On the Hedging of Interest Rate Margins on Bank Demand Deposits

Abstract

In recent years, we have seen a very rapid increase in outstanding bank deposits. This increase has been particularly high since the outbreak of the COVID 19 pandemic, due to the lockdown that has, among other things, drastically reduced household consumption since the beginning of March 2020. This very sharp increase in outstandings increases the risk of banks which offer interest on deposits. In this paper, we deal with the mitigation of the risk contained in interest rate margins of demand deposits. We introduce and analyze hedging strategies of an asset and liability manager who focuses on the bank’s net operating income in a given quarter under standard accounting rules. Demand deposits are assumed to be correlated with market interest rate and to a commercial risk that cannot be fully hedged on the financial markets. We distinguish several types of dynamic hedging strategies based on both quadratic and quantile criteria. We provide explicit formula for all hedging strategies and we discuss their respective robustness. We show in particular that the quantile hedging criterion leads to somewhat riskier strategy since its gain may be nil, due to its knockout feature. We argue that our contribution establishes a stronger basis for the coverage of bank deposits, which is particularly important in the context of the COVID-19 pandemic and its economic consequences.