidation, and idle reserve holdings |
| Deposit risk | Larger-than-expected cash outflow due to changes in depositor behavior |
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What You'll Learn
Deposit interest rate bids increase with banks' risk
Banks have faced the challenge of rising deposit costs over the past two years. Rates paid on deposits have increased sharply since March 2022, when monetary policy tightened. This has compelled banks, especially community banks, to increase the rates they pay for deposits. These higher funding costs have implications for bank earnings and capital. Banks can increase earnings by raising the interest rates charged on loans more than the rates paid for deposits.
Deposit betas vary across time and account and institution types. Betas for checking accounts tend to be lower than for time deposits, as consumers want ready access to funds and are willing to earn little to no interest. Internet banks tend to have very high deposit betas because their customers shift money across online institutions to find the highest interest rates. A cumulative deposit beta measures the change in deposit rates since the start of the most recent rate-hiking cycle.
When interest rates change, the yields on banks' assets and liabilities also change. Rising interest rates reduce the present value (PV) of fixed-rate assets but also decrease the PV of fixed-rate liabilities as alternative sources of financing become more expensive. The nature of bank liabilities is critical to determining the economic value of equity (EVE) of the bank. Deposits make up roughly 80% of bank liabilities, so EVE calculations are highly sensitive to deposit behaviour. A significant portion of deposits do not respond one-for-one with interest rates, so a large portion of deposit funding is exposed to interest rate risk.
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Corporate depositors prefer higher interest rates
Corporate depositors tend to prefer higher interest rates. This is supported by the fact that banks have been compelled to increase the rates they pay for deposits. These higher funding costs have implications for bank earnings and capital. When interest rates rise, banks have the opportunity to increase earnings by raising the interest rates charged on loans more than the rates paid for deposits.
Depositors' sensitivity to interest rates can be measured by a "deposit beta". Betas generally range from 0 to 1. A beta closer to 1 indicates that a bank's deposits are highly sensitive to interest rate changes, whereas a beta closer to 0 indicates very little sensitivity to changing interest rates.
During and after the COVID-19 pandemic, banks were flush with deposits due to government stimulus payments and limited spending opportunities. However, as consumers increased their spending, banks faced competition from other funding options, such as credit unions, fintech firms, and money market funds. As a result, banks had to increase deposit rates to retain their core funding.
While deposit rates have increased, they have not kept pace with yields on alternative investments. Despite this, depositors tend to stay with banks due to the convenience and safety of bank deposits. Deposit products that impose withdrawal restrictions, minimum balances, or have long maturities must compensate depositors with higher rates.
In summary, corporate depositors prefer higher interest rates, and this preference has implications for banks' funding strategies and earnings. Banks aim to balance retaining core funding with managing the costs associated with higher interest rates.
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Risky banks exit the market
Risky banks exiting the market is a phenomenon that has been observed in the context of corporate depositor behaviour and financial crises. The exit of risky banks from the market can occur due to various factors, including depositor discipline, changes in interest rates, and liquidity risks.
Depositor discipline refers to the behaviour of corporate depositors in response to the risk level of banks. In auctions of unsecured money market deposits, firms generally prefer higher deposit interest rates and are willing to accept higher risk. However, when the interest rate offered by risky banks increases above the central bank's rate, these banks may exit the market as they lose their competitive advantage.
During financial crises, banks may face challenges in maintaining their liquidity position. While banks honoured credit lines during the 2007-2009 crisis, the provision of liquidity comes at a cost, including bank suspension and liquidation. Risky banks with weaker financial positions may struggle to withstand these pressures and may be forced to exit the market temporarily or permanently.
Liquidity risk, specifically deposit risk, can also contribute to risky banks exiting the market. Deposit risk arises when there is an unexpected cash outflow due to changes in depositor behaviour. This can include early withdrawals, roll-over risk, and run risk, where depositors remove their funds from the bank. When faced with significant deposit outflows, risky banks may not have the financial stability to withstand the impact, leading to their exit from the market.
The exit of risky banks from the market can have important implications for the financial system. It can affect banks' access to unsecured corporate funding and their ability to provide liquidity during crises. Additionally, the exit and potential re-entry of risky banks can influence the understanding of deposit markets and the development of Fintech solutions in the financial industry.
In summary, the exit of risky banks from the market is a dynamic process influenced by various factors, including depositor behaviour, interest rates, and liquidity risks. Understanding the factors contributing to risky banks' exit can provide insights into depositor discipline, market stability, and the overall health of the financial system.
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Banks' liquidity provision in financial crises
Banks are particularly vulnerable to liquidity problems because much of their revenue is generated by lending long-term loans and borrowing short-term from depositors' accounts. A liquidity crisis refers to a widespread increase in demand for and decrease in supply of liquidity in an economy. This can be triggered by large, negative economic shocks or normal cyclical changes. During such a crisis, banks tend to increase their holdings of liquid assets and reduce new lending.
The 2007-2008 financial crisis was a significant shock to the banking system, and it raised questions about liquidity risk. The global financial system experienced urgent demands for cash from counterparties, short-term creditors, and borrowers. Credit fell, and banks cut back on lending. Central bank emergency lending programs helped mitigate the decline.
During a financial crisis, banks may struggle to attract deposits and provide liquidity to borrowers shut out of securities markets. This was observed during the 2007-2009 crisis, where banks honoured credit lines drawn by firms, but their ability to meet the demand for liquidity was impacted.
Risky banks may face challenges in obtaining funding from corporate depositors. Research analyzing auctions of unsecured money market deposits shows that deposit interest rate bids increase with banks' risk. Firms generally prefer higher deposit interest rates, but they may also consider the credit risk of the bank. Risky banks may exit the market when interest rates increase above the central bank's rate, impacting their access to unsecured corporate funding and liquidity provision.
Overall, banks' liquidity provision during financial crises is complex and depends on various factors, including their initial liquidity-risk exposure, the availability of central bank support, and their ability to attract deposits and manage credit demand.
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Deposit risk and its implications
Deposit risk is a type of liquidity risk faced by financial institutions, arising from deposits with or without defined maturity dates. This risk is associated with potential cash outflows due to changes in depositor behaviour, including early withdrawals, redemption, rollover, and run risks. The early withdrawal of time deposits before their maturity date poses a significant threat to financial institutions, potentially leading to a loss of liquidity. Consequently, financial institutions may struggle to refinance by borrowing to repay existing deposits, a scenario known as refinancing risk.
The primary factors influencing early withdrawal and rollover risks include interest rates, the term to maturity and age of the deposit, the financial institution's credit rating, and the amount of deposit insurance. A critical consideration in managing deposit risk is the evaluation of "Cash Flow at Risk" (CFaR), which helps assess the potential cash outflows a financial institution may encounter.
The implications of deposit risk can be far-reaching. For instance, during the bank failures in spring 2023, the reliance on deposit franchises as a hedge against interest rate risk was exposed as depositors became concerned about the bank's solvency. This highlights the delicate balance between deposit rates and the effectiveness of hedging strategies in insulating the economic value of equity (EVE) from interest rate shocks.
Deposit insurance, which guarantees deposits up to a legal limit, can have both positive and negative consequences. On the one hand, it can prevent or reduce the occurrence of bank runs. On the other hand, it may encourage banks to take on unnecessary risks, increase their leverage, or invest in riskier assets, ultimately increasing the government's exposure to losses. This moral hazard, as described by Professor William Lovett, diminishes the incentives for depositors and shareholders to monitor their banks' activities critically.
The inherent nature of banking, which involves providing financial liquidity, contributes to the unstable balance sheet of banks. Banks accept liquid deposits and reinvest them in long-term, illiquid loans, assuming the risk of holding these illiquid assets. This dynamic underscores the importance of understanding and effectively managing deposit risk to maintain the stability and credibility of financial institutions.
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Frequently asked questions
Deposit risk is a form of liquidity risk that occurs when a larger-than-expected cash outflow is removed from a financial institution due to changes in depositor behaviour.
There are three main factors: early withdrawal or redemption risk, roll over risk, and run risk. Early withdrawal occurs when a depositor withdraws funds before the maturity date. Roll over risk happens when a depositor doesn't agree to roll over their matured time deposit. Run risk is associated with non-maturity deposits where the depositor can remove funds at any time.
In auctions of unsecured money market deposits, firms observe banks' interest rate bids and make decisions based on their preferences for higher deposit interest rates.
Risky banks may exit the market when the interest rate they offer exceeds the central bank's interest rate. They can re-enter the market when their risk profile improves in the long term.
During the 2007-2009 financial crisis, banks honoured credit lines drawn by firms, demonstrating their ability to provide liquidity during challenging economic periods.
