Research

This paper examines, theoretically and empirically, the impact of deposits on banks’ balance-sheet composition. I propose a novel mechanism where a bank’s wholesale borrowing constraint determines the effect of deposits on the bank. Unconstrained banks treat deposits and wholesale funding as substitutes. However, deposits relax the whole- sale borrowing constraint because deposits are effectively subordinate to wholesale debt. Thus for constrained banks, deposits and wholesale funding can be complements. For such banks, an increase in deposits enables them to borrow more aggressively from wholesale creditors and hence issue more loans. Empirically, using the cross-sectional variation in deposit fluctuations driven by monetary policy rate changes, I estimate the causal effect of deposits on banks’ balance-sheet composition. The empirical evidence supports the model predictions. In response to a 1% increase in deposit growth as a share of assets, unconstrained banks reduce wholesale funding growth by 0.2% of assets, while constrained banks increase their wholesale funding growth by 0.76% of assets. At the aggregate level of the banking sector, I find that deposit shocks account for a significant share of the variance of wholesale funding and loan growth. My findings also shed light on how monetary policy affects bank funding composition and vulnerability.