Variable Deposit Betas, Convexity, and Changes in Bank Interest Rate Risk Exposure

Abstract

Whether maturity transformation exposes banks to interest rate risk depends in part on the effectiveness of bank deposits as a hedge against interest rate shocks. In this paper, we provide evidence that, despite an increase in the average maturity of bank assets, the duration of bank equity declined in the post-financial crisis era. We argue that one factor contributing to the decline was an increase in the average duration of deposits due to a decline in deposit betas when interest rates are low. The dynamics nature of the duration of deposits also explains why deposits provided a poor hedge against recent rate hikes. Overall we find that variable deposit betas combined with mortgage lending leads to a negative convex relationship between the value of bank equity and interest rates.

Keywords: Interest Rate Risk, Hedging, Deposit Betas

JEL Classification: G21, G38