By Kevin WalshToday, bankers face a situation that they have not seen for more than 10 years: rising interest rates.
Rising rates present risks that warrant monitoring. Rising rates are potentially problematic for banks because they tend to compress net interest margins, the main source of earnings for most banks. Rising rates typically trigger outflows of low-cost deposits, increase deposit betas and flatten the yield curve. The higher rates go, experience suggests, the more likely it is that customers will move deposits to secure higher yields. It is important for bank management to re-examine and fully understand the sensitivity of deposit assumptions embedded in asset liability models and the potential impact to earnings and liquidity they present across a wide range of market scenarios.
Banks experienced significant growth in deposits after the financial crisis as customers sought safety in insured deposits. Deposits have increased steadily as a share of bank balance sheets since 2008, when the economy was mired in the Great Recession.[perfectpullquote align=”left” bordertop=”false” cite=”” link=”” color=”” class=”” size=””]Bank net interest margins have increased largely because of their ability to manage deposit costs effectively.[/perfectpullquote]At present, deposits fund a larger portion of bank balance sheets when compared with levels prior to 2008, and the deposit mix has shifted toward a higher percentage of non-maturity deposits that offer little or no interest to customers on the one hand, but are highly mobile on the other. As broad market interest rates have begun to slowly rise, banks have not yet exhibited pressure to increase rates offered on deposits, unlike previous periods of rising interest rates. While deposit levels have continued to grow and deposit rates have remained relatively stable, it is uncertain whether that condition will continue in an environment of continued rising interest rates.
During this period of deposit growth and stable-to-moderately rising rates, bank net interest margins have increased largely because of their ability to manage deposit costs effectively. Growth was centered in low-cost, non-maturity deposits as customers moved money to non-maturity accounts for safety and because of the relatively low yields for term products available in the broader market. The shift in deposit mix at this point in the cycle has been more favorable to banks than in the past.
Deposit beta measures the responsiveness of bank deposit rates to changes in market rates. Lower betas since 2015 indicate banks have not increased deposit rates as much as in prior cycles. Since the Federal Reserve began increasing short-term interest rates in December 2015, OCC-supervised banks have increased deposit yields by only 12 percent of the increase in the federal funds rate. In the previous cycle of increasing interest rates, from 2004 to 2006, interest-bearing demand account rates increased 32 percent of the federal funds target rate, but have only increased 1 percent of the fed funds target rate in the current rising rate period.
It is uncertain how much longer this condition can continue. But experience suggests customers become more interested in higher yields as interest rates increase. At some point, banks will have to raise deposit rates to compete with rates customers can get from competitor banks—or from nonbank investment products. Higher deposit costs may erode banks’ profitability.
Given that rates have been low and stable for such a protracted period, bank managers should take time to re-evaluate, fully understand and potentially recalibrate the sensitivity of deposit assumptions embedded in their asset liability models.
Kevin Walsh is deputy comptroller for market risk at the Office of the Comptroller of the Currency.