Lecture Materials FUNDING

Transcription

1 Lecture Materials FUNDING Thomas A. Farin Chairman of the Board FARIN Financial Risk Management Fitchburg, Wisconsin & Darryl Mataya SVP & Chief Development Officer FARIN Financial Risk Management Fitchburg, Wisconsin August 2016

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3 FUNDING - DEVELOPING FUNDING STRATEGIES EVALUATING BEHAVIORS OF NON- MATURITY DEPOSITS Session 2 1

4 Session 2 - Agenda Deposit Analytics Contractual vs. Actual Behavior Pricing Betas Decay Rates Surge Balances 2

5 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? 3

6 Non-Maturity Deposits 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 Segmentation Strategies Rates respond very slowly to changes in market rates on nonrate sensitive portion Rates respond more quickly to changes in market rates on rate sensitive portion Weighted average cost moves relatively slowly in response to changes in market rates Lots of barrier to entry options Product design Tiers Transactional Channel 4

7 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 Relationship between CD and NMD rates 5 5

8 2 Most Common Core Study Outputs 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 component? What s about missing component? SURGE BALANCES 6

9 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. 7

10 Pricing Betas Starting rate (a) = 0.4% Beta (b) =.75 Y = a + bx = Rate Paid 8

11 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? 9

12 Core Study Beta Results Study uses a variety of indexes, lags and results show betas ranging between to

13 Effect of Beta Study on Deposit Rates 200 bp Ramp Over 12 Months It doesn t matter how long this funding is around, it is variable rate 11

14 Surge & Decay Surge balances can vary considerably. Betas on surge balances are very high as the customer will reprice the balances for you. Decay rates seem low until you consider we are looking at balance decays rather than account number decays. This is just regulatory BS 12

15 Best Decay Rate Methods Single pool account study Most common approach Track changes in initial study group accounts over time. Calculate the changes in account balances and # of account on accounts Strengths Able to correlate changes in actual accounts and balances Recognized as industry standard Weaknesses Data required from pre crisis starting point 2007 or earlier for most relevant analysis Ignores all new accounts Applies old account behaviors to all newly opened accounts 13

16 Best Decay Rate Methods Emerging Standard: Multi Pool (Vintage) Track initial study group single pool method and subsequent pools of new accounts over time Track behaviors of newer accounts vs. older more seasoned accounts Strengths Doesn t ignore accounts representing 50% of total deposit balances in a sector Develops better metrics on new account behaviors Helps to estimate surge deposits vs. core Weaknesses More data and analysis required Many ALM models unable to process outputs properly vs 14

17 Surge-Adjusted Decays What happens when the remaining balances from study group represent an insignificant amount compared to total balances? 15

18 MMDA Net Avg Balance Avg balance of newer depositors greater and more VOLATILE than old study accounts. Do the new accounts act like the old? 16

19 MMDA Remaining Balance Newer depositors controlling greater amount of total deposits 17

20 Market Value Sensitivity Td Today s market kt values are well below book. What will happen if rates go up on accounts with high betas and high surge percentages? 18

21 Weighted Average Life Argument WALs only look at principal life & drop when rates rise as surges run off. Since WALs fail to consider betas (interest expense cash flows), they aren t a very good measure of hedging power of NMDs. 19

22 Effective Duration - Core Eff Dur = - Chg MV / Chg MR Effective Duration looks at how principal and interest cash flows are impacted by changes in rates. It considers decay rates, surge balances, truncation, and pricing betas. These are effective durations of non-surge (core) balances 20

23 Effective Duration - Core Auto Loans 15 Yr FRM 30 Yr FRM 21

24 Common Mistake in ALM Modeling Many ALM reports fail to properly apply cost of increasing interest rates on surge balances ALM model fails to break out the surge balance into separate line item Pricing beta used on the account represents the core repricing Result can be significant underestimation of interest expense in rising rates What if your surge balances moved by 75-90% of change in market rates? Too much money being treated as low cost, long duration Does this help explain why we have truncation? 22

25 Sensitivity Testing Unaccounted Cost of Surge Home First Bank Account Business DDA Core Business DDA Surge Now Core Now Surge MMDA Core MMDA Surge Savings Core Savings Surge Strategy 1 - Current Beta/Surge Strategy 2 - Current Beta/Higher Surge Rate Ret % Ret $ Beta Rate Ret % Ret $ Beta 0.53% 100% 14, % 71% 10, % % 29% 2, % 100% 41, % 64% 26, % % 36% 14, % 100% 10, % 64% 6, % % 36% 3, % 100% 45, % 64% 29, % % 36% 16, Strategy 1 Current model assumes all $ stays in current line item and low beta applies to all balances in account Strategy Total $ / 2 Average Uses % surge balance 0.64% assumptions 100% 112,384 and premium 25.64% account 1.05% betas 99% from 110,707 core study % Comparing the impact on a 2% immediate change in rates 23

26 Sensitivity Testing Unaccounted Cost of Surge Home First Bank Account Business DDA Core Business DDA Surge Now Core Now Surge MMDA Core MMDA Surge Savings Core Savings Surge Total $ / Average % Strategy 1 - Current Beta/Surge Strategy 2 - Current Beta/Higher Surge Rate Ret % Ret $ Beta Rate Ret % Ret $ Beta 0.53% 100% 14, % 71% 10, % % 29% 2, % 100% 41, % 64% 26, % % 36% 14, % 100% 10, % 64% 6, % % 36% 3, % 100% 45, % 64% 29, % % 36% 16, % 100% 112, % 1.05% 99% 110, % Strategy 1 Current model assumes all $ stays and low beta applies to all balances in account Strategy 2 Use the surge balance assumptions and premium account betas from study. Using a 2% immediate change in rates Strategy 1 vs Strategy 2 Cost up by $459k annually (+40bp) Duration shortens 1.2 Yrs (4.4 Yrs) 24

27 Using Results of Core Study Modeling Pricing betas drive cost of funds on non maturity deposits as rates change in A/L Models. In other words they drive the interest cash flows. Decay rates drive the principal cash flows in A/L models. Crucial to Economic Value of Equity EVE calculations. Strategy Development Surge balances are a relatively short term funding source. Beta will be in the range of 1.0 because funds will move back into CDs with a beta of 1.0 or leave for the markets and need to be replaced at market rates High beta non surge are a close to variable rate funding source. Low beta non surge are a longterm fixed rate funding source. 25

28 DEVELOPING FUNDING STRATEGIES SESSION 3 - CDS Tom Farin Chairman of the Board tfarin@farin.com 26

29 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. 27

30 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, longterm Actual Counterpart Adjustablerate mortgage Key Inputs to A/L Model How much will you raise rates as market rates increase? 28

31 Learning How To Segment Effectively Segmentation Goals Pay Up for Rate Sensitive Funds Don t Pay Up for Non Rate Sensitive Funds Use Barriers to Entry to Block Cannibalization into Premium Products Reducing Combined Beta Geographic Minimum Balance or Tiering New Money Transaction Barriers Channel Barriers Stealth Products 29

32 ST CD Competitive Pricing Example Competitive Rates by Sector Month CD as of Oct How much would I need to raise rates to grow here? Prom Std Us 50% (0.16) *Marquette 1st Mid 5/3ArcherBofA Bridge Charter Chase Citi First FirstMerit Americ B H ar- MB National Cit PrivateBank Old Old Republic Standart SB TCF U.S. Plank Second Ban Bank Month CD 30

33 Rate Trends ST (10-15 Mo) CDs Rate Trends by Sector Month CD Mkt Range Mkt Low Average FHLB Advance - 12 M 50 Pct 12 Mo CD

34 CDs - High Cost of Paying Up CDs - Cost of Paying Up Current Strategy 1 Strategy 2 Account Rate Maturities Rate Ret % Ret $ Beta Rate Ret % Ret $ Beta 3 Month CD 0.10% 10, % 90% 9, % 100% 10, Month CD 0.15% 30, % 90% 27, % 100% 30, Year CD 0.20% 60, % 90% 54, % 100% 60, Strategy 1: Don t react $10 mm runoff Strategy 2: Pay up No runoff Total/Average 0.18% 100, % 90% 90, % 100% 100,000 Balance Expense Cost Bnchmk Spread Beta Ballpark Duration (years) Strategy 1 90, % 0.60% 0.43% - IB Checking 2.50 Strategy 2 100, % 0.60% 0.03% 1.00 MMDA 1.50 Marginal Cost 10, % 0.60% 3.58% Reg Savings 2.50 Marginal Cost Model Summary NIB Checking 2.50 Strategy 2 raised $10000 thousand of new funds. 3 Month CD 0.25 Interest expense increased by $418 thousand. 6 Month CD 0.50 Marginal cost of the additional funds was 4.18%. Benchmark is 0.60%. 1 Year CD Year CD Farin & Associates, Inc. Mkt Rate Increase 0.40% etc. Marginal cost of holding onto $10.0 million is 4.18%, 3.58% over benchmark Rates up 40 bp Benchmark moves from 20 bp to 60 bp.

35 CDs - Advantage of Defensive Segmentation CDs - Deploying CD Special Current Strategy 1 Strategy 2 Account Rate Maturities Rate Ret % Ret $ Beta Rate Ret % Ret $ Beta 3 Month CD 0.10% 10, % 90% 9, % 85% 8,500-6 Month CD 0.15% 30, % 90% 27, % 85% 25,500-1 Year CD 0.20% 60, % 90% 54, % 85% 51, Month CD Special 0.60% 15,000 Strategy 1: Don t react $7.5 mm runoff Total/Average 0.18% 100, % 90% 90, % 100% 100,000 Balance Expense Cost Bnchmk Spread Beta Ballpark Duration (years) Strategy 1 90, % 0.60% 0.43% - IB Checking 2.50 Strategy 2 100, % 0.60% 0.36% 0.16 MMDA 1.50 Marginal Cost 10, % 0.60% 0.21% Reg Savings 2.50 Marginal Cost Model Summary NIB Checking 2.50 Strategy 2 raised $10000 thousand of new funds. 3 Month CD 0.25 Interest expense increased by $81 thousand. 6 Month CD 0.50 Marginal cost of the additional funds was 0.81%. Benchmark is 0.60%. 1 Year CD Year CD Farin & Associates, Inc. Mkt Rate Increase 0.40% etc. Strategy 2: Run Special Assumes 40% cannibalization No runoff Marginal cost of holding onto $7.5 million is 0.81%, 0.21% over benchmark Rates up 40 bp Benchmark moves from 20 bp to 60 bp. Would you retain retail funds or replace with wholesale?

36 CDs - Segmentation Defensive vs. Offensive Strategy 1: Run Defensive Special Assumes 40% cannibalization No New Money Strategy 2: Run Offensive Special Assumes 40% cannibalization $5 mm New Money Marginal cost of $5 million new money is 1.56%, 0.96% over benchmark Rates up 40 bp Benchmark moves from 20 bp to 60 bp. Would you grow with retail funds or wholesale?

37 Pay Up vs Special (+200 bp) CDs - Pay Up vs.special (200bp) Current Strategy 1 Strategy 2 Account Rate Maturities Rate Ret % Ret $ Beta Rate Ret % Ret $ Beta 3 Month CD 0.10% 10, % 100% 10, % 75% 7, Month CD 0.15% 30, % 100% 30, % 65% 19, Year CD 0.20% 60, % 100% 60, % 60% 36, Month CD Special 0.00% 2.20% 37,000 Strategy 1: Assumes 100% retention No new money Total/Average 0.18% 100, % 100% 100, % 100% 100,000 Balance Expense Cost Bnchmk Spread Beta Ballpark Duration (years) Strategy 1 100,000 2, % 2.20% 0.03% 1.00 IB Checking 2.50 Strategy 2 100,000 1, % 2.20% 0.33% 0.85 MMDA 1.50 Marginal Cost - (307) 0.00% 2.20% -2.20% Reg Savings 2.50 Marginal Cost Model Summary NIB Checking 2.50 Strategy 2 ran off 0 thousand of funds. 3 Month CD 0.25 Interest expense decreased by 307 thousand. 6 Month CD 0.50 Marginal cost of the additional funds was 0.00%. Benchmark is 2.20%. 1 Year CD Year CD Farin & Associates, Inc. Mkt Rate Increase 2.00% etc. Strategy 2: Run Defensive Special Assumes 37% cannibalization No new money Saves $307K, 31 bp 35

38 Offensive vs Defensive Special (+200 bp) CDs - Def vs. Off Special (200bp) Current Strategy 1 Strategy 2 Account Rate Maturities Rate Ret % Ret $ Beta Rate Ret % Ret $ Beta 3 Month CD 0.10% 10, % 75% 7, % 75% 7, Month CD 0.15% 30, % 65% 19, % 65% 19, Year CD 0.20% 60, % 60% 36, % 60% 36, Month CD Special 2.20% 37, % 52,000 Strategy 1: Defensive special no new money Total/Average 0.18% 100, % 100% 100, % 115% 115,000 Balance Expense Cost Bnchmk Spread Beta Ballpark Duration (years) Strategy 1 100,000 1, % 2.20% 0.33% 0.85 IB Checking 2.50 Strategy 2 115,000 2, % 2.20% 0.11% 0.96 MMDA 1.50 Marginal Cost 15, % 2.20% 1.39% Reg Savings 2.50 Marginal Cost Model Summary NIB Checking 2.50 Strategy 2 raised $15000 thousand of new funds. 3 Month CD 0.25 Interest expense increased by $538 thousand. 6 Month CD 0.50 Marginal cost of the additional funds was 3.59%. Benchmark is 2.20%. 1 Year CD Year CD Farin & Associates, Inc. Mkt Rate Increase 2.00% etc. Strategy 2: Run offensive special $15K new money Marginal cost 3.59%, 139 bp above benchmark. If you need to raise new funds, doing so with CDs can be very expensive. 36

39 CDs - Lessons from This Series Marginal cost will always be lower if you segment as opposed to paying up. That means you need to have decided on your strategy before rates begin to rise which prepares you for Deploying the segmentation strategy when first drip happens. Marginal cost of attracting and retaining rate sensitive CD customers is high. It is even higher for new CDs.

40 Learning How To Segment Effectively Segmentation Goals Pay Up for Rate Sensitive Funds Don t Pay Up for Non Rate Sensitive Funds Use Barriers to Entry to Block Cannibalization into Premium Products Reducing Combined Beta Geographic Minimum Balance or Tiering New Money Transaction Barriers Channel Barriers Stealth Products 38

41 Tiered vs Defensive Special (+200 bp) CDs - Def vs. Tiered (200bp) Current Strategy 1 Strategy 2 Account Rate Maturities Rate Ret % Ret $ Beta Rate Ret % Ret $ Beta 3 Month CD 0.10% 10, % 75% 7, % 75% 7, Month CD 0.15% 30, % 65% 19, % 65% 19, Year CD 0.20% 60, % 60% 36, % 60% 36, Month CD Special <$50K 2.20% 37, % 15, Month CD Special >=$50K 2.60% 32,000 Total/Average 0.18% 100, % 100% 100, % 110% 110,000 Balance Expense Cost Bnchmk Spread Beta Ballpark Duration (years) Strategy 1 100,000 1, % 2.20% 0.33% 0.85 IB Checking 2.50 Strategy 2 110,000 2, % 2.20% 0.19% 0.92 MMDA 1.50 Marginal Cost 10, % 2.20% 1.28% Reg Savings 2.50 Marginal Cost Model Summary NIB Checking 2.50 Strategy 2 raised $10000 thousand of new funds. 3 Month CD 0.25 Interest expense increased by $348 thousand. 6 Month CD 0.50 Marginal cost of the additional funds was 3.48%. Benchmark is 2.20%. 1 Year CD Year CD Farin & Associates, Inc. Mkt Rate Increase 2.00% etc. Strategy 1: Defensive special no new money Strategy 2: Defensive <$50 Offensive >=$50K $10K new money Marginal cost 3.48%, 128 bp above benchmark. If you need to raise new funds, doing so with CDs can be very expensive. 39

42 Geographic vs Defensive Special (+200 bp) CDs - Def vs. Geographic (200bp) Current Strategy 1 Strategy 2 Account Rate Maturities Rate Ret % Ret $ Beta Rate Ret % Ret $ Beta 3 Month CD - A 0.10% 8, % 75% 6, % 75% 6, Month CD - A 0.15% 24, % 65% 15, % 65% 15, Year CD - A 0.20% 48, % 60% 28, % 60% 28, Month CD Special - A 2.20% 29, % 29,600 3 Month CD - B 0.10% 2, % 75% 1, % 1, Month CD - B 0.15% 6, % 65% 3, % 3, Year CD - B 0.20% 12, % 60% 7, % 7, Month CD Special - B 2.20% 7, % 18,000 Total/Average 0.18% 100, % 100% 100, % 111% 110,600 Balance Expense Cost Bnchmk Spread Beta Ballpark Duration (years) Strategy 1 100,000 1, % 2.20% 0.33% 0.85 IB Checking 2.50 Strategy 2 110,600 2, % 2.20% 0.20% 0.91 MMDA 1.50 Marginal Cost 10, % 2.20% 1.02% Reg Savings 2.50 Marginal Cost Model Summary NIB Checking 2.50 Strategy 2 raised $10600 thousand of new funds. 3 Month CD 0.25 Interest expense increased by $341 thousand. 6 Month CD 0.50 Marginal cost of the additional funds was 3.22%. Benchmark is 2.20%. 1 Year CD Year CD Farin & Associates, Inc. Mkt Rate Increase 2.00% etc. Strategy 1: Defensive special no new money Strategy 2: Defensive Mkt A Offensive MktB $10.6K new money Marginal cost 3.22%, 102 bp above benchmark. If you need to raise new funds, doing so with CDs can be very expensive. 40

43 New Money vs Defensive Special (+200 bp) CDs - Def vs. New Money (200bp) Current Strategy 1 Strategy 2 Account Rate Maturities Rate Ret % Ret $ Beta Rate Ret % Ret $ Beta 3 Month CD 0.10% 10, % 75% 7, % 75% 7, Month CD 0.15% 30, % 65% 19, % 65% 19, Year CD 0.20% 60, % 60% 36, % 60% 36, Mo CD Special - No New Money 2.20% 37, % 32, Mo CD Special - New Money 2.60% 20,000 Strategy 1: Defensive special no new money Total/Average 0.18% 100, % 100% 100, % 115% 115,000 Balance Expense Cost Bnchmk Spread Beta Ballpark Duration (years) Strategy 1 100,000 1, % 2.20% 0.33% 0.85 IB Checking 2.50 Strategy 2 115,000 2, % 2.20% 0.22% 0.90 MMDA 1.50 Marginal Cost 15, % 2.20% 0.53% Reg Savings 2.50 Marginal Cost Model Summary NIB Checking 2.50 Strategy 2 raised $15000 thousand of new funds. 3 Month CD 0.25 Interest expense increased by $410 thousand. 6 Month CD 0.50 Marginal cost of the additional funds was 2.73%. Benchmark is 2.20%. 1 Year CD Year CD Farin & Associates, Inc. Mkt Rate Increase 2.00% etc. Strategy 2: Defensive No New Offensive New $15K new money Marginal cost 2.73%, 53 bp above benchmark. If you need to raise new funds, doing so with CDs can be very expensive. 41

44 Long-Term CDs Segmentation strategies are similar to those with short-term CDs except: There may be more sleepy money less cannibalization. Segmentation strategies take longer to have an effect Lower CD turnover because of laddered term structure. Generally a lower percentage of funding. Issues relating to effectiveness of early withdrawal penalties. Generally I recommend: Avoiding aggressively pricing CDS of 36 months or more, which means keep your specials relatively short. 42

45 Penalty Effectiveness 5 Yr CD Penalty Effectiveness Calculator Original Term (Months) 60 Remaining Term (Months) 60 Offer Rate 1.50% Penalty Type - (0) Months or (1) % of Principal 0 Penalty Amount - Months 12 Annual Penalty In BP 30 Amount of Shock Protection (BP) 30 5 Yr CD at original term 12 Mo Penalty If long-term rates go up more than 30 bp, customer s early withdrawal option goes in the money. 43

46 Penalty Effectiveness 5 Yr CD Penalty Effectiveness Calculator Original Term (Months) 60 Remaining Term (Months) 60 Offer Rate 1.50% Penalty Type - (0) Months or (1) % of Principal 0 Penalty Amount - Months 24 Annual Penalty In BP 60 Amount of Shock Protection (BP) 60 5 Yr CD at original term 24 Mo Penalty Doubling the penalty doubles the protection. But is it enough? 44

47 Penalty Effectiveness 5 Yr CD Penalty Effectiveness Calculator Original Term (Months) 60 Remaining Term (Months) 60 Offer Rate 5.00% Penalty Type - (0) Months or (1) % of Principal 0 Penalty Amount - Months 24 Annual Penalty In BP 200 Amount of Shock Protection (BP) Yr CD at original term 24 Mo Penalty Penalties of days interest are much more effective when rates go up. But it is when rates are low that we need the penalty the most. And when rates are up, we remain need them the least. 45

48 Penalty Effectiveness 5 Yr CD Penalty Effectiveness Calculator Original Term (Months) 60 Remaining Term (Months) 60 Offer Rate 1.50% Penalty Type - (0) Months or (1) % of Principal 0 Penalty Amount - Months 24 Annual Penalty In BP 60 Amount of Shock Protection (BP) 60 Penalty Effectiveness Calculator Original Term (Months) 60 Remaining Term (Months) 36 Offer Rate 1.50% Penalty Type - (0) Months or (1) % of Principal 0 Penalty Amount - Months 24 Annual Penalty In BP 100 Amount of Shock Protection (BP) Yr CD at original term 24 Mo Penalty 5 Yr CD at remaining term 24 Mo Penalty As remaining term of CD gets lower, penalty effectiveness gets higher. 46

49 Penalty Effectiveness 5 Yr CD Penalty Effectiveness Calculator Original Term (Months) 60 Remaining Term (Months) 60 Offer Rate 1.50% Penalty Type - (0) Months or (1) % of Principal 0 Penalty Amount - Months 24 Annual Penalty In BP 60 Amount of Shock Protection (BP) 60 Penalty Effectiveness Calculator Original Term (Months) 60 Remaining Term (Months) 60 Offer Rate 1.50% Penalty Type - (0) Months or (1) % of Principal 1 Penalty Amount - % of Principal 5 Annual Penalty In BP 100 Amount of Shock Protection (BP) Yr CD at original term 24 Mo Penalty 5 Yr CD at remaining term 5% of Principal Penalty Penalty specified as a percentage of principal is more effective when rates are low. 47

50 Penalty Effectiveness 5 Yr CD Penalty Effectiveness Calculator Original Term (Months) 60 Remaining Term (Months) 60 Offer Rate 1.50% Penalty Type - (0) Months or (1) % of Principal 1 Penalty Amount - % of Principal 5 Annual Penalty In BP 100 Amount of Shock Protection (BP) 100 Penalty Effectiveness Calculator Original Term (Months) 60 Remaining Term (Months) 60 Offer Rate 5.00% Penalty Type - (0) Months or (1) % of Principal 1 Penalty Amount - % of Principal 5 Annual Penalty In BP 100 Amount of Shock Protection (BP) 100 Protection provided by penalty is independent of rate paid. 48

51 What Happens If? You ve been through the effects of the financial crisis. Ran off rate sensitive single relationship funding (primarily CDs, some MMDAs) You are fairly liquid as loan demand hasn t taken off Core customers are coming to you and asking how long they should hang on with your rates well below market. Solution: Consistently applied well thought through exception pricing policy.

52 Exception Pricing Example 12 month CD shows a negative ROA because all-in cost is above the FHLB benchmark rate. Customer is asking for a better rate of 0.80%. Clearly if this is a single Relationship CD, the answer should be no. But what if the customer also has an active checking account?

53 Exception Pricing Example Checking account has an average collected balance Of $5,000 and produces $45.00 in annual interchange income and $120 in annual overdraft Income. Checking account ROA Is 7.29%. Average cost With amortized fees is 7.68% below benchmark.

54 Exception Pricing Example Checking account has an average collected balance Of $5,000 and produces $45.00 in annual interchange income and $120 in annual overdraft Income. Checking account ROA Is 7.29%. Average cost With amortized fees is 7.68% below benchmark. Checking account pulls relationship ROA up to 2.45%.

55 Exception Pricing Example 40 BP exception on the 12 month CD takes rate from 0.40% to 0.80%. ROA on the CD drops to = 0.73%. But relationship return is still 2.11%. If the customer relationship is at risk, it makes sense to approve the exception.

56 CDs - Lessons from This Series Barriers to entry as part of segmentation strategy can reduce marginal cost Most effective barriers in this sequence are: New money special Well thought through exception pricing strategy Marginal cost of attracting and retaining rate sensitive CD customers is high even with creative use of barriers to entry.

57 Questions? 55

58 DEVELOPING FUNDING STRATEGIES MANAGING PORTFOLIOS OF NON- MATURITY DEPOSITS SESSION 4 Thomas A. Farin Chairman of the Board tfarin@farin.com 56

59 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? 57

60 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 58

61 Non-Maturity Deposit Cash Flows Principal Driven by Decay Rates Need to Consider Surge Balances Varies with Rate Environment Interest Driven by Pricing Betas Index Beta Lag Varies with Rate Environments 59

62 Learn How To Segment Effectively Typical CD Segmentation Goals Pay Up for Rate Sensitive Funds Don t Pay Up for Non Rate Sensitive Funds Use Barriers to Entry to Block Cannibalization into Premium Products Reducing Combined Beta Geographic Minimum Balance or Tiering New Money Relationship Pricing Exception Pricing Transaction Barriers Channel Barriers Stealth Products Non-Maturity Deposits Except New Money 60

63 New Product Defensive (Rates up 200 bp) Defensive pricing set new rates where old rates would have moved Example shows introduction of new product to hold existing money Weighted cost cut by 28 bp saving $453,000. Beta cut from.51 to.37 61

64 New Product Defensive (+200) Weighted cost cut by 28 bp saving $453,000. Beta cut from.51 to.37 62

65 The Power of Pricing The following examples illustrate the power of marginal pricing and product differentiation Example 1: Introduce new MMDA and price defensively for retention of existing balances Example 2: Part A: Introduce new MMDA with a 6 month aggressively priced teaser rate priced offensively Part B: Roll back rates to 70% of market and run off some of the growth. 63

66 New Product Offensive (Rates up 200 bp) Offensi ve Same beta as last example, price new MMDA more aggressively (offensive) to grow. Assuming $35 mm in growth & cost of shift, marginal cost is 1.21% or 107 bp below alternative cost benchmark of 2.28% 64

67 New Product Offensive 6 Month Teaser (up 200 bp) After 6 months, rate rolls back to 70 th percentile assuming 15% of new $ runs off Marginal savings on money that leaves is 7.79% or 551 bp above alternative cost 65

68 Problem with Premium Accounts Issue Created to attract rate sensitive customers But over time lobby behavior loads with more and more non rate sensitive accounts We don t want to pay up for non rate sensitive funds in premium service lines Solution bottom of rate cycle Merge service lines to get everyone back in same pool. Inexpensive because Tiers are compressed Premium account rates pushed down against regular account rates. 66

69 Solution Rising Rates Merging service lines puts both rate sensitive and non-rate sensitive funds in same pool. Introduce new premium product in rising rate environment. No balances in premium account when introduced Rate sensitive funds move to new service lines which is priced using premium beta from study / Merged service line priced using regular account beta / 67

70 Using a New Premium MMDA CreateLow Beta NMDs Current Strategy 1 Strategy 2 Account Rate Maturities Rate Ret % Ret $ Beta Rate Ret % Ret $ Beta MMDA - 1K 0.10% 10, % 100% 10, % 100% 10, MMDA - 10K 0.15% 30, % 100% 30, % 100% 30, MMDA - 50K 0.20% 60, % 92% 55, % 92% 55, MMDA - 100K 0.25% 100, % 90% 90, % 90, Prem MMDA - 1K 0.15% 20, % 100% 20, % 14, Prem MMDA - 10K 0.20% 60, % 100% 60, % 36, Prem MMDA - 50K 0.25% 120, % 104% 125, % 62, Prem MMDA - 100K 0.30% 200, % 105% 210, % 84, New Prem MMDA - 1K 1.20% 6,000 New Prem MMDA - 10K 1.40% 24,000 New Prem MMDA - 50K 1.60% 62,500 New Prem MMDA - 100K 1.80% 126,000 Defensive pricing price at same rate as old pricing assumption Total/Average 0.25% 600, % 100% 600, % 100% 600, Balance Expense Cost Bnchmk Spread Beta Ballpark Duration (years) Strategy 1 600,000 8, % 2.20% 0.85% 0.55 IB Checking 2.50 Strategy 2 600,000 6, % 2.20% 1.17% 0.39 MMDA 1.50 Marginal Cost - (1,901) 0.00% 2.20% -2.20% Reg Savings 2.50 Existing MMDA products merged & priced like regular MMDAs, New MMDA introduced and priced like old premium MMDA Average cost declines to 1.03% from 1.35% saving $1.901 MM 68

71 Using a New Premium MMDA CreateLow Beta NMDs Current Strategy 1 Strategy 2 Account Rate Maturities Rate Ret % Ret $ Beta Rate Ret % Ret $ Beta MMDA - 1K 0.10% 10, % 100% 10, % 100% 10, MMDA - 10K 0.15% 30, % 100% 30, % 100% 30, MMDA - 50K 0.20% 60, % 92% 55, % 92% 55, MMDA - 100K 0.25% 100, % 90% 90, % 90, Prem MMDA - 1K 0.15% 20, % 100% 20, % 14, Prem MMDA - 10K 0.20% 60, % 100% 60, % 36, Prem MMDA - 50K 0.25% 120, % 104% 125, % 62, Prem MMDA - 100K 0.30% 200, % 105% 210, % 84, New Prem MMDA - 1K 1.20% 6,000 New Prem MMDA - 10K 1.40% 24,000 New Prem MMDA - 50K 1.60% 62,500 New Prem MMDA - 100K 1.80% 126,000 Total/Average 0.25% 600, % 100% 600, % 100% 600, Balance Expense Cost Bnchmk Spread Beta Ballpark Duration (years) Strategy 1 600,000 8, % 2.20% 0.85% 0.55 IB Checking 2.50 Strategy 2 600,000 6, % 2.20% 1.17% 0.39 MMDA 1.50 Marginal Cost - (1,901) 0.00% 2.20% -2.20% Reg Savings 2.50 Based on rethinking pricing actions, low beta MMDAs grow from $185MM to $381.5MM Subsector beta drops from 0.68 to

72 Offensive New MMDA Tiered Barrier New MMDA Tiered Barrier Current Strategy 1 Strategy 2 Account Rate Maturities Rate Ret % Ret $ Beta Rate Ret % Ret $ Beta MMDA - 1K 0.10% 10, % 100% 10, % 100% 10, MMDA - 10K 0.15% 30, % 100% 30, % 100% 30, MMDA - 50K 0.20% 60, % 92% 55, % 92% 55, MMDA - 100K 0.25% 100, % 90% 90, % 90, Prem MMDA - 1K 0.15% 20, % 100% 20, % 14, Prem MMDA - 10K 0.20% 60, % 100% 60, % 36, Prem MMDA - 50K 0.25% 120, % 104% 125, % 62, Prem MMDA - 100K 0.30% 200, % 105% 210, % 84, New Prem MMDA - 1K 0.60% 5,000 New Prem MMDA - 10K 0.80% 22,000 New Prem MMDA - 50K 2.00% 72,500 Tiered barrier New Prem MMDA - 100K 2.15% 85,000 New Prem MMDA - 250K Aggressive upper tiers 2.25% 60,000 Total/Average 0.25% 600, % 100% 600, % 104% 626, Balance Expense Cost Bnchmk Spread Beta Ballpark Duration (years) Strategy 1 600,000 8, % 2.20% 0.85% 0.55 IB Checking 2.50 Strategy 2 626,000 7, % 2.20% 1.02% 0.46 MMDA 1.50 Marginal Cost 26,000 (744) -2.86% 2.20% -5.06% Reg Savings 2.50 Potential to raise $26MM at negative marginal cost. 70

73 Surge Balance Strategies 20% Surge Returns to CDs $43.1 K New money raised at MC of 1.2% 71

74 Channel Barrier ING competitor Fee vs Rate Play on Checking Business Checking 72

75 Pay Up on NOW Marginal Cost is reasonable below benchmark 73

76 Premium Checking Note: This example also applies to business checking. 74

77 Reward Checking 75

78 Reward Checking Segmentation Cannibalization reduced by product redesign. Saves $405K an 28 bp on average cost Betas on existing products cut 50%. 76

79 Internet Savings Channel Barrier Reduces Cannibalization Marginal Cost is 100 bp below benchmark 77

80 Questions? 78

81 FUNDING- DEVELOPING FUNDING STRATEGIES EFFECTIVELY USING WHOLESALE AND BLENDED FUNDING SESSION 5 Thomas A. Farin Chairman of the Board tfarin@farin.com 79

82 Liquidity & Funding Management Funding Management Defined as the process of sourcing liabilities Sets forth how you intend to remain fully funded at the minimum cost consistent with the overall risk appetite. Balances cost efficiency and stability. Outlines targeted funding mix impact on operating and funding cost stability Refers to the in ability raise funds in the desired type/term/cost on an ongoing basis Liquidity Management Managing cash flows across the balance sheet to ensure sufficient sources of funds for intended uses of funds. Sets limits on Liquid asset levels Acceptable mismatches Use of alternative sources Refers to in ability to raise sufficient funds to finance needs at any point in time. 80

83 What is Wholesale Funding Wholesale Funding Funding from a source other than your depositors. Core Deposits Regulatory Definition Generally exclude wholesale funding May also exclude funding from customers considered to be brokered CDARS CDs over the FDIC insurance limit 81

84 Uses of Wholesale Funding 1. As a source of liquidity In your operating strategy As part of a contingency funding plan 2. When cost is significantly below the marginal cost of customer deposits 3. As a structured funding source to fund long-term assets Balloons Lock ARMs Fixed rate mortgages Long term investments 82

85 Sources of Wholesale Funding Federal Home Loan Bank Fed Discount Window Repurchase Agreements Fed Funds Purchased Brokered Deposits CDARs and similar insured products Internet CDs (Qwickrate, etc.) 83

86 Federal Home Loan Bank Advances Requires collateral Both term and structured products Prices at a small spread above the Treasury curve Uses As funding as part of a business plan As a contingency funding source. When the marginal cost of retail funding is above advance rates As a structured product to fund different classes of assets 84

87 Fed Discount Window Requires collateral Short-Term Funding Sources Prices close to the Fed Funds Rate Uses As funding as part of a business plan As a contingency funding source When the marginal cost of short term retail funding is above the discount rate 85

88 Repurchase Agreements Requires collateral Short-Term Funding Prices at a small spread above or below the Treasury curve Uses As funding as part of a business plan As a contingency funding source. When the marginal cost of retail funding is above the Repo rate 86

89 Fed Funds No collateral required Overnight funding Prices above or below the Fed Funds target rate Uses As funding as part of a business plan As a contingency funding source. When the marginal cost of retail funding is above the Fed Funds rate 87

90 Brokered CDs No collateral required Term products Prices at a small spread above or below the Treasury curve. May be cheaper than advances in a rising rate environment. Uses As funding as part of a business plan As a contingency funding source. When the marginal cost of retail funding is above Brokered CD rates As a structured product to fund different classes of assets but limited to term bullet funding. 88

91 CDARs and Similar Products No collateral required Money Market and Term products Funds from your customers deposit insurance extended beyond $250,000 Prices at a small spread above or below the Treasury curve. May be cheaper than advances in a rising rate environment. Uses As funding as part of a business plan As a contingency funding source. When the marginal cost of retail funding is above CDARs rates As a structured product to fund different classes of assets but limited to term bullet funding. 89

92 Optimal Earning Asset Matrix Every balance sheet mix carries maximum return\volatility combinations Finding your optimal earnings frontier is key to strategic\capital plan What strategy has higher earnings potential and less risk ROE Volatility of earnings Where is your current and projected performance vs. actual? Given your risk appetite what is your domain of optimal return? 90

93 Funding Longer Duration Loans FHLB Advances Relatively cheap now Will lead deposit rates in rising rate environment Can be purchased With no imbedded options With options granted to the FHLB cheaper With imbedded options granted to the member more expensive Can raise exactly what you need, at a known rate, when you need it Requires collateral SWAPs, CAPs and other off balance sheet instruments Options Deposits Long Term CDs Recently Expensive Will lag the market in rising rate environments Uncovered Options Non Maturity Deposits Cheap source of long term funding especially when rates are up. But do you bet the whole shop on the results of a core study? 91

94 Case Institution $1.5 Billion Deposits Had been shrinking Capital Plan allows $30-50 million asset growth in 2014 Loan/Asset Ratio is low Loans can grow more than deposits Needs to grow to drive down Non earning assets/assets Operating expenses/assets Growth for now goes into investments at relatively low yield Pressure is for growth to be at low marginal cost Where should he grow funding Wholesale funding Retail funding 92

95 Identify Loan Growth Opportunities Case Institution 15 and 30 Year FRMS Conforming Non Conforming Fully Amortizing Commercial R/E Loans 15 Year FRM 20 Year FRM But, Farin, there is too much interest rate risk in these products! After all, isn t that what caused thrifts to fail? So we take interest rate risk we could manage and pass it to the customer who can t manage IRR. What do we get back? Why can t we figure this out? 93

96 Consider How to Fund Loan Growth FHLB Advances Relatively cheap now Will lead deposit rates in rising rate environment Can be purchased With no imbedded options With options granted to the FHLB cheaper With imbedded options granted to the member more expensive Can raise exactly what you need, at a known rate, when you need it Requires collateral SWAPs, CAPs and other off balance sheet instruments Case Institution Deposits Long Term CDs Recently Expensive Will lag the market in rising rate environments Uncovered Options Non Maturity Deposits Cheap source of long term funding especially when rates are up. But do you bet the whole shop on the results of a core study? 94

97 Questions Is management willing to Bet the Bank on a Core Deposit Study? Your career could be at stake. How will your regulator react to funding long-term fixed-rate loans entirely with non-maturity deposits? Your CAMEL(S) rating could be at stake. Can you convince your Board of Directors that this strategy makes sense? Especially if you ve told them that portfolioing fixed-rate loans is stupid, especially at the bottom of the rate cycle. Is there a better approach? 95

98 Blended Funding Making LT Assets Using FHLB Advances Concept Use FHLB Advances to provide structural support under fixedrate loans Partially match the cash flows with totally predictable funding behavior Potentially pay a bit more for prepayment protection Tradeoffs Higher cost You may not need the funding But what are you earning on your investment portfolio now? Supplement FHLB Advances with non maturity deposits to plug funding gap taking advantage of: Low cost of NMDs Lower pricing betas through segmentation Decay rates Inherent extension risk hedge Results in: A close to fully hedged position Less reliance on the accuracy of the core study 96

99 Effective Duration - Core Auto Loans 15 Yr FRM 30 Yr FRM 97

100 Remaining Principal Loan/Advance 120, ,000 80,000 Outstanding Principal Note that amortizing advance cash flows are right on top of the loan so they are hidden in the graph 60,000 40,000 20, Loan Rem Prin Adv Rem Prin Comparing cash flows of a 100% match funded scenario for 15 Yr Fully Amortizing Commercial Real Estate Loan at 4.5% Funded with 15 Year Amortizing Advance at 2.68%. 98

101 Yield/Adv Cost/Blended Cost Gross Spread 182 bp (142 bp w\ prepayment option on adv.) Risk/Cost (option& credit) Adjusted Spread 102 bp Capital Requirement 10% ROE (RAROC) 10.2% vs 15% Goal 99

102 Yield/MMDA Cost/Spread Funding Mix: 100% MMDA funding Assumed beta 30% Offer rate today 0.30% Gross Spread 420 bp Risk/Cost Adjusted Spread 340 bp Capital Requirement 10% ROE (RAROC) 34% vs 15% Goal 100

103 Yield/MMDA Cost/Spread Rates Up 500 bp Funding Mix: 100% MMDA funding Assumed beta 30% Offer rate today 0.30% Showing cost of MMDA in +5% shock MMDA Cost 180 bp (Beta 0.3 * 5% increase in rates plus 0.30% start rate) Gross Spread 270 bp Risk/Cost Adjusted Spread 190 bp ROE (RAROC) 19% vs 15% Goal 101

104 Yield/MMDA Cost/Spread Rates Up 500 bp, Beta to 0.6 Funding Mix: 100% MMDA funding Increased beta to 60% Offer rate today 0.30% Showing cost of MMDA in +5% shock MMDA Cost 330 bp (Beta 0.6 * 5% increase in rates plus 0.30% start rate) Gross Spread 120 bp Risk/Cost Adjusted Spread 40 bp ROE (RAROC) 4% vs 15% Goal This is a sensitivity test! 102

105 Comparative ROE s Using scenario testing, find the boundary of acceptable returns and funding mix. Review your comfort level regarding nonmaturity behaviors Don t bet the institution on the core results But, don t underperform or over pay for risk protection you don t need! 103

106 Defining Your Funding Strategy Concept: Based on core study information, allocation the sources based on duration of cash flows, like you would an investment ladder. Distribute sources by targeted amount and based on duration Funding Sources %of Ttl Assets 0-1 Yr 1-3 Yr 3-5 Yr 5-7 Yr 7-10 Yr Yr Yr > 20 Yr DDA 10% 5% 25% 30% 25% 15% NOW 10% 5% 25% 30% 25% 15% Savings 15% 5% 15% 35% 20% 15% 10% MMDA 28% 25% 25% 20% 20% 10% Retail CDs 7% 75% 15% 10% Brokered CDs 3% 75% 15% 10% Rate Board CDs 2% 90% 10% Total Deposits 75% 24% 21% 24% 18% 11% 2% 0% 0% Borrowings 10% 5% 15% 25% 25% 15% 15% Equity 12% 25% 25% 25% 25% Total Funding Sources 97% 19% 18% 24% 20% 13% 6% 0% 0% Core study results should build your funding distribution map and validate annu 104