Speaker 1: Hello, and welcome to another episode of The Oddlots Podcast.
Speaker 1: I'm Tracy Alloway.
Speaker 2: And I'm joll Why isn't thal Joe?
Speaker 1: What do you know about the dark arts of asset
Speaker 1: liability management?
Speaker 2: Only things that have been told to us about it
Speaker 2: on the Odd Lots. O.
Speaker 1: Wait, that's actually quite a lot.
Speaker 2: Yeah, No, that's true. It seems tough. Deposits can be flighty,
Speaker 2: sometimes they can be stable. Sometimes when rates go up
Speaker 2: they get passed on to deposits. Sometimes they don't deposit.
Speaker 2: Beta's change over time, some things that. Yeah, that's about Okay,
Speaker 2: that's about it.
Speaker 1: No, that's pretty good. Podcast over, We're done, podcast over. No,
Speaker 1: you're absolutely right about your characterization of deposits. And I
Speaker 1: think one of the really interesting things about banking is
Speaker 1: it is kind of built on this tension, which is
Speaker 1: that in theory, you know, I can put my money
Speaker 1: in a bank as a deposit, and then I am
Speaker 1: theoretically entitled to pull it out at any time, And I,
Speaker 1: for one, can't really imagine a business where like, at
Speaker 1: any single point, I could see a majority of my
Speaker 1: customers suddenly vanish. But it is also true in practice
Speaker 1: that people who put their money in banks, they don't
Speaker 1: tend to move it around that much. And that is
Speaker 1: the thing, like the magic behavior that enables banks to
Speaker 1: actually lend money or buy assets like bonds and things
Speaker 1: like that.
Speaker 2: Yeah, and you know, obviously part of the reason anyone
Speaker 2: is having this conversation still is we all have we
Speaker 2: remember this past March with SVB, but I recall at
Speaker 2: the time and some of our episodes around them, thinking
Speaker 2: about how I don't know if paradox is the word,
Speaker 2: funny is the word, or weird it is that on
Speaker 2: some bank deposits are extremely sticky and long duration, and
Speaker 2: I think, you know, there's that stat maybe it's fake,
Speaker 2: but you know, people are more likely to get divorced
Speaker 2: than leave a bank, is one of those things that
Speaker 2: people say. And if you have a customer, that's great.
Speaker 2: On the other hand, sometimes the deposits do leave and
Speaker 2: can leave in five seconds and it doesn't take very much.
Speaker 2: So it always seemed to me that rather, I'm like,
Speaker 2: I wonder our deposits do they exist on some continuum
Speaker 2: of sticky to long duration or do they are Is
Speaker 2: it more like Schrodinger's Schrodinger's deposits either they're there or
Speaker 2: they're not there, but that there's no sort of in between.
Speaker 3: Stay.
Speaker 1: Yeah. We did that great episode with Joe Abat over
Speaker 1: at Barclay's about bank deposits, and we've been joking on
Speaker 1: the podcast since that in order to improve the transmission
Speaker 1: of monetary policy, everyone needs to go out, do their
Speaker 1: market research, find a high paying bank account somewhere and
Speaker 1: actually move their money. And you know, I am joking,
Speaker 1: but also kind not. There is an interaction between banks
Speaker 1: and deposit rates and the effective transmission to monetary policy.
Speaker 1: I mean, banks are supposed to be the primary mechanism
Speaker 1: through which a lot of monetary policy is transmitted, and
Speaker 1: so the question of how deposits are actually working, so
Speaker 1: whether or not they're sticky, whether or not that stickiness
Speaker 1: changes in an environment where rates are going up or down,
Speaker 1: and also how those deposits sort of feed into monetary policy.
Speaker 1: That is a really big topic and I think we
Speaker 1: should do more on it totally. You know.
Speaker 2: The thing that really strikes me, and this is in
Speaker 2: a bank run is the perfect example of nonlinearity, right,
Speaker 2: and so something is one state and then something is
Speaker 2: suddenly a very different state. And we went from and
Speaker 2: I think we've learned in recent times how tricky that
Speaker 2: is to manage, and I think understanding the actual management
Speaker 2: of that nonlinearity in practice something we can dive into further.
Speaker 1: Right And I did call it the dark art of
Speaker 1: asset liability management at the opening, and to some extent
Speaker 1: it is kind of opaque, like no one gets a
Speaker 1: lot of transparency into how an individual bank is actually
Speaker 1: managing things like deposit and interest rate risk. So I'm
Speaker 1: glad we can do this episode, and more than that,
Speaker 1: we are really doing it with the perfect guest. We
Speaker 1: have someone who's been on All Blots many times.
Speaker 2: He's now climbing the rank really one, don't you think,
Speaker 2: I mean of the moment must be he's up there.
Speaker 1: Yeah, all right, So we're going to be speaking to
Speaker 1: one of our perennial favorite guests, Josh Younger, formerly of
Speaker 1: JP Morgan, now a senior advisor over at the Federal
Speaker 1: Reserve Bank of New York. Josh, thank you for coming
Speaker 1: back on All Blots for like the fifth sixth time.
Speaker 3: I don't know, I've lost count, but it's great to
Speaker 3: be back. I really appreciate the opportunities. It's great to
Speaker 3: talk about.
Speaker 1: This and I should just mention that we're recording this
Speaker 1: on November ninth, and Josh, you have something to say
Speaker 1: to our audience.
Speaker 3: Yes, I almost memorized it, but we'll see. We'll see
Speaker 3: if I get all the parts right. But these views
Speaker 3: are my own, and those are my co authors from
Speaker 3: the paper that we wrote, and they don't necessarily reflect
Speaker 3: the views of the Federal Reserve System, the Federalser Bank
Speaker 3: of New York, or the federalzer Bank of Dallas.
Speaker 1: Oh yeah, I should mention that. I mean I kind
Speaker 1: of figured that Josh would be an expert on this anyway.
Speaker 1: But one of the reasons we wanted to talk to
Speaker 1: him is because he did just publish a paper at
Speaker 1: the Federal Reserve Bank of Dallas called Deposit Convexity, Monetary Policy,
Speaker 1: and Financial Stability, and it gets into the nuts and
Speaker 1: bolts of all the themes that Joe and I were
Speaker 1: just discussing in the intro. So, speaking of the paper,
Speaker 1: I mean, one of the things that you mentioned in
Speaker 1: the research is that you and your authors have sort
Speaker 1: of personal experience with the way banks actually deal with
Speaker 1: interest rate risk. Can you talk to us a little
Speaker 1: bit about how banks typically manage like, how are they
Speaker 1: thinking about things like deposits and interest rate exposure.
Speaker 3: Yeah, so it's very tempting. I mean, Joe you were
Speaker 3: saying earlier. The deposits are there until they're not. And
Speaker 3: but they're also an overnight demandable liability, meaning you can
Speaker 3: get your money back whenever you want your money back,
Speaker 3: and you tend not to. So it's a very behavioral process,
Speaker 3: and so a lot of the work of managing the
Speaker 3: interest rate risk of a bank is really understanding that
Speaker 3: behavior because deposits are typically by far the largest source
Speaker 3: of funding for most banks. Depending on the kind of
Speaker 3: banking you're doing, you might have more or less of it,
Speaker 3: but it's typically a huge chunk and it's not something
Speaker 3: you can I mean, we made an attempt to write
Speaker 3: it down on paper, but it's all based on the
Speaker 3: premise that people tend to leave their money at banks
Speaker 3: for long periods of time, even if that interest rate
Speaker 3: is below what the broader market would consider risk free.
Speaker 3: You know, there's lots of reasons for that. You certainly
Speaker 3: need bank deposits to like, live your life, right, So
Speaker 3: people usually call this convenience yield because you use bank
Speaker 3: deposits for actual transactions as opposed to like money market
Speaker 3: fund shares, which you don't. But if as a bank
Speaker 3: you have one set of liabilities, you have to understand
Speaker 3: and then on the asset side sometimes there's there's some complexity,
Speaker 3: like mortgages are relatively complex. Lots of loans have embedded
Speaker 3: quote unquote options, meaning the floors and caps and things
Speaker 3: like that, but those are sort of easier to model
Speaker 3: from first principles like financial math perspective, and so you
Speaker 3: have a pretty good understanding of the interest rate risk
Speaker 3: on the light on the asset side of the portfolio,
Speaker 3: and a lot of the legwork is spent understanding the
Speaker 3: liability side, specifically deposits.
Speaker 2: In light of that. So Tracy mentioned we talked to
Speaker 2: we did an episode with Joel Bote over at Barclays,
Speaker 2: and that was just a few weeks before SVB, and
Speaker 2: we didn't know there was no intention, But the question
Speaker 2: then was, well, rate hikes have gone up or sorry,
Speaker 2: rates have gone up. By then at that point, the
Speaker 2: Fed had done a ton of hiking. And yet you know,
Speaker 2: you look around and deposit rates are of the rates
Speaker 2: that banks were paying out on people's deposits hadn't gone
Speaker 2: up that more so we explored this idea of deposit
Speaker 2: beta in your research, what is what can we say
Speaker 2: in just based on your research about the nature of
Speaker 2: how banks time the passing along of higher rates, So
Speaker 2: it brings up kind of the mechanism which as we
Speaker 2: talk about this beata, what does it represent?
Speaker 3: Why does it move? Because there's a temptation to think
Speaker 3: there's one big book of deposits and a giant lever
Speaker 3: somewhere in the bank.
Speaker 1: We should just say so beta is like the degree
Speaker 1: to which these two things are moving.
Speaker 3: Intent.
Speaker 1: So benchmark interest rates going up, are rates paid out
Speaker 1: on retail bank deposits or other types of bank deposits
Speaker 1: actually going up.
Speaker 3: Yeah. So if a quote unquote market yields the yield
Speaker 3: you would get from money market fund for example, are
Speaker 3: close to that goes up by one hundred basis points,
Speaker 3: how much of that is represented in your deposit rate paid?
Speaker 3: As a bank you think bank thinks about paying our
Speaker 3: interest on deposits, so we call it rate paid, But
Speaker 3: obviously the depositor is getting paid that interest. It's the
Speaker 3: rate you earn. And a beta to a twenty five
Speaker 3: percent would mean for ever one hundred basis points or
Speaker 3: one percentage move in market yield twenty five basis points
Speaker 3: or a quarter of a percentage point is actually reflected
Speaker 3: in the deposit rate. So you know, the teendation is
Speaker 3: to say, well, there's just this big book of deposits.
Speaker 3: There's a giant dial somewhere in the bank, and you know,
Speaker 3: you kind of move the dial less than the market
Speaker 3: yield moved, and you do that to achieve some business outcome.
Speaker 3: And there's sort of two things to think about with that.
Speaker 3: The first is that the actual beta, the changes in
Speaker 3: beta or the level of the beta, is to a
Speaker 3: great extent the consequence of the deposit mix, meaning how
Speaker 3: much of these things are in time deposit certificates of
Speaker 3: deposit things with term exposure, and how much of that
Speaker 3: is let's say zero interest checking And so as.
Speaker 1: Demand deposits, they're called right where you can withdraw them
Speaker 1: anytime when you want on demand.
Speaker 3: Yeah, so you can say I want a demand deposit account.
Speaker 3: I want to get my money whenever I want, or
Speaker 3: you say I'll get my money in three months and
Speaker 3: I want to earn a slightly higher rate of interest
Speaker 3: for that. And typically those time deposits are priced at
Speaker 3: some spread or difference to the market yield and demand
Speaker 3: deposits typically a very low interest rate, and so as
Speaker 3: customers move from demand deposits to time deposits, there's naturally
Speaker 3: more reactivity just because they're terming out their deposits. So
Speaker 3: that's one source of behavior. And then there is to
Speaker 3: some extent a dial that reflects savings and checking account rates,
Speaker 3: particularly on the institutional side, so the rate's paid to
Speaker 3: corporations and investment managers and things like that, who tend
Speaker 3: to be much more sensitive to these economic considerations. They
Speaker 3: leave a lot more money on the table basically when
Speaker 3: deposit rates are incrementally higher or lower. And in that case,
Speaker 3: the question is do I want to grow my business
Speaker 3: or shrink my business or keep it the same. So
Speaker 3: there's kind of a debate when you're talking about a beta.
Speaker 3: Are you talking about the market neutral beta meaning my
Speaker 3: market share to say is constant? Are you talking about
Speaker 3: the beta re car to grow my business? You're talking
Speaker 3: about betaver card to shrink my business. There's been a
Speaker 3: lot of discussion about how size can sometimes be more expensive,
Speaker 3: not more profitable, and so you might want to shrink
Speaker 3: a business for example. And so when we think about
Speaker 3: topics around interest rate risk management. I always like to
Speaker 3: think in terms of the sort of market neutral beta,
Speaker 3: which is what is the market beta I need to
Speaker 3: pay to keep all the deposits I currently have, or
Speaker 3: at least my share of the deposits in the system,
Speaker 3: because that's more reflective of like the actual underlying interest
Speaker 3: rate risk of deposit liabilities as opposed to the business
Speaker 3: management and planning decisions of an individual institution.
Speaker 1: Getting back to the idea that you know, in theory,
Speaker 1: people can pull their money out of banks whenever they want,
Speaker 1: unless they're in something like a certificate of deposit. But
Speaker 1: in practice they tend not to. And I remember this
Speaker 1: is something we spoke to Abata about, Like there are
Speaker 1: a lot of people who have an account at a
Speaker 1: specific bank because they're getting something else out of it.
Speaker 1: You know, there's a relationship there, a business relationship, they
Speaker 1: know each other, maybe they're getting a loan, a business
Speaker 1: loan or something like that. How sticky are deposits in practice?
Speaker 1: And does it vary by you know, deposit type beyond
Speaker 1: whether it's a demand deposit versus a termed out depositive.
Speaker 3: Yeah, the type of depositor is really important. And so
Speaker 3: you know, maybe taking a big step back. So think
Speaker 3: about the system as a whole. Why do we think
Speaker 3: deposits are long lived? If you go back to the
Speaker 3: state banking here of the eighteen thirties and go all
Speaker 3: the way to today, for most of that period, deposit
Speaker 3: balances are growing at or faster than gross domestic product,
Speaker 3: which tells you that the deposits in the system as
Speaker 3: a system are there for the most part. Now there
Speaker 3: are more outlets now than there were back then. To
Speaker 3: leave the banking system, go to see money market fund
Speaker 3: There certainly weren't money market funds in the eighteen fifties.
Speaker 3: But like generally speaking, deposits tend to grow with or
Speaker 3: faster and GDP. So even if you take your deposit
Speaker 3: out of one bank, you're probably putting it at another bank.
Speaker 3: So deposits in the system are very long lived. But
Speaker 3: then there's a question of the type of depositor and
Speaker 3: so on the one hand, of what we call retail depositors,
Speaker 3: I'm just using liquidity coverage ratio terminology. This is what
Speaker 3: the regulators have used to establish different types of deposits.
Speaker 3: So there's a common language for this now. Retail or
Speaker 3: stable retail deposits are you know, individuals, like people at
Speaker 3: this table, we tend to be relatively insensitive to rates
Speaker 3: on the whole because we use our deposits for for
Speaker 3: the most part, for lots of stuff. So we go
Speaker 3: buy coffee with it, and we go to the movies
Speaker 3: or whatever, like you pay your pay your gas bill.
Speaker 3: Even if it's direct deposit from your bank account, it's
Speaker 3: still from a bank account. It's not from a money
Speaker 3: market fund. And so you know, the convenience yield, so
Speaker 3: to speak, of having bank deposits is relatively high. And
Speaker 3: even if most people don't keep a lot of money
Speaker 3: at the bank, there are a lot of people and
Speaker 3: so that adds up to a big deposit base. So
Speaker 3: most of the useful money in the economy is in
Speaker 3: posit format used by individuals. And then if you go
Speaker 3: so that, we call that a low beta deposit or
Speaker 3: a sticky deposit. And that's again a statement about the
Speaker 3: rate paid, not necessarily the propensity for that deposit to
Speaker 3: leave the bank. We can talk about that separately, but
Speaker 3: this is assuming I pay whatever rate is necessary to
Speaker 3: keep that deposit. So that's a relatively low beta, low
Speaker 3: rate deposit. Not much reactivity to market yield. And then
Speaker 3: if you go into what the regulations term the wholesale space,
Speaker 3: wholesale deposit space, which is really institutions, asset managers who
Speaker 3: have excess cash, corporations who have excess cash. They kind
Speaker 3: of split it into two buckets. One is what it's
Speaker 3: called operational deposits. Operational are used to meet payroll and
Speaker 3: various expenses. If you import export, you have to pay
Speaker 3: somebody with that deposit, and so those still need to
Speaker 3: be in the banking system somewhere. Now you can move
Speaker 3: them around between banks, but the rate paid on those
Speaker 3: tends to be a little lower than market yields, for example,
Speaker 3: just because they still need to be a bank deposit
Speaker 3: at the s end of the day, so there's still
Speaker 3: a convenience yield, so to speak, to have that. And
Speaker 3: then at the high beta end of the spectrum, you
Speaker 3: have non operational deposits, which is excess cash that's being
Speaker 3: left in a deposit account for or reasons on known
Speaker 3: it could easily go to a money market fund. It's
Speaker 3: money that corporations don't need to meet regular payroll and expenses,
Speaker 3: and so they're kind of keeping it because it's convenient
Speaker 3: to have some excess savings just in case maybe or
Speaker 3: something like that, but it's not being used on a
Speaker 3: daily basis, So in principle it could be in anything.
Speaker 3: It's more of an investment in deposit accounts. So to
Speaker 3: keep those funds you need to pay a relatively high
Speaker 3: data pretty close to one because otherwise they'll just go
Speaker 3: somewhere else or to a money market fund.
Speaker 2: What happens when the FED embarks on and we've had
Speaker 2: we had this hiking cycle. Maybe it's over pass hiking cycles.
Speaker 2: What is your research show really happens to deposit betas
Speaker 2: over time as a hiking cycle picks up.
Speaker 3: Yeah, So here we're thinking about the consolidated beta of
Speaker 3: the whole institutions. This is if you take whatever fraction
Speaker 3: you have in retail, wholesale, operational, wholesale, non operational, and
Speaker 3: even wholesale funding and term funding. You just think of
Speaker 3: the funding rate the bank has to pay to fund itself.
Speaker 3: That beta, just the ratio of that rate to the
Speaker 3: risk free overnight rate tends to increase as interest rates rise.
Speaker 3: So this is related to the propensity of corporations in particular,
Speaker 3: but also individuals to move their excess savings into money
Speaker 3: market funds when interest rates are above zero and the
Speaker 3: opportunity cost of keeping them in a bank increases. That's
Speaker 3: not true for everybody, but on average and over the
Speaker 3: long sweep of history, it's tended to be the case
Speaker 3: that the beta goes up when rates go up.
Speaker 1: Wait, so this is different to how people normally think
Speaker 1: of the way bank deposit rates work, which is people
Speaker 1: tend to think of them as like a linear thing,
Speaker 1: like rates go up one hundred basis points, and then
Speaker 1: deposits will go up one hundred basis points. Maybe not
Speaker 1: one hundred exactly for obvious reasons that we've discovered on
Speaker 1: the podcast, but by yeah, but by like a set
Speaker 1: amount each time. But you're kind of arguing that actually
Speaker 1: it's a non linear relationship and as interest rates go up,
Speaker 1: the beta the relationship actually gets stronger.
Speaker 3: Yeah, exactly. So, like linear means is static beta. Static
Speaker 3: beta means twenty five percent of every interest rate increase
Speaker 3: goes through to deposits, for example. And so if that
Speaker 3: beta increases, non linear relationship starts turning up and getting
Speaker 3: some convexity to it, and that means that the last
Speaker 3: hundred basis points are not the same as the first
Speaker 3: hundred basis points, for example, from the depositors perspective.
Speaker 1: So on that note, you mentioned money market funds. Just
Speaker 1: then like how much of this dynamic is driven by
Speaker 1: competition with money market funds, Because if I think about
Speaker 1: like things that have changed in the financial system, it
Speaker 1: feels like MMFs are a bigger presence, although maybe they're
Speaker 1: not compared to two thousand and eight, I can't remember
Speaker 1: the numbers, but it feels like nowadays there is this
Speaker 1: range of options for where you want to put your
Speaker 1: excess cash, and we have seen in flows to money
Speaker 1: market funds pick up. We have seen that play a
Speaker 1: role in things like SVB and silver Gate obviously or sorry, arguably.
Speaker 1: So I'm just wondering, like, how do banks compete with
Speaker 1: MMFs and how does that feed into that non linear
Speaker 1: relationship that you just describe.
Speaker 3: So they're competing primarily with each other. I would argue,
Speaker 3: like a bank has expenses that a money market fund
Speaker 3: does not, namely capital and liquidity, and so you know,
Speaker 3: money market funds are essentially a pass through instrument, and
Speaker 3: so they don't have branches, they don't have payment processing services,
Speaker 3: they don't have all of the overheaded bank deals with
Speaker 3: so it's kind of a it's number to think that
Speaker 3: a bank could quote unquote compete with the money f
Speaker 3: I'm purely on the yield that they offer because it's
Speaker 3: a very different business.
Speaker 1: Right, But this is what I mean, Like, banks are
Speaker 1: always going to have expenses, so they're always going to
Speaker 1: have to pay out less than a money market fund,
Speaker 1: Like they won't be able to pass on that full
Speaker 1: interest rate hike.
Speaker 3: Right generally speaking, yes, and now they can compete with
Speaker 3: each other, and they could try to source deposits that
Speaker 3: have they're associated with profitable activities. So we haven't really
Speaker 3: talked about what you're using these deposits for. If using
Speaker 3: them to just hold excess cash, it's probably less attractive.
Speaker 3: If you have businesses like wealth management and market making
Speaker 3: trading that generate non interest revenue, it might be more interesting,
Speaker 3: but you have to have something to do with the funding.
Speaker 3: But and that's why in some cases banks we're very
Speaker 3: happy to see these deposits roll off. And when you
Speaker 3: have non operational deposits supporting cash holdings, there's not much
Speaker 3: spread in that you still have all of the expenses,
Speaker 3: so you have a relatively high interest deposit funding to
Speaker 3: support non spread earning cash assets, and like that's really
Speaker 3: not what they're in the business of doing. And so
Speaker 3: under those circumstances, higher rates and money market fund runoff
Speaker 3: to money market funds is like reasonably fine. But then again,
Speaker 3: if you have you know, again, very profitable businesses that
Speaker 3: need funding, you want to you want to bid to
Speaker 3: retain that funding, because otherwise you have to shrink the business.
Speaker 3: And so I would think of this as more of
Speaker 3: to some extent, commuting with money funds, but also banks
Speaker 3: competing with each other for those marginal deposits that support
Speaker 3: profitable activity.
Speaker 1: Joe, do you remember, I think it must have been
Speaker 1: just a couple of years ago when banks were complaining
Speaker 1: about access deposits.
Speaker 2: Absolutely for one thing. Yeah, absolutely, and it was it
Speaker 2: was always sort of. It took me actually many odd
Speaker 2: Loots episodes to even understand the coherence of that statement.
Speaker 2: Now in November twenty twenty three, I can understand why
Speaker 2: having too many deposits would be a problem, but it
Speaker 2: took me a while to wrap my head around that concept. Obviously,
Speaker 2: in the case of SVB was kind of you know,
Speaker 2: that one was very straightforward, because there were not many
Speaker 2: natural things they could do on the asset side of
Speaker 2: the business with all of that VC cash that they
Speaker 2: were getting in and so for they were in a
Speaker 2: traditional lending bank. But that actually segs to my next question,
Speaker 2: which is in the time of moving rates, when rates
Speaker 2: are stable whatever its banking doesn't seem that hard. But
Speaker 2: in a time of when rates are on the move,
Speaker 2: and as you mentioned, say the market neutral beta is
Speaker 2: such a that you know, banks want to keep their
Speaker 2: business the way it is. Move around the deposit, move
Speaker 2: around the rate, to hold on to your deposits. Moving
Speaker 2: around the assets does not seem very easy, and they're
Speaker 2: liquid and in many cases are long dating. Talk to
Speaker 2: us about, you know, as the deposit mixed changes or
Speaker 2: they have to pay out, what kind of strain that
Speaker 2: pay places on the asset side for the banks.
Speaker 3: Yeah, well, I think the key is that the bank
Speaker 3: is exposed to interstrate risk from these deposits. So as earlier,
Speaker 3: the question is, how can you have long term interest
Speaker 3: rate risk from overnight demandable liabilities demand deposits. I can
Speaker 3: get my money back any time. This is an overnight liability, right,
Speaker 3: And the answer is if people keep their money there
Speaker 3: for a long time. That beta below one, meaning not
Speaker 3: all of those interest rate increases get passed through, generates
Speaker 3: a ton of interest rate risk for that kind of liability.
Speaker 3: And you can think of it by splitting it up
Speaker 3: into what we know we call replicating portfolio. What's equivalent
Speaker 3: to a fifty percent beta deposit liability. It's fifty dollars
Speaker 3: worth of Fed Funds linked floaters perfectly floating rate liabilities,
Speaker 3: and fifty dollars worth of zero coupon debt. Right that
Speaker 3: generates an interest rate expense that's fifty percent of the
Speaker 3: Fed Funds rate or the overnight funding rate. And so
Speaker 3: if you think about it in those terms, if I
Speaker 3: give you fifty dollars worth of zero coupon funding, you
Speaker 3: would say, well, that's going to be worth a lot
Speaker 3: more when rates are higher than lower. So if I
Speaker 3: make money when rates go up and I lose money
Speaker 3: when rates go down, well that sounds a whole lot
Speaker 3: like short duration. And so that's why deposits as a
Speaker 3: general matter have duration risk associated with them. And that
Speaker 3: duration risk is tied to the beta, not necessarily the runoff,
Speaker 3: although that's important as well, even without even if you're
Speaker 3: realizing exactly the expected runoff that you would anticipate given
Speaker 3: the level of rates and all the things we described.
Speaker 3: Or if you have a static balance, even as that
Speaker 3: beta moves around, your interest rate risk changes. And so
Speaker 3: the job of a bank alm department is to try
Speaker 3: to anticipate, on the one hand, that behavior and on
Speaker 3: the other the mix of assets that satisfies all the
Speaker 3: other criteria and mitigates the risks associated with the interest
Speaker 3: rate exposure of the deposits on the liability sides. You
Speaker 3: have to pick the right assets, and to do that
Speaker 3: you really have to understand your deposits. And so part
Speaker 3: of the point we're making in the paper is that
Speaker 3: the fact that the BEATA is variable, while not particularly
Speaker 3: controversial people have kind of known this intuitively for a
Speaker 3: long time, has important consequences for what happens on the
Speaker 3: asset side of the balance sheet, especially when rates go
Speaker 3: up quickly.
Speaker 2: When you say important consequences on the asset side, expand
Speaker 2: on that a little bit.
Speaker 3: Yeah, So the bank is subject generally speaking to risk controls.
Speaker 3: So you can't just take all the risks you want.
Speaker 3: There are risk limits on the duration of your equity.
Speaker 3: There's a rule called the economic value sensitivity rule. That's
Speaker 3: a basal requirement that looks at the sort of fair
Speaker 3: value sensitivity the entire balance sheet under interest rate changes.
Speaker 3: And so the key is that that generally speaking, banks
Speaker 3: have to hedge their interest rate risk. Now they can
Speaker 3: take positions relative to it to some extent, but they are,
Speaker 3: due to regulatory risk management requirements, going to hedge most
Speaker 3: of it. And so when beta's change relative to expectations,
Speaker 3: you have to do something on the asset side of
Speaker 3: the portfolio to adjust for it. And it's important to
Speaker 3: bear in mind that. And we'll talk about you know,
Speaker 3: policy transmissions through like bank lending channel type things which
Speaker 3: we have in the paper.
Speaker 1: But the.
Speaker 3: Securities holdings of a bank, the treasuries they buy, the
Speaker 3: mortgage backed securities they buy, are not the only source
Speaker 3: of duration. When they make a mortgage and keep it
Speaker 3: as a loan, or when they make a long term
Speaker 3: loan to a corporation, that's also interest rate.
Speaker 1: Risk, right, which is also moving around when rates are going.
Speaker 3: Up exactly yea. So banks have a lot of negative convexity.
Speaker 3: Negative convexity means that as rates go up, the exposure
Speaker 3: of the bank increases to that risk. So when rates
Speaker 3: go higher, they get longer duration, when rates go lower,
Speaker 3: they get shorter duration. This is just like being short
Speaker 3: an option, and so banks have options through a variety
Speaker 3: of channels. On the asset side, that's through the mortgages
Speaker 3: and other things, and on the liability side, which is
Speaker 3: a huge chunk of it. Probably coequal, if not larger,
Speaker 3: source of negative convexity is the sensitivity of those deposits
Speaker 3: and the beta, in particular to interest rates.
Speaker 1: Wit could I just ask on this topic the relationship
Speaker 1: between the deposit mix and the assets that a bank
Speaker 1: is actually investing in. Do in practice, does like a
Speaker 1: treasurer at a bank talk to the risk manager or
Speaker 1: whoever's in charge of the deposit mix, because I imagine
Speaker 1: a treasurer is just I always had it in my
Speaker 1: head as like someone sat there and they have like
Speaker 1: X million or billions of dollars to play around with
Speaker 1: and they can kind of, you know, within a certain framework,
Speaker 1: do what they want with it. But do you think
Speaker 1: they would actually consider like, oh, actually, this is what
Speaker 1: my deposit mix looks like. Here's a rough estimate of
Speaker 1: my duration. How much of this is sticky? And isn't
Speaker 1: and this is going to limit or shape my asset
Speaker 1: or my lending decisions.
Speaker 3: Well, that comes to the risk limits. So I can
Speaker 3: always speak in generality. Yeah, but when the industry is subject,
Speaker 3: when each institution has to satisfy risk limits, that means
Speaker 3: they can't take all the risks that they want. Now,
Speaker 3: where those particular things live within the institution, I can't
Speaker 3: really say, But as a general matter, like if your
Speaker 3: deposits are losing duration or gaining duration, that affects all
Speaker 3: of the other activities that you're taking, which can contribute
Speaker 3: or detract from the duration of the asset side. Because
Speaker 3: it's all about the collect it's all about the consolidated
Speaker 3: exposure of the whole balance sheet. Because you think about
Speaker 3: it as one giant interest rate exposure for the entire institution.
Speaker 3: You roll it all up, all those lines of business,
Speaker 3: all the lending businesses, all the deposit taking businesses. At
Speaker 3: the end of the day, you have one number, and
Speaker 3: that number has to be held within limits. That number
Speaker 3: is how many dollars you gain or lose when rates
Speaker 3: go up or down. And that's the thing. And you
Speaker 3: can compare that to the equity of the institution. You
Speaker 3: can compare that to the overall risk of the institution,
Speaker 3: and you can compare that to a bunch of different things,
Speaker 3: and there's all kinds of nuance underlying that, but generally
Speaker 3: speaking that the whole balance sheet has to be structured
Speaker 3: such that it does not have too much exposure in
Speaker 3: aggregate to change his interest rates.
Speaker 2: So I noticed reading your paper that one of the
Speaker 2: authors you cite regularly was actually a recent guest on
Speaker 2: the show Itamar Directxler, and we talked about the fact that,
Speaker 2: you know, we talked about sort of this in the
Speaker 2: context of the nineteen seventies and the impairment of monetary
Speaker 2: policy back then do to it's sorry different, but the
Speaker 2: nature of deposits and deposits moving out in that curtailing
Speaker 2: lending and so forth. But talk to us, what are
Speaker 2: the consequence is from your research and maybe bring it
Speaker 2: forward to today when you think about and people try
Speaker 2: to understand the transmission of monetary policy, which as Tracy
Speaker 2: mentioned earlier, in many ways goes through the banking system,
Speaker 2: like kind of have to what does some of your
Speaker 2: research imply for that?
Speaker 3: So a lot of our work is built off of
Speaker 3: what they've done and they basically make the argument that
Speaker 3: the fact that the beta is less than one means
Speaker 3: the deposit franchise has value, meaning your funding advantage from
Speaker 3: deposits that cost you less than the risk free rate
Speaker 3: to support is worth more when rates are higher and
Speaker 3: less when rates are lower. Whenever you make money when
Speaker 3: rates move around. That's interest rate risk, and so the
Speaker 3: deposit franchise generates short duration risk, which again just means
Speaker 3: you make money when rates go up, and so that
Speaker 3: balance is the long duration exposure. On the asset side
Speaker 3: of the portfolio. You can think of this somewhat differently
Speaker 3: and say the value of the bank is related to
Speaker 3: its funding cost. If its funding cost is lower, its
Speaker 3: value is higher. And so the rightquote unquote discount rate
Speaker 3: to apply to the assets of a bank is its
Speaker 3: funding curve, not necessarily sort of the risk free rate.
Speaker 3: In general, it's an equivalent statement. So we're just adjusting
Speaker 3: what they're saying and arguing that if the beta is variable,
Speaker 3: their beta is generally static, because they're making a pedagogical
Speaker 3: point about how interest rate risk is generated in a
Speaker 3: bank portfolio, and we're just saying that variability, that convexity
Speaker 3: can affect the decisions that banks make in a way
Speaker 3: that matters for a variety of participants in the market.
Speaker 3: So you mentioned monetary policy transmission. So the academic literature
Speaker 3: talks about the bank lending channel. The original version of
Speaker 3: the bank lending channel is more related to reserve requirements
Speaker 3: and the creation destruction reserves to facilitate monetary policy setting,
Speaker 3: and therefore that has an impact on not just the
Speaker 3: pricing of lending, but the quantity of lending. That's the
Speaker 3: key is banks can make fewer loans as a consequence
Speaker 3: of certain monetary policy decisions, or more loans is the
Speaker 3: consequence of certain policies decisions. And so Dreshler and his
Speaker 3: collaborators make an argument that deposit rates are a secondary
Speaker 3: channel for this, or now that there are no reserve requirements,
Speaker 3: a primary channel for this, where if the deposit rate
Speaker 3: goes up, you're expected funding costs for certain loans goes up.
Speaker 3: That gets fed through into pricing and quantities, and therefore
Speaker 3: you know there's a channel through which policy rate decisions
Speaker 3: can affect bank credit allocation decisions. In our argument in
Speaker 3: this paper is one the convex the nonlinearity of deposit
Speaker 3: rates amplifies that channel to some extent, just because the
Speaker 3: change in expected funding costs for a given loan is
Speaker 3: higher if you think betas are going up when rates
Speaker 3: are going up. And the secondary effect is that if
Speaker 3: the bank is losing capacity to support duration in its lending,
Speaker 3: which is another way to say this, if the deposits
Speaker 3: are getting shorter, that means the assets have to get shorter,
Speaker 3: and that means there's less space to make long term
Speaker 3: fixed rate loans, and so mortgages, for example, are long
Speaker 3: term and fixed rate. Some commercial term lending is long
Speaker 3: term and fixed rate. You know, a ten year loan.
Speaker 3: Commercial real estate lending is sometimes long term fixed rate,
Speaker 3: and so you know that in addition to all the
Speaker 3: securities holdings that they have are all sources of duration exposure.
Speaker 3: And so when deposits get shorter, the ability to make
Speaker 3: long term asset to generate long term assets included within
Speaker 3: that long term fixed rate loans is simply lesser as
Speaker 3: a general.
Speaker 1: Matter, if deposits are getting shorter in a rising rate environment,
Speaker 1: like how does that interact with the macroeconomic outlook as well?
Speaker 1: Because I take the point about you know, funding costs
Speaker 1: and things like that, but Also, if interest rates are
Speaker 1: going up, it's probably because the economy is doing relatively well,
Speaker 1: and so in that environment maybe banks would want to
Speaker 1: lend more. But you have this sort of natural constraint
Speaker 1: that's going on through the deposit through the deposits impact
Speaker 1: on the asset side.
Speaker 3: Yeah, it's a duration capacity constraint. And I should be
Speaker 3: clear when I say deposits are shorter, I don't mean
Speaker 3: they're more prone to run off. I mean that the
Speaker 3: beta is higher. Therefore, in this example, or I have
Speaker 3: zero coupon debt and floating rate debt, that mixture changes
Speaker 3: such that I have less long term zero coupon debt
Speaker 3: and more floating rate debt when the beta is higher. Right,
Speaker 3: So it's just a higher degree to which the cost floats.
Speaker 3: That means less interest rate risk in my liabilities. We
Speaker 3: can call it shorter because it has less risk. And
Speaker 3: when my liabilities get shorter, my balance sheet gets longer.
Speaker 3: Because I'm short my liabilities, they get less duration. Then
Speaker 3: the whole balance she gets more duration, and so there's
Speaker 3: less capacity to support the long term fixed rate lending
Speaker 3: that I was referring to. So this is where it's
Speaker 3: about quantities, not pricing. Oh, I seek, it's within the
Speaker 3: constraints on the bank's ability to take interest rate risk.
Speaker 3: There's simply less room for long term fixed rate lending.
Speaker 1: And then just on the general impact of having non
Speaker 1: linear deposit beta. As rates are going up, does that mean,
Speaker 1: like rates increase, that the effect of monetary policy tightening
Speaker 1: gets amplified through the bank channel.
Speaker 3: Well, there's a lot of academic literature about I would
Speaker 3: necessarily amplified, but it's definitely there's a lot of academic
Speaker 3: work that argues that this is one of the ways
Speaker 3: that that monetary policy affects the economy because it's not
Speaker 3: necessarily an applicification mechanism, it's just a mechanism. So you know,
Speaker 3: basically argument is, in addition to the traditional channel, there's
Speaker 3: this sort of duration channel that affects a very specific
Speaker 3: subset of lending, but but but still affects it.
Speaker 1: Should we should we all be researching higher paying bank accounts?
Speaker 1: Is that the suggestion should we do this?
Speaker 3: There are companies that do that. I mean, it's I
Speaker 3: wouldn't necessarily say that's the solution to this particular problem,
Speaker 3: but it you know, I've been I've always found it
Speaker 3: interesting that this is generally true like this, the beta
Speaker 3: effect is true, this cycle is true, last cycle. There's
Speaker 3: a bank accounts have a value that's reflected in these betas,
Speaker 3: and it is frustrating for people who want kind of
Speaker 3: like a no arbitrage type model where no money is
Speaker 3: left on the table. But at the end of the day,
Speaker 3: the behavior of depositors is clear and the value they see,
Speaker 3: which is not necessarily reflected in the interest rate, is real.
Speaker 3: And uh and this is this is the risk that
Speaker 3: the bank has, which makes it very hard to manage.
Speaker 3: That's behavioral.
Speaker 2: I still think we should pay banks for holding our money.
Speaker 2: I mean, I know, don't no, I don't no. I know,
Speaker 2: in theory, we're lending them money. But come on, they're
Speaker 2: providing a service.
Speaker 1: A negative interest rate thing all over again.
Speaker 2: They're providing a service they make, they run a nice website.
Speaker 2: I can pay my billage. We really, I really think
Speaker 2: we should be paying them. I don't understand how they
Speaker 2: pay us. I can't take interest.
Speaker 1: Producers, please cut the spit off the podcast. No, keep
Speaker 1: it in all right, Well, Josh, really appreciate you coming
Speaker 1: on the show for another appearance. Again, I've lost count
Speaker 1: that was a really great insight into how this kind
Speaker 1: of opaque aspect of the banking business, but really the
Speaker 1: heart of the banking business actually works.
Speaker 3: So thank you so much, thanks for having me.
Speaker 2: I think Josh gets a mug.
Speaker 1: Now, because yeah, have we given you a month?
Speaker 3: Okay, sorry, I'll take another month, but but I have
Speaker 3: a month.
Speaker 1: You take a mug and give it to you next
Speaker 1: time you see your own powers, give it to him
Speaker 1: and tell him that we want to come on the show. Joe,
Speaker 1: have I convinced you to open up a certificate of
Speaker 1: deposit or like a different bank account.
Speaker 2: No, I'm gonna I'm gonna email my bank tonight and
Speaker 2: ask if there's any way that I can get pay
Speaker 2: They pay them a little bit for the great service
Speaker 2: they provide me.
Speaker 1: I think you've missed the entire point of this conversation. No,
Speaker 1: but it is really interesting in some respects. It's always
Speaker 1: surprising to me how much new information there is to
Speaker 1: learn about the way that finance and economics actually works.
Speaker 1: Because you think that in you know, throughout history, people
Speaker 1: have modeled deposit betas as sort of linear or having
Speaker 1: a stable relationship with benchmark interest rates. But then a
Speaker 1: paper like this comes along and actually says, no, it
Speaker 1: doesn't really work like that.
Speaker 2: It really is fascinating how young it all seems, how
Speaker 2: new it all seems. There's a line in Josh's paper saying,
Speaker 2: first deposit convexity amplifies the bank lending channel of monetary
Speaker 2: transmission EG and then he cites a paper from Berneki
Speaker 2: and Ail and Blinder in nineteen eighty eight, like that's
Speaker 2: not even that long ago. The idea that some of
Speaker 2: these really interesting ideas or sort of core ideas, some
Speaker 2: of them. The key paper that you say it is
Speaker 2: thirty It feels like in the we're just it's day
Speaker 2: one in our understanding of this. Sometimes it feels like that.
Speaker 1: No, absolutely, and we're also still trying to understand it
Speaker 1: in a very different environment. And we didn't even really
Speaker 1: touch on this maybe Josh mentioned it once, but you know,
Speaker 1: we've had QI and so interest rate hikes are happening
Speaker 1: at the same time that the FED is reducing its
Speaker 1: balance sheet, and that impacts assets as well. We also
Speaker 1: have things like the reverse Repo Facility, the RRP, which
Speaker 1: we didn't have before, and so we're still learning things
Speaker 1: about how all of this works. Against a very different
Speaker 1: financial and economic backdrop, So there really are so many
Speaker 1: moving parts.
Speaker 2: And then just the idea of the pressure that this
Speaker 2: puts on the asset side and the constraints that come up,
Speaker 2: and the idea that okay, one thing moves, and then
Speaker 2: you know, you can only be so limited in how
Speaker 2: quickly you can hedge or alter or change your asset
Speaker 2: mix for the bank. So lots of interesting stuff.
Speaker 1: Yeah, I wouldn't want to be a risk manager at
Speaker 1: a bank, but I also wouldn't want to pay them
Speaker 1: for managing my money, So I'm a hypocrite.
Speaker 3: All right?
Speaker 1: Shall we leave it there?
Speaker 2: Let's leave it there.
Speaker 1: This has been another episode of the Odd Blots podcast.
Speaker 1: I'm Tracy Alloway. You can follow me at Tracy Alloway.
Speaker 2: And I'm Jill Wisenthal. You can follow me at the Stalwart.
Speaker 2: Follow our producers Carmen Rodriguez at Carmen armand dash Ol
Speaker 2: Bennett at Dashbot and Kelbrooks at Kelbrooks. And thank you
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