Lecture Materials FUNDING. Thomas A. Farin Chairman of the Board FARIN Financial Risk Management Fitchburg, Wisconsin

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1 Lecture Materials FUNDING Thomas A. Farin Chairman of the Board FARIN Financial Risk Management Fitchburg, Wisconsin August 7 & 8, 2017

3 Funding - Developing Funding Strategies General Requirements & CDs Session 1 1

4 Liquidity & Funding Management Goals 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 (wholesale) sources Refers to (in-)ability to raise sufficient funds to finance needs at any point in time. 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 2

5 Pre-Session Agenda Sources of Funding? Retail Funding Wholesale Funding Capital What are the Goals of a Funding Strategy? Metrics for Analyzing Deposit Behavior Pricing Betas Pricing Lags Decay Rates Surge Balances Benchmarks Analytic Tools for decision making Average Cost Marginal Cost Deposit Strategies Depositor Segmentation 3

6 Remainder of Funding Section Attend three lectures that build a foundation Apply the concepts taught in the pre-session Attend a two session lab in which you will become familiar with the tools used in the intersession project and get a running start. Produce an intersession project in which you develop a funding strategy for at least one deposit sector. Ideally present your strategy to senior management 4

7 Retail Funding Strategy Goals Keep the bank fully funded liquidity needs Minimize the cost of funding the bank Use retail & wholesale funding effectively While Hedging interest rate risk Using funding that is stable Living within policy (and regulatory) guidelines Funding Strategy Inputs Performance analysis Market share trends Capital Plan Your current deposit structure and pricing How you stack up relative to the competition. Funding Strategy Outputs Growth goals. Deposit sector and subsector targets Pricing strategy Segmentation Pricing rules 5

8 We Divide Deposits into Four Sectors Checking All of your full-service checking accounts Business Personal Savings and Money Markets where you customers park shortterm liquidity Savings accounts Money Market Accounts Short-Term CDs (0-15 Mo) 0-4 Mo 5-9 Mo Mo Long-Term CDS (>15 Mo) Mo Mo Mo 54 Mo 6

9 What Would You Need to Know Trends in your performance relative to peers (BPA) Trends in Market Share Capital Plan At Sector Level Current Deposits and Rates Competitor Rates Current Sector Pricing Rule Pricing Strategies Recommended Pricing Rule 7

10 BPA Ratios - Most Important to Funding Strategy ROE Top of tree Organic Capital Growth Rate (net of Dividends) ROA Second Level at top of tree Input to capital planning model Equity Multiplier Inverse of capital ratio Setting capital goals Input to capital model Loan/asset or loan/deposit ratio Do we want to grow deposits faster or slower than assets? Cost of funds trends and relative to peer Major factor in net interest margin Major factor in gain or loss of market share Deposit mix, trends, relative to peer How are you funding yourself Do you have significant CD surges? Why is cost of funds above or below peer? 8

11 What if you saw? Underperforms Relative to peer. Why??? Peers are improving, they aren t why??? 9

12 One of the Issues is Loan Mix But it is not deposit cost 43bp vs 57 bp peers. Have gone from over peers to under peers 10

13 Trends in Deposit Mix CDs NMDs Are surge balances continuing to develop? 11

14 Deposit Mix vs. Peers Brokered Deposits NMDs How do you feel about this strategy? Is what you see consistent with a cost of funds below peers? 12

15 Does this make sense? Non-maturity deposits have an average cost below CDs. But we have less of them than peers Brokered CDs have a high average cost But we have more of them than peers Yet our average cost of funds is below peers Anyone have any theories as to why this is happening? 13

16 Is this Consistent with this? Above Competition At or Below 14

But given the high brokered funds position, deposit growth goals could be higher

17 Capital Planning Trend Analysis looks back in time Capital plans look forward. C/A = 1/EM = 1/8.79 = 11.37% Capital plan limits asset growth to 3% per year. But given the high brokered funds position, deposit growth goals could be higher to displace brokered. Let s say we set our deposit growth goal to 5-7% per year. 15

18 DEVELOPING A FUNDING STRATEGY FOR SHORT-TERM CDS 16

19 Deposit Audit ST CDs ABC Bank offers 3 terms of short-term CDs, 3 Mo, 6 Mo, and 1 Yr. They are not tiered. They have not offered CD specials in some time. Balances have declined In the last 5 years. 17

20 Survey Data Current pricing rule: Price regular CDs at or near the bottom of the market based on survey data. Not currently running specials. 18

ST CD Pay Up Accounts, rates, and maturities are from the deposit audit. I am going to evaluate these two strategies in a 200 bp rising rate environment.

21 ST CD Pay Up Accounts, rates, and maturities are from the deposit audit. I am going to evaluate these two strategies in a 200 bp rising rate environment. After the fed has raised rates 75 bp with no significant response from competitors because of the lag between wholesale and retail rate increases. So I m really only taking benchmark rates up another 125 bp. Because CD betas are around 1.0 (100%) I m taking CD rates in Strategy 1 up by 2% (the full market rate increase). 19

22 ST CD Pay Up CDs have been declining as a percentage of funding as a result of the current pricing strategy. Looks to be around 10% in So I m going to assume that a continuation of the existing pricing strategy will cost us 10% of balances in the next year, strategy 1. 20

23 Lags between wholesale rates and deposit rates through two rate cycles national data Falling Rate Lag Rising Rate Lag CD rates show a strong correlation to movements in Treasury rates but lag 3-6 months behind Treasury movements. So far in the last year the Fed has raised rates 75 bp with no competitive rate reaction. So we are in a lag period. 21

ST CD Pay Up FHLB DM + 1.25% I assumed in strategy 1 we would retain 90% of maturing funds based on history. I accomplished this by typing formulas in Column F that set the retention at 90%.

24 ST CD Pay Up FHLB DM % I assumed in strategy 1 we would retain 90% of maturing funds based on history. I accomplished this by typing formulas in Column F that set the retention at 90%. I also entered a benchmark rate in F22. As market rates are already up by 75 bp, They had only 125 bp to go to hit the market rate increase of 200 bp. So I took the 9 month advance rate and added 125 bp to get the benchmark of 2.74% 22

25 CD Pay Up - Defensive To hold onto all maturing funds, I figure I would have to price Somewhere between the 50 th and 75 th percentile of competitors. The Arrows indicate where I felt I would Have to price. Keep in mind, I have to pay attention to competitor specials. 23

26 ST CD Pay Up - Defensive Average cost fans doesn t look too bad. Average cost of strategy 2 is 34 bp under the benchmark. But average cost fails to capture the cost of paying up on existing funds to attract new funds. Marginal cost is equal to the change in expense divided by the change in balances. $43 thousand in additional expense on $1 million in additional balances is a marginal cost of 4.34%, 160 bp over benchmark. Marginal cost is 4.34% while average cost is 2.41% 24

27 Retail Funding Generally Deposits gathered from customers Types Non-Maturity Deposits CDs Popular With regulators Cost of funds can be below wholesale alternatives When you want more you often pay up on existing funds to attract new funds Segmentation techniques can work here Sources of Funding Wholesale Funding Generally, funds gathered from non-customers Examples FHLB Advances, Brokered CDs, Fed Funds, etc. Not as popular with regulators Cost of funds at or above Treasury rates When you want more you pay the market rate Segmentation techniques don t work here Do you understand why our case bank may have decided to fund with Brokered CDs rather than customer CDs and how average cost of funds could be lower? 25

ST CD - Defensive Segmentation In this segmentation strategy rates on regular CDs were raised using a beta of 0.75.

28 ST CD - Defensive Segmentation In this segmentation strategy rates on regular CDs were raised using a beta of But a 13 month CD special was introduced at a rate that matched the top rate paid on 12 month CDs in the pay up strategy. Over 50% of the funds switched to the special. Marginal cost of the $1 million retained was 1.44%, 130 bp under benchmark. Why was the marginal cost below the rate paid on the special? Enough was saved on the non-rate sensitive customers to cover the amount paid up on the money that shifted plus a portion of the cost of the $1 million. 26

29 Conclusions from Defensive Testing A CD segmentation strategy properly and consistently tested will almost always result in a a lower marginal cost than a pay up strategy. If some of the assumptions being made trouble you, do a sensitivity test on those assumptions. Rate assumptions Cannibalization assumptions New money assumptions But our capital plan has us growing deposits. How about some offensive strategies? Let s say our goal is to grow ST CDs by 5% - consistent with our capital plan. 27

30 CD Pay Up - Offensive To grow ST CDs pricing will have to Be at or near the top of the market. 28

31 ST CD - Offensive Segmentation Rate increased to top of market (2.8%). Balances in sector grow by 5%. Marginal cost is 21 bp over benchmark. Can we do better? 29

Barrier to Entry Strategies - CDs Segmentation strategies incorporating barriers to entry: Minimum balance requirements Tiering Geographic

32 Barrier to Entry Strategies - CDs Segmentation strategies incorporating barriers to entry: Minimum balance requirements Tiering Geographic segmentation New money specials Relationship pricing Barrier Strategy Existing Customers - less than 100% cannibalization New customers and new money 30

33 ST CD - Off Seg - Tiered Barrier Rate increased to top of market in upper tier (2.8%). Balances in sector grow by 3%. Marginal cost is 37 bp below benchmark. Why does this work? 31

34 ST CD - Off Seg Geographic CD Special priced defensively in market A, offensively in market B (3.0%). Balances in sector grow by 11%. Marginal cost is 4 bp below benchmark. Why does this work? 32

35 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. 33

36 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. 34

37 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? 35

38 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. 36

39 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. 37

40 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) 100 Penalty specified as a percentage of principal is more effective when Rates are low. 5 Yr CD at original term 24 Mo Penalty 5 Yr CD at remaining term 5% of Principal Penalty 38

41 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. 39

42 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. Paying up for long-term CDs could be ineffective if you lack significant early withdrawal penalties.

43 Funding - Developing Funding Strategies Non-Maturity Deposits Session 2 41

44 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 Key Inputs to A/L models How will pricing respond to changes in rates? (Pricing betas) How long will the funds be out there? (Decay rates) How much of the balances are non-core? (Surge Balances) Farin & Associates, Inc

45 Pricing Betas Defined - The extent to which a change in market rates is passed along to a deposit account s customers. For example, if market rates increase 200 bp and your beta for premium MMDAs is 0.6 (60%) then the beta would predict you will raise MMDA rates by 120 bp 200 bp X 0.6 = 120 bp Betas can be: SWAG d Derived statistically from historic data (core deposit study) Examiners prefer the latter 43

46 Example Core Study Beta Results This is the pricing beta section of an actual core deposit study. If you don t have your own betas available, you might consider using these for estimating response to changes in market rates for various kinds of non-maturity deposits. 44

47 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 nonmaturity 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 45 45

Surge & Decay From same study as Betas. In a rising rate environment, CD surge balances are likely to return to CDs. As a result, their pricing betas will be close to 1.0.

48 Surge & Decay From same study as Betas. In a rising rate environment, CD surge balances are likely to return to CDs. As a result, their pricing betas will be close to 1.0. What isn t surge is core and will have pricing betas more in line with the betas in the core deposit study. In this example, 75.66% of MMDAs are core (100%-24.34%) Decay rates seem low until you consider we are looking at balance decays rather than account number decays. 46

49 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. We also use them in modeling strategies in the marginal cost model. Decay rates drive the principal cash flows in A/L models. Crucial to Economic Value of Equity (EVE) calculations. 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 (core portion) are a close to variable rate funding source. Low beta non-surge (core portion) are a long-term close to fixed-rate funding source. 47

50 Non-Maturity Deposits Segmentation Strategies Ideally, strategy causes rates to respond very slowly to changes in market rates on non-rate sensitive portion Strategy causes rates to 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 Geographic 48

51 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. 49

52 Using Duration (Johannes Slide) Chg MV = -D * Chg MR Percent Change in Price Duration Change in Interest Rates -.10 = - 5 x = - 8 x.01 $100 $ 90 $90 $81 $10 Example of 1 st case: Rates rise 2% and duration of both assets and liabilities is 5. Both will fall 10% in value

53 But What If Change in market rates causes a change in duration? Prepayment speeds change on mortgages Callable bonds get called Surge balances return to the source Solution: Use a simulation model to model changes in cash flows under different rate environments 51

54 Market Value Sensitivity This is the non-maturity deposit section of an EVE report calculated by a simulation model Today s market values are well below book. What will happen if rates go up on accounts with high betas? 52

55 Solving the duration equation for Effective Duration If: Chg MV = -D * Chg MR Then: D = -Chg MV / Chg MR The D in the second formula is the effective duration. 53

56 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 54

57 Effective Duration - Core Auto Loans 15 Yr FRM 30 Yr FRM 55

58 MMDA Survey Data Pricing strategy is to pay in the bottom third of the market based on survey data. 56

59 MMDA Pay Up Current pricing strategy has maintained savings and money market balances in last year so 100% retention is assumed. 57

60 MMDA Pay Up FHLB DM % Strategy 1 - In 200 bp rising rate environment savings beta used for savings, regular money market beta used for regular MMDAs, Premium MMDA beta used for premium account. Benchmark rate is 2 yr FHLB advance rate plus 125 bp. 58

61 MMDA Pay Up Strategy 1 Based on the historical response to this strategy, retention is assumed to be 100%. 59

62 MMDA Pay Up Survey Data Pricing changes deemed necessary for 10% growth. Would take rates at or near the top of the market 60

63 MMDA Pay Up Rates are raised on Premium MMDA close to the top of the market. This is a segmentation strategy as I m only paying up on one of the products in the sector. Other Rates are not changed. Overall sector growth is assumed to be 10%. Marginal cost is 34 bp under the benchmark. 61

64 Issue Problem with Premium Accounts 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. 62

65 Solution Rising Rates 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 (+/-) 63

66 New Premium MMDA Old Premium MMDA priced using regular MMDA beta. New Premium MMDA priced near the top of the market. Similar amount of new money raised at much lower marginal cost. 64

67 Checking Sector Similar strategies can be used in checking except: Checking customers are less rate sensitive than money market customers. Some checking products don t bear interest Remember the more features of a product that are important to a customer other than rate, the less sensitive they will be to rate paid. Discussion question What barriers to entry are in a Rewards checking account? Is the product really aimed at going after checking dollars? 65

68 Questions? 66

69 Funding- Developing Funding Strategies Effectively Using Wholesale and Blended Funding Session 3 Thomas A. Farin Chairman of the Board tfarin@farin.com 67

70 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 68

71 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 69

72 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.) 70

73 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 71

74 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 72

75 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 73

76 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 74

77 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. 75

78 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. 76

$Optimal Earning Asset Matrix Every balance sheet mix carries maximum return\volatility combinations Finding your optimal earnings frontier is key to strategic\capital plan What strategy has$

79 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 What are the most common reasons why you might be performing at the portfolio B level when you could be performing at the A level. 77

80 Case Institution $1.5 Billion Deposits Had been shrinking Capital Plan allows $30-50 million asset growth next year 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 78

81 Case Institution Identify Loan Growth Opportunities 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? 79

82 Funding Longer Duration Loans Options Deposits Long-Term CDs Recently Expensive Will lag the market in rising rate environments Uncovered Options Non-Maturity Deposits Cheap source of longterm funding especially when rates are up. But do you bet the whole shop on the results of a core study? 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 80

83 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? 81

84 Blended Funding Making LT Assets Using FHLB Advances Concept Use FHLB Advances to provide structural support under fixed-rate 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 82

85 Effective Duration - Core Auto Loans 15 Yr FRM 30 Yr FRM 83

86 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%. 84

87 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 85

88 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 86

89 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 87

90 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! 88

91 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! 89

92 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 90

Lecture Materials FUNDING

Lecture Materials FUNDING Thomas A. Farin Chairman of the Board FARIN Financial Risk Management Fitchburg, Wisconsin tfarin@farin.com 608-661-4219 & Darryl Mataya SVP & Chief Development Officer FARIN