The authors show how the relationships between interest rate changes, deposit growth rates, and loan growth rates have changed in the last ten years, discuss some possible reasons, and assess the likely impact of rising interest rates on loans and deposits going forward.Bank loans ; Bank deposits ; Interest rates

Darrin R. Halcomb

Hesna Genay

English

Research Papers in Economics

Chicago Fed Letter
Rising interest rates, bank loans, and deposits
by Hesna Genay, economist, and Darrin R. Halcomb, associate economist
The authors show how the relationships between interest rate changes, deposit growth
rates, and loan growth rates have changed in the last ten years, discuss some possible
reasons, and assess the likely impact of rising interest rates on loans and deposits
going forward.
ESSAYS ON ISSUES THE FEDERAL RESERVE BANK NOVEMBER 2004
OF CHICAGO NUMBER 208
Historically, rising interest
rates have been associated
with slower growth of bank
loans and deposits.
Between January 2001 and June 2004,
the federal funds rate declined steadi-
ly to reach a historically low 1%. Be-
tween June and October, however, the
Federal Reserve raised the target fed
funds rate in three increments to 1.75%.
Moreover, based on recent economic
data and the statements of the Federal
Open Market Committee (FOMC),
market participants expect interest
rates to rise further: In early October,
the fed funds futures market predict-
ed that the target rate will reach a little
over 2% by the end of 2004 and 2.5%
by May of 2005.
What is the likely impact of rising in-
terest rates on bank loans and depos-
its? Historically, rising interest rates
have been associated with slower growth
of bank loans and deposits. Further-
more, the impact of rising interest rates
on bank loans has depended on bank
size, with small banks typically suffer-
ing greater declines in loan growth
during periods of rising interest rates
than large banks.
In this Chicago Fed Letter, we show that
these relationships between interest
rate changes, deposit growth rates, and
loan growth rates have weakened in the
last ten years. We discuss some possible
reasons and the likely impact of rising
interest rates on loans and deposits
going forward.
Theoretical implications
First, consider the effects of a contrac-
tionary monetary policy that raises short-
term interest rates. Changes in
monetary policy can be transmitted to
the real economy through various chan-
nels. In the “credit channel,” bank
loans and deposits play a central role
and interest rate changes are transmit-
ted to aggregate spending through
the balance sheets of banks and nonfi-
nancial firms.1
Under a contractionary monetary pol-
icy, the Federal Reserve raises the tar-
get fed funds rate and reduces the supply
of reserves in the banking system.2 Be-
cause certain deposit liabilities of banks
are subject to reserve requirements, a
higher fed funds rate and a smaller
supply of reserves can slow down growth
of bank deposits.
The effects of slower deposit growth on
bank loans are likely to depend on the
banks’ ability to substitute other forms
of funding for deposits. If banks can
easily access other sources of funding,
then they may be able to fund loan
growth at the same rate as before the
increase in interest rates. For instance,
banks with an extra capital cushion may
have greater access to financial markets,
allowing them to substitute other liabil-
ities for core deposits.1. Interest rate sensitivity of deposits and loans at small and large banks
NOTES: Large banks are in the top 1st percentile and small banks are in the bottom 75th percentile of the asset distribution in each quarter. Data are adjusted for mergers, entry, and exit
in each quarter. Core deposits are defined as total deposits minus time deposits in greater than $100,000 denominations. The figure reports the sum of coefficient estimates on four
lags of quarterly changes in the effective federal funds rate. The regression model also includes four lags of annualized quarterly growth rates of nominal gross domestic product, four
lags of quarterly growth rates of total Consumer Price Index, and four lags of the dependent variable. The dark blue bars indicate cumulative interest rate sensitivities that are signifi-
cant at 5% or better; pale blue bars indicate estimates that are statistically insignificant.
SOURCE: Authors’ calculations from banks’ Report of Condition and Income (call report).
percent
Small Large Small Large Small Large
banks banks  banks banks banks  banks
Core deposits Total loans C&I loans
Small Large Small Large Small Large
banks banks  banks banks banks  banks
Core deposits Total loans C&I loans
A. 1976–1993 B. 1976–2003
percent
-10
-8
-6
-4
-2
0
2
4
On the other hand, if banks cannot
fully counteract the decline in deposits
by increasing other forms of funding,
they have to slow the growth rate of
their assets to match the slower deposit
growth. As a result, higher interest
rates can lead to slower loan growth
through their effect on deposits.
Are there impediments to the ability
of banks to substitute nondeposit lia-
bilities for deposits? One potential im-
pediment is imperfections in capital
markets, such as asymmetric informa-
tion between investors and banks seek-
ing funding. Information asymmetries
can raise the cost of external, nonde-
posit sources of funding or limit their
supply to banks. As a result, growth of
bank loans and other assets can be
limited by deposit growth.
Capital market imperfections and the
financial constraints they impose are
one potential source for differences in
the interest rate sensitivity of large
and small banks. Typically, information
on small banks is less readily available
to investors than information on large
banks. This information gap between
small banks and investors can poten-
tially restrain their ability to fully sub-
stitute for deposits with other sources
of funding. As a result, small banks
may rely more on deposits.
At the end of 2003, insured deposits
funded 61.7% of total assets at small
banks (banks with total assets less than
$1 billion), almost twice the 31% at large
banks (banks with total assets greater
than $1 billion). On the other hand,
fed funds and brokered deposits pur-
chased in capital markets financed only
2.3% and 2.0%, respectively, of total
assets at small banks. In contrast, fed
funds financed 7.8%, and brokered
deposits financed 4.0%, of total assets
at large banks.
If small banks are subject to greater cap-
ital market imperfections than large
banks, then we would expect rising in-
terest rates and slower deposit growth
to have a greater adverse effect on loan
growth at small banks.
Empirical evidence
A number of studies compare the sen-
sitivity of loan growth at large and small
banks to changes in interest rates and
deposit growth.3 These studies, which
use data through the mid-1990s, show
that either a 1% increase in interest
rates or a 1% decline in deposit growth
is associated with a greater decline in
growth rates of loans at small banks
than at large banks.
In figure 1, panel A, we replicate the
type of response documented in these
studies. Using the same methodology
as in Kashyap and Stein (1995), we sort
banks according to their size for every
quarter in the 1976–93 period.4 We form
two portfolios: Banks in the top 1st per-
centile of the size distribution in any
quarter are classified as “large,” and
banks in the bottom 75th percentile
are “small.” For each portfolio, we cal-
culate annualized quarterly growth rates
of core deposits (total deposits minus
time deposits greater than $100,000),
total loans, and commercial and in-
dustrial (C&I) loans. We regress these
growth rates on four lags of changes
in the effective fed funds rate and a
set of control variables. The sum of co-
efficients on the interest rate changes
provides us with a measure of interest
rate sensitivity of core deposits, total
loans, and C&I loans for large and
small banks (see figure 1, panel A).
During the 1976–93 period, rising in-
terest rates are associated with slower
growth of core deposits at both large
and small banks. A 1% increase in the
fed funds rate over four quarters is
-4
-2
0
2
4
6
8
10Michael H. Moskow, President; Charles L. Evans,
Senior Vice President and Director of Research;
Douglas Evanoff, Vice President, financial studies;
David Marshall, Vice President, macroeconomic policy
research; Richard Porter, Senior Policy Advisor,
payment studies; Daniel Sullivan, Vice President,
microeconomic policy research;  William Testa, Vice
President, regional programs and Economics Editor;
Helen O’D. Koshy, Editor; Kathryn Moran,
Associate Editor.
Chicago Fed Letter is published monthly by the
Research Department of the Federal Reserve
Bank of Chicago. The views expressed are the
authors’ and are not necessarily those of the
Federal Reserve Bank of Chicago or the Federal
Reserve System.
© 2004 Federal Reserve Bank of Chicago
Chicago Fed Letter articles may be reproduced in
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Prior written permission must be obtained for
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ISSN 0895-0164
associated with a 2.96% decline in the
growth of core deposits at small banks
and a 3.66% decline at large banks. The
interest rate sensitivity of core depos-
its is statistically significant for each
size category, and the sensitivities of
the two portfolios are not statistically
different from each other.
However, loan growth rates (both total
and C&I loans) at large banks and small
banks respond differently to rising in-
terest rates. At small banks, a 1% rise
in the fed funds rate over four quarters
is associated with a 2.32% decline in
total loan growth and a 9.5% decline
in C&I loans (these sensitivities are sta-
tistically significant). In contrast, rising
interest rates are associated with posi-
tive, but statistically insignificant, chang-
es in loan growth rates at large banks.
In other words, during the 1976–93
period, rising interest rates are associ-
ated with slower loan growth at small
banks, but have no discernible effect
on loan growth at large banks.
These results are consistent with small
banks facing greater capital market
imperfections and financial constraints
in funding their loan growth. They
also provide evidence consistent with
the credit channel of monetary policy
transmission.
In figure 1, panel B, we extend our sam-
ple period to the end of 2003 and re-
estimate our models. Clearly, the results
for the entire 1976–2003 period are
very different from the earlier period.
Over the 1976–2003 period, a cumula-
tive 1% increase in interest rates over
four quarters is still associated with de-
clines in the growth rates of core de-
posits at large and small banks: a 1.27%
decline at small banks and a 2.2%
decline at large banks. However, the
estimates are no longer statistically
significant. Moreover, rising interest
rates are no longer associated with
statistically significant declines in the
growth rates of total and C&I loans at
small banks. And, surprisingly, rising
interest rates are associated with statis-
tically significant increases in the growth
rates of loans at large banks: A 1% rise
in interest rates is associated with a
3.48% increase in the growth rate of
total loans and a 7.7% rise in the
growth rate of C&I loans.
Our results suggest that the relation-
ship between interest rate changes,
deposit growth, and loan growth
changed significantly sometime during
the mid-1990s.
Developments since the mid-1990s
Although pinpointing the exact source
of the change in the relationships be-
tween interest rates, deposits, and loans
is beyond the scope of this article, we
can point to some developments since
the mid-1990s that might have played
a role.
One of the distinguishing features of the
period since 1993 has been the strength
and stability of the U.S. economy. The
U.S. emerged from a recession in 1991
to enjoy the longest business cycle ex-
pansion in its history. During this peri-
od, economic growth has been rapid,
yet remarkably stable. We have also en-
joyed a low and stable inflationary en-
vironment, accompanied by similarly
low and stable short-run interest rates.
Macroeconomic stability, deregulation,
and technological advances have allowed
both financial and nonfinancial firms
to improve their balance sheets and
offered them new financing options.
These developments could have altered
demand for loans and deposits in ways
that are not captured by our model.
Today, firms are able to meet their fund-
ing needs from a much wider array of
financial instruments and institutions
than before. Deregulation has allowed
banks to move into insurance and in-
vestment banking, but it has also allowed
investment banks, finance companies,
and other intermediaries to provide
traditional banking services.
In addition, technological innovation
has allowed better management and
transfer of risk in financial markets.
Firms that were previously too small
or opaque to borrow in the bond mar-
kets are now able to access these mar-
kets. Consequently, at the end of 2003,
corporate bonds comprised 27.6% of
total liabilities of nonfinancial corpo-
rate businesses, up from 22.8% at the
end of 1993. At the same time, the share
of bank loans in total liabilities declined
from 8.9% in 1993 to 5.9% in 2003.5
These changes were particularly pro-
nounced during the most recent
recession. Over the last three years,
corporations have increased the share
of bonds in their liabilities from 23%
to 27%, while decreasing their reli-
ance on bank loans.
Moreover, changes in technology and
improvements in productivity allowed
firms to trim costs even as consumer
demand remained strong during this
most recent recession. The resulting
record profits and lower expenses
have led to an unprecedented increase
in the rate at which firms generate in-
ternal funds.
Overall, these developments might
have changed the demand for loans
by businesses significantly. The rela-
tively simple model we estimate may
not be able to fully capture changes in
loan demand and instead may attribute
them to changes in the interest-rate
sensitivity of loan growth.
The market forces that increased the
sources of funding for nonfinancial
businesses have also brought significant
changes to the banking industry. Banks
recovered from the 1991 recession ina remarkable fashion, with capital levels
becoming stable yet substantial by the
mid-1990s. As we noted before, strong
profits and higher capital levels can
provide a cushion against the impact
of lower deposit growth on loan vol-
ume by permitting greater access to
financial markets.
In recent years, consolidation has been
the byword in the banking sector. Today,
banks with assets greater than $1 billion
account for over 85% of total banking
sector assets, up from 73% at the end of
1993. If larger size allows banks greater
access to capital markets, then the rela-
tionship between deposit and loan growth
for all banks would be closer to that ob-
served for large banks in the past. Indeed,
evidence suggests that banks of all sizes
now rely more on market (nondeposit)
sources. Today, deposits fund a smaller
share of total assets (66.2% at the end
of 2003) than a decade ago (74.3% at
the end of 1993). As a result, a decline
in deposit growth is likely to have a
smaller impact on loan growth today,
irrespective of bank size.
Conclusion
These and more recent developments
may also alter our expectations about
how interest rate increases will affect
bank loans and deposits going forward.
The business caution that has charac-
terized the economy in recent years
has eased some, with firms boosting
investment and increasing payrolls.
As a result, demand for bank borrow-
ing may continue to increase, though
this rise could be tempered by the avail-
ability of alternative funding sources.
However, the earlier caution has left
businesses with greater financial slack
than they had at similar points in pre-
vious economic recoveries, reducing
the demand for bank loans. Since the
last recession, firms have been allocating
a smaller portion of their internal funds
to capital investment and a greater
fraction to purchasing financial assets.
Over the eight quarters since the end
of the last recession, 88% of internally
generated funds, on average, were used
to fund capital investment. In contrast,
over the eight quarters following the
previous five recessions, capital spending
averaged 109% of internally generat-
ed funds, with the gap being financed
with external funds. As a result, nonfi-
nancial firms have only very recently
begun to increase their bank borrowing.
On balance, it would not be surprising
to see C&I lending increase in the short
run, despite the presence of higher
short-term interest rates. In the longer
term, the historical economic trends
and cycles are more likely to return, so
that higher interest rates are associated
with slower loan and deposit growth.
Still, the strength of this effect in the
future may be mitigated by the finan-
cial market changes that have oc-
curred over the last 15 years.
1 See Ben S. Bernanke and Alan S. Blinder,
1992, “The federal funds rate and the chan-
nels of monetary transmission,” American
Economic Review, Vol. 82, No. 4, pp. 901–921.
2 See Cheryl L. Edwards, 1997, “Open mar-
ket operations in the 1990s,” Federal Re-
serve Bulletin, November, pp. 859–874.
3 See Anil K Kashyap and Jeremy C. Stein,
1995, “The impact of monetary policy on
bank balance sheets,” Carnegie-Rochester
Conference Series on Public Policy, Vol. 42,
pp. 151–195; Ruby P. Kishan and Timothy
P. Opiela, 2000, “Bank size, bank capital,
and the bank lending channel,” Journal of
Money, Credit, and Banking, Vol. 32, No. 1,
pp. 121–141; Jith Jayaratne and Donald P.
Morgan, 2000, “Capital market frictions
and deposit constraints at banks, “Journal
of Money, Credit, and Banking, Vol. 32, No. 1,
pp. 74–92; and Hesna Genay, 2000, “Re-
cent trends in deposit and loan growth:
Implications for small and large banks,”
Chicago Fed Letter, December, No. 160.
4 As in Kashyap and Stein, we adjust our
sample for mergers, entry, and exit. The
results do not change if the period extends
to 1994 or 1995.
5 Part of the shift away from bank loans
toward bonds may be due to firms length-
ening the maturity structure of their lia-
bilities in a low interest-rate environment.

Rising interest rates, bank loans, and deposits

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