New Study Measures Impact of U.S. Treasury Supply Versus Fed's Monetary Policy on Bank Deposit Funding
New Research from Columbia Business School Challenges Conventional Wisdom of Bank Funding
NEW YORK, Jan. 28, 2020 /PRNewswire/ -- As economists debate how to regulate the interconnected U.S. banking system in the face of systemic risk, bank deposit reserves have become one of the most important measures for financial stability. The interest rate set by the Federal Reserve and requirements for how much money banks must carry in reserve have long been considered the most important factors in bank funding capacity. But new research from Columbia Business School Professor Yiming Ma, finds that another key policy variable, the supply of Treasury securities – not just the Fed's monetary policy rate – can directly impact banks' deposit funding capacity.
In the research, Ma identifies a new relationship between the supply of Treasury securities and the funding structure of the U.S. banking sector: treasuries shrink deposit funding at commercial banks by reducing investors' demand for holding deposits. Monetary policy rate hikes, however, which have long been viewed by economists as determining liquidity conditions in the market, mainly reduce the supply of deposits in the banking sector. As a result, Treasury issuance and monetary policy rate hikes both crowd out deposits in the banking sector but with opposite distributional effects. Regions where more banks compete experience the largest deposit outflow with Treasury growth, whereas local markets served by fewer banks are most affected by changes in monetary policy. Furthermore, treasuries can curb the increased reliance on wholesale types of funding, which is often viewed as a risk to financial stability.
"Setting monetary policy that balances economic growth and financial stability becomes more challenging each year as the banking system becomes more complex," said Professor Ma. "The Fed should not set key indices like the federal funds rate in isolation. The relationship we find between the supply of Treasuries, the Fed's monetary policy rate, and deposit outflows show that monetary policy and Treasury supply should be considered together when the Fed sets rates."
The study, co-written with Wenhao Li, Assistant Professor of Business and Finance at the USC Marshall School of Business and Yang Zhao, PhD candidate at the Stanford Graduate School of Business, compared commercial banks' branch-level deposit volumes and rates with Treasury volumes and yield rates, using data from 1997 to 2016. They find that the relationship between Treasury supply and bank deposit outflows is more pronounced in counties with greater banking competition. It also disproportionately impacts institutional investors – hedge funds, pension funds, and mutual funds, among others – who rely on wholesale-funded banks.
The Treasury supply relationship also sheds light on the effect of the Reverse Repurchase (RRP) Facility – the repurchasing market used by the Fed to help control the federal funds rate. Researchers found that when the Fed adjusted the RRP rate as part of a comprehensive approach to monetary governance, passthrough to deposit funding was improved by about a quarter. The results also demonstrate that the RRP Facility can be a moderating factor against the distributional effects of standard monetary policy on deposit funding in different geographic regions.
"Models of imperfect deposit competition, like the one we use in this study, reveal that standard monetary policy does not act in isolation to affect the banking sector. This new outlook on monetary policy proves that we should not only pay attention when policy rates fluctuate, but also whether treasury supply grows or deflates – and, that the scope of monetary policy plays an important role too," said Professor Ma.
Other key takeaways include:
- BANK LIABILITY IS IMPACTED BY TREASURY SUPPLY – Treasury supply can affect the structure of bank funding and overall financial stability. Institutional investors are particularly sensitive to increases in Treasury supply, which lowers banks' ratio of wholesale funding.
- THE RRP FACILITY IMPROVES OVERALL EFFICIENCY OF MONETARY POLICY – Hikes in the RRP rate resemble an increase in the Treasury supply in reducing the reliance on wholesale funding. This means that deploying the RRP Facility can mitigate risks in wholesale funding build-up that can come with tightened monetary policy.
- FUTURE CONSEQUENCES OF THIS MODEL – Models of imperfect competition could be extrapolated further to explore how banks choose their competitive environment.
The study can be found online: The Passthrough of Treasury Supply to Bank Deposit Funding.
To learn more about the cutting-edge research being conducted at Columbia Business School, please visit www.gsb.columbia.edu.
SOURCE Columbia Business School
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