From Depositors’ Confidence to Credit Stability: The Role of Deposit Insurance

Interest Rate Risk, Bank Stability, and Valuation

This article surveys recent theoretical and empirical advancements on the impact of interest rates on bank valuations and stability—two crucial concerns for financial researchers, policy makers, and regulators. We begin by highlighting the distinctive feature of the regional banking crisis of 2023—the prevalence of liquid assets on bank balance sheets—in contrast to earlier crises such as the savings and loan crisis of the 1980s and 1990s, where illiquid assets contributed to banking failure. In Section 2, we present a theoretical framework that integrates both asset illiquidity and the risk of self-fulfilling solvency runs on the deposit franchise. We show the conditions under which the deposit franchise fails to hedge asset declines due to rising interest rates and demonstrate how and why this amplifies bank fragility. Sections 3–5 explore empirical methods for assessing these effects. We review approaches to measuring the interest rate sensitivity of bank asset values, highlighting their limitations. We also examine recent advances in quantifying bank fragility, particularly the challenges of valuing the deposit franchise under both stable conditions and crisis scenarios. Additionally, we discuss new measures of bank fragility that capture the potential endogenous collapse of franchise value during crises. Applying these measures leads us to conclude that US banks face significant unhedged interest rate exposure in their asset portfolios. When combined with their high leverage, this exposure substantially increases the risk of solvency runs. Liquidity interventions, while useful in the short term, are insufficient for addressing the systemic risks posed by this vulnerability.

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.

CLIMATE-INDUCED CREDIT RISKS AND THE FINANCIAL STABILITY OF COMMERCIAL BANKS IN KENYA

Excess Liquidity, Moral Hazard, and Credit Risk in Indonesian Commercial Banks

This research investigates how liquidity creation induces moral hazard behavior and affects credit quality in Indonesian commercial banks. This study examines the effect of liquidity creation, liquidity risk, and central bank policies on credit risk in Indonesian commercial banks, proxied by the non-performing loan (NPL) ratio. Using panel data from 46 banks listed on the Indonesia Stock Exchange over 2015–2024, we apply the Two-Step System Generalized Method of Moments (SYS-GMM) to address endogeneity inherent in dynamic panel models. Results indicate that liquidity creation has a significant positive effect on NPL, consistent with the moral hazard hypothesis. Liquidity risk (LDR) also significantly and positively affects NPL. Reserve requirements (GWM) and BI-Rate do not produce a direct and significant effect on NPL. Return on assets (ROA) significantly and negatively affects NPL. These results suggest that credit risk in Indonesian commercial banking is predominantly influenced by bank-level intermediation behavior rather than by macroeconomic or policy variables. The research concludes that excess liquidity conditions incentivize aggressive credit expansion without proportionate attention to borrower quality, particularly in an oligopolistic market structure with implicit state guarantees.

Implications of deposit diversification for funding stability

Who holds, who harms? The effect of creditor composition on Tanzania’s financial stability

This study aims to examine the impact of public debt composition by creditor type on financial stability in Tanzania, using quarterly data and an autoregressive distributed lag (ARDL) model. Specifically, the analysis focuses on the roles of debt held by the central bank, commercial banks, pension funds and external creditors, with financial stability proxied by the capital adequacy ratio. Using an ARDL model, this study examines the long-run and short-run effects of public debt held by the central bank, commercial banks, pension funds and external creditors, while controlling for key macroeconomic variables such as GDP growth, inflation, interest rates and foreign exchange reserves. The results reveal that the identity of the creditor plays a critical role. In the long run, debt held by commercial banks is positively associated with financial stability. In contrast, debt held by external creditors and the central bank is linked to increased financial vulnerability. Pension fund holdings show no significant effect. Short-term findings suggest that sudden increases in commercial bank debt and declines in foreign reserves temporarily compromise financial stability. These results underscore the significance of public debt size and its holders, providing crucial insights for designing debt management strategies that foster macrofinancial resilience in Tanzania.