How can banks protect themselves from the destabilizing effects of rising interest rates, as seen in the recent collapse of Silicon Valley Bank (SVB) and First Republic Bank? In a new paper titled “Banking on Uninsured Deposits,” experts at Wharton and elsewhere offer a formula where banks would build protective buffers. One strategy adjusts the interest sensitivity of the bank’s assets proactively to be more responsive to interest rate increases; the other approach restricts dependence on uninsured deposits.
“You have to act like your market power over your deposits is worse than it really is,” Wharton finance professor Itamar Drechsler said on the Wharton Business Daily radio show that airs on SiriusXM. Drechsler coauthored the paper with New York University finance professors Alexi Savov, Philipp Schnabl, and Olivier Wang. He explained how the approach he recommended would play out for a bank: The bank must act as if its depositors “will demand [higher] interest rates than they are expected to in reality.”
That adjustment leads the bank to shorten its duration and increase the interest sensitivity of its assets by a specific amount. The bank then benefits to a degree from interest-rate increases, which serves to offset an incentive of uninsured depositors to run when interest rates increase. “Of course, this is a tradeoff: The bank is no longer perfectly hedged to interest rates, so its profitability will decrease somewhat when interest rates fall,” Drechsler said. “This tradeoff is worthwhile because the incentive of uninsured depositors to run is lower when interest rates are low.”
In their paper, Drechsler and his co-authors explained how banks usually respond to changes in interest rates. They modeled a bank with a low “deposit beta” — a low sensitivity of deposit rates to the market interest rate. As a result, the bank earns a “deposit spread,” the difference between the interest rate it pays depositors and the rate it charges its borrowers. This deposit spread increases when the Fed increases market interest rates, because banks do not have to pass on all of the higher interest rates they charge to their borrowers (i.e., because banks have low deposit betas). “This is the source of [banks’] deposit franchise,” the paper states.
Since high interest rates lead to higher profits from the deposit franchise, banks hedge against the possibility that interest rates fall. They do so by investing in long-term loans and securities, since their value increases when interest rates fall.
If banks correctly estimate their deposit beta, then following this strategy works well to hedge banks against all interest rate changes, up or down, Drechsler said. The key is that the value of banks’ deposit franchise increases when rates rise.
Coping with Fleeing Depositors
Of course, for this to work the deposit franchise must remain intact when rates rise. If for some reason depositors decide to run from the bank, then the damage will be particularly large when rates are high, since this is when the deposit franchise is most valuable.
“You have to act like your market power over your deposits is worse than it really is.”— Itamar Drechsler
Yet, this is exactly the reason that the risk of a run increases when rates are high, specifically for uninsured deposits, Drechsler noted. Insured bank deposits do not have an incentive to run, since their value is guaranteed by the government. In contrast, uninsured depositors may have an incentive to run if they are concerned the bank may be insolvent. “The classical bank run problem is that a run can cause the bank to be insolvent even if it is entirely solvent in the absence of a run,” he said.
Citing banking literature, Drechsler said the risk of a run occurs because the bank owns illiquid assets that it cannot quickly sell at full value if there is a run. This is the reason deposit insurance was created. He pointed out that what the paper highlighted, however, is different. It showed that there may be substantial run risk independent of the bank’s assets, if the bank’s deposit franchise value is high. This is because the run destroys the franchise value. Thus, if a substantial fraction of the bank’s value is derived from its deposit franchise, then the bank can be at risk of a run even if it owns only liquid assets. This is most likely to occur at high interest rates because this is when the bank’s deposit franchise is high.
That run risk comes from only uninsured depositors, since insured depositors do not have an incentive to run, Drechsler continued. More precisely, the run risk exists only if a sufficiently large part of the bank’s total value is generated by the deposit franchise of uninsured depositors (i.e., by a high share of low-beta uninsured deposits). This was certainly the case at SVB, where the average deposit had a low beta (SVB paid low deposit rates) but more than 95% of deposits were uninsured, he noted. When deposits began to leave — initially due to a down cycle in the tech sector — the value of SVB’s deposit franchise decreased, and the incentive of uninsured depositors to run increased. With SVB’s value extremely dependent on uninsured, low beta deposits, the run incentive quickly became very strong, he explained.
Solving the Risk Management Dilemma
Thus, the paper highlighted that a bank whose deposit franchise depends significantly on uninsured depositors faces “a risk management dilemma.” The increase in the value of the deposit franchise when interest rates rise hedges the bank’s profits to increases in interest rates, but also becomes a source of run risk. As the paper stated, “A bank can hedge itself to interest rates or liquidity risk but not both. If it hedges to interest rates, it becomes exposed to a run if interest rates rise. If it hedges to liquidity risk, it becomes exposed to insolvency if rates fall.”
The paper presented an approach to mitigating this risk management dilemma: Banks must ensure that the uninsured deposits franchise does not contribute too large a fraction of the bank’s value. Historically this was the case because uninsured deposits came mostly from large CDs (certificates of deposit) that paid competitive market interest rates and therefore earned little interest spread. They had a “deposit beta of one” (the highest possible value), meaning they adjusted their deposit rates exactly in line with market interest rates. Banks earned little off these deposits and also spent little servicing and obtaining these deposits. Hence, these uninsured deposits generated little of the bank’s value. “In this case the bank’s interest rate and liquidity risk management objectives align,” the paper stated.
“The percentage of depositors that are uninsured has climbed a lot over the last 10 years.”— Itamar Drechsler
But in the very low interest rate environment that prevailed pre-COVID, low-beta uninsured deposits came to contribute a significant fraction of the deposit franchise at many banks, Drechsler said. To prevent them from contributing too large a fraction, and hence keep a ceiling on the run risk, banks need their assets to grow in tandem with the value of their uninsured deposit franchise. One efficient way they could do so is to buy interest rate options, which pay off only when interest rates get high enough that the size of the uninsured deposit franchise becomes a run risk, he added. “A less efficient but arguably more robust approach would be to increase capital buffers as rates increase, which would also keep the relative size of the uninsured deposit franchise from getting large enough to risk a run.”
Risks Arising from Uninsured Deposits
The degree of sensitivity banks nowadays have to uninsured deposits is a relatively new phenomenon. The paper noted that, historically, uninsured deposits were primarily large time deposits (CDs) and other forms of wholesale funding.
That changed after 2012, when uninsured deposits became primarily checking and savings accounts; their deposit betas were low, and banks also incurred high costs servicing them. “It is this decoupling of interest rate and liquidity risk that creates the bank’s risk management dilemma,” the paper stated. In that setting, “uninsured checking and savings accounts pose an ongoing risk to the banking system.”
“The percentage of depositors that are uninsured has climbed a lot over the last 10 years,” Drechsler noted. “That’s one of the things that [banks] will have to reckon with. If [depositors are] uninsured, they do not feel as safe as they would if they have the government guarantee, or the insurance. And they may decide then to run if they feel [their bank is] in trouble. Silicon Valley Bank had 95% uninsured depositors and they did obviously run.”