By Shohini Kundu, Tyler Muir, and Jinyuan Zhang

About the authors: Shohini Kundu, Tyler Muir, and Jinyuan Zhang are professors at UCLA Anderson School of Management.

The U.S. economy has surprised many forecasters by avoiding recession as inflation has come down. The Federal Reserve's interest-rate management since the Covid pandemic appears mostly brilliant in hindsight. But we believe another, unappreciated factor was at work, one behind the control of the Fed.

Over the past decade or so, there has been a sweeping change in how banks reward depositors. As a result, money is staying inside the banking system -- making it available for lending that bolsters business and consumers -- when, in prior periods of rising rates, more cash might've left banks and switched to money-market funds.

There's a potential economic downside to this development, as well, and we'll explain that below.

First, as many savers have noticed, a group of what we call high-rate banks -- PNC, Marcus by Goldman, Citi, Ally, and Capital One -- offer from 4% to 4.5% on savings accounts, fairly close to market interest rates.

In contrast, traditional, low-rate banks -- JPMorgan Chase, Wells Fargo, Bank of America -- continue to pay close to 0% on savings accounts. (Many offer other savings products with higher yields.) A customer with $10,000 in his or her savings account saw an extra $450 in interest over the last year from high-rate banks, and the magic of compounding means such gains amplify over time.

U.S. bank savings deposits exceed $10 trillion. Low-rate bank depositors are forgoing in the aggregate hundreds of billions in annual interest. As long as that sharp difference in yields lasts, we can expect high-rate banks to continue to grow and, perhaps, some big low-rate banks to adopt their rivals' model.

This stark divergence in banks' business models is relatively new, enabled by the rise of online and mobile banking. High-rate banks save costs by operating online and eschewing physical branches. Since 2009, these banks have decreased their number of branches by a staggering 63%. Avoiding the costs of running physical branches allows them to pass along to depositors higher rates of interest and that has led them to attract yield-seeking customers. Competition in this market is fierce, both because their customers are always looking for higher yields, and because physical location matters much less.

In contrast, a customer seeking in-person banking services might give up a higher deposit rate for a bank that is convenient to their home or work. This can blunt competition among in-person banks.

Starting in early 2022, the Fed rapidly increased interest rates from 0% to more than 5%. The banking sector has typically seen outflows during such periods as banks held fast to lower deposit rates. Indeed, aggregate bank deposits fell by more than 5% from Spring 2022 to Spring 2023. But the decline was almost entirely at low-rate banks; high-rate banks didn't see a significant outflow. This gave their approach to lending more weight as the economy adjusted to higher interest rates.

High-rate banks seek to make loans that align with their deposits, meaning higher rates and briefer maturities. As a result, they tend toward business loans, which often reprice like an adjustable mortgage, and consumer credit such as car and credit card loans. The low-rate banks tend more toward longer-term and lower-rate loans, also aligning with their deposit bases.

We suspect the high-rate banks' newfound strength helped the economy avoid recession by preventing an even larger outflow of deposits from the banking sector, and because they actually provide consumer and business loans -- the outflow doesn't matter so much for low rate banks if they aren't lending as much. Many economists believed the Fed's higher interest rates would prompt a significant credit crunch, producing a recession. As we explain in a working paper, high-rate bank lending avoided that result by providing a credit cushion.

The higher-rate, shorter-term lending comes with risk, however, and we think this is a growing issue for banking regulators. We calculate that with a 10% shift of bank deposits from low-rate banks to high-rate banks, the overall banking sector's loan portfolio would see a 5% shorter maturity and, significantly, a 20% rise in credit risk.

The banking sector's traditional role in what's known as maturity transformation -- adapting short-term deposits to longer-term loans and other assets -- is lessened by the rise of high-rate banks. In the new banking landscape, low-rate banks are immediately more vulnerable to interest-rate changes because high-rate banks steal away their depositors. And high-rate banks bring added credit risk to the system.

This suggests to us that a one-size fits all regulatory scheme might not work any longer. Capital ratios and liquidity standards may need to be reassessed, based on institutions' peculiar risk profiles. A more granular approach to monitoring deposit flows and asset allocation within the banking sector can offer a deeper understanding of the risks hidden beneath the surface of the banking system.

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October 31, 2024 03:00 ET (07:00 GMT)

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