Higher Deposit Costs Continue to Challenge Banks

This post is part of a series titled “Supervising Our Nation’s Financial Institutions.”

One of the pressures the banking industry has faced over the past two years is the rising cost of deposits. Rates paid on deposits have risen sharply since March 2022, when the Federal Reserve began tightening monetary policy. Although last week’s reduction in the Fed’s target range for the federal funds rate promises relief, there are factors other than monetary policy at play. One such factor is an apparent change in the rate sensitivity of depositors as interest rates rose. More so than in previous periods of interest rate hikes, banks—especially community banks—have been compelled to increase the rates they pay for deposits. These higher funding costs have implications for bank earnings and capital.

Funding Cost Fundamentals

When interest rates rise, banks have an opportunity to increase earnings by raising the interest rates charged on loans by more than they raise the rates paid for deposits.Banks can borrow money to fund assets, but for most banks, deposits make up the bulk of bank funding. Banks prefer depositors who are relatively rate insensitive—they won’t move their deposits elsewhere for higher rates—during rising interest rate environments. Understandably, banks aim to keep deposit rates at the levels needed to keep and, if desired, attract new deposits.

Depositor sensitivity to interest rates can be measured by a “deposit beta,” which is defined as the portion of an increase in a base interest rate, such as the federal funds rate, that is passed along to the rate paid on deposit accounts. With a beta of 0.5, for example, a 50-basis point increase in the federal funds rate would increase deposit interest rates by 25 basis points. Betas generally range from 0 to 1. A beta closer to 1 indicates that a bank’s deposits are highly sensitive to interest rate changes—there is close to a 1-to-1 increase in deposit rates for base rate changes—while a beta closer to 0 indicates very little sensitivity to changing interest rates.

Deposit betas vary across time and across types of accounts and institutions. Deposit betas associated with internet banks tend to be very high, for example, because their customers tend to shift money across online institutions in search of the highest interest rates. Betas for checking accounts tend to be lower than for time deposits, such as certificates of deposit, because consumers want ready access to funds and are willing to earn little to no interest on them.

Why Deposit Costs Continue to Rise

Economists and bank supervisors tend to examine cumulative deposit betas when assessing the effects of rising interest rates on the costs of bank deposits. A cumulative deposit beta measures the change in deposit rates (or interest expense) since the start of the most recent rate hiking cycle. The paths of the current cumulative deposit beta and the effective federal funds rate (EFFR) from the start of this rate hiking cycle to the present are illustrated in the figure below.

The Effective Federal Funds Rate and the Cumulative Deposit Beta for All U.S. Banks

SOURCES: Federal Reserve Bank of New York and author’s calculations from Call Report and Uniform Bank Performance Report data.

NOTE: The effective federal funds rate (EFFR) is calculated as the effective median interest rate of overnight federal funds transactions during the previous business day.

Between March 2022 and July 2023, the Fed hiked the federal funds rate a cumulative 525 basis points. Even though the EFFR was essentially constant between the last rate hike in the third quarter of 2023 and the second quarter of 2024, the cumulative deposit beta continued to rise, meaning banks had to continue to increase the rates paid on deposits to keep or attract that type of funding.

Banks were flush with deposits during and right after the COVID-19 pandemic because of government stimulus payments and limited spending opportunities, reducing the incentive for banks to increase deposit rates as the Fed’s interest rate hikes started. Those “excess” deposits, however, have been depleted over the past two years as consumers have increased their spending and banks have had increasing competition with credit unions, fintech firms, money market funds and other options for funding.

Implications for Earnings, Capital

Increasing deposit betas aren’t, by themselves, necessarily problematic. If banks can increase the rates earned on loans by as much or more than the increase in deposit (or other funding) costs, earnings will likely rise or stay steady, at least in the short term.

Problems arise when banks cannot pass on the increased costs of keeping depositors to higher loan rates, causing a decline in net interest income and a likely decline in overall profitability. This cycle of funding pressure and earnings preservation is a vicious one: A bank that does not have the excess space in its interest margin to pay up to keep deposits often ends up losing them, restricting its ability to originate new loans and purchase investments, narrowing margins and lowering profitability further. Over time, deficient earnings can limit capital accumulation and the ability to appropriately fund the allowance for lease and loan losses, an account that absorbs losses when loans are charged off.

What’s Next

Typically, there is a transition period between tightening and easing cycles, and deposit costs could stay at or just below current levels for a while before beginning a more pronounced decline. How that decline positively affects bank earnings depends on how quickly loan rates decrease, the costs and availability of other types of funding, competition, and other factors. All institutions will need to look ahead and plan for different market conditions to promote continued profitability and customer retention.

Note

1. Banks can borrow money to fund assets, but for most banks, deposits make up the bulk of bank funding.