Developing Deposit Strategies for Rising Rates Session 1. Agenda

Transcription

1 Developing Deposit Strategies for Rising Rates Session 1 Thomas A. Farin President tfarin@farin.com 1 Agenda Session 1 - Deposit Analytics Are We In a Rising Rate Environment? Establishing Cash Flows Contractual vs. Actual Behavior Pricing Betas Decay Rates Surge Balances Methods for Calculating Decay Rates Session 2 Determining Where to Grow Deposits Where are your loan growth opportunities? How Will You Fund Loan Growth? Determine Where You Will Grow Deposits Blending Retail and Wholesale Funding Session 3 Developing Segmentation Strategies CDs Basics Barriers to Entry Non-Maturity Deposits Basics Barriers to Entry Surge Balances 2 1

2 Are We Already In a Rising Rate Environment? Conventional Wisdom The Fed has said they are not going to move rates for months Question What part of the curve do they control Fed Funds and Prime What part of the curve does the market control Short-Term Wholesale Rates Long-Term Wholesale Rates How does the Fed influence ST & LT rates? By buying back Treasury and Agency/GSE debt What is happening here? Retail deposit rates lag behind movements in wholesale rates. Why? That s what core deposit studies say That s what has happened historically But is the past a legitimate predictor of the future? Can you afford to bet your institution s cost of funds on history repeating itself? What drives deposit rates? Relationship between supply and demand Movement in wholesale rates (alternative funding) 3 48 Mo CD - Chicago Metro Market 4 Yr FHLB Advance CD response at top of market No CD response at market median 2

3 48 Mo CD - Chicago Metro Market Initiators are big banks 60 Mo CD - Chicago Metro Market 5 year FHLB Advance Median Rate Top Rate 3

4 60 Mo CD - Chicago Metro Market Initiators are big banks MMDA - Chicago Metro Market Top of Market 1 Year FHLB Advance Median Rate Paid 4

5 MMDA - Chicago Metro Market Initiators are big banks MMDA - Major National Players Top of market 1 Year FHLB Advance Median of market 5

6 MMDA - Major National Players Initiators are big banks Rising Rates - 6 Keys 1. Develop a Capital Plan Asset Growth Goals Loan Growth Goals Funding Growth Goals 2. Get a Handle on your MND & CD Behaviors 3. Identify Loan Growth Opportunities 4. Consider How to Fund Loan Growth 5. Determine Where You Will Grow Deposits 6. Learn How to Segment Effectively 12 6

7 Capital Planning Steps 1. Assess Your Static Position 2. Assess Your Dynamic Position 3. Design Stress Scenarios 4. Run A Stress Test 5. What is Your Definition of Failure 6. Modify Your Base Plan 7. Develop Contingency Capital Plan 8. Set Your Capital Goals 9. Develop the Written Portion of the Plan Growth Goals Assets Loans Deposits I need to have a sense for where I m going before I can develop a rising rates strategy. 13 NMD & CD Behaviors When we price a deposit We are pricing a bundle of cash flows. A good pricing model puts an A/L wrapper around a deposit or a bundle of deposits being priced. Approach and results should be consistent with. A/L model results Profitability system results Market results Assuming deposit (or branch) is sold. 14 7

8 CDs Contractual Behaviors Generally fixed rate Stated term Early withdrawal penalty Automatic renewal General Rule The more features of an account that are important to a customer other than rate, the less sensitive they will be to rate paid CD Features Rate Term Penalty Actual Behaviors Rates on some of these accounts respond relatively quickly in response to changes in market rates Balances stay with the institution after maturity 65% to 85% of the time. Acts like: Stable supply, variable rate (reprices at renewal), long-term Actual Counterpart Adjustable-rate mortgage Key Inputs to A/L Model How much will you raise rates as market rates increase? Farin & Understanding Cash Flows Interest Fees and Expenses Contractual Flows 16 8

9 Adjusting for Risks/Costs Generally, we would start with a risk free rate (fed funds, 1 Month Treasury or Agency), then adjust for: Interest Rate Risk Credit Risk not assumed to exist on a deposit Servicing Cost Option Risk could be an adjustment for an inadequate early withdrawal penalty. To arrive at a benchmark rate where we are indifferent between the retail source (loan or deposit) and the wholesale source (investment or borrowing) All four methods introduced in this session for assessing loan and deposit profitability are some variation on this same theme. 17 Adjusting for Interest Rate Risk Interest Rate Risk When you are pricing loans and deposits you are pricing cash flows not maturities. With fixed-rate loans, pieces reprice as cash flows come in. Few reprice at maturity. Principal cash flows are often uncertain Prepayment options, decay rates Variable rate instruments reprice When cash flow pieces come in When contractual repricing occurs, but Variable rate loans may not respond immediately or completely at reset points Reset frequency Restrictions on adjustments (floors & caps) To manage interest rate risk, institutions need to match repricing of the loans to repricing of deposits. Two approaches: Simplistic match based on duration x More complex Match fund x individual repricing flows. While in the real world you may not match, in making pricing decision, we should assume matching. X Approach taken in this course 18 9

10 Deposit Cash Flow Matching Example 12 Month CD On deposits, benchmarks are always a wholesale funding cost. Weighted average funding cost is calculated from these matches. 19 Non-Maturity Deposits Contractual Behaviors Immediately repricable Immediately withdrawable Sounds like fed funds General Rule The more features of an account that are important to a customer other than rate, the less sensitive they will be to rate paid NMD Features Rate Immediate Access Transaction Capability Actual Behaviors Rates on some of these accounts respond moderately and slowly in response to changes in market rates Balances are retained for long periods of time in spite of rate behavior Acts like: Stable supply, semifixed rate, long-term Actual Counterpart laddered portfolio of fixed-rate long-term CDs Key Inputs to A/L models How will pricing respond to changes in rates? How long will the funds be out there? Farin & 10

11 Non-Maturity Deposit Cash Flows Interest Driven by Pricing Betas Index Beta Lag Varies with Rate Environments Principal Driven by Decay Rates Need to Consider Surge Balances Varies with Rate Environment 21 Pricing Betas Definition A pricing beta is a variable 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

12 How Betas Play Out in Industry 1.0 Lag Premium MMDA & CDs Regular Savings Pricing Betas a = 0.4% b =.75 Y = a + bx = Rate Paid 24 12

13 Pricing Betas Questions: 1. Which of these cost of funds profiles would you prefer to have with rising rates? 2. What would that information allow you to do with asset and funding allocation? 25 Ranked by Correlation Treasuries, Agencies, FHLB Advances 3, 6, 12, 24, 36, 60 months lagged 0-12 months = 234 combinations 26 13

14 Rate Paid vs. Equation (Back Test) Passbook Savings 27 Forecast Rates 12 Month Gradual 28 14

15 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 CDs Non-maturity deposits 29 Non-Maturity Deposit Life Key Concept Non-maturity deposits don t all mature at the same time. Instead, balances in accounts decay off the books over time. Decay rates can be statistically measured. Once measured, decay rates can be used to forecast cash flows coming off pools of non-maturity deposits For all these reasons, your decay rates could be dramatically different than national averages. Cash Flow Decay rates affected by: Life events death, divorce, population turnover Satisfaction with the institution Movements in market rates and your pricing strategy. Economic events local (plant closings), and national (911, stock market health, economic outlook, etc.) Technology Interaction between CSRs and customers Flight to quality (Surge) Relationship between CD and NMD rates (Surge) Farin & Associates, Inc 15

16 But before we calculate decay rates, we need to deal with surges Non-Maturity Deposits as a Percent of Assets All US banks on UBPR Stock CD Surge Fast Decay Core Slow Decay Relative pricing of non-maturity deposits vs. CDs Decay Rate Methods Account No Method Begin with a set of accounts and balances Track what happens to balances of these accounts over time No new money considered Weaknesses Lots of data and account numbers needed Over long horizons characteristics of accounts at beginning of study may be inconsistent with the accounts you have now. Strengths Recognized as industry standard technique. Origination Date Method 1. Total Balances BOM 12, Total Balances EOM 12, New Account EOM Balances Old Account EOM Balances (#2-#3) 11, Chg in Old Balances (#1-#4) Decay Rate (#5/#1 * 12) 20.00% Weaknesses Not recognized as industry standard Strengths Account numbers not needed Over long horizons sample moves with changes in customer characteristics. Note: in most cases both methods will yield roughly the same results Farin & 16

17 Rolling Decays as Surge Indicators Decay rate on outstanding study balances Decay rate on outstanding study accounts Marginal (12 month rolling) decay rate 33 After Surge Adjustment After surge adjustment (20% surge) the marginal decay rate tracks along the cumulative average decay rate

18 Average Balances Before and After Surge 35 Surge-Adjusted Decays 36 18

19 Decay Rates Surge Balance Burnout Truncation Assumption: 20% of balances are surge balances 37 Lesson 3: Understand NMD Cash Flows Interest Decay Rate Fees and Expenses Contractual Flows Benchmarks like on other deposits are the FHLB Advance curve 19

20 NMD Cash Flow Matching Example Cash flows continue until they truncate Money Market, $50K Tier, 15% Decay Rate On deposits, benchmarks are always a wholesale funding cost. Weighted average funding cost is calculated from these matches. 39 Practical Issues in Studies Pricing Betas Ideally, at least ½ of a rate cycle Betas not affected by type of rate environment but lags are. Choose an appropriate level of aggregation Affected by changes in pricing strategy, competitive environment Decay Rates Ideally at least ½ of rate cycle Use most recent date available (surge balance identification) Choose an appropriate level of aggregation Studies need to be updated because of changes in level of surge balances

21 Conclusions When we are pricing deposits we are pricing cash flows. Actual behavior is more important tan contractual behavior. Core studies study actual behavior. Once we have established principal and interest cash flows for different rate environments we can begin to apply core analysis tools