The following article appeared last week on Banking Strategies/BAI.org and was written by Dr. Dan Geller, Market Rates Insight’s executive vice president and our head of market research.
Banks are understandably upset about the decline in their fee revenues caused by recent regulatory changes but they should also be kicking themselves for missing another revenue opportunity right under their noses. We're talking here about the $150 billion they could have saved on interest expense by accelerating the pace of interest-rate decreases over the last four years in the wake of the financial crisis. We can now say, with the benefit of hindsight, that accelerating this pace would not have lowered the liquidity level of banks; in fact, deposit balances would have continued to increase regardless of the decline in interest rates!
The key factor missed by most bankers has to do with the inelasticity of federally-insured bank deposits during a period of intense economic turmoil and public fear. An elasticity analysis of the relationship between deposits’ annual percentage yield (APY) and balances, since the start of the recession in December of 2007, shows that bank deposits are among the most inelastic of commodities, even more so than gasoline, which is highly inelastic due to its absolute necessity. The latest figures on deposit balances and APY indicate that the long-term elasticity of deposits is 0.22 (highly inelastic) compared to 0.58 for gasoline. The closer the elasticity figure gets to 0.00, the less sensitive is demand to changes in price, or APY in the case of deposits.
In the four years since the recession started, interest expense at financial institutions insured by the Federal Deposit Insurance Corp. (FDIC) has fallen by about $300 billion, from $372 billion in 2007 to an estimated $75 billion by the end of this year. Meanwhile, total deposit balances surged from $8.4 trillion to $10 trillion dollars during the period – a historic record. Had banks conducted an elasticity analysis in 2008 and 2009, they could have detected the unusually high level of inelasticity between deposits’ APY and balances and could have accelerated the pace of rate decreases. Such acceleration could have reduced deposits rates to their current level but much sooner, perhaps as early as 2008. Moreover, understanding the reason deposit balances exhibit such high inelasticity to APY could have provided banks with the confidence to accelerate the pace of rate decreases.
The reason for this inelasticity is that there is simply no substitution for insured deposits as a “safe” place to park your money. Typically, demand for a product is more sensitive to price changes in the long run because consumers change their behavior over time by either reducing consumption or by finding a substitute product. For example, when gasoline prices go up and stay high for a long time, consumers tend to buy more fuel-efficient cars (hybrid or electric), drive less and/or use more public transportation. However, in the case of deposits, there is no other way to ensure that the principal amount is 100% safe, as in the case of insured deposits. All other options, such as equities, mutual funds, bonds and alike, carry some level of risk to the principal.
While there’s no use crying over spilt milk, it’s not too late for bankers to leverage this unusual level of inelasticity to reduce interest expense. We estimate that about $75 billion dollars in interest expense remains to be recovered by assertive deposit price reduction as long as savers lack an alternative in the current shaky economy.