Deposits in a rising rate environment: one size does not fit all

When it comes to deposit behavior when interest rates are rising, there is no crystal ball. The impact of rising rates is wrought with uncertainty. Conventional wisdom suggests that if interest rates rise, there will be a drop – or slowdown — in deposit growth. The basis of this logic is that as market rates rise, financial institutions won’t increase deposit rates as much — that is, their deposit betas are less than 1 – and that will lead to fewer deposits. While there is truth to this view, there are other nuances and factors to consider, specifically relating to risk.

When market rates rise (often reflected in the stock prices) the cost of holding deposits increases but the risk of holding other assets increase even more. In other words, if you’re thinking about getting a particular rate of return, say 5%, and you’re willing to tolerate a variable amount of risk to reach that return, as market rates rise it’s easier to devote a larger percentage of your portfolio to bank deposits and still achieve that 5% portfolio return. To the extent that depositors are risk averse, then a rise in rates could lead them to hold more deposits than they otherwise would.

However, this may not be how it actually plays out. The outcome of such a scenario would depend on multiple factors: the importance of opportunity costs and the importance of risk relative to a target rate of return. Thus, even from a theoretical perspective, the relationship between deposits and deposit rates can move in different directions.

Now let us take this theoretical discussion in a slightly different direction. Let’s consider the link between deposits and deposit rates as reflecting the net impact of deposit supply (by non-financial economic agents) or deposit demand (by financial institutions). If we presume the deposit supply curve is upward sloped, higher rates would lead to greater supply of deposits. If we presume the deposit demand curve is downward sloped, higher rates would lead to lower demand for deposits. In both cases, that’s holding everything else constant – which would mean other rates would be constant.

In the real world, all those other factors won’t typically be constant, but let’s ignore that for the example. What you will observe in the market is not the deposit supply curve or the deposit demand curve. You’re going to observe market equilibrium, the intersection of the demand and supply curves.

Moreover, when you consider what’s going to happen over time, it’s going to reflect how the deposit supply and demand curves are changing. For example, if depositors’ behavior doesn’t change but financial institutions face a growing demand for loans, it’s likely that their demand for deposits is going to increase. That, in turn, will lead to higher rates and a higher level of deposits. (You would be keeping the demand curve unchanged and shifting the supply curve to the right.) In this case, you would observe deposit rates and deposits both rising – a positive correlation between the two.

In contrast, if we were moving back into a recession, perhaps deposit demand might initially stay the same while households might want to increase deposits in preparation for a rainy day. Then the deposit supply curve would be shifting to the right and you would observe a decrease in deposit rates together with an increase in deposits.

The bottom line then is that any combination of rate and deposit level movement is possible depending on what’s happening to deposit supply and demand. Overall, however, you would find that there’s a positive relation between rates and deposits empirically, which would suggest that shifts in deposit demand by financial institutions may be more important than what conventional wisdom would suggest. However, empirically, you’ll find a lot of different movements across financial institutions.

There is no one-size fits all. While there is no crystal ball, there are things an institution can do to better understand deposit behaviors in the rising rate environment. An institution-specific analysis on non-maturity deposits will enable you to understand how your base behaves historically, giving you better information to run “what if” scenarios on your deposits.

Author: Richard Sheehan, Ph.D., Director of Analytics at MountainView Financial Solutions