Variable Deposit Betas and Bank Exposure to Interest Rate Risk

Abstract

Following the global financial crisis, banks lengthened the average asset maturity relative to the average maturity of their liabilities, principally by increasing their investments in mortgage-related assets. Whether such 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 interest pass-through rates on deposits vary significantly with interest rates, which reduces the effectiveness of deposits as a hedge when interest rates increase. The dynamic nature of the deposit betas explains, in part, why the duration of bank equity varies with interest rates and why deposits have provided a poor hedge against post-pandemic rate hikes.

Keywords: Interest Rate Risk, Hedging, Deposit Betas

JEL Classification: G21, G38