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LIQUIDITY AND DEPOSITS

Back to basics:
non-determinant deposits
With the strong trend in banking of mark-tomarket risk management, bankers face the
difficult task of calculating the market value for
non-maturity deposits and credit card loans.
Suresh Sankaran, vice-president and director
at strategic consulting services firm Fiserv IPSSendero, sheds some light on the matter

movements in market rates or other factors.


In the context of core deposit valuation, the focus of substantial analytical attention is on determining whether the offered deposit rate influences
the customers option to alter maintained balances and the manner of
any such behaviour. How long is a non-maturity deposit? appears to be
the 64,000 question for A/L managers. The industry promotes institutions to develop a reasonable or possibly correct solution, encouraged
in part by regulators who have engaged bankers in a running debate on
deposit duration for a number of years now.
This article will present the argument that rather than look to more
substantial portion of the liabilities of major banks consists of non- sophisticated (ie, adulterated) approaches to optimise risk, an approach
maturity deposits. Similarly, credit card loans can be a significant part that will look at analysing customer deposits within the context of gap and
of a typical banks assets. Common characteristics among all such duration will result in better balance sheet management than the use of
accounts include:
any fancy derivatives.
n no specific maturity
n individual account holders can add or subtract balances as they wish Why look at core deposit value?
n the interest rate on these accounts is usually, but not always, a func- The simulated EV of an institutions assets and liabilities across various rate
tion of open market interest rates
scenarios is a meaningful proxy on the degree to which the net interest
n the balances in aggregate often move in response to changes in open spread is exposed to long-term mismatch and option risks. The EV of core
market interest rates.
deposits is relevant, even for financial institutions intending to hold-toAs federal regulators have noted, the treatment of non-maturity
maturity all earning assets, because rate movements create embedded
deposits will be, for many banks, the single most important assumption gains or losses that can translate into higher or lower spread earnings over
in measuring their exposure to interest rate movement. The regulators
time. Traditional income simulation for complex balance sheets may not
continue to rely on a banks internal modelling systems to determine
fully capture the worth of future opportunity costs.
the value and interest rate sensitivity of such accounts. This presents all
The interest rates on these deposits are usually, but not always, a funcbankers with the difficult task of accurately calculating the market value tion of open market interest rates. Similarly, the level of deposit balances in
of deposits and credit card loans, as well as developing effective hedging aggregate often moves in sympathy with open market interest rates. With
strategies to protect this value against market rate movements.
the emerging trend of mark-to-market risk management in banking, all
Similarly, with the continued consolidation trend in the banking indus- bankers are faced with the dilemma of calculating the economic value of
try, accurate valuation of demand deposits, in particular, becomes critical such deposits.
in determining the value of an institution or a single branch. Acquiring
For example, under a rising rate environment, economic depreciation
and/or target banks will need to measure the deposit franchise value based occurs in fixed rate loans, investments reflecting their re-pricing and
on the unique characteristics of an institutions deposit portfolio.
term characteristics. Put another way, the assets now bear a positive opporIt has now come home to roost with the Northern Rock debacle which tunity cost in the new rate scenario existing instruments have reduced
was NOT a credit risk problem but a plain liquidity crisis which was as a earnings power relative to assets that can be originated with the current
result of others credit risk woes.
markets coupon.
This problem is largely due to the exclusion of retail deposits when it
comes to prudent liquidity management, and this article chooses to address A simple approach
the key issue of valuing retail deposits.
The lack of a contractual maturity date forces the balance sheet manager to
Retail deposits are a major funding source to financial institutions and make assumptions about the future behaviour of these instruments.
are therefore prominent inputs for the asset/liability (A/L) modelling proc- Although almost all deposits may be withdrawn overnight, it may not be
ess. Current, savings and money market accounts possess contractual fea- within the realm of reason to assign these balances to the overnight bucket
tures whereby the consumer can withdraw (or add to) balances at any time. of the gap report or to discount them at the overnight rate. A simple rule
These funding products present a serious analytical challenge for the A/L applied by many organisations assumes that 20% of the deposit balance is
analyst as management administers the rate paid on the deposit. The bank highly volatile, while the remaining 80% is more stable and therefore stays
holds an option to adjust the degree to which the rate resets, in response to on the books longer.

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LIQUIDITY AND DEPOSITS

While this simple approach allows the practical distribution of nondeterminant maturity deposits into liquidity and sensitivity gap reports, it
does not allow for the changing of cashflows based on changing interest
rates or macro factor variables. Therefore, this approach does not provide
us with alternative economic value or duration numbers for such accounts,
which constitute a significant portion of a retail banks balance sheet. The
only way to calculate these is to generate a repayment schedule for all
deposits, taking into consideration the behaviour of the customer and the
impact of administered rates.
In todays world of complex derivatives and incomprehensible ratings,
we need to move back to a structure of hedging on-balance sheet asset
exposures with simple on-balance sheet liability exposures, and use the
liability-modelling framework to provide a structural hedge for the asset
exposures.
In the case of non-determinant maturity deposits, the value of the
deposit could also be the premium that a third party is willing to pay above
the face value of the deposits to assume ownership of a banks deposit franchise. In this case, value means the net present value benefit of owning the
deposit franchise or the value of cash provided by depositors less the present
value cost of the deposit franchise.
There is a good reason for looking at the franchise for valuation. The
pricing of non-determinant maturity deposits is exactly the same for any
new customer as it is for existing customers, since banks operate on the

policy of individually insignificant customers. The bank cannot control


the flow of new deposit accounts by changing the pricing structure without
passing on these pricing benefits to existing customers. This is not the case
for any other balance sheet item with a contractual maturity.
Valuation and cashflow profiles
With non-maturity deposits as funding, interest rate risk management
becomes a balancing act in rate administration. The bank must manage
against the threat of customer attrition due to competition1 as well as
potential for erosion in the net interest margin. Given the choice, a bank
might prefer holding the rate sensitivity of deposit products equal to zero
when rates are rising. In reality, institutions pricing decisions in the local
as well as national economy weigh on management to a certain extent at
each ALCO meeting. In the struggle to attract, retain, and service highbalance clients, savings money plus interest-bearing checking consumers, a
successful deposit strategy must include competitive pricing.
In a rising rate environment, the bank may be required to offer higher
account rates to maintain the customer relationship. Core deposits represent a major portion of the funding mix at many banks, so the basis or
spread between the asset portfolio yield and cost of core liabilities is a significant source of earnings. If the upward re-pricing of liabilities is similar
to the re-pricing behaviours afforded by earning assets, net interest earnings are protected.

1. Balances and associated monthly movements: January 2002January 2008


Period

Historical
balances

Jan 02

694,316

Feb 02

697,712

3,396

Mar 02

711,380

13,668

Apr 02

729,654

May 02

761,357

Jun 02

792,496

31,139

Jul 02

820,717

28,221

Aug 02

816,665

(4,052)

Sep 02

847,639

30,974

34

Oct 04

1,061,381

10

Oct 02

846,214

(1,425)

35

Nov 04

1,000,957

11

Nov 02

839,067

(7,147)

36

Dec 04

1,049,777

48,820

12

Dec 02

857,020

17,953

37

Jan 05

1,034,382

(15,395)

13

Jan 03

869,772

12,752

38

Feb 05

1,044,785

14

Feb 03

880,977

11,205

39

Mar 05

15

Mar 03

878,521

(2,456)

40

Apr 05

16

Apr 03

898,088

19,567

41

17

May 03

936,117

38,029

42

18

Jun 03

963,864

27,747

43

Jul 05

1,109,443

19

Jul 03

964,240

376

44

Aug 05

1,100,378

20

Aug 03

972,592

8,352

45

Sep 05

1,095,157

(5,221)

21

Sep 03

980,729

8,137

46

Oct 05

1,081,138

(14,019)

22

Oct 03

941,579

(39,150)

47

Nov 05

1,103,686

23

Nov 03

935,642

(5,937)

48

Dec 05

1,121,924

24

Dec 03

890,453

(45,189)

49

Jan 06

1,131,835

9,911

25

Jan 04

919,625

29,172

50

Feb 06

1,139,242

7,407

mortgageriskmagazine.com 05.2008

Month-tomonth delta

Period

Historical
balances

Month-tomonth delta

Period

Historical
balances

Month-tomonth delta

26

Feb 04

933,231

13,606

27

Mar 04

930,939

(2,292)

51

Mar 06

1,163,777

24,535

52

Apr 06

1,166,684

28

Apr 04

945,964

15,025

2,907

53

May 06

1,182,351

15,667

18,274

29

May 04

953,868

31,703

30

Jun 04

770,311

7,904

54

Jun 06

1,183,687

1,336

(183,557)

55

Jul 06

1,163,732

(19,955)

31

Jul 04

981,960

32

Aug 04

995,965

211,649

56

Aug 06

1,163,080

(652)

14,005

57

Sep 06

1,163,271

33

Sep 04

994,252

191

(1,713)

58

Oct 06

1,182,398

19,127

67,129

59

Nov 06

1,184,084

1,687

(60,424)

60

Dec 06

1,209,662

25,578

61

Jan 07

1,241,912

32,249

62

Feb 07

1,289,523

47,611

10,403

63

Mar 07

1,294,655

5,132

1,037,911

(6,874)

64

Apr 07

1,313,042

18,387

1,055,301

17,390

65

May 07

1,334,627

21,585

May 05

1,076,970

21,669

66

Jun 07

1,340,796

6,169

Jun 05

1,095,881

18,911

67

Jul 07

1,355,684

14,888

13,562

68

Aug 07

1,360,294

4,610

(9,065)

69

Sep 07

1,371,197

10,903

70

Oct 07

1,394,041

22,844

71

Nov 07

1,408,389

14,348

22,548

72

Dec 07

1,451,715

43,325

18,238

73

Jan 08

1,427,030

(24,685)

27

LIQUIDITY AND DEPOSITS

Understanding historical trends


It is important to ensure that at least an economic cycle worth of data in
terms of deposit balances and rates are available before we commence our
modelling framework. Table 1 (on previous page) gives us information
relating to balances and associated monthly movements for the last six
years. Based on this list, a simple average monthly movement can be constructed with ease, as shown in table 2.
You can see that the maximum outflow for the specified confidence
interval can be changed by merely changing the confidence interval. Therefore, if an organisation wishes to use a higher confidence interval, the corresponding outflow will be higher, as can be seen in table 3.
We are now ready to move to the next step, which is to construct the
forecast balances of these deposits over a defined modelling horizon, say
five years. This is done by adding the average monthly change to the last

available balance and constructing a trend, as can be seen in table 4.


Graphically, the historical balances and the trends are represented in
chart 1 below.
Based on these trends and the confidence interval that we have
selected, we can then work out the minimum balance for each period
that will remain, based on the last available outstanding balance using
the following formula:
A + mD + V * K *sqrt(Fp), where:

5. Portfolio of non-determinant maturity accounts


Balance as on January 2008

1,427,03?

Minimum balance as on Feb 2013

1,336,67?

Balance with a maturity of five years

1,336,67

2. Simple average monthly movement (95% confidence)


Average monthly change

10,177

2,200,000

Volatility of monthly change

38,899

2,000,000

95%

1,800,000

Confidence interval for analysis


Maximum outflow for CI specified

(53,80?) [CANT SEE]

Outflow as % of last balance

1,600,000

3.771%

1,400,000

3. Simple average monthly movement (99% confidence)

1,200,000
1,000,000

Average monthly change

10,177

Volatility of monthly change

38,899

800,000

99%

600,000

Confidence interval for analysis


Maximum outflow for CI specified

(80,316)

Outflow as % of last balance

5.628%

2002

2004

2006

2008

2010

2012

Chart 1: Historical balances and forecasts

4. Forecast balances

28

Period

Forecast

Period

Forecast

Period

Forecast

74

Feb 08

1,437,206

94

Oct 09

1,640,738

114

Jul 11

1,844,269

75

Mar 08

1,447,383

95

Nov 09

1,650,914

115

Aug 11

1,854,446

76

Apr 08

1,457,559

96

Dec 09

1,661,091

116

Sep 11

1,864,623

77

May 08

1,467,736

97

Jan 10

1,671,268

117

Oct 11

1,874,799

78

Jun 08

1,477,913

98

Feb 10

1,681,444

118

Nov 11

1,884,976

79

Jul 08

1,488,089

99

Mar 10

1,691,621

119

Dec 11

1,895,152

80

Aug 08

1,498,266

100

Apr 10

1,701,797

120

Jan 12

1,905,329

81

Sep 08

1,508,442

101

May 10

1,711,974

121

Feb 12

1,915,505

82

Oct 08

1,518,619

102

Jun 10

1,722,150

122

Mar 12

1,925,682

83

Nov 08

1,528,795

103

Jul 10

1,732,327

123

Apr 12

1,935,859

84

Dec 08

1,538,972

104

Aug 10

1,742,504

124

May 12

1,946,035

85

Jan 09

1,549,149

105

Sep 10

1,752,680

125

Jun 12

1,956,212

86

Feb 09

1,559,325

106

Oct 10

1,762,857

126

Jul 12

1,966,388

87

Mar 09

1,569,502

107

Dec 10

1,773,033

127

Aug 12

1,976,565

88

Apr 09

1,579,678

108

Jan 11

1,783,210

128

Sep 12

1,986,742

89

May 09

1,589,855

109

Feb 11

1,793,387

129

Oct 12

1,996,918

90

Jun 09

1,600,032

110

Mar 11

1,803,563

130

Nov 12

2,007,095

91

Jul 09

1,610,208

111

Apr 11

1,813,740

131

Dec 12

2,017,271

92

Aug 09

1,620,385

112

May 11

1,823,916

132

Jan 13

2,027,448

93

Sep 09

1,630,561

113

Jun 11

1,834,093

133

Feb 13

2,037,624

LIQUIDITY AND DEPOSITS

A = last periods balance


mD = monthly delta
V = volatility (standard deviation) of monthly change
K = inverse of the normal cumulative distribution for mean = 0 and standard deviation = 1
Fp = number of observations from last available historical balance

Therefore, 1,336,673 out of 1,427,030 can be modelled as a five-year


instrument with amortising characteristics. This will provide us with an
economic value, which is considerably different from the book value of
1,427,030. Hedging decisions can be taken based on such maturity analyses undertaken. The amount that is specified as the minimum balance
available at the end of the modelling horizon can be controlled easily
through the confidence interval chosen and this gives a degree of comfort
This will give us the minimum balance that will remain with the when it comes to taking structural liquidity decisions.
bank for every month into the modelling horizon and can be repreCan core deposits be modelled as funding the life of earning assets
sented as follows in table 6.
and remain true to the spirit of economic valuation? Actually, practical
Graphically, this can be represented on chart 2 below.
arguments against core deposit decay modelling fit in quite nicely with
Based on these calculations, the inferences in table 5 (opposite page) can the theory behind EV analysis. The central principle of net interest
be drawn for the portfolio of non-determinant maturity accounts.
spread economic valuation assumes that earning assets are funded to
their maturities.

2,200,000

Historical balances
Trends
Minimum balances

2,000,000
1,800,000
1,600,000
1,400,000
1,200,000
1,000,000
800,000
600,000

2002

2004

2006

2008

2010

2012

Chart 2: Non-determinant maturity analysis

Summary
Core deposits are valuable to an institution due to the combination of
managements ability to exercise lagged, below market pricing and the customers willingness to accept those pricing differentials in exchange for
services and convenience. Given the strong profit allure contained in asset
mismatch strategies using core deposit leverage, an interest rate risk measurement process should include assessment of basis risk in the banks nonmaturity funding. In addition to presenting a historical approach to nondeterminant deposit maturity measurement, this article offers a solution to
the deposit duration debate that is faithful to the EVE methodology. Analysis that fails to address the basis risk in core liabilities may result in a distorted view of the balance sheets risk/reward trade-off. Basis risk information can yield guidance on prudent volume controls over asset-led mismatch
and options strategies. l

6. Minimum balance that remains with the bank into the modelling horizon
Period

Forecast

Minimum

Period

Forecast

Minimum

Period

Forecast

Minimum

74

Feb 08

1,437,206

1,346,714

94

Oct 09

1,640,738

1,226,050

114

Jul 11

1,844,269

1,264,835

75

Mar 08

1,447,383

1,319,407

95

Nov 09

1,650,914

1,226,468

115

Aug 11

1,854,446

1,267,988

76

Apr 08

1,457,559

1,300,822

96

Dec 09

1,661,091

1,227,105

116

Sep 11

1,864,623

1,271,224

77

May 08

1,467,736

1,286,751

97

Jan 10

1,671,268

1,227,947

117

Oct 11

1,874,799

1,274,541

78

Jun 08

1,477,913

1,275,565

98

Feb 10

1,681,444

1,228,982

118

Nov 11

1,884,976

1,277,934

79

Jul 08

1,488,089

1,266,429

99

Mar 10

1,691,621

1,230,198

119

Dec 11

1,895,152

1,281,403

80

Aug 08

1,498,266

1,258,845

100

Apr 10

1,701,797

1,231,585

120

Jan 12

1,905,329

1,284,944

81

Sep 08

1,508,442

1,252,491

101

May 10

1,711,974

1,233,133

121

Feb 12

1,915,505

1,288,556

82

Oct 08

1,518,619

1,247,142

102

Jun 10

1,722,150

1,234,834

122

Mar 12

1,925,682

1,292,235

83

Nov 08

1,528,795

1,242,633

103

Jul 10

1,732,327

1,236,680

123

Apr 12

1,935,859

1,295,981

84

Dec 08

1,538,972

1,238,843

104

Aug 10

1,742,504

1,238,663

124

May 12

1,946,035

1,299,790

85

Jan 09

1,549,149

1,235,674

105

Sep 10

1,752,680

1,240,778

125

Jun 12

1,956,212

1,303,662

86

Feb 09

1,559,325

1,233,050

106

Oct 10

1,762,857

1,243,018

126

Jul 12

1,966,388

1,307,594

87

Mar 09

1,569,502

1,230,910

107

Dec 10

1,773,033

1,245,377

127

Aug 12

1,976,565

1,311,585

88

Apr 09

1,579,678

1,229,203

108

Jan 11

1,783,210

1,247,850

128

Sep 12

1,986,742

1,315,632

89

May 09

1,589,855

1,227,885

109

Feb 11

1,793,387

1,250,432

129

Oct 12

1,996,918

1,319,735

90

Jun 09

1,600,032

1,226,922

110

Mar 11

1,803,563

1,253,119

130

Nov 12

2,007,095

1,323,892

91

Jul 09

1,610,208

1,226,281

111

Apr 11

1,813,740

1,255,907

131

Dec 12

2,017,271

1,328,102

92

Aug 09

1,620,385

1,225,938

112

May 11

1,823,916

1,258,792

132

Jan 13

2,027,448

1,332,363

93

Sep 09

1,630,561

1,225,867

113

Jun 11

1,834,093

1,261,769

133

Feb 13

2,037,624

1,336,673

mortgageriskmagazine.com 05.2008

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