Deposit competition and policy implications [BOK Issue Note 2023-33]

deposit competition policy implications financial sector depository institutions interest rate spread
Financial Stability Department(02-750-6627)

1. Some Korean commercial banks expanded deposits from the second half of 2022 to the first half of 2023 to cope with stricter liquidity regulation and wholesale funding constraints. In turn, non-banking depository institutions (NBDIs) such as mutual credit cooperatives and mutual savings banks also swiftly increased deposit interest rates to secure their deposits, intensifying deposit competition within the financial sector. While deposit competition among depository institutions enables depositors to broaden their choices and enhance interest rate benefits, an excessive surge in deposit interest rates in the short term may lead to deteriorating funding stability and profitability or an increase lending interest rates. This paper examines the impact of deposit competition among depository institutions on their financial indicators by different monetary policy phases. Our findings provide novel implications for deposit risk management for depository institutions and effective regulatory measures for policymakers.

2. This study employs the deposit interest rate spread, measured as the difference between the weighted average 1-year deposit interest rates of new transactions and the certificates of deposit rates (CDs), to assess the degree of competitiveness in the deposit market. The deposit interest rate spread in the third quarter of 2022 in the banking sector reached 83 basis points, marking the highest level since 2014. Subsequently, to respond such deposit interest rate increases, the NBDIs’ spread significantly expanded to 142 basis points, particularly during the fourth quarter of 2022. Moreover, NBDIs maintained higher deposit interest rates by raising deposit interest rates more aggressively than banks, resulting in 64.9% of deposits flowing into NBDIs, including mutual credit cooperatives and mutual savings banks, in the first half of 2023.

3. Our analysis of the nexus between the intensification of deposit competition and depository institution risk based on panel fixed-effect models shows that as deposit competition deepens (i.e., the widening deposit interest rate spread), the ROA volatility of depository institutions expands, leading to deteriorating earning stability. Moreover, depository institutions confronted with impediments in transmitting the augmented funding costs to loan interest rates (i.e., those with a low level of interest margin) exhibit not only a decline in ROA but also a contraction in the equity ratio. The result suggests that the impact of deposit competition on the risk of depository institutions depends on the degree to which heightened funding costs are transmitted to loan interest rates.

4. Our findings emphasize the need for vigilant monitoring of potential liquidity risk in depository institutions. Also, (if necessary) regulatory flexibility in debt issuances should be considered to facilitate funding diversification beyond deposits. This regulatory approach is crucial given the potential spillover of deposit competition from banks to the non-bank sector, where reliance on deposits is prevalent. Lastly, cooperative federations covering NBDIs should enhance their capacity to provide timely liquidity support to their member institutions facing short-term funding strains, reinforcing their pivotal role in maintaining financial stability.

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