Why large banks provide lower deposit rates than small banks
In this paper, d’Avernas et al. develop a model that explains the pricing behavior of large and small banks based on differences in preferences and technologies, rather than on market power derived from concentrated market shares. The authors build on the model by Drechsler, Savov, and Schnabl (2017) and extend it to include heterogeneity in households’ preferences and banks’ liquidity services. For the empirical part of the paper, they use data for U.S. banks from Bank Call reports that aggregate deposit products and the RateWatch Data from S&P Global which includes branch-level deposit rates, for the period from 2001 to 2019. Their findings include:
- Large banks tend to offer uniform deposit rates across their branches, provide lower deposit rates than small banks, and are more likely to be located in markets with less deposit-rate-elastic customers.
- Despite being located in areas typically associated with greater financial sophistication, customers of large banks earn lower average deposit rates and exhibit lower deposit-price elasticities. The paper suggests that customers of large banks value superior liquidity services more highly, which leads to lower deposit-rate elasticities.
d’Avernas et al. also discuss the implications of these findings for bank valuations and financial stability. They note that the franchise values of deposit businesses are a key driver of bank value and that large banks, despite having higher spreads and lower elasticities, have lower valuation ratios. The authors argue that understanding the deposit business at large vs. small banks is crucial for measuring financial stability, especially in light of recent bank failures and discussions regarding bank interest-rate risks.
The Deposit Business at Large vs. Small Banks
Authors: Adrien d’Avernas, Andrea L. Eisfeldt, Can Huang, Richard Stanton, Nancy Wallace
From: Stockholm School of Economics, UCLA Anderson School of Business, Gies College of Business, U.I. Urbana-Champaign, Haas School of Business, U.C. Berkeley
When the interest rate sensitivity of deposits is not constant
In this paper, Greenwald et al. explore the dynamic relationship between bank deposits, monetary policy, and financial stability, with a focus on the concept of deposit convexity. The authors challenge the conventional modeling of bank deposits’ interest rate sensitivity (beta) as constant, revealing that the beta of deposit rates to market rates actually increases as market rates rise. They use a simple model of interest rate risk on banks’ deposits and data from Bank Call reports of U.S. banks (as in the paper above) and look at how bank deposit interest rates and total funding costs have evolved over three recent monetary policy tightening cycles: 2004–2007, 2015–2019 and the cycle that began in 2022 (for data through June 2023). They find that:
- “Modeling interest rate risk with static betas tends to overstate the duration of deposits when rates are low and understate duration when rates are high. Importantly, relying on this overstated duration of deposits increases run risk in the transition away from the effective lower bound (ELB) on interest rates by allowing for the fair value of fixed-income assets to deteriorate more quickly than the fair value of the deposit franchise actually increases.”
Implications for Monetary Policy and Financial Stability:
- Amplification of Monetary Policy Transmission: Deposit convexity enhances the bank lending channel of monetary policy transmission. Rising interest rates, by shortening the effective duration of deposits, reduce banks’ incentive to lend more rapidly than if deposit betas were static.
- Increased Financial Fragility: The paper highlights how deposit convexity can exacerbate financial fragility. Dynamic betas, by altering the interest rate risk profile of banks, can contribute to banking stresses, as recent events have underscored.
Deposit Convexity, Monetary Policy, and Financial Stability
Authors: Emily Greenwald, Sam Schulhofer-Wohl, Joshua Younger
From: Federal Reserve Bank of Dallas, Federal Reserve Bank of New York
