As loan growth materializes, it is important to renew the focus on liquidity management, have an overall liquidity plan and a contingency funding plan. In order to create and implement such plans, it is important to understand the attributes of deposits. Even if a bank is not experiencing stronger loan growth, it is necessary to understand the elasticity of core deposits in order to make accurate modeling assumptions.
Anyone who experienced a higher interest rate environment remembers depository institutions having to compete with money market funds and other non-bank investment instruments that paid comparatively high rates. As the economy emerges from the bottom of a 10-year interest rate trough, depositors are starving for interest income. Institutions are finding that customers are willing to buy longer term CDs in exchange for yield. We simply do not know how long deposits will remain on books in a higher rate environment or how much we will have to pay to keep them.
The primary core deposit assumptions used for interest rate simulation models are beta and decay. Deposit beta is an indication of how rates correlate to the market. For example, if you use a beta of 0.25 on your savings rate, for every projected market rate move of 100 basis points, the savings account rate will move 25 basis points.
Decay is the measure of deposit attrition, or how long deposit accounts will likely remain open. If you decay a savings account over a 60-month period, you make the assumption that the savings account will have a 60-month maximum life. The normal range for decay is 24 months for sensitive deposits and 84 months for more static accounts.
Historically these numbers have been typically supplied by market averages, vendors, the Office of Thrift Supervision (which was merged with the Office of the Comptroller of the Currency in 2011) and management estimates. Various forms of deposit studies are gaining popularity but remain the least common means of obtaining core deposit assumptions. Meanwhile other modeling assumptions utilize prepayment rates, discount rates and spreads and are much more precise. The higher degree of precision for these non-deposit modeling assumptions helps reduce simulation risk. The irony here is that even though non–deposit assumptions are much more precise, they have a lesser impact on simulation results. This means that the greatest amount of simulation risk comes from assumptions with the least amount of basis!
In order to demonstrate the impact of these core deposit assumptions, we can take a typical Bank asset/liability management simulation and compare the results of the Economic Value of Equity (EVE shock/stress both with and without these beta and decay assumptions.) This serves as a stress test of the deposit assumptions. To stress the assumptions, we will simply set all betas to one and all maturities to one month. Then we can compare the results. To keep it simple, we will look at it graphically:
Note how the EVE variance is between +7 percent and -14 percent when the betas and decays are utilized in the simulation. Once they are removed, this variance is between +10 percent and -30 percent, showing that it almost doubles in a rising rate scenario. In this case, removing the assumptions or making material changes to them can cause a financial institution to approach or exceed prudent risk limits. Additionally, this will also impact the net interest income shock as well, but a complete simulation will need to be performed to assess the impact.
The graph shows that core deposit assumptions are an important variable in the modelling results, especially if used as a management tool. As mentioned, this can be also used as a regulatory stress test. Stress tests are good but they do not serve the purpose of creating valid assumptions for management purposes. This can be accomplished by a core deposit study. A detailed core deposit study is a fairly involved and costly project but it will produce the most accurate assumptions. An abbreviated core deposit study can be used to understand the correlation of deposit line items to market rates and back into decay rates. There are a number of companies offering such services for institutions without in house expertise. It is worth exploring such options as the regulators are most likely to focus on core deposits as interest rates rise.