As the Federal Reserve has hiked rates from 0% to over 4.75%, the average interest rate on bank deposits has remained low, around the FDIC's national average for savings accounts of 0.37%. This has led many to ask the simple question.
Why aren’t banks raising the interest rate on deposits?
The Hotel California Banking System
One reason is that they simply don't have to. The banking industry is like the Hotel California.
"Relax," said the
night Bank man
"We are programmed to receive
You can check out any time you like
But you can never leave!"
In today’s economy, to have a money balance of any size is to have a bank account, period. There is no way out of it, or around it.
But what about cash?
Sure, you can withdraw cash, but you’re still a creditor to the Federal Reserve, the bank of all banks.
This answer isn’t complete though. Banks could still compete with one another to raise deposits. For example, if Bank ABC wanted to attract deposits, they could offer 1%, while Bank XYC across the street only offers 0.50%.
So why don't they do it?
For a more complete answer, we must revisit the concept of stateful.
Banks Are Stateful
Banks, like humans, are stateful. What does it mean to be stateful? Stateful is when a saved memory or experience alters future decisions or outlooks. People are stateful because they have memories and past experiences, which necessarily impact their future actions.
Banks borrow short (accept demand deposits) and lend long (buy long-dated Treasuries or MBSs). The bank must buy an asset for every deposit they accept (liability). Remember from our article on the collapse of SVB that banks…
“…need to get a yield on their assets that is greater than the cost of their deposits including the overhead of administering the program, employing people, etc. No one, not even a bank, is above or outside the market. If you have deposit inflows in 2020, then you buy what’s available at that time. You are a price-taker.”
Banks are stateful because they cannot wake up one morning and forget about all the assets they purchased during a predominantly low-to-zero-to-negative interest rate environment, despite a small hiccup from 2015-2018.
And they accelerated purchases of assets in 2020, during a period when interest rates made historical lows, including the 10-year note hitting 0.57%!
Consider what we said recently about SVB’s collapse,
“Even if the banks weren't trying to recapitalize themselves by offering low-interest rates and earning higher rates, they would not be able to offer anywhere near the current market rate. This is because banks are stateful. They cannot simply sell everything they bought over the last ten years (let alone ten months). They have to wait to roll their maturities to capture the (momentarily) higher rates.”
This is the primary reason why banks cannot raise rates on deposits. The average yield of their asset portfolio is much lower than the 4.75% rate that Powell just hiked to, which banks could earn on their new deposits.
What are Banks Earning?
How much lower is difficult to say. Bank balance sheets are notoriously opaque. However, if we were to get out a pen and turn our napkin over, we could use the Federal Reserve’s balance sheet as a proxy for the banking system at large.
According to the analysis here, the average duration of the Fed’s portfolio was 8 years in 2018. Using crude math, we guess the average yield of the Fed’s portfolio in 2018 to be around 2.61%.
If the Fed simply holds to maturity replacing assets at the market as they roll off, and keeps the same average duration, then their average yield would almost certainly decrease from 2018 to 2022, given that interest rates declined during this period across the entire curve.
With a little back-of-the-napkin math (and, admittedly some large assumptions) you can see why banks would be reluctant to raise rates on deposits when a) they don’t have to, and b) they would be directly eating into what little margin they have.
Incentives, Incentives, Incentives
The third and final reason why banks aren’t likely to raise rates on deposits is that they can get the required funding elsewhere, namely, at the Federal Reserve.
We wrote last week about how the Federal Reserve created a new program to provide new funding lines in response to bank troubles.
We only have one point to make here. It’s this. If the Federal Reserve is offering Troubled Republic Bank and other banks $1.00 for $0.80 (80 cents) worth of collateral- albeit at higher rates- they’d be a fool not to take it. And this folks, is called an incentive.
When it comes to describing the incentives native to today's monetary and banking systems there’s a preferred adjective we like to use, perverse.
And this is about as perverse an incentive as they come. One thing is for sure, as long as the Fed is incentivizing banks with this funding, banks will be in no hurry to raise the rates on deposits.
Unfree, Unsound, and Unsustainable
Whatever word you want to use for the current system, "free" is not that word. Everything we’ve described above is in direct contravention of the principles of a free market in money and credit.
There is no way to avoid being a creditor to the Federal Reserve, and the banking system.
There’s no way to effect any real change in interest rates. Instead, (short-term) interest rates are set by a non-elected committee of twelve people, acting on behalf of billions.
And lastly, there’s no penalty for engaging in harmful, wealth-destroying activity (so it would seem at least, but the bill will come due). Another term for interest-rate manipulation, especially to the downside, is financial repression.
We need the freedom to choose what money we want to make transactions with. We need a financial system that is responsive to the changes in the desires and time preferences of savers and wage earners, as well as the marginal productivity of entrepreneurs and companies.
We need a system where individuals are responsible and accountable for the consequences of their decisions, for good or ill. In other words, we need a system where incentives are properly aligned.
About the Author:
Keith Weiner is the founder of the Gold Standard Institute USA in Phoenix, Arizona, and CEO of precious metals investment company Monetary Metals. He also created DiamondWare, a technology company that he sold to Nortel Networks in 2008.