Interest Rate Risk Basics Measuring & Managing Earnings & Value at Risk

Transcription

1 Interest Rate Risk Basics Measuring & Managing Earnings & Value at Risk Presented By: David W. Koch Chief Operating Officer FARIN & Associates, Inc.. 1

2 Session Overview Session 1 Define Interest Rate Risk Identify Overall Measurement Tools Gap Analysis Income Simulation Market Value Analysis (EVE/NEV) Define Earnings at Risk Key Measurements Major Assumptions Interpreting Results Session 2 Define Market Value Key Measurement Points Major Assumptions Interpreting Results Common Faults in Market Value Reporting Combining Income and Value at Risk Analysis 2

3 Value at Risk MEASURING INTEREST RATE RISK

4 Interest Rate Risk Market Value Portion of Definition Market value risk is the risk that a change in market interest rates will raise or lower the market value of instruments in an institution s portfolio. Example: you just purchased a new five year treasury yielding 5%. Immediately after purchase, 5 year treasury rates move to 6%. Because A potential purchaser would expect to earn 6% and your treasury pays 5%, you would need to make up the difference of 1%. That s 1% per year for 5 years or a discount on sale of approximately 5%. Market value risk is not a problem as long as the market value of both assets and liabilities is moving in the same direction and at approximately the same speed.

5 Value at Risk Concept Consider 401K or Personal Investments Value of Bonds goes UP when Rates go DOWN why? Bonds are fixed rates that will earn More as compared to new rates, creating Market Value greater than Book Value Only real value if you SELL the asset Aren t the financial instruments on a balance sheet the same as your 401K investments? Rates Price 5

6 Interest Rate Risk Market Value of Capital (Equity) Present value of expected cash flows from assets Less: present value of expected cash flows from liabilities Plus: present value of expected cash flows from offbalance sheet activities Sum divided by the present value of assets = Present Value of Equity Ratio (capital/assets or EVE/NEV Ratio) 6

7 Measuring Value at Risk Duration Analysis A measure of an instrument s change in value for every 1% change in market rates Discounted Cash Flow Analysis Valuing the estimated future cash flows based upon time value of money Re-project cash flows for each interest rate scenario and value 7

8 Duration Measures An Instrument s Price Sensitivity Weighted average of PV of an instrument s cash flows Can be used in simple valuation formula (chg MV = - D x chg MR) Can Be Used To Measure Price Sensitivity Of: An instrument A portfolio of similar instruments A portfolio of dissimilar instruments Advantages Single price sensitivity index Easily calculated Disadvantages Not good for evaluating effect of rate shocks on income Does not consider option risk Difficult to explain to boards and non-financial managers Measures risk but not return Control Ratios Duration assets = Duration liabilities Duration of capital 8

9 Duration - Teeter Totter Approach Year Year Year Year Year Year 6 Analysis is for a $6,000 loan paying 6 equal annual principal payments plus interest on remaining balance at 10% rate. NPV - Cash Flows Year Cash Flow Pres Value 1 1,600 1, ,500 1, ,400 1, , , , Total 8,100 6,000 9

10 Duration Period Payment NPV Wtd NPV 1 1,600 1,455 1, ,500 1,240 2, ,400 1,052 3, , , , , , ,726 Total 8,100 6,000 18,092 Analysis is for a $6,000 loan paying 6 equal annual principal payments plus interest on remaining balance at 10% rate. Cash flows marked to market using a 10% discount rate. Duration = 18,092 / 6,000 = Years Duration Calculation Project Amount & Timing of Cash Flows Calculate Net Present Value of Cash Flows - (PV = FV / (1+i) n) n - payment number i - discount rate PV - market value FV - future cash flow Weight NPVs by timing (Period x NPV) Calculate Duration (Wtd NPV/NPV) 10

11 Price Duration To Price Effect of Rate Changes on Price $110 $105 $100 $95 Value - SD $90-3% -2% -1% 0% 1% 2% 3% Rate Change (%) Chg MV = - D x Chg MR % = x 2% 11

12 Static Value at Risk Today Horizon Remaining life of all instruments Immediate & Permanent Rate Shocks Current Balance Sheet In static value at risk analysis, all cash flows over their remaining lives are generated for every financial instrument on the balance sheet for each rate environment. Discount rates are then Used to mark the cash flows to market. 12

13 Discount Rate Static Value at Risk Modified Discounted Cash Flow PV = FV (1+i) n PV Present Value FV Future Value I Periodic Discount Rate n Count of Future Period Year Cash Flow Pres Value 1 1,600 1, ,500 1, ,400 1, , , , Total 8,100 6,000 1,200 / ( ) 5 = 745 (10% discount rate) 13

14 Keys to Value at Risk Elements effecting Value at Risk Remaining term to maturity or repricing Longer term = greater volatility Rate on similar investments vs. your rate Called the Discount Rate Greater the difference the greater the change in value (Your rate discount rate) * remaining term gives you an idea of the change in value. Issues impacting Value at Risk How do non-maturity deposits work? No stated maturity Rates don t change when market rates move Creates Value as offer rates LAG market rates 14

15 Market Value Basics SAMPLE Market Value Summary Assets Book Value -100 bp Flat +100 bp +200 bp +300 bp Total Cash 5,000 5,000 5,000 5,000 5,000 5,000 5 Year Bond 1,000 1,050 1, Total Investments Market to Book Mortgage-Fixed 45,000 47,275 46,500 44,265 42,850 40,975 Market to Book Mortgages - Variable 18,750 18,850 18,775 18,750 18,595 18,495 Market to Book Total Loans 185, , , , , ,258 Market to Book Nonearning Assets 4,250 4,250 4,250 4,250 4,250 4,250 Total Assets 219, , , , , ,758 Market to Book

16 Market Value Basics SAMPLE Market Value Summary Liabilities Book Value -100 bp Flat +100 bp +200 bp +300 bp Non-Interest Checking 18,000 17,575 15,000 14,375 13,295 12,750 Short Term CDs 85,000 89,828 88,500 87,173 85,845 85,181 Long Term CDs 40,000 38,330 37,950 37,191 36,432 35,294 Total CDs 125, , , , , ,475 Market to Book Savings 45,000 44,255 42,750 41,932 40,028 39,195 Market to Book MMDA 18,750 18,850 18,485 18,010 17,798 17,538 Market to Book Total Non-Maturity 63,750 63,105 61,235 59,942 57,826 56,733 Market to Book Borrowings Equity 12,500 22,753 26,515 27,453 29,415 25,800 Total Liabilities & Equity 219, , , , , ,758 Equity/Assets 5.70% 9.82% 11.57% 12.14% 13.20% 11.96% 16

17 EVE Policy Limit Conversion Policy limits commonly set as a % change in equity values Less effective as this fails to consider HOW MUCH capital remains, only looks at VOLATILITY Below is an example that could be used to express limits as a % change in EVE Ratio Assumes Current EVE ratio (Flat Rates) of 12% Example of OTS TB 13 A Limits Converted to % Change for OCC For a +2/-2% shock Green Yellow Red After Shock EVE Ratio > 10% and the % change in EVE ratio is: <= 40% of Base EVE Ratio 40-60% of Base EVE Ratio > 60% of Base EVE Ratio After Shock EVE Ratio < 10% but >= 6% and the % change in EVE ratio is: <= 25% of Base EVE Ratio 25-50% of Base EVE Ratio > 50% of Base EVE Ratio After Shock EVE Ratio < 6% but >= 4% and the % change in EVE ratio is: <= 15% of Base EVE Ratio 15-30% of Base EVE Ratio > 30% of Base EVE Ratio After Shock EVE Ratio is < 4% and the % change in EVE ratio is: <= 10% of Base EVE Ratio 10-25% of Base EVE Ratio > 25% of Base EVE Ratio 17

18 Valuing Cash Flows The Key Assumption ISSUES IN VAR ANALYSIS 18

19 Price Option Risk Issue Effect of Rate Changes on Price $110 $105 $100 $95 Value - SD $90-3% -2% -1% 0% 1% 2% 3% Rate Change (%) Formula assumes these are independent variables. What if they aren t? Chg MV = - D x Chg MR % = x 2% 19

20 Option Risk Definition The risk that a party to a financial instrument will exercise its imbedded options causing cash flows to vary by rate environment. The IRR Issue If cash flows cash flows vary with rate environment analysis of IRR is complicated along with the ability to hedge IRR. Convexity As a result of imbedded options, market values track along a curve rather than a straight line. Examples of Imbedded Options Prepayment Options in Consumer Loans Annual and Lifetime Caps in ARMs Early Withdrawal Options In CDs Bump Rate CDs Options To Convert From ARMs to Fixed-rate Mortgages Step-up Bonds Derivative Mortgage-Backed Securities Callable Bonds and FHLB Advances 20

21 Option Risk Newly Issues 30 Yr.. FHLMC Prepay Estimates Note that in rising rates, prepayments decline on 4% coupon by 75% in up 2% but little change up 3% Moderately Seasoned 30 Yr.. FHLMC Prepay Estimates Note how 4%+ coupons have slower base prepayments Less volatility (33% drop in up 2%) due to slower starting levels 21

22 Option Risk 22

23 Convexity Risk 23

24 Convexity Risk 125 MBS prepayments increase in falling rate environment shortening duration, decelerating rise in value MBS D = Advance D MBS Advance Duration is Dependent on Market rates. 75-3% -2% -1% 0% 1% 2% 3% MBS prepayments decrease in rising rate environment lengthening duration, accelerating drop in value. Duration Rates 24

25 Reading a Market Value Report NPV Ratio after 200 bp shock Interest Sensitivity Measure bp bp bp Over 400 bp Over 12% Minimal (1) Minimal (1) Minimal (1) Moderate (2) 8% to 12% Minimal (1) Minimal (1) Moderate (2) Significant (3) 4% to 8% Minimal (1) Moderate (2) Significant (3) High (4) Below 4% Moderate (2) Significant (3) High (4) High (4) 25

26 Modified Discounted Cash Flow PV = ( FV Cash Flows ) t ( 1 + i ) PV Present Value FV Future Value i Discount Rate t Time i - the discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.) 26

27 General Approach Discount Rate Assets: What is the current return for a set of similar cash flows in today s market? When rates are higher today than our return, assets are priced lower than book Liabilities: How much would it cost me today to purchase similar funding? Combination of retail rates and wholesale rates? Higher costs today = lower price Remember lower liability prices are GOOD Assets = Liabilities + Equity Less Liability = Higher Equity 27

28 Arriving At Discount Rate In valuing a financial instrument, you should always look at it through the eyes of a potential acquirer who will ask: If I was to acquire this asset (or funding) in an alternative way, what would I expect to earn or pay? Does the alternative have essentially the same risks and servicing costs? If not, I need to adjust for the difference. How should Deposits be Viewed? EVE/NEV is an Institutional Analysis, not a customer viewpoint. If we value an asset based on wholesale alternatives with adjustments, why not use the same for deposits? 28

29 Valuing Financial Instruments Sources for Discount Rate What s the right answer for which source for the discount rate? Is there a method to selecting between multiple choices? Discount Rate Progressions Market (Wall Street) Price Market Proxy Competitive Market Average My Rate (Last Resort) 29

30 Arriving At Discount Rate If the security or debt instrument I choose is a less than perfect match to my deposit or borrowing, what risks and costs might I need to adjust for? Interest rate risk Option risk Credit risk Servicing cost 30

31 Arriving At Discount Rate Is the valuation method fundamentally the same for both assets and liabilities? Yes, because: A financial instrument is a contract, given in exchange for cash, that calls for repayment of the cash (principal & interest) in the future. It is someone s asset (the holder of the contract). And someone else s liability (the issuer of the contract). The instrument has the same value regardless of whether you are the issuer of the contract or the holder of the contract. 31

32 Arriving At Discount Rate General rule: When valuing a fixed-rate financial instrument, use a yield curve when ever possible: It s how the market does it. It makes it much easier to value seasoned portfolios. Considers the slope of market rates in the time-value calculation 32

33 30 Yr. Mortgage Example 30 Yr. 60 Day Delivery Rate = 3.75% Average Duration: 7 Yrs. 7 Yr. Treasury Rate Risk = 1.0% Treasury = Risk Free Curve Duration Match accounts for Interest Rate Risk What is the 1.75% spread covering? Credit Risk Option Risk (Extension/Prepayment) Option risk less with shorter remaining terms Lower spread to treasury widening to 1.75% on long end of the curve 33

34 Cash Flow Yield Arriving At Discount Rate Two 15 year FRMs, one 14 years from maturity, the other 8 years away. 15 Yr FRM Cash Flows 1,400,000 1,200,000 1,000, , , , , % 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% New Loan Old Loan Disc Rate D old D new Year 34

35 Arriving At Discount Rate Does it make sense to use the same discount rate in valuing the loan 8 years from maturity as the loan 14 years away? If they were both issued at the same rate and were valued today, which loan would be most likely to be sold at a premium? Do you value a new 5 Yr. bond the same way you value a 10 Yr. bond with 5 Yrs remaining? 35

36 Managing the Non-Maturity Deposit Portfolio MAJOR ASSUMPTION AREAS 36

37 Two Most Crucial A/L Assumptions Pricing Betas the extent to which a change in market rates is passed along to deposit customers Income at risk analysis EVE analysis Decay rates The speed at which non-maturity deposits decay off books over time EVE analysis Liquidity analysis What is the greatest commonly expressed fear about NMD funding? 37

38 Pricing Betas & Decay Rates Oh My! Thank goodness he s retiring OTS Core Deposit Assumptions OTS was the primary source of pricing betas and decay rates for the industry for over 25 years. The OTS NPV model was run for the last time on 12/31/11 data. OTS assumptions were developed 30 years ago and haven t changed materially since. 38

39 Pricing Betas Definition A pricing beta is an index that is used to predict the effect of an increase in market rates on rates paid on a product. For example, if market rates increase 200 bp and your beta for MMDAs is 0.5 (50%) then the beta would predict you will raise MMDA rates by 100 bp 200 Bp X 0.5 = 100 Bp Betas can be: SWAG d Derived statistically from historic data. Examiners prefer the latter Betas can also be modified by use of segmentation strategies. 39

40 Pricing Betas Statistical The Science Pick/plot a representative set of market rates for dates studied. Plot your actual pricing on account you are evaluating for study dates Regress lines against each other to find best fit varying Lags Betas From best fit take off Index (market rate) Lag Beta Spread The Goal Predict the effect of movements in market rates on how you will price a core deposit account The Art Use a statistically valid set of historical data Understand that this is a modeling tool and does not represent how the institution actually prices Application A/L Modeling Income at risk Value at risk 40

41 Pricing Betas For example, if market rates increase 200 bp and your beta for MMDAs is 0.5 (50%) then the beta would predict you will raise MMDA rates by 100 bp 200 Bp X 0.5 = 100 Bp Betas can be: SWAG d Derived statistically from historic data. Examiners prefer the latter Betas can also be modified by use of segmentation strategies. 41

42 Modeling Non-Maturity Accounts Rate projections in many ALM Models Assume a relationship between market rate movements and offer rate For every 1% change in Short-Term Treasury offer rate moves by.25% with a 3 month lag Some use a direct formula between long-term treasury rates and offer rate Correlations are statistically low and offer little bearing on reality Use of long-term rate is to see stability usually found in share accounts Some change formula for rates up/down 42

43 Importance of Offer Rate Paid Example $200 Million Passbook Account Rate Paid Formula -200 bp Flat Rates +200 bp 50% Change in Offer Rate for 1% Change in Treasury Rate 196,030,129 Price = ,585,268 Price = ,619,164 Price = Formula that steps rates when Fed Funds changes & max rate of.75% 194,727,952 Price = ,217,771 Price = ,993,975 Price = Rate paid in +200 impacts equity by $7.6 million. (181, ,993) With less volatile liabilities, what strategies are possible for asset mix? 43

44 MMDA vs. Market Rates Lag Volatility Q. Which of these market rate trends looks most like our MMDA pricing (dark blue line)? A. None Why? We don t move MMDAs by full change in market rates, and Deposit rate changes lag behind movements in market rates 44

45 MMDA vs. Market Rates Volatility Lag What we want to learn Which market rate gives us the best fit (correlation) How many months of lag gives us the best fit to the market rate (lag) What % of the change in market rates gets passed along to the depositor (beta) What is the starting spread between the market rate and the deposit account rate (spread) These are all current inputs to your A/L model!!!! 45

46 MMDA vs. 2 Year Treasury Steps: 1. 2 year Treasury is best fit 2. Lagging 5 months matches timing of rate moves (red line) too volatile 3. Lagging 5 months with 0.53 beta matches timing and volatility (green line) 46

47 MMDA vs. 2 Year Treasury Steps: 1. 2 year Treasury is best fit 2. Lagging 5 months matches timing of rate moves 3. Lagging 5 months with 0.53 beta matches timing and volatility (red line) 4. Setting spread = % lays lines on top of each other (green line) 47

48 Running Sensitivity Tests on Betas Increasing pressure by regulators to stress test key assumptions What is the goal of the test? Think Heat Stress Test Assumed Beta is too fast/high or too slow/low Run a series of potential tests to see the impact of a change in assumptions on results How would that risk impact your overall capital plan or needs? 48

49 Sample of Premium Consumer MMDA Premium MMDA Mean Beta: 70% with a 2.5 month lag 13.5% standard deviation 1 Std Deviation Min Beta: 57% 1 Std Deviation Max Beta: 84% 2 Std Deviation Min Beta: 43% 2 Std Deviation Max Beta: 97% Mean Term 18 months Index off 18 month rates! 49

50 Client Example Net Interest Inc 2 different stress test assumptions Beta moves faster/slower than anticipated More funds are surge and thus sensitive than anticipated Stress Tests Looked at each individually Combined the 2 tests to arrive at multiple outputs 50

51 Client Example Net Interest Inc. Beta Change Only Analysis #1: Impact of a change in beta but no change in the sensitive balances Flat rates GI Base Dec- GI High Dec I & P 100 I & P 200 I & P 300 Year 1 NIM Base Static - Dec-2013 $ 16,302,345 $ 16,361,534 $ 15,768,596 $ 15,587,705 $ 14,940,835 $ 14,434,875 Base Static UP Betas - Dec-2013 $ 16,282,145 $ 16,335,475 $ 15,517,196 $ 15,236,358 $ 14,258,083 $ 13,418,234 Base Static DN Betas - Dec-2013 $ 16,331,209 $ 16,379,704 $ 16,013,581 $ 15,901,302 $ 15,549,851 $ 15,341,401 Cost of Higher Beta $ ( 20,200 ) $ ( 26,059 ) $ ( 251,401 ) $ ( 351,347 ) $ ( 682,752 ) $ ( 1,016,641 ) Cost of Lower Beta $ 28,864 $ 18,169 $ 244,985 $ 313,597 $ 609,016 $ 906,527 % difference Higher -0.12% -0.16% -1.59% -2.25% -4.57% -7.04% % Difference Lower 0.18% 0.11% 1.55% 2.01% 4.08% 6.28% GI Base Dec- GI High Dec- Flat rates Year 2 NIM I & P 100 I & P 200 I & P 300 Base Static - Dec-2013 $ 15,861,714 $ 15,754,276 $ 12,989,433 $ 14,920,475 $ 14,057,739 $ 13,298,005 Base Static UP Betas - Dec-2013 $ 15,840,316 $ 15,661,733 $ 11,489,077 $ 14,439,237 $ 13,107,847 $ 11,866,601 Base Static DN Betas - Dec-2013 $ 15,892,206 $ 15,844,483 $ 14,281,948 $ 15,304,608 $ 14,815,031 $ 14,439,983 Cost of Higher Beta $ ( 21,397 ) $ ( 92,543 ) $ ( 1,500,355 ) $ ( 481,239 ) $ ( 949,892 ) $ ( 1,431,404 ) Cost of Lower Beta $ 30,492 $ 90,207 $ 1,292,515 $ 384,133 $ 757,292 $ 1,141,978 % difference Higher -0.13% -0.59% % -3.23% -6.76% % % Difference Lower 0.19% 0.57% 9.95% 2.57% 5.39% 8.59% 51

52 Client Example Net Interest Inc. Change in Surge Only Analysis #2: Impact of a change in sentivity of balances, but no change in the beta Flat rates GI Base Dec- GI High Dec I & P 100 I & P 200 I & P 300 Year 1 NIM Base Static - Dec-2013 $ 16,302,345 $ 16,361,534 $ 15,768,596 $ 15,587,705 $ 14,940,835 $ 14,434,875 20MM Static - Dec-2013 $ 16,272,914 $ 16,325,322 $ 15,663,984 $ 15,470,717 $ 14,733,082 $ 14,127,189 50MM Static - Dec-2013 $ 16,221,089 $ 16,264,614 $ 15,473,450 $ 15,259,241 $ 14,360,227 $ 13,591,205 Cost of $20 MM Runoff $ ( 29,431 ) $ ( 36,212 ) $ ( 104,612 ) $ ( 116,989 ) $ ( 207,753 ) $ ( 307,685 ) Cost of $50 MM Runoff $ ( 81,256 ) $ ( 96,920 ) $ ( 295,146 ) $ ( 328,464 ) $ ( 580,608 ) $ ( 843,669 ) % difference $20MM -0.18% -0.22% -0.66% -0.75% -1.39% -2.13% % Difference $50MM -0.50% -0.59% -1.87% -2.11% -3.89% -5.84% GI Base Dec- GI High Dec- Flat rates Year 2 NIM I & P 100 I & P 200 I & P 300 Base Static - Dec-2013 $ 15,861,714 $ 15,754,276 $ 12,989,433 $ 14,920,475 $ 14,057,739 $ 13,298,005 20MM Static - Dec-2013 $ 15,840,965 $ 15,712,702 $ 12,775,893 $ 14,860,129 $ 13,948,691 $ 13,115,559 50MM Static - Dec-2013 $ 15,786,945 $ 15,606,547 $ 12,140,775 $ 14,659,688 $ 13,597,098 $ 12,607,971 Cost of $20 MM Runoff $ ( 20,749 ) $ ( 41,573 ) $ ( 213,540 ) $ ( 60,346 ) $ ( 109,047 ) $ ( 182,446 ) Cost of $50 MM Runoff $ ( 74,768 ) $ ( 147,729 ) $ ( 848,658 ) $ ( 260,787 ) $ ( 460,640 ) $ ( 690,034 ) % difference $20MM -0.13% -0.26% -1.64% -0.40% -0.78% -1.37% % Difference $50MM -0.47% -0.94% -6.53% -1.75% -3.28% -5.19% 52

53 Client Example Net Interest Inc. Change in Surge of $20mm & Beta Changes Analysis #3: Impact of a change in sentivity of balances of $20 MM from Base PLUS changes in Beta Flat rates GI Base Dec- GI High Dec I & P 100 I & P 200 I & P 300 Year 1 NIM Base Static - Dec-2013 $ 16,302,345 $ 16,361,534 $ 15,768,596 $ 15,587,705 $ 14,940,835 $ 14,434,875 20MM Stat UP Betas - Dec-2013 $ 16,249,176 $ 16,297,810 $ 15,411,039 $ 15,120,440 $ 14,057,971 $ 13,133,148 20MM Stat DN Betas - Dec-2013 $ 16,293,442 $ 16,337,871 $ 15,865,532 $ 15,735,099 $ 15,252,360 $ 14,911,213 Cost of $20 MM Up Beta $ ( 53,170 ) $ ( 63,724 ) $ ( 357,557 ) $ ( 467,266 ) $ ( 882,864 ) $ ( 1,301,727 ) Cost of $20 MM Down Beta $ ( 8,904 ) $ ( 23,663 ) $ 96,935 $ 147,394 $ 311,525 $ 476,338 % difference $20MM UP -0.33% -0.39% -2.27% -3.00% -5.91% -9.02% % difference $20MM DOWN -0.05% -0.14% 0.61% 0.95% 2.09% 3.30% GI Base Dec- GI High Dec- Flat rates Year 2 NIM I & P 100 I & P 200 I & P 300 Base Static - Dec-2013 $ 15,861,714 $ 15,754,276 $ 12,989,433 $ 14,920,475 $ 14,057,739 $ 13,298,005 20MM Stat UP Betas - Dec-2013 $ 15,840,965 $ 15,712,702 $ 12,775,893 $ 14,860,129 $ 13,948,691 $ 13,115,559 20MM Stat DN Betas - Dec-2013 $ 15,786,945 $ 15,606,547 $ 12,140,775 $ 14,659,688 $ 13,597,098 $ 12,607,971 Cost of $20 MM Up Beta $ ( 20,749 ) $ ( 41,573 ) $ ( 213,540 ) $ ( 60,346 ) $ ( 109,047 ) $ ( 182,446 ) Cost of $20 MM Down Beta $ ( 74,768 ) $ ( 147,729 ) $ ( 848,658 ) $ ( 260,787 ) $ ( 460,640 ) $ ( 690,034 ) % difference $20MM -0.13% -0.26% -1.64% -0.40% -0.78% -1.37% % Difference $50MM -0.47% -0.94% -6.53% -1.75% -3.28% -5.19% 53

54 Client Example Net Interest Inc. Change in Surge of $50mm & Beta Changes Analysis #4: Impact of a change in sentivity of balances of $50 MM from Base PLUS changes in Beta Flat rates GI Base Dec- GI High Dec I & P 100 I & P 200 I & P 300 Year 1 NIM Base Static - Dec-2013 $ 16,302,345 $ 16,361,534 $ 15,768,596 $ 15,587,705 $ 14,940,835 $ 14,434,875 50MM Stat UP Betas - Dec-2013 $ 16,199,305 $ 16,240,891 $ 15,251,347 $ 14,946,037 $ 13,757,402 $ 12,705,161 50MM Stat DN Betas - Dec-2013 $ 16,236,364 $ 16,274,693 $ 15,643,025 $ 15,485,267 $ 14,805,175 $ 14,264,371 Cost of $50 MM Up Beta $ ( 103,041 ) $ ( 120,643 ) $ ( 517,249 ) $ ( 641,668 ) $ ( 1,183,434 ) $ ( 1,729,713 ) Cost of $50 MM Down Beta $ ( 65,982 ) $ ( 86,841 ) $ ( 125,571 ) $ ( 102,438 ) $ ( 135,660 ) $ ( 170,503 ) % difference $50MM UP -0.63% -0.74% -3.28% -4.12% -7.92% % % difference $50MM DOWN -0.40% -0.53% -0.80% -0.66% -0.91% -1.18% GI Base Dec- GI High Dec- Flat rates Year 2 NIM I & P 100 I & P 200 I & P 300 Base Static - Dec-2013 $ 15,861,714 $ 15,754,276 $ 12,989,433 $ 14,920,475 $ 14,057,739 $ 13,298,005 50MM Stat UP Betas - Dec-2013 $ 15,754,557 $ 15,505,962 $ 10,685,173 $ 14,179,533 $ 12,664,939 $ 11,236,373 50MM Stat DN Betas - Dec-2013 $ 15,793,805 $ 15,648,308 $ 12,967,911 $ 14,896,920 $ 14,083,391 $ 13,371,221 Cost of $50 MM Up Beta $ ( 107,157 ) $ ( 248,313 ) $ ( 2,304,260 ) $ ( 740,942 ) $ ( 1,392,800 ) $ ( 2,061,632 ) Cost of $50 MM Down Beta $ ( 67,909 ) $ ( 105,968 ) $ ( 21,522 ) $ ( 23,555 ) $ 25,652 $ 73,216 % difference $50MM UP -0.68% -1.58% % -4.97% -9.91% % % difference $50MM DOWN -0.43% -0.67% -0.17% -0.16% 0.18% 0.55% 54

55 Pricing Beta Conclusions Applications A/L Modeling Income at Risk Value at Risk (core deposit intangible) Branch Valuation Credibility Issues Do you really price MMDAs off 2 year Treasury? What issues rise when historical betas are used to predict the future? Betas affected by Growth/Shrinkage Strategies Tier Structure Betas for different tiers will be different Segmentation Strategies Account Groupings Consumer Preferences Competitive/economic environment Betas Apply to Non-maturity deposits, But also to CDs 55

56 Pricing Beta Conclusions Management Must Understand Current Model Assumptions Is this a likely path we would follow? Are these really reasonable assumptions on rate sensitive balances? Management should engage in study of institution specific behaviors and trends core study! A lack of understanding or commitment leads to more risk or capital coverage for assumption risk. If you don t understand you can t claim you are right! 56

57 Modeling Non-Maturity Deposits If you can prove no direct correlation in rate movement to market rates, then how long do non-rate sensitive funds stay with you? Many have contracted to perform Core Deposit Study. Some Use Regulatory approaches Some Assume no long-term funding Thoughts for modeling: If you practice proper pricing using tiers, does that change the assumption used on each tier versus an average? How are the changing market demographics likely to impact the future portfolio of non-maturity accounts? 57

58 Modeling Non-Maturity Deposits If you can prove no direct correlation in rate movement to market rates, then how long do non-rate sensitive funds stay with you? Many have contracted to perform Core Deposit Study. Some Use Regulatory approaches Some Assume no long-term funding Thoughts for modeling: If you practice proper pricing using tiers, does that change the assumption used on each tier versus an average? How are the changing market demographics likely to impact the future portfolio of non-maturity accounts? 58

59 Cash Flow Decay Rates The Science Pick a grouping of non-maturity deposit accounts at an appropriate level of aggregation Plot runoffs that occurred to a set of accounts over the study period. Separate normal from abnormal runoff or growth Calculate decay rate for normal runoff Calculate decay rate for abnormal balances Use decay rates to generate potential cash flows. The Goal Predict the cash flows coming off a pool of non-maturity deposits (the term) The Art Use a statistically valid set of historical data Pick a time frame covering at least ½ of a rate cycle Application A/L Modeling Income at risk Value at risk 59

60 Decay Rates Surge Balance Burnout Truncation Assumption: 20% of balances are surge balances 60

61 Decay Rate Comparison Last published OTS data indicates much FASTER decay rates than Mean of actual study data Note that OTS data made minor adjustments in decay rates for surge balances as rates change. 61

62 Decay Rates by Sector These results show base decay on non-surge balances by sector type for sample of FARIN Core Analytic clients Note that these balances are subjected to truncation assumptions Banks: 15 Yrs CU s: 10 Yrs 62

63 Non-Maturity Accounts & Surge Surge Balances: Balances within a NMD that are not anticipated to remain Sources of Surge Market Inflows Stock market Other FI Deposits Internal Account Movement CDs to MMDA Most ALM Models are applying long-term treatment to surge balances What happens to Surges in recovering economy? How does that impact risk? 63

64 Non-Maturity Accounts & Surge Studies show following estimates and standard deviations on surge amounts by deposit type 64

65 Impact One Customer Higher NPVs under all rate environments and increased asset sensitivity due to: Increased duration of NMDs (lower decay rates) Higher spreads to benchmarks (higher average benchmark cost Question Can we develop pricing strategies that reduce pricing betas and slow decay rates? 65

66 What Should You Do? 1. Get a handle on how your deposits actually behave (core funding study) Betas CDs and NMDs Decay Rates NMDs 2. Develop your core funding strategy for rising rates Product introductions Pricing strategies 3. Model your business plan interest rate risk given Behaviors from study Core funding strategy for rising rates 4. Evaluate your interest rate risk based on modeling performed in previous step. If you find: Significant asset sensitivity extend assets and shorten term funding Neutral to moderate you are set tune a bit if you like Significant liability sensitivity lengthen liabilities and shorten assets 66

67 What Should You Do? 5. Define the role Non-Core Funding plays in your business plan As a benchmark tool for making pricing decisions FHLB Advances were used extensively in my presentation as benchmarks in determining whether deposits were well or poorly priced. They were also used as discount rates in market value calculations. As a structural tool to cost-effectively mitigate interest rate risk When using non-core funding as a structural tool, it is very helpful to be able show examiners modeling results that support its use as an interest rate risk management tool. As a profitability enhancement tool when non-core funding is significantly cheaper than core When using non-core funding for this purpose it is important you document the analysis to support the use of non-core funding as a substitute for core. As a contingent funding tool for dealing with liquidity stress events. 67

68 Key Assumptions Summary Institutions with large balances of non-maturity deposits must understand their behaviors Account pricing actions (Institution s option) Customer actions (customer option) These funds may represent a hedge on longer term asset risks if history repeats Demographics are shifting which may change the core life of new account holders Tier rate programs and introduction of premium accounts can skew decay rates Discount rate assumptions are a critical component to value at risk calculation and should: Reflect true market rates for instrument being valued Be based on a curve rather than a single point when possible NOT be your offering rate unless you are the only one to offer the product 68