Volker Duenger, MD, Head of Treasury Risk Control ALM, UBS

Below is an insight into what can be expected from Volker’s session at Balance Sheet Management Europe 2023.

The views and opinions expressed in this article are those of the thought leader as an individual, and are not attributed to CeFPro or any particular organization.

What are the key reasons behind the changes in deposit behavior?

For four decades, we have seen a trend of falling interest rates, and central banks that established forward guidance. This interest rate cycle has broken out of that prevailing trend, and we have seen rapid interest rate increases by the Fed and other major central banks to levels not seen since 2007. With current high inflation rates, preserving the value of savings is an immediate challenge, and investors are, therefore, reviewing their investment strategies. Compared to a short while ago when TINA (“there is no alternative”) dominated market perception, cash in the form of money market funds is now an alternative with attractive returns unavailable during the zero rate environment.

Not only has the market side changed, but digitization has profoundly changed the investment landscape. Technology and the internet make diverse financial assets much more accessible, reduce costs, provide transparency on various institutions’ investment returns, interest rate levels, and deposit rates, and give the tools to participate and benefit at the press of a button on your mobile phone.

The combined effects of a rapidly changing investment environment with transparency and availability of investment opportunities affect the investment landscape, and the new technologies will impact how we manage our investments. Deposits will have to compete more with other investments, which creates a challenge for modeling deposit behavior as the new normal has yet to be established.

How can diversification help financial institutions overcome concentration risk?

The events of 2023 brought back to the spotlight that concentrated risks (such as unrealized losses on long-dated bond positions financed in the case of SVB primarily by uninsured deposits with a homogenous client group) can become an existential threat to financial institutions. A strategy may appear highly profitable but needs to work through the economic cycle and provide flexibility to financial institutions to change and evolve when the economic outlook, client behavior, or business models change.

A diverse strategy for a financial institution will have broad access to many funding sources that support a diverse set of assets on the balance sheet. Asset and liability risks still need to be managed responsibly. Still, it reduces the impact for particular risk events: If funding only consists of uninsured deposits, then specific news, threats to the credit rating, or even rumors can trigger significant outflows with a grave impact on the funding and liquidity position of that financial institution. Suppose the balance sheet is overweight (unhedged) long-dated assets under accrual accounting. In that case, higher interest rates create unrealized losses that prevent sales and limit balance sheet flexibility due to the significant impact on the institution’s capital and leverage ratio.

A diverse balance sheet reduces volatility and feedback effects: The institution can much better withstand shocks, creating the confidence essential for a financial institution to keep deposits and minimize vulnerability to liquidity events.

How can financial institutions overcome increased deposit volatility in a digitized world?

Institutions must understand their contractual and behavioral liquidity and funding position in normal and stressed situations and reflect this in their monitoring, modeling, and behavioral assumptions for risk modeling and management. Recent events have shown that technology is a game changer. Nowadays, information is spread quickly on social media networks and can trigger immediate short-term reactions across the entire retail client base, something that previously would only have occurred over several months or, at most, weeks.

Financial institutions must manage this increased deposit volatility, and responses will evolve and differ for each institution in line with its specific situation. Responses can, for example, consist of different product offerings (by incentivizing fixed term or evergreen deposits with fixed call periods that contractually reduce deposit volatility), managing volatility via economic incentives, establishing enhanced early warnings and monitoring frequency,  securing and regularly testing contingent funding sources such as central bank facilities, as well as more broadly enhancing timely or intraday risk management capabilities as well as structural measures including diversifying the balance sheet to reduce vulnerability to deposit volatility.

Banks could introduce deposit accounts with complex withdrawal restrictions (that do not allow early withdrawals even with penalty fees). This would come at a higher client rate but guarantee higher deposit stability.

Why should liquidity and interest rate risk be embedded into deposit behavior model authorization?

Deposits represent a substantial value for banks and an important funding source – the traditional core of banking is the maturity transformation of taking (short-term) deposits for (long-term) lending.

Optimizing deposit modeling enhances the institution’s profitability. Still, it must balance the funding value for the maturity transformation with managing the liquidity risks and associated costs for liquidity buffers and contingent funding sources when deposit outflows exceed model assumptions.

The interest rate tenor (the contractual tenor in case of fixed-term deposits, or the replication portfolio tenor otherwise) will generally be lower than the modeled funding tenor as institutions must re-hedge when clients shift to a different product. Still, the institution will have ongoing funding benefits if the clients deposit their money with its balance sheet.

Why is it important to have a backstop available in a scenario of deposit attrition?

The maturity transformation that banks perform enables the funding of investments by deposits. The bank can, therefore, not hold the total amount of deposits in cash and instead applies a fractional reserve system in which they keep a specific amount of cash available for immediate withdrawal. This introduces a liquidity risk managed by fractional reserves, additional liquidity buffers, and further buffer backstop facilities (often in the form of regular and emergency central bank facilities). These additional facilities ensure the trust in banks and the fractional reserve system, namely that banks can honor deposit withdrawals in normal and stressed times.