15%-20% from wholesaleIncreased funding from wholesale up to the crisis
Quarterly, bank I, acount type iDelta r
Modeling Non Maturity Deposits
Modeling Non Maturity DepositsRobert J. Wyle, CFASenior Director, Moody‟s Analytics
May 12, 2013Agenda» Introduction» The Linkage of Non Maturity Deposits to Macro-Economic Variables» Non Maturity Deposit Modeling Basics– Interest Rate Risk Review– Basics of NMD Modeling– NMD Vintage Methodology – More Advanced– Modeling Non Maturity Deposit Retention and Offered Rate– Simple NMD FTP Approximations» Non Maturity Deposit Funds Transfer Pricing» Conclusion: Linkages between deposit valuation, interest rate risk, and FTP2
May 12, 2013Introduction» Non maturity deposits include demand deposit accounts (DDAs), negotiable order ofwithdrawal (NOW) accounts, money market deposit accounts (MMDAs), and passbooktype accounts.» These deposits play and important role in the profitability and interest rate riskmanagement of depository institutions.» The term non maturity arises form the fact that these deposits, unlike other types of bankfunds, such as CDs, carry no explicit maturity date.» The lack of a contractual maturity for NMD necessitates the development of behavioralmodels based on time series analysis.» NMD behavioral models are needed for the estimation of deposit decay/runoff, interestcash flows, and balance projections needed to calculate market value, earnings, andfunds transfer pricing» Macro economic variables play an important role in terms of runoff and thecannibalization of existing deposits into different deposit categories and cash.» It is critical that the NMD modeling assumptions between NII forecasting, marketvaluation, and FTP functions be consistent.3
May 12, 2013Data Sources5» Banks call reports– 522 banks with assets– Quarterly interest expense and average account balance, 2002Q1 – 2011Q4– Other fields relating to financial and performance ratios» Moody‟s Economy.com (MEDC)/Federal Reserve Bank– Interest rate markets data– Other macroeconomic data
May 12, 20136Funding Sources by Liability Type15161718192021606264666870727476Wholesale(%)Retail(%)Retail funding (left axis) Wholesale funding (right axis)
May 12, 2013Y-variables» Cross-sectional means‟ of individual banks‟ funding source time-series» Modeled as relative % changeModelsSome observations» Savings and MMDAs increase with VIX and the effect persists for some time» Both wholesale and retail CDs increase with 2Y Treasury yield and loans growthrate» Higher consumer credit is followed by higher wholesale CDs, fed funds and repos7A Simple Time-Series Analysis of Funding Sources𝛥𝑆𝑎𝑣𝑖𝑛𝑔𝑠𝑡 = 1.08 + 0.56 ∗ 𝛥𝑆𝑎𝑣𝑖𝑛𝑔𝑠𝑡−1 + 0.08 ∗ 𝛥𝑉𝐼𝑋𝑡−1𝛥𝐶ℎ𝑒𝑐𝑖𝑛𝑔𝑠𝑡 = 1.22 − 3.24 ∗ 𝛥𝐿𝑂𝐶𝑠𝑡−1𝛥𝑆𝑚𝑎𝑙𝑙𝐶𝐷𝑠𝑡 = 3.54 + 3.82 ∗ 𝛥𝑇𝑟𝑠𝑦2𝑌𝑡−1 − 1.05 ∗ 𝑉𝑜𝑙𝑇𝑟𝑠𝑦2𝑌𝑡−1 + 4.02 ∗ 𝛥𝑆𝑝𝑟𝑒𝑎𝑑3𝑀𝐶𝑜𝑟𝑝𝐵𝐵𝐵𝑡−1𝛥𝐽𝑢𝑚𝑏𝑜𝐶𝐷𝑠𝑡 = −3.44 + 3.42 ∗ 𝛥𝑇𝑟𝑠𝑦2𝑌𝑡−1 + 0.63 ∗ 𝛥𝐶𝑜𝑛𝑠𝐶𝑟𝑒𝑑𝑖𝑡𝑡−1 + 0.24 ∗ 𝛥𝐿𝑜𝑎𝑛𝑠𝑡−1𝛥𝐹𝑒𝑑𝐹𝑢𝑛𝑑𝑠𝑡 = −2.32 + 4.98 ∗ 𝛥𝐿𝐼𝐵𝑂𝑅3𝑀𝑡−1 + 0.86 ∗ 𝛥𝐶𝑜𝑛𝑠𝐶𝑟𝑒𝑑𝑖𝑡𝑡−1 + 0.28 ∗ 𝛥𝐹𝑒𝑑𝐹𝑢𝑛𝑑𝑠𝑇𝑜𝑡𝑎𝑙𝑡−1𝛥𝑂𝑡ℎ𝑒𝑟𝑆𝑇𝐵𝑤𝑖𝑛𝑔𝑠𝑡 = −5.91 + 1.93 ∗ 𝛥𝐶𝑜𝑛𝑠𝐶𝑟𝑒𝑑𝑖𝑡𝑡−1
May 12, 2013Modeling Funding Cost Dynamics8– Linking current interest rates by liability type with past rates and macro-variables,with possible lags– Strong serial correlation in quarter-to-quarter in liability rates– Magnitude of changes vary across banks– Strongly correlated with the broad interest rate market variables (Treasury and LIBOR– Coefficients have the same sign across most of the banks in the sample, , , , ,i t l i t l i m i m i tl mr r X Checking rate Savings rate CD Retail rate CD WholesalerateFed FundsAnd Repo rate# of lags in Y 1 2 3 3 1Adj-R2 (%) 30.54 60.73 62.06 64.07 80.51significantvariablesFedFund_ChGDP_Ch_lag1LIBOR1M_chT2Y_ch_lag1LIBOR3M_chT2Y_ch_lag2LIBOR3M_chT2Y_ch_lag2FedFunds_ch
May 12, 2013Deposit Modeling and Stress Testing Conclusions» Macro economic variables matter when constructing stress testingassumptions because macro economic exogenous variables influenceretail consumer and institutional behavior.» Whereas most banks do not have experience with bank runs, there area wealth of banks who have. All of these banks must file FDIC callreports. Therefore, banks can construct stress testing scenarios basedon publicly available time series data.» Surge deposits need to be removed from the modeling of NMD andmodel based upon macro economic models.9
May 12, 201311Interest Rate Risk – Review» The market value (price) of an interest earning asset or liability is thepresent value of all future cash flows.» In the case of a fixed rate, fixed maturity ,option free bond (i.e. 10-YearTreasury bond), the future cash flows are known with certainty. In thisinstance, changes in the bond price are driven by changes inmarket/discount rates.– If market rates rise, future cash flows are discounted at a higher rate,generating a lower present value - reducing the price of the bond/asset.– If market rates fall, future cash flows are discounted at a lower rate,generating a higher present value - increasing the price of thebond/asset.» Similarly, the above also applies to liabilities where the future cash flowsrepresent payments versus receipts.» As many of the Bank‟s loan and security positions are fixed rate, thesepositions gain in value with falling rates and fall in value with rising rates.Whereas, fixed rate liability positions (CDs) gain in value in rising ratesand decline in value in falling rates.
May 12, 201312Interest Rate Risk - Duration» The most often used metric to quantify the interest rate sensitivity of an asset orliability is duration. Duration in this context does not simply mean average life, butrather refers to the change in the market value of an asset or liability for a changein interest rates, more specifically for a parallel shock in the yield curve.– If an asset has a duration of 5, a 100 bps parallel increase in interest rates will cause themarket value of the asset to decline by 5%.» For a fixed rate instrument, the longer the maturity of a fixed rateinstrument the higher the duration. Floating rate instruments havedurations that are limited to the reset period of the index rate, providedthey do not contain embedded caps, floors, or other rate provisions.» The duration of a financial institution‟s equity is a function of theasset/liability mismatch scaled by the institutions leverage; consider thefollowing example:Amount Duration Weighting FactorAssets 10 B 2.00 20Liabilities 9 B 1.50 13.5Equity 1 B 6.50 6.5
May 12, 201313Interest Rate Risk – Equity at Risk• The net change in the Market Value of the Bank’s asset, liability and derivative portfoliois the interest rate risk exposure to the Bank’s equity or Equity at Risk. Typically, theMarket Value sensitivity of the Bank’s assets will exceed the Market Value sensitivity ofthe Bank’s liabilities. The resulting exposure is then hedged to be within policy limitsby the derivative portfolio.Change in Market Value by Parallel Rate Shock 1/31/05Assets (Long)Market Value -100 -50 -25 +25 +50 +100 +200Investment Securities 12,913 272 157 84 -92 -192 -409 -877Consumer Loans 8,019 98 48 24 -24 -48 -95 -189Residential Loans 3,890 64 35 19 -20 -41 -85 -176Other Assets (Including Servicing Rights) 500 -5 -2 -1 1 2 3 4Pending Transactions 4 -7 -4 -2 2 5 10 19Total Assets 25,325 421 235 123 (133) (274) (575) (1,220)Liabilities (Short)Market Value -100 -50 -25 +25 +50 +100 +200Retail Non-Maturity Deposits 9,333 -211 -105 -52 52 103 205 404Time Deposits 2,062 -21 -11 -5 5 11 21 42Wholesale Funds 11,942 -79 -35 -17 15 28 50 83Other Liabilities 251 0 0 0 0 0 0 0Total Liabilities 23,589 (312) (151) (74) 72 142 276 529HedgingMarket Value -100 -50 -25 +25 +50 +100 +200Derivatives 33 -302 -152 -76 75 151 307 629Equity at Risk 1/31/05 1,769 -193 -68 -27 15 19 8 -62
May 12, 201314Interest Rate Risk - Modeling Assumptions» While there are numerous modeling assumptions used in estimatingEquity at Risk, many of these assumptions can be validated by looking tomarket prices for liquid securities (prepayment rates on a mortgage loanportfolio).» However, in some cases the assumptions behind the valuation cannot bevalidated from market data. In these cases the asset or liability isinstitution specific. This is either due to unique contractual features orspecific customer preferences and behavior.» When evaluating the market value sensitivity of Non-maturity depositaccounts, evaluating account specific customer behavior is necessary todraw inference as to the price sensitivity of the account. Furthermore,evaluating account specific institution behavior is necessary if productstrategy is shifting over time or is likely to shift in the future.
May 12, 201315Deposit Modeling - Summary» In order to calculate the market value of a deposit account, thecash flows that the account generates must be modeled. Thediscounted present value of these cash flows against the currentcurve generates the market value.» The two critical items to be determined in modeling the cash flowsof a Non-maturity account, and therefore the interest ratesensitivity, are:– Deposit balance retention - the decay of deposits in existing accountsover time.– The degree of correlation (pricing coefficient) between the rate paid tothe customer (offered rate) on the account and short term interest rates.
May 12, 2013Retention Rate» The retention rate is defined as the percentage of balances retainedfrom a certain point in time forward for a constant set of accounts. Thisincludes both attrition and churn.» Balances are assumed to undergo a natural decay as existingaccounts run off over time161tRetentiontBalanceBalancesNewAccounttBalance
May 12, 2013Non-Maturity Deposit Balance Survival/Decay Function,by Category, 01/2002-12/20040102030405060708090100191725334149576573818997105113121129137145153161169177185193201209217225233Age, in monthSurvivalRate,%Checking Saving MM1 MM2 MM3 MM4 MMP1 MMP2 MMP317
May 12, 201318Market Value and Duration» Identifying balance retention (balance decay) allows for the modeling ofprincipal cash flows, while the correlation of offered rates to market ratesallows for the modeling of interest cash flows.» Determining a set of principal and interest cash flow for a given yieldcurve results in a market value and deposit premium.» Calculating the market value under an up and down parallel shock (+/-100 bps) allows for the calculation of effective duration.» Note that duration is an output measure that is calculated from thechange in market value (price), where market value was determined froma given pricing coefficient, retention and yield curve.V0 = initial priceV- = price if yield changes by -yV+ = price if yield changes by +yΔi = change in yieldDe =V- - V+2(V0)(Δi )
May 12, 201319Effect of Model Inputs on Duration• Accounts that exhibit low correlation with movements in short rates will exhibit higher durationfor a given retention as the offered rate will respond slowly to movements in market rates (i.e.behave more like a fixed rate instrument).• Retention measures how long money remains in an account. For a given correlation to marketrates, high retention will result in higher duration.Low Retention High RetentionLow Correlation toMarket RatesMedium Duration High DurationHigh Correlation toMarket RatesLow Duration Medium Duration
May 12, 2013NMD VINTAGE METHODOLOGY– MORE ADVANCED22
May 12, 2013Fundamentals» What is a vintage methodology?» What are the components of a vintagemethodology?How do IcharacterizeNMDmaturities?
May 12, 2013Vintage Runoff Methodology Defined» A vintage runoff methodology seeks to segregate balances based on historicaltranches called vintages.» A vintage consists of all of the individual accounts for a non-maturity depositaccount type that are opened in a particular month.» Cash flow behavior characteristics are applied to each vintage by calculatingthe monthly runoff within each vintage.» Therefore, the vintage account runoff model characterizes the manner in whichaccounts close over time.
May 12, 2013Key Challenges» How long and why?» How to determine repricing assumptions and separatethem from maturity assumptions if possible – rate risk vs.term risk» How to segment portfolios to capture the key behaviorcharacteristics defining cash flow» Locking in profit
May 12, 2013Balances» Fixed Core Balances– Long term stable source of funding– Accounts where repricing characteristics don‟t entail significant interest raterisk.» Variable Core Balance– Long term stable source of funding– Accounts where repricing characteristics entail significant interest rate risk.» Volatile Balance– Balance that fluctuates and is not statistically predictable from one month tothe next.
May 12, 201328Core and floating balance decomposition» The core volatile split may be determined in a numberof ways:– The difference between a moving average and the actualbalance (not recommended)– The lower bound for the 95% confidence leverage averagemonthly balances at the deal level. That is to say, nextmonth, there is a 95% possibility that the average balanceper account will be greater than the core balance.– Linear regression» The fixed core/floating core split can either be anegotiated rate or is the beta of the offered ratefunction.
May 12, 2013Different Lives» Liquidity Term– Term corresponding to which cash flows are truncated» Reprice Term– Frequency with which the funds transfer credit for interest bearingaccounts is repriced» Re-Strip Term– Term corresponding to how often the surviving balances within avintage will be re-stripped» Weighted average Life– Term corresponding to the observed liquidity premium
May 12, 2013Retention Rate Example31Jan 31, 20xxFeb 2820xxVintage Vintage Vintage VintageAge Balance Age Balance SMM = (Feb Bal - Jan Bal)/Jan Bal00 $ 1,965.24 1 $ 1,914.88 2.56%1 $ 1,162.05 2 $ 1,132.87 2.51%2 $ 1,575.71 3 $ 1,535.22 2.57%3 $ 1,715.09 4 $ 1,672.96 2.46%4 $ 1,653.69 5 $ 1,611.00 2.58%5 $ 1,208.11 6 $ 1,177.72 2.52%. .. .. .30 $ 669.30 31 $ 653.14 2.41%31 $ 740.74 32 $ 722.28 2.49%32 $ 751.75 33 $ 733.44 2.44%Average SMM 2.50%This represents one "snap-shot" calculation. You really want to have more, like aDec 31 to Jan 31, Nov 30 to Dec 31, etc.
May 12, 2013Runoff Example32Exponetial Model Piece-wise linear modelStart End % of OriginalConstant SMM Period Period Balance5.00% 0 3 4.75%3 7 3.98%7 10 3.32%Period Balance Balance0 $ 100.00 $ 100.001 $ 95.00 $ 95.252 $ 90.25 $ 90.493 $ 85.74 $ 85.744 $ 81.45 $ 81.765 $ 77.38 $ 77.796 $ 73.51 $ 73.817 $ 69.83 $ 69.838 $ 66.34 $ 66.519 $ 63.02 $ 63.1910 $ 59.87 $ 59.87Here is a simple example of piece-wise linear (constant runoff balanceeach period) Vs. exponential (constant runoff rate each period)Note that even with the 5% SMM I assume the piece-wise doesan OK job of approximating.
May 12, 2013Typical Behavior Factors that Drive Cash Flows» Seasonal variations» Interest rate sensitivity (level, direction, and magnitude of month over month change)» Long term trend i.e. age» Coupling with term deposit balance behavior34
May 12, 201335Offer Rate Functions» The offered rate or paid rate function quantifies thecorrelation between the offered rate and benchmark shortterm interest rates.» Generally, the offered rate in each future period is correlatedwith some market rate(s) in that period and the offer rate inthe previous period.)1(*1 tLIBORtLIBORtOfferRatetOfferRate
May 12, 2013Intro to FTP: Conjuring an Image of Internal Politics» FTP is rooted in a mark-to-market based risk management framework.However, financial institutions are managed based on accrual income.Therefore, FTP is the link through which a market-based financial riskmanagement system is translated into financial incentives for large and diverseorganizations rooted in financial accounting systems. As such, the FTPconcept is fraught with controversy since it is used to benchmark performance.At times it may seem more art – perhaps even “black art” – than science.» “The manager of the transfer pricing book is almost always viewed withsuspicion by line unit managers. Borrowers from the book feel rates are toohigh and lenders to the book feel rates are too low. If large interest rate riskpositions are taken within the book in an attempt to make profits, any resultinggains or losses will reinforce the suspicions of line units. If there are profits,line units will feel that they have been „ripped off‟ by the pricing of transactionswith the transfer pricing book. If there are losses, the transfer pricing bookmanager will be regarded as incompetent.”37
May 12, 201338Why do we need Funds Transfer Pricing?» Funds transfer pricing (FTP) is an internal measurement and allocation process thatassigns a profit contribution value to funds gathered and lent or invested by the bank. Itis a critical component of the profitability measurement process, as it allocates the majorcontributor to profitability, net interest margin.» FTP allows banks to measure business profitability separately from interest rate risk.Specifically, FTP allows a Bank to:» Measure business unit profitability independent of interest rate risk» Centralize the measurement and management of all interest rate risk to a central fundingunit» Evaluate the attractiveness of asset based activities separately from liability basedactivities to support ongoing pricing decisions
May 12, 201339A Simple Example of FTPBalance SheetLoan 5 YCustomer PositionMarket Rate2.1%3.0%Contribution MarginAssets: 0.9%Position CustomerDeposit 2 YMarket Rate1.8% 1.6%Contribution MarginLiabilities: 0.2%Treasury Contribution0.3%Interest Margin1.4%
May 12, 201340Creation of Profit CentersProfit Center “Asset” Profit Center “Liability”Deposit 2Y1.6%Profit Center “Treasury”Loan 5Y2.1%Financing 5Y2.1%Loan 5Y3%Client ClientInvestment 2Y1.8%Deposit 2Y1.8%asset / liability contribution is not affected by interest rate riskAsset Contribution0.9%Liability Contribution0.2%Treasury Contribution0.3%interest rate risk is solely managed in the Treasurytotal margin = asset contribution + liability contribution + treasury contribution
May 12, 201341Calculation of the Three ComponentstInterest rateLiabilities (Deposits)Assets (Loans)3.0%5.0%asset contributionliability contributiontreasurycontributionInterestmargin4.5%3.5%
May 12, 201342Common FTP Methodologies» Pooled Approaches: Funds are assigned to one or more pools created under a pre-defined set of criteria. Criteria for pool classification may be based on type, term,repricing term, origination, or other fund attributes. The transfer rate assigned toindividual pools is derived either internally, based on actual rates earned or paid, oralternatively, by market-derived interest rates.– Single Pool– Multiple Pool» Contemporary market rates» Historical market rates at time of transaction origination» Co-Terminus Funds Transfer Pricing: Matched-term methods assign unique transferrates to each source and use of funds at the time of origination. But rather than use adiscrete series of pools, matched-term methods derive transfer rates from continuousterm structure pricing curves that represent prevailing rates for wholesaleinvestment/borrowing alternatives available to the institution.
May 12, 2013FTP Methods – Strip Funding» Strip funding is similar to the concept of replicating portfolios. That is, one can modelany stream of cash flows with a portfolio of zero coupon bonds. Therefore, one canvalue that stream of cash flows by adding together the market values of each of thecomponent zero coupon instruments. Similarly, if each cash flow of an instrument werematch funded at the prevailing cost of funds, the discounted cash flow of the constituentstrip of zero coupons should equal the price of the instrument.» Strip funding is defined as the transfer spread that equates the price of an instrumentwith the present value of its cash flows discounted against its funding curve. Therefore,the transfer spread, in this context, is defined as the economic profit in basis pointsabove the cost of funding.» The transfer spread never changes once it is assigned unless there is a change incontractual features; even for floating rate instruments.» The static strip funding method is typically used for option free instruments.» The stochastic strip funding method includes the convexity cost of embedded options.This is accomplished by generating arbitrage free random interest rate paths and solvingfor the average transfer spread that equates the price at origination with the sum of theaverage discounted cash flows. Stochastic strip funding is typically used for instrumentswith embedded options like mortgages.43
May 12, 2013Other FTP MethodsThere are many other different types of transfer pricing methodologies usedaround the world besides strip funding.» Average Rate Method» Rate Index Method» Weighted Average Life Method» Duration Method» Maturity Method44
May 12, 2013Calculating a Monthly FTP Rate» The monthly FTP rate is composed of up to three components.– An over-night-rate volatile-balance.– A fixed-rate core-balance.– A floating-rate core-balance.» All non-maturity deposit products have a volatile component, and atleast one of the core components.45
May 12, 2013Calculating a Monthly FTP Rate» The monthly FTP rate is the sum of the following threecomponents:– Volatile balance FTP component.» Volatile balance fraction* Over-night rate (Fed. Funds Target).– Fixed-core FTP component.» Fixed-core balance fraction * Fix-core FTP rate.– Floating-core FTP component.» Floating-core balance fraction* Floating-core FTP rate.46
May 12, 2013Simpler Methods - Vintage Method Approximation» Lock in the current FTC or a reasonable proxy. A good rule of thumb is to use an FTCthat is consistent with how funds on the asset side of the balance sheet were invested.The single point on the swap curve chosen for the FTC in this method corresponds tothe current duration assumption per product or tier.» The impact of new volumes and decay can be approximated by adjusting the initial FTCusing a forward-looking moving average over time. This moving average is rolledforward over an assumed weighted average life equal to twice the existing duration perproduct category or tier. For example, The FTC0+1 would be 119/120th of FTC0 and1/120th of the FTC0+1 spot rate for a 5 yr duration product. This growing average isthen rolled forward using the same methodology.» The balance used to calculate the dollar value for the FTC should be based on a corebalance and a volatile balance. The core balance can be estimated using a number ofapproaches. The volatile balance is calculated as the difference between the monthend balance and the core balance. The volatile balance is credited using a short termindex i.e. one month LIBOR plus the term liquidity premium.50
May 12, 2013Simpler Methods - Moving Average Method» Calculate all NMD FTCs using a moving average rate. The term of themoving average should correspond to the product level or tier level depositduration. The point on the yield curve used to calculate the moving averageshould correspond to the duration as well.» The balance used to calculate the dollar value for the FTC should be basedon a core balance and a volatile balance. The core balance can be estimatedusing a number of approaches. The volatile balance is calculated as thedifference between the month end balance and the core balance. The volatilebalance is credited using a short term index i.e. one month LIBOR plus theterm liquidity premium.52
May 12, 2013Evaluating both Methods» Both methods are easy to implement and maintain» The moving average method benefits the business unit when ratesare falling and benefits the funding center when rates are rising.Therefore, it is possible to game this framework.» The vintage approximation is harder to explain. However, it is harderto game because it uses current spot rates to approximate the FTCfor new vintages.54
May 12, 2013Conclusion» There are linkages between the framework for the valuation, interest rate riskquantification, and performance measurement for non-maturing deposits(NMD).» Despite the fact that there is a wide range of practice and sophistication acrossthe globe, the underlying deposit modeling assumptions for net interest income(NII) simulation, valuation, risk measurement, and performance managementmust be consistent. Otherwise, inconsistent and perhaps naïve decisionmaking may result.» Bottom up analysis of the data must be performed in order to understand thevarious behavior factors that drive cash flows under various interest rate andeconomic scenarios.» NMD behavior models will more accurately quantify the risk of the balancesheet and can be a source of value creation and return enhancement for afinancial institution.» The impact of macro economic factors on deposit retention and decay must beanalyzed and modeled independently.55