Working Paper

Deposit Convexity, Monetary Policy and Financial Stability

Abstract: In principle, bank deposits can be withdrawn on demand. In practice, depositors tend to maintain stable balances for long periods, allowing banks to fund long-dated assets. Nevertheless, the cost of deposit funding influences banks’ capacity for maturity transformation. Banks and researchers conventionally model the response of deposit interest rates to market interest rates as constant, implying that deposits have nearly constant duration. Contrary to this standard assumption, we show empirically that the “beta” of deposit rates to market rates increases as market rates rise, causing the duration of deposits to fall. The amount of duration risk delivered to bank balance sheets via this channel from March 2022 to September 2023 is comparable in magnitude to the amount of duration risk absorbed by each of the several large-scale asset purchase programs the Federal Reserve has undertaken since 2008. Dynamic betas present a significant challenge to bank portfolio hedgers by introducing large and dynamic risks that are difficult to model and impractical to replicate on the asset side of the balance sheet. As a result, deposit convexity amplifies monetary policy transmission and increases financial fragility, mechanisms that recent banking stresses have highlighted.

Keywords: banks; Depository institutions; interest rates; bank run; financial markets; central bank; monetary policy; Policy Effects;

JEL Classification: E43; E44; E52; G12; G21;

https://doi.org/10.24149/wp2315

Bibliographic Information

Provider: Federal Reserve Bank of Dallas

Part of Series: Working Papers

Publication Date: 2023-10-10

Number: 2315