Deposit run off

What Is Deposit Run-Off?

Deposit run-off refers to the rate at which deposits are withdrawn from a bank or other financial institution over a specified period. It represents the outflow of funds from a bank's balance sheet as depositors choose to move their money elsewhere. This phenomenon is a critical component of liquidity risk management within the broader category of Banking and Financial Risk Management. While some level of deposit run-off is normal in daily operations, an accelerated or unexpected deposit run-off can signal underlying issues with the institution's stability, potentially leading to a financial crisis if not managed effectively. Understanding deposit run-off is essential for assessing a bank's vulnerability to sudden outflows and its ability to meet its obligations.

History and Origin

The concept of deposit run-off has been implicitly understood for as long as banks have existed, particularly since the adoption of fractional reserve banking. Historically, the most dramatic instances of rapid deposit run-off manifested as "bank runs," where widespread panic led to simultaneous withdrawals. The Great Depression in the United States, for example, saw thousands of bank failures due to such widespread withdrawals, severely damaging the economy¹⁴. This period underscored the fragility of financial systems reliant on public confidence and spurred significant regulatory reforms. One of the most pivotal responses was the creation of the Federal Deposit Insurance Corporation (FDIC) in 1933, designed to provide deposit insurance and thereby prevent widespread panic and subsequent deposit run-off.¹³. The FDIC's establishment aimed to restore and maintain public trust, making it safer to keep money in banks¹².

Key Takeaways

• Deposit run-off is the rate at which funds are withdrawn from a bank's deposits over time.
• It is a key indicator of a bank's liquidity risk and funding stability.
• Regulatory frameworks, such as Basel III, incorporate expected deposit run-off rates to ensure banks maintain adequate liquid buffers.
• Unexpected or rapid deposit run-off can trigger severe liquidity crises and potentially lead to bank failure.
• Effective asset-liability management is crucial for mitigating the risks associated with deposit run-off.

Formula and Calculation

The concept of deposit run-off is central to the calculation of a bank's Liquidity Coverage Ratio (LCR), a regulatory metric designed to ensure banks have sufficient High-Quality Liquid Assets (HQLA) to withstand a 30-day liquidity stress scenario. The LCR incorporates specific "run-off factors" applied to various types of deposits.

The formula for LCR is:

Where:

• Stock of HQLA: The total amount of unencumbered assets that can be easily and immediately converted into cash.
• Total Net Cash Outflows over 30 days: Calculated as total expected cash outflows minus total expected cash inflows, capped at 75% of outflows.

To determine the "Total Expected Cash Outflows," different deposit categories are multiplied by their assigned run-off factors. For instance, according to Basel III guidelines, stable retail deposits might have a 5% run-off factor, while less stable deposits or certain types of wholesale funding could have significantly higher factors, ranging up to 100%¹¹,¹⁰.

The calculation of the portion of a deposit category that contributes to cash outflows is:

Interpreting the Deposit Run-Off

Interpreting deposit run-off involves understanding the implications of different rates and patterns of withdrawals. A low and consistent rate of deposit run-off indicates a stable funding base for a bank, reflecting depositor confidence and predictable liquidity needs. Higher run-off rates, especially for specific deposit categories, suggest greater volatility and a higher degree of liquidity risk.

Regulators and bank management use these run-off rates, particularly within the stress testing framework, to gauge how much liquid capital a bank must hold. A sudden surge in deposit run-off, especially among uninsured deposits, is a red flag, indicating a potential loss of confidence or a shift in depositor behavior. Analyzing the composition of deposits (e.g., insured vs. uninsured, operational vs. non-operational) provides critical context, as different types of deposits exhibit varying degrees of stickiness and thus different run-off characteristics.

Hypothetical Example

Consider a regional bank, "SecureTrust Bank," with $1 billion in total deposits.

• $600 million are stable retail deposits, primarily insured checking and savings accounts.
• $300 million are uninsured corporate operational deposits.
• $100 million are uninsured non-operational wholesale funding.

Based on regulatory guidelines, SecureTrust Bank assigns the following hypothetical run-off factors for a 30-day stress scenario:

• Stable Retail Deposits: 5%
• Uninsured Corporate Operational Deposits: 25%
• Uninsured Non-Operational Wholesale Funding: 40%

The expected deposit run-off for SecureTrust Bank would be calculated as follows:

• Retail Deposit Run-off: $600,000,000 \times 0.05 = $30,000,000
• Corporate Operational Deposit Run-off: $300,000,000 \times 0.25 = $75,000,000
• Wholesale Funding Run-off: $100,000,000 \times 0.40 = $40,000,000

Total expected deposit run-off in this scenario = $30,000,000 + $75,000,000 + $40,000,000 = $145,000,000.

This $145 million represents the projected cash outflow from deposits over the 30-day period due to anticipated withdrawals under stress, which the bank must be prepared to cover with its High-Quality Liquid Assets (HQLA) to maintain its Liquidity Coverage Ratio.

Practical Applications

Deposit run-off is a cornerstone of effective risk management for financial institutions and a critical metric for regulators. Its practical applications span several key areas:

• Liquidity Risk Management: Banks actively monitor deposit run-off rates to ensure they maintain sufficient liquid assets to meet potential withdrawals. This involves robust asset-liability management to match the liquidity profile of assets with the expected behavior of liabilities.
• Regulatory Compliance: Global regulatory frameworks, most notably Basel III, mandate that banks calculate and maintain a Liquidity Coverage Ratio (LCR). The LCR explicitly incorporates various deposit run-off factors to determine the required buffer of High-Quality Liquid Assets (HQLA)⁹,⁸. The European Central Bank, for instance, details how the LCR applies these run-off rates to ensure short-term liquidity resilience⁷.
• Stress Testing: Regulatory stress testing scenarios often include severe assumptions for deposit run-off to assess a bank's resilience under adverse conditions⁶. These tests help identify potential vulnerabilities before they escalate into financial crises.
• Pricing and Product Design: Banks consider expected deposit run-off when designing new deposit products and setting interest rates. Deposits with lower expected run-off rates may be offered lower interest rates, as they provide a more stable funding source.
• Contingency Funding Plans: Understanding deposit run-off is vital for developing effective contingency funding plans, outlining how a bank would secure alternative funding in the event of an unexpected and significant outflow of deposits.

Limitations and Criticisms

While the concept of deposit run-off is fundamental to liquidity management, its application and predictive power face several limitations and criticisms, particularly in periods of rapid technological change and heightened market volatility.

One primary criticism is that standard regulatory run-off factors, such as those used in the Liquidity Coverage Ratio (LCR), may underestimate the speed and scale of withdrawals during severe, confidence-driven events. The rapid and significant deposit run-off experienced by Silicon Valley Bank (SVB) in March 2023 highlighted this issue. SVB saw 24% of its deposits, or $42 billion, withdrawn in a single day, with potentially more queued up⁵. This exceeded the assumed run-off rates for certain deposit categories under typical LCR calculations, especially for uninsured deposits that proved to be "flighty"⁴,³. The incident demonstrated how social media and digital banking can accelerate withdrawals, leading to a much faster contagion effect than historical models might predict².

Furthermore, the behavioral assumptions underlying deposit run-off factors may not fully capture the nuances of depositor behavior during a crisis. While deposit insurance plays a crucial role in stabilizing insured deposits, large, uninsured deposits are more susceptible to rapid withdrawal, as seen with SVB where over 90% of deposits were uninsured¹. This concentration of uninsured funds increases a bank's vulnerability to sudden deposit run-off and poses a significant challenge for risk management that relies on historical averages or less severe stress scenarios.

Deposit Run-Off vs. Bank Run

While closely related, "deposit run-off" and "bank run" describe different aspects of deposit outflows, with the latter often being an extreme manifestation of the former.

Deposit run-off refers to the general, ongoing, and often anticipated withdrawal of deposits from a bank. It encompasses both routine outflows (e.g., customers paying bills, transferring funds, or seeking higher interest rates elsewhere) and expected, but potentially accelerated, withdrawals under various market conditions or mild stress scenarios. It is a continuous process that banks manage through their daily liquidity risk practices and regulatory calculations like the Liquidity Coverage Ratio (LCR). Deposit run-off rates are often expressed as percentages of deposit balances expected to be withdrawn over a given period, reflecting normal business or mild stress.

A bank run, on the other hand, is a specific and severe form of deposit run-off characterized by a sudden, frantic, and widespread withdrawal of deposits driven by a loss of confidence or fear of the bank's insolvency. It is typically a panic-driven event where a large number of depositors simultaneously attempt to convert their deposits into cash, overwhelming the bank's ability to meet its obligations. Bank runs can trigger a cascade of failures and contribute to systemic risk within the financial system. While both involve deposit outflows, a bank run is an acute crisis, whereas deposit run-off is a broader term encompassing all forms of deposit outflows, including those managed under normal operating conditions.

FAQs

What causes deposit run-off?

Deposit run-off is caused by various factors, including routine customer transactions (e.g., bill payments, transfers), customers seeking higher returns at other financial institutions, shifts in market interest rates, and, in more severe cases, a loss of confidence in the bank's solvency or liquidity.

How do banks manage deposit run-off?

Banks manage deposit run-off through robust liquidity risk management, which includes maintaining a diversified and stable deposit base, holding sufficient High-Quality Liquid Assets (HQLA), engaging in active asset-liability management, and developing contingency funding plans.

Is deposit run-off always a negative sign?

No, some level of deposit run-off is normal and expected as part of a bank's regular operations. It only becomes a concern when the rate or volume of withdrawals is unexpectedly high, signaling potential liquidity stress or a loss of depositor confidence.

What is the role of deposit insurance in preventing deposit run-off?

Deposit insurance, such as that provided by the FDIC in the U.S., plays a crucial role in preventing panic-driven deposit run-offs. By guaranteeing that depositors will recover their insured funds even if a bank fails, it instills confidence and reduces the incentive for depositors to rush to withdraw their money.

How do regulators use deposit run-off in their assessments?

Regulators use deposit run-off assumptions in stress testing and through metrics like the Liquidity Coverage Ratio (LCR) to assess a bank's ability to withstand liquidity shocks. They assign specific run-off factors to different deposit types to determine the amount of liquid assets a bank must hold.