Backdated deposit beta

What Is Deposit Beta?

Deposit beta is a financial metric used primarily in the banking sector to quantify the responsiveness of a bank's deposit interest rates to changes in broader market interest rates. It is a key concept within interest rate risk management, helping financial institutions understand and predict the cost of their deposit funding. A deposit beta of 0.4, for example, indicates that if the prevailing market interest rate increases by 100 basis points, a bank will, on average, raise its deposit rates by 40 basis points²⁸. This metric is crucial for banks as deposits constitute a significant portion of their balance sheet funding.

History and Origin

The concept of deposit beta gained prominence as a tool for understanding the dynamics between bank funding costs and monetary policy. While banks have always managed the relationship between the rates they offer depositors and broader economic rates, the formalization and widespread use of the "deposit beta" as a distinct measure in academic literature and industry practice evolved with increasingly volatile interest rate environments. Researchers Itamar Drechsler, Alexi Savov, and Philipp Schnabl are credited with introducing the deposit beta to academic literature through a series of papers, including "Banking on Deposits: Maturity Transformation without Interest Rate Risk" (2021) and "The Deposits Channel of Monetary Policy" (2017)²⁷. These works have significantly contributed to understanding how central bank actions, particularly changes to the federal funds rate, transmit through the banking system to influence deposit costs.

Key Takeaways

• Deposit beta measures how sensitive a bank's deposit rates are to changes in general market interest rates.
• A higher deposit beta indicates that a bank's deposit costs are more responsive to market rate fluctuations.
• It is a crucial metric for banks in managing their profitability and net interest margin.
• Deposit betas can vary significantly by type of deposit, institution, and economic cycle.
• Understanding deposit beta is vital for effective risk management in the banking industry.

Formula and Calculation

The deposit beta is calculated as the ratio of the change in a bank's deposit rate to the change in a benchmark market interest rate. This can be expressed as:

Where:

• (\Delta \text{Deposit Rate}) represents the change in the interest rate paid on deposits by a bank.
• (\Delta \text{Market Interest Rate}) represents the change in a reference market interest rate, such as the federal funds rate or a Treasury bill rate.

For example, if the federal funds rate increases by 0.50% (50 basis points) and a bank responds by increasing its savings accounts rate by 0.25% (25 basis points), the deposit beta for that savings account would be 0.50 or 50%²⁵, ²⁶. It can be calculated for individual rate decisions or as a cumulative measure over a full interest rate cycle²³, ²⁴.

Interpreting the Deposit Beta

Interpreting the deposit beta involves understanding its implications for a bank's financial health and its responsiveness to the broader economic environment. A deposit beta typically ranges from 0 to 1 (or 0% to 100%). A beta closer to 1 (or 100%) indicates that the bank is passing on nearly all of the market rate changes to its depositors, meaning its deposit costs are highly sensitive. Conversely, a beta closer to 0 implies that the bank's deposit rates are largely unresponsive to market changes, providing a more stable, lower-cost funding base²².

For commercial banks, a low deposit beta in a rising rate environment is generally favorable for profitability, as their funding costs rise slower than their asset yields. However, a very low beta might also indicate that deposits could be at risk of moving to competitors offering higher rates, particularly during periods of intense competition for funds²¹. Different types of deposits, such such as time deposits versus checking accounts, often exhibit varying deposit betas, with time deposits typically being more rate-sensitive²⁰.

Hypothetical Example

Consider a regional bank, "Community First Bank," operating in an environment where the prevailing federal funds rate, used as a benchmark for short-term market rates, is 2.00%. Over a quarter, the Federal Reserve raises the federal funds rate by 50 basis points, bringing it to 2.50%.

In response, Community First Bank adjusts its average interest rate paid on its core deposits from 0.75% to 1.00%.

To calculate the deposit beta for Community First Bank for this period:

• Change in Deposit Rate = 1.00% - 0.75% = 0.25% (25 basis points)
• Change in Market Interest Rate = 2.50% - 2.00% = 0.50% (50 basis points)

Applying the formula:

This indicates that Community First Bank's deposit beta is 0.50. For every 100 basis point increase in the market rate, the bank's deposit rates would, on average, increase by 50 basis points. This hypothetical example demonstrates how a bank's funding costs are directly impacted by changes in broader market rates, highlighting the importance of managing deposit beta.

Practical Applications

Deposit beta is a critical tool for financial institutions in several areas:

• Asset-Liability Management (ALM): Banks use deposit beta to forecast future interest expenses and model how changes in interest rates will impact their net interest margin and overall profitability. This forms a core part of their ALM strategies¹⁹.
• Interest Rate Risk Measurement: Regulators, such as the Office of the Comptroller of the Currency (OCC), emphasize the importance of managing interest rate risk. Deposit betas are integral to this assessment, allowing banks to quantify their exposure to fluctuating rates¹⁷, ¹⁸.
• Pricing Strategy: Understanding deposit beta helps banks determine competitive deposit rates that attract and retain customers without excessively eroding profitability. Banks with lower betas may have a competitive advantage in rising rate environments by not needing to increase rates as quickly as competitors¹⁶.
• Stress Testing: Financial institutions conduct stress tests by modeling various interest rate scenarios and assessing their impact on profitability and capital adequacy. Varying deposit beta assumptions is a key component of these stress tests to understand potential vulnerabilities¹⁵.
• Monetary Policy Transmission: From a macroeconomic perspective, deposit betas are a measure of how effectively monetary policy changes by central banks are transmitted through the banking system to the real economy. For instance, the Federal Reserve Bank of New York actively researches how deposit rates respond to monetary policy shifts and the factors influencing deposit betas¹⁴.

Limitations and Criticisms

While deposit beta is a valuable metric, it has several limitations and criticisms:

• Historical Nature: Deposit betas are often calculated using historical data, meaning they reflect past behavior and may not perfectly predict future responsiveness. Market dynamics, competitive landscapes, and depositor behavior can change, leading to shifts in deposit betas over time¹², ¹³. For example, the rapid pace of Federal Reserve rate hikes in 2022-2023, coupled with digital banking innovations and social media, challenged historical beta assumptions for many banks, leading to higher-than-expected deposit cost increases¹¹.
• Varying Conditions: The sensitivity of deposits to interest rates can vary significantly depending on the economic cycle, the competitive environment, and the specific characteristics of the deposits (e.g., consumer vs. commercial, liquid vs. fixed-term). A single deposit beta may not capture the full complexity of a bank's deposit base⁹, ¹⁰.
• Zero-Lower-Bound Issues: When market interest rates are near zero, the concept of a deposit beta can become less meaningful or even misleading, as deposit rates may not fall proportionally or at all below zero⁸.
• Qualitative Factors: Deposit beta is a quantitative measure and does not fully account for qualitative factors influencing depositor behavior, such as customer loyalty, brand reputation, or the convenience of banking services. Banks may choose to maintain lower deposit rates to preserve profitability, relying on these non-rate factors to retain customers⁷.
• Liquidity Considerations: In times of stress or rapid market changes, deposit outflows can be swift, particularly with the ease of digital transfers. While deposit beta measures rate sensitivity, it may not fully capture the dynamics of sudden liquidity risk driven by non-rate factors, as highlighted by a Bank for International Settlements (BIS) working paper on fragile wholesale deposits⁶.

Deposit Beta vs. Asset Beta

Deposit beta and asset beta are related but distinct concepts used in banking to measure interest rate sensitivity on different sides of a bank's balance sheet.

• Deposit Beta: As discussed, this measures the sensitivity of a bank's deposit interest rates (a liability for the bank) to changes in external market interest rates. It indicates how much the cost of a bank's funding changes in response to market shifts.
• Asset Beta: This concept, conversely, refers to the sensitivity of a bank's loan rates and investment yields (its assets) to changes in market interest rates. For instance, a high asset beta would mean that the interest earned on a bank's loans and investments quickly reprices upwards when market rates rise.

Confusion between the two can arise because both relate to how a bank's interest income and expenses react to rate movements. However, deposit beta specifically focuses on the funding cost side, while asset beta focuses on the earning asset side. Banks actively manage the difference between asset and deposit betas to optimize their net interest margin and manage their overall interest rate risk. Generally, banks aim for assets to reprice with a higher beta than deposits in a rising rate environment to increase their profitability⁵.

FAQs

How does deposit beta affect a bank's profitability?

A lower deposit beta generally benefits a bank's profitability, especially when market interest rates are rising. This is because the bank's funding costs (what it pays on deposits) increase more slowly than the interest rates it earns on its loans and investments, thus expanding its net interest margin. Conversely, a high deposit beta can squeeze profits in a rising rate environment.

Do all types of deposits have the same deposit beta?

No, deposit betas can vary significantly across different types of deposits. For example, highly liquid accounts like checking accounts often have a lower beta (less sensitive to rate changes) compared to time deposits or certain savings accounts where depositors are typically more rate-sensitive and willing to move funds for higher yields⁴.

What is a "good" deposit beta for a bank?

There isn't a universally "good" deposit beta; it depends on the bank's strategy, asset mix, and the prevailing interest rate environment. In a rising rate environment, a lower deposit beta is generally desirable for profitability. However, a bank must balance a low beta with the need to retain deposits and remain competitive, as an excessively low beta could lead to deposit outflows if customers seek higher yields elsewhere.

How do central bank actions influence deposit beta?

Central bank actions, particularly changes to the benchmark federal funds rate, directly influence the market interest rates to which deposit betas are measured. When a central bank raises its target rate, banks face pressure to increase their deposit rates to remain competitive, leading to an increase in their deposit betas as they pass through more of the rate hike³.

Is deposit beta a regulatory requirement?

While deposit beta itself is not a direct regulatory requirement, its underlying concept is central to bank supervision and interest rate risk management. Regulators, such as the OCC and the Federal Reserve, expect banks to have robust processes for identifying, measuring, monitoring, and controlling their interest rate risk exposures, for which deposit beta analysis is a crucial component¹, ².