This study largely consists of two parts. The first part analyzes the relationship between market rates and bank profitability while the second examines the relationships between deposit and market interest rates, and that between deposit and loan size. Each part encompasses a micro-theoretic analysis that focuses on imperfect competition in the deposit market, and an empirical analysis that uses Korea’s aggregate-level and bank-level variables.

The theoretical analysis found that as deposit banks gain market power through imperfect competition in the deposit market, the sensitivity of deposit interest rates to market rates becomes very low. That is, when the market rate falls, the loan rate also falls to a similar level but the deposit interest rate does not, which reduces banks’ net interest margin, and leads to a deterioration in profitability. However, when it is additionally considered that banks can endogenously adjust the maturity of their assets and liabilities, a fall in the market rate would not have a meaningful effect on their loan-deposit margin because the deposit interest rate and loan rate have a low sensitivity to the market rate. The fact that the deposit rate has little sensitivity to the market rate means that banks are secure in terms of financing, and as such, they are not very exposed to interest rate risks; even when they handle highly profitable loans (fixed-rate or long-term loans) instead of variable rate or short-term loans. Accordingly, loan rates become less sensitive to market rates.

This theoretical prediction is supported by the empirical analysis in subsequent sections. By analyzing aggregate-level data, a very small negative relationship was found between the market rate and banks’ net interest margin. In addition, a panel cointegration analysis using bank-level data revealed that a 1%p drop in the market rate caused an approximate 0.05%p decrease in banks’ net interest margin. In other words, the profitability of banks is somewhat insensitive to the changes in market interest rates. Recently in Europe and Japan, some have argued that low interest rates could erode banks' profitability, and become a risk to the financial sector. Such an argument, however, could be dispelled by the implications from this study that indicate that the risk would not be as dire as expected.

Additionally, if the market power of deposit banks is strong enough, a fall in the market rate due to a policy rate cut will raise the demand for deposits. When faced with a choice between deposit or non-deposit investment products (financial products, real assets, etc.), deposit and market rates are important considerations for investors. This is because the rate of return on deposits is equivalent to the interest rate of the deposits while the (risk-adjusted) rate of return on non-deposit investment products is closely linked to the market interest rate. However, due to its unique characteristic as a means of payment (settlement), the interest rate of deposits is, in general, lower than the market interest rate. Thus, the difference between the market and deposit rates is negatively associated with the value of the deposits compared to that of non-deposit investment products. And, as the difference decreases, the demand for deposits increases. This study theoretically proves that when the market power of deposit banks is sufficiently high, the resultant decrease in the deposit interest rate is relatively small, even if the market rate decreases. This means that the difference between market and deposit rates narrows, leading to an increase in the demand for deposits.

The second part is again supported by empirical analysis. An analysis of aggregate-level data shows that a decrease in the market rate is closely correlated with an increase in the deposit demand. In addition, a panel cointegration analysis using bank-level data reveals that a 1%p drop in the market rate causes a 5.45% increase in deposits. It is also found that when the deposit, as a source of loans, increases by 1%, the loan increases by 0.73%. These results can be understood to mean that if the monetary authority cuts the policy rate to induce a 1%p decrease in the market rate, deposits will grow, leading to a 3.7% increase in loans. This suggests the existence of a new channel of monetary policy--the deposits channel.

Preface
Executive Summary

Chapter 1 Introduction

Chapter 2 Overview of Deposit Banks

Chapter 3 Does an Increase in Market Interest Rates Improve Deposit Bank Profitability?
　Section 1 Empirical Analysis at the Aggregate Level
　Section 2 Theoretical Framework: Imperfect Competition in the Deposit Market
　Section 3 Empirical Analysis at the Bank Level

Chapter 4 Is There a Deposit Channel in Monetary Policy?
　Section 1 Empirical Analysis at the Aggregate Level
　Section 2 Theoretical Framework: Imperfect Competition in the Deposit Market
　Section 3 Empirical Analysis at the Bank Level

Chapter 5 Conclusion and Policy Implications

References
Appendix
ABSTRACT