In 2022 and 2023, as it worked to tamp down inflation, the Federal Reserve raised the upper limit on the fed funds rate with unprecedented magnitude and speed. In a mere 17 months, the rate rose 525 basis points (bps)—from 0.25% in February 2022 to 5.50% in July 2023. Suddenly, banks were forced to manage the effects of significantly higher interest rates on their balance sheets. Those that strategized successfully—and those that did not—became apparent in a liquidity crisis that toppled three banks and siphoned deposits as customers sought safety and higher returns.
This article on deposit betas—calculations that measure the degree to which banks pass fed funds rate increases through to customers—explores how deposit betas can behave in various stages and types of rate cycles, and why understanding them is critical to managing your institution’s funding costs.
But first, here is a quick primer/refresher on how rates are raised, how increases reverberate through the financial system, and how they affect the rates banks charge and offer in varying degrees.
When the Federal Open Market Committee (FOMC) changes the fed funds rate target range, it adjusts the interest rate paid on reserve balances (balances banks hold at the Fed). This in turn impacts the rate paid to participants in the overnight reverse repurchase market and also the primary credit rate the Fed offers to banking institutions that borrow from the Fed. These rates influence every other rate in the financial system.
Banks and other market participants respond to changes in them by adjusting rates on their own products and offerings. But their ability to change rates on their own products is of course subject to the business needs and demands of customers and the actions of competitors. The challenge of managing the fed funds rate moves amid such competitive market conditions is often a fine balancing act with plenty to lose if done incorrectly.
Success can depend on a bank’s ability to understand the historical relationship between moves in the fed funds target rate and the degree to which rate changes can be passed to customers.
The relationship between changes in the fed funds rate and changes in the rates a bank offers on loans is referred to as “asset beta.” The relationship between changes in the fed funds rate and changes in a financial institution’s deposit rates is measured using a related concept called “deposit beta.”
Deposit betas can be measured for each individual rate decision. They are traditionally measured cumulatively over a full phase of rating actions—such as the Fed’s rate-raising campaign from February 2022 to July 2023. If your institution raised the average rate on interest-bearing deposits by 275 bps while the fed funds target rate rose 525 bps, your institution’s deposit beta was 52% (275 divided by 525).
Deposit betas vary over different parts of the rate cycle and have different behavioral characteristics regardless of whether the cycle is marked by rising or falling rates.
In a rising rate environment, banks that are asset sensitive—in other words they have high asset betas—but have deposits that are less sensitive to rising rates (low deposit betas) experience margin expansion: The yield on earning assets increases faster than funding costs.
However, in a falling rate environment, the same balance structure with low deposit betas could cause margin compression. To wit: The yield on earning assets would decrease faster than funding costs. It’s clear, then, that understanding how deposit betas behave at each stage of the rate cycle is critical in managing the funding cost of your financial institution. This is true for community banks, large banks, and all banks in between. The good news is that monitoring and tracking deposit betas does not require advanced skills or models. And it is a fairly simple process, which we will explain in the rest of this article.
How Sensitive Are Deposit Rates to Changes in the Fed Funds Rate?
At $17.4 trillion as of the end of third quarter in 2023, deposits are a significant source of funding for banks. Not too long ago, banks paid next to nothing on deposits. However, customers and the competitive marketplace demanded that rates on deposits respond positively to Fed rate hikes and quantitative tightening measures.
An important consideration in deciding the degree to which you will match fed funds rate changes in your own products is understanding how other banks have historically moved. As an example, during the recent 525 bps fed funds rate increase, the cumulative increase in the cost of interest-bearing deposits across all U.S. commercial banks was 259 bps, resulting in a cumulative deposit beta of 49.3%. Since each rate cycle is unique, it is important to understand that the cumulative deposit beta for all banks for this recent cycle was higher than the prior two rising phases (2016-2019 and 2004-2006) but less than the 1999-2000 rising phase (see Figure 2).
Understanding these differences is important when comparing deposit betas across different rate cycles and trying to understand the nuances of the current cycle. Even banks that were diligent about understanding deposit betas over previous rate cycles found their historical beta coefficient assumptions challenged this time given how quickly the Fed moved rates and the unexpected impact of social-media-driven depositor behavior. Each cycle and each balance sheet is unique. It is important to think about what is distinctive about the current cycle.
For example, the Fed’s recent hawkishness includes both rate hikes and quantitative tightening. In the last two falling rate cycles, after cutting the fed funds rate to almost zero, the Fed engaged in quantitative easing to support the economy. On top of putting downward pressure on rates, this move increased excess reserves in the system, resulting in banks reducing deposit rates at a faster pace long after the last rate cut. Such quantitative measures were not a part of the rate cycles prior to 2009.
In addition, the Fed is now much more transparent about current and forward-looking monetary policy actions compared to prior rate cycles. This allows banks to better deal with uncertainties regarding deposit rates as they are affected not only by the current rate environment but also by the expected future path of monetary policy.
Trend of Deposit Betas Through a Rate Cycle
Generally, deposit betas are “stickier” (in other words, they tend to increase at a slower pace) early in a rising rate cycle. In the mid and later stages of a rising rate cycle, they may be higher. This lack of pressure on banks to pass Fed rate hikes through to depositors early in a rising rate cycle is potentially caused by excess liquidity in the financial system. It also reflects some level of inertia as customers evaluate the trade-off between the hassle of moving their funds for higher rates elsewhere. As monetary tightening kicks into high gear, however, the resulting increase in interest rates on a range of competing higher-earning products forces banks to increase deposit interest rates to retain deposits, resulting in higher deposit betas.
The behavior of deposit betas reverses when the fed funds rate falls. While banks with a high level of core deposits are slow to increase deposit rates (and deposit betas) in the early part of a rising rate cycle, they tend to be quicker to decrease deposit rates (and deposit betas) early in a falling rate cycle. It is worth noting, however, that banks with greater reliance on wholesale deposits, non-core deposits, online deposits, and concentrated funding sources may have less ability to moderate deposit betas than competitors with higher core deposits. This is another reason to measure, monitor, and understand your deposit base and behavior by customer type and product before making decisions about setting deposit pricing and promotional rates.
Factors To Consider as We Move Forward
The following are key factors to consider when evaluating deposit rates and deposit betas, and positioning balance sheets.
Fed Monetary Actions
The Fed’s “higher for longer” policies and the availability of competing fixed-income alternatives to bank deposits continue to pressure funding costs at banks. That, in turn, could keep deposit betas elevated for longer. On the other hand, in a falling rate environment, banks would seek to reduce deposit rates to decrease pressure on funding costs. This behavior along with a reduction in the availability of high-yield alternatives could result in higher deposit betas in the early part of the falling phase of the rate cycle.
The Fed’s quantitative easing (QE) and quantitative tightening (QT) programs can move the needle on deposit betas. But the overall impact on deposit betas is complicated when the Fed simultaneously engages in quantitative measures and rate actions.
In a falling rate environment, QE increases bank reserves and decreases funding pressure on banks. Banks could take actions to reduce reliance on wholesale funding and constrain deposit inflows, which could cause deposit betas to decrease at a faster rate. On the other hand, QT decreases bank reserves and increases funding pressure on banks, which in a falling rate environment could counter the impact of rate cuts on deposit betas, causing deposit betas to decrease more slowly. The impact of QT and rate hikes on deposit beta is directionally the same, resulting in deposit betas increasing more quickly. Engaging in QE and rate hikes simultaneously may not be ideal from a monetary policy standpoint but the overall impact of such a policy could increase deposit betas at a slower rate.
In the past, banks generally followed a “gas station mentality” in setting deposit rates and customers had limited ability to rate-shop. Digital banking innovations in recent years allow customers to rate-shop and move money from one account to another without barriers. That forces banks to bid up deposit rates, resulting in a higher deposit beta in a rising rate environment and a lower deposit beta in a falling rate environment. The 2023 crisis showed that the combination of digital banking platforms and social media could significantly increase the magnitude and speed of deposit runoffs and cause funding problems to escalate in a short period of time, resulting in higher deposit rates and betas. Deposit analytics based on internal performance data and external interest rate and macroeconomic factors is commonly used in banking. However, advances in technology, easier access to information, and social-media-driven customer behavior should be properly accounted for within the deposit analytics framework to avoid errors in measuring betas.
Deposit Concentration Risk
When banks end up with a concentrated deposit base, it’s often as a byproduct of business strategy. If these concentrated deposits were to unexpectedly move to higher-yielding alternatives, banks could be forced to increase deposit rates, causing deposit betas to increase. Even banks with diversified deposit bases could encounter concentration risks when deposit runoffs impact only certain segments of the deposit base, resulting in increased concentration in the remaining deposits. The impact on deposit betas from concentration risks is not uniform across deposit segments (in other words insured vs. uninsured deposits, wholesale vs. retail deposits, short vs. long duration, and interest-bearing vs. non-interest-bearing deposits). Therefore, banks need to take a granular approach to measuring and monitoring deposit concentration risk.
Scenario Analysis and Sensitivity Analysis
Banks typically evaluate the sensitivities of net interest income (NII) and economic value of equity (EVE) using a range of interest rate scenarios (for example: static, ramped, twists, and most-likely scenarios). When running interest rate scenario analysis, however, it is not uncommon for banks to use a constant deposit beta assumption under all scenarios. While that may be appropriate when evaluating NII and EVE sensitivities over a full rate cycle, it would produce misleading results at any point in the cycle. Some banks use a product-specific deposit beta assumption that varies with the rate environment when performing interest rate scenario analysis. Since deposit beta assumptions are an important component of balance sheet management, model validation teams can provide an independent view of the robustness of deposit beta assumptions.
The 2023 liquidity crisis showed that the flight-to-safety behavior of customers could cause system-wide liquidity risk to escalate in a short period of time. As deposit outflows increased, liquidity concerns forced banks to scramble for deposits. They bid up deposit rates, resulting in a sharp increase in deposit betas for new deposits at banks outside of the Globally Systemically Important Banks (GSIBs). Therefore, banks need to pay attention to assumptions regarding deposit betas in their stress testing and scenario analysis programs. The results of stress testing and scenario analysis programs should be factored into interest-rate risk and liquidity risk assessments and inform decisions regarding the setting of deposit rates and risk appetite limits around NII and EVE sensitivity.
In addition to the above factors, some banks use promotional rates, incentives, loyalty programs, tiered deposit rates, and multi-dimensional customer relationships to keep deposit rates and betas lower in a rising rate environment. Considering all the factors, deposit betas clearly are never constant throughout a rate cycle and are affected by a range of internal and external market-based factors. A bank’s asset/liability management committee (ALCO) needs to keep this in mind when evaluating balance sheet management strategies in any interest rate environment. Finally, such balance sheet management decisions, including deposit beta decisions, need to be made within the context of risk appetite. The ALCO, senior management, and the board must be aligned in understanding the risk and reward trade-off of higher or lower beta assumptions.
The Fed remains data dependent in setting monetary policy. While, as of December 2023, we were at or near the peak fed funds rate expected in this rate cycle, the risk of reinflation remains and could force the Fed to hike the fed funds rate higher than the market expects. That could push both deposit rates and beta higher. Even if the Fed is done hiking the fed funds rate, its higher-for-longer policy stance could continue to pressure deposit betas. During prior rate cycles, banks encountered rate pressure on deposits for a few quarters after the final rate hike, potentially due to the lagged effect of the hikes. Similar lagged effects could keep deposit rates and betas higher for a few more quarters this time as well.
The Fed could be forced to abandon its current higher-for-longer” monetary policy stance if economic activity deteriorates significantly in coming quarters. In that situation, deposit rates could fall at a faster pace (meaning a higher beta). While a fall in deposit rates may be favorable for banks in terms of deposit costs, rate cuts compress the net interest margin—a key measure of bank profitability.
The relationship of interest rate risk to liquidity risk has never been more pronounced. The speed and magnitude at which deposits can move in today’s environment of digitization and social media require a deep understanding of deposit behavior by customer type and product type. Deposit betas have a direct effect on a firm’s profitability, interest rate risk profile, and liquidity risk profile. It is increasingly important for banks of all sizes to regularly measure, monitor, and manage deposit betas throughout the rate cycle—and across products and segments—as part of their interest rate and liquidity risk management practices.
Venkat Veeramani is SVP and chief economist for Wintrust Financial Corporation.
Jim Lentino is EVP and chief risk officer for Wintrust Financial Corporation.
The authors also wish to acknowledge the contributions of Jason West and Tinting Yang in the research for this article.