5. Conclusion and policy implications
In summary, we find evidence that bank-specific risk acting through risk-pricing in the wholesale market has a positive own-bank and positive local market rival-bank effect on the pricing of retail deposits. The coefficients on these two components have stable values for all models considered. These results imply that small CDs act as substitutes for wholesale deposits as predicted risk premiums on wholesale funds increase. These results imply that the deposit insurance guarantee on small CDs allow banks to attenuate their rate response risk pricing of wholesale funds by substituting into cheaper small CDs.
Our results have implications for competition, monetary policy, and financial stability. The inclusion of risk in a framework with rival banks defines a risk-induced local-market price competition. The results showing the possibility that some retail deposits are complements to wholesale funds further complicates the effect of risk on rate competition.
The existence of a lending channel depends on the extent to which a bank can move between uninsured and insured funds as policy tightens (Bernanke & Gertler, 1995). Kishan and Opiela (2012) shows that changes in policy rates affect bank risk premiums, which produce a lending channel. Our bank-market results, in conjunction with that study, imply that a bank that manages its risk and operates in certain markets might be able to mitigate the effects of contractionary policy on its funding costs, thereby bypassing the lending channel.
On the one hand, our results imply that the effects of risk pricing on retail rates can produce competitive rate contagion that spreads from local markets to the macro-financial markets, promoting instability. On the other hand, our results imply that instability in a local market could be defused by spreading competitive rate pressures across markets. Understanding how this risk contagion operates is important for policies used to improve financial stability.
As part of prudential regulation, regulators are concerned when a bank’s deposit rates deviate substantially from those of its peers. Bank rates that are out of line might indicate high risk. Our results for a bank’s response to own and rival risk imply that a bank could spread its risk-induced rate hikes over non-competitive markets, thereby decreasing the information content of peer-rate comparisons.
