Josh Younger Explains How Banks Really Manage Rate Risk

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1:15Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway. And I'm Joe Weisenthal. Joe, what do you know about the dark arts of asset liability management? only things that have been told to us about it on the odd lots wait that's actually quite a lot yeah no that's true it seems tough deposits can be flighty sometimes they can be stable sometimes when rates go up they get passed on to deposit sometimes they don't deposit betas change over time um some things that uh yeah that's about okay that's about it no that's pretty good podcast over we're done podcast over no you're absolutely right about your characterization of deposits and i think one of the really interesting things about banking is it is kind of built on this tension which is that in theory you know i can put my money in a bank as a deposit and then i am theoretically entitled to pull it out at any time and i for one can't really imagine of business where like at any single point I could see a majority of my customers suddenly vanish.

2:25But it is also true in practice that people who put their money in banks, they don't tend to move it around that much. And that is the thing, like the magic behavior that enables banks to actually lend money or buy assets like bonds and things like that. Yeah. And, you know, obviously part of the reason anyone is having this conversation still is we all have, we remember this past March with SVB. But I recall at the time in some of our episodes around then thinking about how, I don't know if paradox is the word, funny is the word, or weird it is, that on some models, bank deposits are extremely sticky in long duration.

3:11And I think there's that stat, Maybe it's fake, but people are more likely to get divorced than leave a bank is one of those things that people say. And if you have a customer, that's great. On the other hand, sometimes the deposits do leave and can leave in five seconds and it doesn't take very much. So it always seemed to me that rather, I wonder, are deposits, do they exist on some continuum of sticky to long duration? Or are it more like Schrodinger's deposits? Either they're there or they're not there, but that there's no sort of in-between stay. Yeah, we did that great episode with Joe Abate over at Barclays about bank deposits.

3:49And we've been joking on the podcast since that in order to improve the transmission of monetary policy, everyone needs to go out, do their market research, find a high paying bank account somewhere and actually move their money. And, you know, I am joking, but also kind of not. There is an interaction between banks and deposit rates and the effective transmission of monetary policy. I mean, banks are supposed to be the primary mechanism through which a lot of monetary policy is transmitted. And so the question of how deposits are actually working, so whether or not they're sticky, whether or not that stickiness changes in an environment where rates are going up or down, and also how those deposits sort of feed into monetary policy.

4:38That is a really big topic. And I think we should do more on it. Totally. You know, the thing that really strikes me in this is a bank run is the perfect example of non-linearity, right? And so something is one state and then something is suddenly a very different state. And we went from, and I think like we've learned in recent times how tricky that is to manage. And I think understanding the actual management of that non-linearity in practice is something we can dive into further. Right. And I did call it the dark art of asset liability management at the opening. And to some extent, it is kind of opaque.

5:15Like no one gets a lot of transparency into how an individual bank is actually managing things like deposit and interest rate risk. So I'm glad we can do this episode. And more than that, we are really doing it with the perfect guest. We have someone who's been on All Thoughts many times now. He's now climbing the ranks. Oh, really? Don't you think? I mean, of the most - He must be. He must be. I mean, he's up there. Yeah. All right. So we're going to be speaking to one of our perennial favorite guests, Josh Younger, formerly of J.P. Morgan, now a senior advisor over at the Federal Reserve Bank of New York.

5:49Josh, thank you for coming back on All Thoughts for like the fifth, sixth time? I don't know. I've lost count, but it's great to be back. I really appreciate the opportunity. It's great to talk about this. And I should just mention that we're recording this on November 9th. And Josh, you have something to say to our audience. Yes, I almost memorized it. But we'll see if I get all the parts right. But these views are my own. And those are my co-authors from the paper that we wrote. And they don't necessarily reflect the views of the Federal Reserve System, the Federal Reserve Bank of New York, or the Federal Reserve Bank of Dallas.

6:23Oh, yeah. Yeah, I should mention that, I mean, I kind of figured that Josh would be an expert on this anyway. But one of the reasons we wanted to talk to him is because he did just publish a paper at the Federal Reserve Bank of Dallas called Deposit Convexity, Monetary Policy and Financial Stability. And it gets into the nuts and bolts of all the themes that Joe and I were just discussing in the intro. So speaking of the paper, I mean, one of the things that you mentioned in the research is that you and your authors have sort of personal experience with the way banks actually deal with interest rate risk.

7:02Can you talk to us a little bit about how banks typically manage this? Like, how are they thinking about things like deposits and interest rate exposure? Yeah, so it's very tempting. I mean, Joe, you were saying earlier that deposits are there until they're not, but they're also an overnight demandable liability, meaning you can get your money back whenever you want your money back and you tend not to. So it's a very behavioral process. And so a lot of the work of managing the interest rate risk of a bank is really understanding that behavior because deposits are typically by far the largest source of funding for most banks.

7:41Depending on the kind of banking you're doing, you might have more or less of it. But it's typically a huge chunk. And it's not something you can, I mean, we made an attempt to write it down on paper, but it's all based on the premise that people tend to leave their money at banks for long periods of time, even if that interest rate is below what the broader market would consider risk-free. Now, there's lots of reasons for that. You certainly need bank deposits to live your life. So people usually call this a convenience yield because you use bank deposits for actual transactions as opposed to money market fund shares, which you don't.

8:13But as a bank, you have one set of liabilities you have to understand. And then on the asset side, sometimes there's some complexity, like mortgages are relatively complex. Lots of loans have embedded, quote unquote, options, meaning they have floors and caps and things like that. But those are sort of easier to model from a first principles like financial math perspective. And so you have a pretty good understanding of the interest rate risk on the asset side of the portfolio. And a lot of the legwork is spent understanding the liability side, specifically deposits. In light of that, so Tracy mentioned we talked to, we did an episode with Joe Abate over at Barclays, and that was just a few weeks before SVB, and we didn't, there was no intention.

8:52But the question then was, well, rate hikes have gone up, or sorry, rates have gone up. By then, at that point, the Fed had done a ton of hiking. And yet, you know, you look around and deposit rates, or the rates that banks were paying out on people's deposits hadn't gone up that more. So we explored this idea of deposit betas. In your research, what can we say, just based on your research, about the nature of how banks time the passing along of higher rates? So it brings up kind of the mechanism, which is we talk about this beta. What does it represent? Why does it move? Because there's a temptation to think there's one big book of deposits and a giant lever somewhere in the bank.

9:36We should just say, so beta is like the degree to which these two things are moving in tandem. So benchmark interest rates going up are rates paid out on retail bank deposits or other types of bank deposits actually going up. Yeah. So for quote unquote market yields, the yield you would get from money market fund, for example, or close to that goes up by a hundred basis points. How much of that is represented in your deposit rate paid as a bank? You think bank thinks about paying interest on deposits, so we call it rate paid. But obviously the depositor is getting paid that interest. That's the rate you earn.

10:05And a beta of 25 % would mean for every 100 basis points or one percentage move in market yield, 25 basis points or a quarter of a percentage point is actually reflected in the deposit rate. So the temptation is to say, well, there's just this big book of deposits. There's a giant dial somewhere in the bank. And you kind of move the dial less than the market yield moved. And you do that to achieve some business outcome. and there's sort of two things to think about with that. The first is that the actual beta, the changes in beta or the level of the beta is to a great extent the consequence of the deposit mix, meaning how much of these things are in time deposit, certificates of deposit, things with term exposure and how much of that is, let's say, zero interest checking.

10:51And so as - Demand deposits they're called, right? Yes. Where you can withdraw them - Anytime. When you want, on demand. Yeah, so you could say, I want a demand deposit account. I want to get my money whenever I want. Or you say, I'll get my money in three months, and I want to earn a slightly higher rate of interest for that. And typically, those time deposits are priced at some spread or difference to the market yield. And demand deposits typically a very low interest rate. And so as customers move from demand deposits to time deposits, there's naturally more reactivity, just because they're terming out their deposits.

11:23So that's one source of behavior. And then there There is, to some extent, a dial that reflects savings and checking account rates, particularly on the institutional side. So the rates paid to corporations and investment managers and things like that, who tend to be much more sensitive to these economic considerations. They leave a lot more money on the table, basically, when deposit rates are incrementally higher or lower. And in that case, the question is, do I want to grow my business or shrink my business or keep it the same? So there's kind of a debate when you're talking about a beta. Are you talking about the market neutral beta, meaning my market share stays constant?

11:57Are you talking about the beta required to grow my business? Are you talking about a beta required to shrink my business? There's been a lot of discussion about how size can sometimes be more expensive, not more profitable. And so you might want to shrink a business, for example. And so when we think about topics around interest rate risk management, I always like to think in terms of the sort of market neutral beta, which is what is the market beta I need to pay to keep all the deposits I currently have, or at least my share of the deposits in the system, because that's more reflective of the actual underlying interest rate risk of deposit liabilities as opposed to the business management and planning decisions of an individual institution.

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14:04Go to public.com slash market and earn an uncapped 1 % bonus when you transfer your portfolio. That's public.com slash market. Paid for by Public Investing. All investing involves the risk of loss, including loss of principal. Brokerage services for U.S. listed registered securities, options and bonds and a self-directed account are offered by Public Investing, Inc. Member FINRA and SIPC. Crypto trading provided by XeroHash. Complete disclosures available at public.com slash disclosures. Getting back to the idea that, you know, in theory, people can pull their money out of banks whenever they want, unless they're in something like a certificate of deposit, but in practice, they tend not to.

14:43And I remember this is something we spoke to Abate about. There are a lot of people who have an account at a specific bank because they're getting something else out of it. There's a relationship there, a business relationship. They know each other. Maybe they're getting a loan, a business loan or something like that. How sticky are deposits in practice? And does it vary by deposit type beyond whether it's a demand deposit versus a termed out deposit. Yeah, the type of depositor is really important. And so, you know, maybe taking a big step back. So think about the system as a whole. Why do we think deposits are long lived?

15:20If you go back to the state banking era of the 1830s and go all the way to today, for most of that period, deposit balances are growing at or faster than gross domestic product, which tells you that the deposits in the system as a system are there for the most part. Now, there are more outlets now than there were back then to leave the banking system, go to, say, a money market fund. There certainly weren't money market funds in the 1850s, but generally speaking, deposits tend to grow with or faster than GDP. So even if you take your deposit out of one bank, you're probably putting it at another bank.

15:51So deposits in the system are very long-lived. But then there's the question of the type of depositor. And so on the one hand of what we call retail depositors, I'm just using liquidity coverage ratio terminology. This is what the regulators have used to establish different types of deposits. So there's a common language for this now. Retail or stable retail deposits are individuals, like people at this table. We tend to be relatively insensitive to rates on the whole, because we use our deposits for, for the most part, for lots of stuff. So we go to buy coffee with it and we go to the movies or whatever, like you pay your gas bill, even if it's direct deposit from your bank account.

16:30It's still from a bank account. It's not from a money market fund. And so the convenience yield, so to speak, of having bank deposits is relatively high. And even if most people don't keep a lot of money at the bank, there are a lot of people. And so that adds up to a big deposit base. So most of the useful money in the economy is in deposit format used by individuals. And then if you go, so we call that a low beta deposit or a sticky deposit. And that's, again, a statement about the rate paid, not necessarily the propensity for that deposit to leave the bank. We can talk about that separately.

17:01But this is assuming I pay whatever rate is necessary to keep that deposit. So that's a relatively low beta, low rate deposit, not much reactivity to market yield. And then if you go into what the regulations term the wholesale space, wholesale deposit space, which is really institutions, asset managers who have excess cash, corporations who have excess cash, they kind of split it into two buckets. One is what's called operational deposits. Operational are used to meet payroll and various expenses. If you import export, you have to pay somebody with that deposit. And so those still need to be in the banking system somewhere.

17:36Now you can move them around between banks, but the rate paid on those tends to be a little lower than market yields, for example, just because they still need to be a bank deposit at the end of the day. So there's still a convenience yield so to speak, to have that. And then at the high beta end of the spectrum, you have non-operational deposits, which is excess cash that's being left in a deposit account for reasons unknown. It could easily go to a money market fund. It's money that corporations don't need to meet regular payroll and expenses. And so they're kind of keeping it because it's convenient to have some excess savings just in case maybe or something like that.

18:12But it's not being used on a daily basis. So in principle, it could be in anything. It's more of an investment in deposit accounts. So to keep those funds, you need to pay a relatively high beta, pretty close to one, because otherwise they'll just go somewhere else or to a money market fund. What happens when the Fed embarks on, and we've had this hiking cycle, maybe it's over, past hiking cycles. What is your research show really happens to deposit betas over time as a hiking cycle picks up? Yeah. So here we're thinking about the consolidated beta of the whole institution. So this is if you take whatever fraction you have in retail, wholesale, operational, wholesale, non-operational, and even wholesale funding and term funding, you just think of the funding rate the bank has to pay to fund itself.

18:57that beta, just the ratio of that rate to the risk-free overnight rate, tends to increase as interest rates rise. So this is related to the propensity of corporations in particular, but also individuals to move their excess savings into money market funds when interest rates are above zero and the opportunity cost of keeping them at a bank increases. That's not true for everybody, but on average and over the long sweep of history, it's tended to be the case that the beta goes up when rates go up. Wait, so this is different to how people normally think of the way bank deposit rates work, which is people tend to think of them as like a linear thing, like rates go up 100 basis points and then deposits will go up 100 basis points, maybe not 100 exactly for obvious reasons that we've discussed on the podcast.

19:47But by a set amount each time, but you're kind of arguing that actually it's a non-linear relationship. And as interest rates go up, the beta, the relationship actually gets stronger. Yeah, exactly. So like linear means a static beta. A static beta means 25 % of every interest rate increase goes through to deposits, for example. And so if that beta increases, the non-linear relationship starts turning up and getting some convexity to it. And that means that the last hundred basis points are not the same as the first hundred basis points, for example, from the depositors perspective. So on that note, you mentioned money market funds just then, like how much of this dynamic is driven by competition with money market funds?

20:28Because if I think about like things that have changed in the financial system, it feels like MMFs are a bigger presence, although maybe they're not compared to 2008. I can't remember the numbers, but it feels like nowadays there is this range of options for where you want to put your excess cash. And we have seen inflows to money market funds pick up. We have seen that play a role in things like SVB and Silvergate, obviously, or sorry, arguably. So I'm just wondering, like, how do banks compete with MMFs? And how does that feed into that nonlinear relationship that you just described? So they're competing primarily with each other, I would argue, like a bank has expenses that a money market fund does not, namely capital and liquidity.

21:11And so, you know, money market funds are essentially a pass through instrument. And so They don't have branches. They don't have payment processing services. They don't have all of the overhead a bank deals with. So it's kind of a misnomer to think that a bank could, quote unquote, compete with a money fund purely on the yield that they offer because it's a very different business. Right. But this is what I mean. Like banks are always going to have expenses. So they're always going to have to pay out less than a money market fund. Like they won't be able to pass on that full interest rate hike, right?

21:39Generally speaking, yes. And now they can compete with each other and they could try to source deposits that have they're associated with profitable activities. So we haven't really talked about what you're using these deposits for. If you're using them to just hold excess cash, it's probably less attractive. If you have businesses like wealth management and market making trading that generate non-interest revenue, it might be more interesting. But you have to have something to do with the funding. And that's why in some cases, banks were very happy to see these deposits roll off. And when you have non-operational deposits supporting cash holdings, there's not much spread in that.

22:13You still have all of the expenses. So you have a relatively high interest deposit funding to support non-spread earning cash assets. And that's really not what they're in the business of doing. And so under those circumstances, higher rates in money market fund, runoff to money market funds is reasonably fine. But then again, if you have, again, very profitable businesses that need funding, you want to bid to retain that funding because otherwise you have to shrink the business. And so I would think of this as more of, to some extent, competing with money funds, but also banks competing with each other for those marginal deposits that support profitable activity.

22:50Joe, do you remember, I think it must have been just a couple of years ago when banks were complaining about excess deposits. Absolutely. For one thing, yeah, absolutely. And it was always sort of, it took me actually many odd lots episodes to even understand the coherence of that statement. Now, in November 2023, I can understand why having too many deposits would be a problem. But it took me a while to wrap my head around that concept. Obviously, in the case of SVB, that one was very straightforward because there were not many natural things they could do on the asset side of the business with all of that VC cash that they were getting in and so forth.

23:29They weren't a traditional lending bank. But that actually segues to my next question, which is in a time of moving rates, when rates are stable, whatever, It seems banking doesn't seem that hard. But in a time of when rates are on the move, and as you mentioned, say the market neutral beta is such that banks want to keep their business the way it is, move around the deposit, move around the rate to hold on to your deposits. Moving around the assets does not seem very easy and they're illiquid and in many cases are elongating. Talk to us about, you know, as the deposit mix changes or they have to pay out, what kind of strain that places on the asset side for the banks?

24:11Yeah, well, I think the key is that the bank is exposed to interest rate risk from these deposits. So earlier the question is, how can you have long-term interest rate risk from overnight demandable liabilities, demand deposits? I can get my money back any time. This is an overnight liability, right? And the answer is if people keep their money there for a long time, that beta below one, meaning not all of those interest rate increases get passed through, generates a ton of interest rate risk for that kind of liability. And you can think of it by splitting it up into what we call replicating portfolio.

24:42What's equivalent to a 50 % beta deposit liability? It's$50 worth of Fed funds linked floaters, perfectly floating rate liabilities, and$50 worth of zero coupon debt. That generates an interest rate expense that's 50 % of the Fed funds rate or the overnight funding rate. And so if you think about it in those terms, if I give you$50 worth of zero coupon funding, you would say, well, that's going to be worth a lot more when rates are higher than lower. So if I make money when rates go up and I lose money when rates go down, well, that sounds a whole lot like short duration. And so that's why deposits as a general matter have duration risk associated with them.

25:20And that duration risk is tied to the beta, not necessarily the runoff, although that's important as well. Even if you're realizing exactly the expected runoff that you would anticipate given the level of rates and all the things we described, or if you have a static balance sheet even, as that beta moves around, your interest rate risk changes. And so the job of a bank ALM department is to try to anticipate on the one hand that behavior and on the other, the mix of assets that satisfies all the other criteria and mitigates the risks associated with the interest rate exposure of the deposits on the liability side.