The 2023 banking crisis brought into sharp focus the downsides of rising interest rates and uninsured deposits. New research co-authored by Wharton’s Itamar Drechsler offers banks a way to manage those risks.
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 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.
The collapse of Silicon Valley Bank and Signature Bank, and the bailout of First Republic, spurred many to scrutinize their banking services and question whether or not they should make changes to ensure their money is safe.
(Image: AP Photo/Jeff Chiu, File)
“You have to act like your market power over your deposits is worse than it really is,” says Wharton finance professor Itamar Drechsler. He explains 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 says. “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 explain 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.
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.
Yet, this is exactly the reason that the risk of a run increases when rates are high, specifically for uninsured deposits, Drechsler notes. 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 says.
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