Deposit Beta: How Bank Funding Costs Track Fed Rates

Key Takeaways

• Deposit beta ratio equals the change in deposit rate divided by the change in a benchmark rate over a period.
• Federal Reserve research found the cumulative US deposit beta in the 2022-2023 cycle reached about 49% on interest-bearing deposits.
• Deposit betas tend to be low early in a hiking cycle and rise nonlinearly as competition for deposits intensifies.
• Banks with high beta have more interest rate-sensitive funding, which compresses net interest margin when rates climb.

What It Is

Deposit beta is the empirical sensitivity of a bank's deposit rate to a market benchmark, typically the federal funds rate. Federal Reserve research uses two main flavors: incremental beta over a short window, and cumulative beta across an entire rate cycle.

The concept is central to bank interest rate risk management and is documented in Liberty Street Economics research from the Federal Reserve Bank of New York, FEDS Notes from the Board of Governors, and Federal Reserve Bank of Dallas working papers.

The Intuition

Banks pay depositors a rate that is almost always below the market rate. The gap is the bank's deposit franchise value. When the Fed raises the funds rate, banks face a choice: pass the increase through to depositors to retain balances, or hold the line and risk losing deposits to money market funds and higher-yielding competitors.

The deposit beta captures that choice. A low beta means the bank is keeping rates sticky and earning a wider spread. A high beta means the bank is paying up to keep deposits, which compresses net interest margin. The beta is not constant. As rates rise further and depositors notice, the beta itself tends to climb.

How It Works

The basic formula is.

Deposit Beta = (Change in Deposit Rate) / (Change in Benchmark Rate)

For example, if the fed funds rate rises 100 basis points from 2.5% to 3.5% and a bank's average deposit rate rises 30 basis points from 0.5% to 0.8%, the incremental deposit beta over that move is 30%.

Betas are reported by deposit category.

Category                              Typical cycle beta range
Non-interest-bearing checking         0% to 5%
Interest-bearing checking             10% to 30%
Savings and money market deposits     30% to 60%
Retail certificates of deposit        70% to 95%
Brokered and wholesale CDs            85% to 100%

A bank with a heavy non-interest-bearing deposit mix runs a structurally lower aggregate beta than one funded with money market deposits and CDs.

Dynamic betas reflect how the relationship changes through a cycle. New York Fed research showed that betas in the 2022-2023 cycle started near 10% in early 2022 and rose past 60% on interest-bearing deposits by mid-2023.

Worked Example

A bank reports its deposit mix and rate movement after a Fed cycle.

Deposit balances and rates:
  Non-interest-bearing checking   $40 B  rate: 0.00% -> 0.00%   beta:  0%
  Interest-bearing checking       $30 B  rate: 0.10% -> 0.35%   beta: 25%
  Savings/money market            $60 B  rate: 0.30% -> 0.85%   beta: 55%
  Retail CDs                      $20 B  rate: 0.60% -> 1.55%   beta: 95%
  Brokered CDs                    $10 B  rate: 1.00% -> 2.00%   beta:100%
Total deposits                  $160 B

Fed funds change: +100 bp

Weighted deposit beta = (0.0%x40 + 25%x30 + 55%x60 + 95%x20 + 100%x10) / 160
                     = (0 + 7.5 + 33.0 + 19.0 + 10.0) / 160
                     = 69.5 / 160 = 43.4%

The bank's weighted deposit beta is 43.4%, close to the Federal Reserve's aggregate estimate for the 2022-2023 cycle. A peer bank with a smaller checking base and a heavier CD mix could easily run a 60% to 70% beta on the same Fed move.

Common Mistakes

1. Treating beta as a constant. Beta is dynamic. It rises through the cycle as competition intensifies and as depositors notice the rate gap.
2. Mixing point-in-time and cumulative betas. Bank disclosures sometimes give the cumulative cycle beta, sometimes the quarterly incremental beta. Always confirm the basis before comparing peers.
3. Ignoring the mix. Two banks with the same beta on each category can have very different aggregate betas if their deposit mix differs.
4. Forgetting non-interest-bearing deposits. A large NIB share is the most powerful driver of low aggregate beta and is highly valuable in a rising-rate cycle.
5. Assuming low beta persists in stress. Episodes such as the 2023 regional bank deposit flight show that betas can spike sharply when depositors lose confidence.

Frequently Asked Questions

What is the deposit beta ratio in simple terms? It is how much of a change in market rates a bank passes through to depositors. A 50% beta means the bank raises deposit rates by 50 basis points when the Fed hikes 100 basis points.

How does deposit beta affect investment decisions? For bank equity investors, a lower beta widens net interest margin in a rising-rate cycle, boosting earnings. A higher beta does the opposite. For credit investors, beta affects how quickly funding costs absorb rate increases.

What is a real-world example of deposit beta dynamics? Federal Reserve research found that the cumulative deposit beta on US interest-bearing deposits reached about 49% during the 525 basis point Fed hiking cycle that began in March 2022. Smaller banks generally ran higher betas than the largest banks in this cycle.

How can investors use deposit beta disclosures effectively? Read the bank's interest rate sensitivity disclosure in the 10-Q. Look at the assumed beta versus the observed beta in recent quarters. A wide gap suggests management's modeling will need revision.

How is deposit beta different from net interest margin? Deposit beta is one input that drives funding cost. Net interest margin is the resulting spread between asset yields and funding cost. Beta affects margin but is not the same measurement.

Sources

1. Federal Reserve Bank of New York Liberty Street Economics, Deposit Betas: Up, Up, and Away? https://libertystreeteconomics.newyorkfed.org/2023/04/deposit-betas-up-up-and-away/
2. Federal Reserve, Is This Time Different: How Are Banks Performing during the Recent Interest Rate Increases Compared to 2004-2006? https://www.federalreserve.gov/econres/notes/feds-notes/is-this-time-different-how-are-banks-performing-during-the-rir-increases-compared-to-2004-2006-20240412.html
3. Federal Reserve Bank of St. Louis, Higher Deposit Costs Continue to Challenge Banks. https://www.stlouisfed.org/on-the-economy/2024/sep/higher-deposit-costs-continue-challenge-banks
4. Federal Reserve Bank of Dallas, Deposit Convexity, Monetary Policy and Financial Stability. https://www.dallasfed.org/-/media/documents/research/papers/2023/wp2315.pdf

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.