On the Risk Management of Demand Deposits and Interest Rate Margins

Abstract

This paper deals with risk mitigation of interest rate margins related to banks demand deposits. We assume that demand deposits are linked to interest rates and business risk, which cannot be fully hedged on financial markets. The dynamics of forward market rates follows a standard market model (i.e. BGM model). The demand deposit is the monetary amount put in to account by clients. It is accounting in M1 (monetary aggregate 1). Using a linear regression, the deposit rates are related to the market rates in linear ways. We take the viewpoint of an asset and liability manager focusing on the bank's net operating income at a given quarter according to standard accounting rules. We use the static hedging strategies for bank deposit. We illustrate our results using data from 1997 -- 2019 for both US and Euro zones. This allows us to illustrate and compare the hedging of the interest rate margin for these two main zones, for which the deposit rate setting are clearly different (roughly speaking, in the US zone the deposit rate is equal to about half of the interest rate while, in the Euro zone, the two rates are much closer).