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Beyond BLS

Beyond BLS briefly summarizes articles, reports, working papers, and other works published outside BLS on broad topics of interest to MLR readers.

November 2023

Do online banks have bigger reactions to the Fed’s rate hikes?

Summary written by: Harry Nitzberg

From 2022 to 2023, rising inflation prompted the Federal Reserve (also known as “the Fed”) to announce several consecutive increases to its target for the federal funds rate (FFR). The FFR is the rate at which banks lend money to each other overnight. When the Fed sets a target FFR, it uses monetary policy to either increase or decrease the money supply in the economy. When the money supply expands, interest rates (including the FFR) fall because money is more plentiful. When the money supply shrinks, interest rates rise. When the FFR decreases, banks can borrow from each other at a lower interest rate. As a result, for banks, the cost of lending to people and businesses is lower. If the FFR increases, banks’ costs to borrow and, in turn, to lend rise.

So, with more of today’s banks moving to online banking, do online banks react differently to the Fed’s FFR target changes? To answer this question, in their article “Monetary policy transmission through online banks” (National Bureau of Economic Research, Working Paper no. 31380, June 2023), Isil Erel, Jack Liebersohn, Constantine Yannelis, and Samuel Earnest examine online and traditional (brick-and-mortar) banks’ reactions to changes in the FFR between 2022 and 2023.

When the Fed announces a new target rate, banks expect that the Fed will change the money supply to push the FFR toward the new target rate. In response, banks increase or decrease the interest rates offered to their customers. By influencing the FFR, the Fed influences bank loans and, in doing so, influences the economy at large. The faster banks change their interest rates in response to changes in the Fed’s target rate, the faster the Fed’s policy will influence the economy.

In their research, Erel and colleagues find that a 100-basis-point increase in the FFR prompted online banks to increase their interest rates by around 30 basis points more than did traditional banks. The authors give two possible explanations: the level of local competition faced by the banks and demographics of bank users.

For traditional banks in areas that have many other banks, when the Fed raises rates, the banks must increase the interest rates paid on their deposits to remain competitive. Yet, even after excluding banks in areas with high bank concentrations from the analysis, the authors still find that online banks had raised their interest rates more basis points than traditional banks. The authors then turn to the demographics data of the banks in their study.

They discover that people who use online banks are usually younger and have higher income. The authors say that one possible reason for this finding is that younger and higher income individuals may be better able to shop around for banks with higher interest rates on deposits, forcing online banks to raise their rates to attract and/or retain depositors.

Erel, Liebersohn, Yannelis, and Earnest conclude that, taken together, the results suggest that as more banks move online, the Fed will need to be aware that the effects of monetary policy on interest rates may not be as evenly impactful as they used to be.