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Deposit Convexity, Monetary Policy and Financial Stability

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Abstract

In principle, bank deposits can be withdrawn on demand. In practice, depositors tend to maintain stable balances for long periods, allowing banks to fund long-dated assets. Nevertheless, the cost of deposit funding influences banks’ capacity for maturity transformation. Banks and researchers conventionally model the response of deposit interest rates to market interest rates as constant, implying that deposits have nearly constant duration. Contrary to this standard assumption, we show empirically that the “beta” of deposit rates to market rates increases as market rates rise, causing the duration of deposits to fall. The amount of duration risk delivered to bank balance sheets via this channel from March 2022 to September 2023 is comparable in magnitude to the amount of duration risk absorbed by each of the several large-scale asset purchase programs the Federal Reserve has undertaken since 2008. Dynamic betas present a significant challenge to bank portfolio hedgers by introducing large and dynamic risks that are difficult to model and impractical to replicate on the asset side of the balance sheet. As a result, deposit convexity amplifies monetary policy transmission and increases financial fragility, mechanisms that recent banking stresses have highlighted.

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  • Emily Greenwald & Sam Schulhofer-Wohl & Josh Younger, 2023. "Deposit Convexity, Monetary Policy and Financial Stability," Working Papers 2315, Federal Reserve Bank of Dallas.
    • Handle: RePEc:fip:feddwp:97131
    DOI: 10.24149/wp2315
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    References listed on IDEAS

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    1. Itamar Drechsler & Alexi Savov & Philipp Schnabl, 2017. "The Deposits Channel of Monetary Policy," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 132(4), pages 1819-1876.
    2. Canlin Li & Min Wei, 2013. "Term Structure Modeling with Supply Factors and the Federal Reserve's Large-Scale Asset Purchase Progarms," International Journal of Central Banking, International Journal of Central Banking, vol. 9(1), pages 3-39, March.
    3. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, vol. 24(Win), pages 14-23.
    4. James D. Hamilton & Jing Cynthia Wu, 2012. "The Effectiveness of Alternative Monetary Policy Tools in a Zero Lower Bound Environment," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 44(s1), pages 3-46, February.
    5. Itamar Drechsler & Alexi Savov & Philipp Schnabl, 2021. "Banking on Deposits: Maturity Transformation without Interest Rate Risk," Journal of Finance, American Finance Association, vol. 76(3), pages 1091-1143, June.
    6. Deborah Leonard & Antoine Martin & Simon M. Potter & Brett Rose, 2017. "How the Fed Changes the Size of Its Balance Sheet: The Case of Mortgage-Backed Securities," Liberty Street Economics 20170711, Federal Reserve Bank of New York.
    7. Canlin Li & Min Wei, 2012. "Term structure modelling with supply factors and the Federal Reserve's Large Scale Asset Purchase programs," Finance and Economics Discussion Series 2012-37, Board of Governors of the Federal Reserve System (U.S.).
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    More about this item

    Keywords

    banks; Depository institutions; interest rates; bank run; financial markets; central bank; monetary policy; Policy Effects;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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