Where Do Deposits Flow? Liquidity Reallocation and Funding Stability
This study empirically tests the deposit channel hypothesis, which holds that increases in deposit markups cause liquidity outflows from the banking sector and a contraction in credit supply. The central question is whether deposit substitution effects, whereby depositors shift funds to other financial instruments during monetary tightening, are reflected in banks’ balance sheets and aggregate lending. The analysis uses data on U.S. retail banks grouped by size (mega, large, medium, and small), and applies an SVARX model with sign restrictions to trace bank responses to monetary tightening. The findings show no clear link between deposit movements and lending volumes. When deposit markups rise, depositors do not exit the banking system but reallocate funds either to other banks or to money market funds (MMFs). The extent of this shift depends on the spread between deposit rates and MMF returns: when the gap is small, depositors tend to retain bank deposits for their safety and payment convenience; as the gap widens, funds increasingly migrate to MMFs. Banks appear to anticipate this behaviour, responding strategically by raising deposit rates while expanding lending. Consequently, outflows at weaker banks are offset by inflows at stronger institutions, which attract additional funding and sustain aggregate credit supply. These results suggest that the deposit channel reflects underlying instability in the banking sector rather than a mechanical effect of higher interest rates, implying that financial stability conditions may matter more for monetary transmission through deposits than the level of the policy rate itself.