Fiserv risk core poorman 2011

Core Deposit Modeling: Hot Topics and Current Best Practices May 3 2011, 10:30 AM Presented by Bank Risk Advisors, Fred Poorman Jr., CFA Core Deposit Consulting Services team: Leonard Matz, Principal, Liquidity Risk Consulting Services Mike Arnold, PhD, Sr. Consultant, Principal ALCO Partners Fred Poorman Jr., CFA, Managing Principal Howard Stern, PhD, Sr. Consultant, Principal Stern Consulting [email protected]

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mailto:[email protected]

overview per conference brochure

Join this fast paced session to explore key issues including: rate sensitivities in a rising rate environment; valuation of core deposits; sensitivity analysis - regulators and best practices; liquidity concerns; core deposit studies and behavioral inputs; core deposits best theoretical approach

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what is a core deposit?

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what is a core deposit?

Accounting: FASB definition, GAAP Fair Value disclosures “the definition will include deposits that do not have a contractual

maturity that management believes are a stable source of funds.”

Quantitative approach to core/stable Look at balances/flows over time Regulatory comment at Midwest regional April 2011; “Surely you don’t

believe that all your recent deposit growth is true stable, core” Product specific behaviors

Qualitative approach to core/stable Bank Risk Advisors (Matz) has 11 factor-approach to defining stability of

deposits for Liquidity modeling, including stress-testing

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different core deposit perspectives

Accounting: FASB definition, GAAP Fair Value disclosures “the definition will include deposits that do not have a contractual

maturity that management believes are a stable source of funds.”

ALCO: balance sheet composition, pricing, key assumption ALM modeling: multi-scenario liquidity, income & value Equity markets: equity analysts, price multiples Liquidity: forecasting & stress testing Marketing: market share, pricing & branding/positioning Profitability: FTP & Liquidity FTP

Please see Leonard Matz presentation next session

Regulatory: impact on CAMELS

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rate sensitivities in a rising rate environment, where were we and where are we going?

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rate sensitivities (CDs) in a rising rate environment

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Preliminary Deposit SensitivitiesFloor Sensitivity

Fed move Product Index Start End Alpha Beta R squared1.75 1 yr CD 1 yr Swap May-99 Dec-00 - 0.90 0.67 4.25 1 yr CD 1 yr Swap May-04 Jun-06 0.10 0.85 0.99 - 1 yr CD 1 yr Swap Jun-09 Mar-11 0.65 1.06 0.28

4.25 1 yr Jumbo CD 1 yr Swap May-04 Jun-06 0.11 0.85 0.98

Weekly national average deposit rates from bankrate.comWeekly market rates from Bloomberg L.P.Statistical measures from SAS Stats, JMP, Bloomberg L.P.See forthcoming White Paper/BALM Article for disclaimer, methodology, results

rate sensitivities (MMDAs) in a rising rate environment

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Fed move Product Index Start End Alpha Beta R squared1.75 MM Jumbo 3 M LIBOR May-99 Dec-004.25 MM Jumbo 3 M LIBOR May-04 Jun-06 0.47 0.79 0.99

1.75 MM 10k tier 3 M LIBOR May-99 Dec-00 - 0.65 0.49 4.25 MM 10k tier 3 M LIBOR May-04 Jun-06 0.80 0.51 0.97


missing data points

rate sensitivities (NOW/Int. Checking) in a rising rate environment

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Fed move Product Index Start End Alpha Beta R squared1.75 NOW/Int Check 3 M LIBOR May-99 Dec-00 - 0.35 0.71 4.25 NOW/Int Check 3 M LIBOR May-04 Jun-06 - 0.23 0.55 4.25 NOW/Int Check 3 M LIBOR May-04 Jun-06 0.33 0.15 0.55 4.25 NOW/Int Check Multi-factor May-04 Jun-06 0.79


rate sensitivity issues

Does past apply? Market & channel changes FDIC rate caps for “problem” institutions Regulatory fiat of no growth for “problem” institutions Is this time different vs. mean reversion

Quantitative & qualitative approaches

Do local, regional, or national markets apply? Impact of deposit concentration limits for 2-4 large banks Internet and brokered CDs

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valuation of core deposits per GAAP

In little noticed actions in September and November 2009, FASB issued the following:

1. The value of the core deposit liability would be determined using a present value of the average core deposit amount discounted by the difference between the alternative funds rate and the all-in-cost-to-service rate over the implied maturity.

2. The core deposit liability amount that would be subject to the remeasurement would be determined as an average amount over the implied maturity time period, which would result in the consideration of future deposits. Considering and valuing future deposits would result in an intangible asset being reflected in the valuation.

3. The Board agreed that core deposits would qualify for remeasurement changes to be recognized in other comprehensive income. The balance sheet presentation of core deposits would be subject to previous presentation decisions. Last point means you can offset AFS Investment value volatility.

Rarely implemented.

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valuation of core deposits per GAAP

present value of the average core deposit amount This is what the industry does. For example, using the Fiserv AL model

discounted by the difference between the alternative funds rate and the all-in-cost-to-service rate Difference means Funding rate – (Servicing cost – Fees)

Brokered CD rate = 2.00% Servicing cost = 1.50% Fees = 0.50%

Difference = 2.00% - (1.50% - 0.50%) =1% Is this standard practice? Please play the raise your hand game

over the implied maturity over can be interpreted to mean across the period, implying periodic

cash flows

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over the implied maturity?

Implied: “involved, indicated, or suggested without being directly or explicitly

stated” source: dictionary.com

“In financial mathematics, the implied volatility of an option contract is the volatility implied by the market price of the option based on an option pricing model. In other words, it is the volatility that, when used in a particular pricing model, yields a theoretical value for the option equal to the current market price of that option.” source: wikipedia.com

An analogue would be that given the market price, discount rate, you could solve for: a single bullet maturity multiple maturities, given periodic cash flows

Maturity: “a financial term indicating the final date for payment of principal and interest” source: wikipedia.com

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what is “over the implied maturity?”

Most practitioners use an estimated: periodic cash flow (sometimes called decay rate) final maturity (some only use decay, OTS tables)

Behavioral studies are one approach we suggest (more later)

Buyer Beware! One consulting shop uses the complement of estimated rate sensitivity:

.1 sensitivity = 10 years, .5 sensitivity = 2 years, etc. Another uses very wide ranges

NOW accounts range from 1.2 to 15.8 to 39.9 years? Typically use balance$ as account#s mislead due to dormant accounts

From established consultants, cash flow is typically less and average lives are more than implied by market prices

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valuation of core deposits (about 5%), branch deal core deposit premiums (SNL)

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valuation of core deposits (about 5%), bank deal core deposit premiums (SNL)

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valuation notes

SNL definition includes retail CDs need to adjust for mix and pricing; may be problematic

Both assisted and unassisted transactions include situations when total assets, total deposits, and core deposits were acquired at a discount Deposit rates are above market Mix is unfavorable with little true core Institutions are sold for less than book value Failed, loss share institutions

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sensitivity analysis: regulatory perspective

Interagency Advisory on Interest Rate Risk Management (OCC 2010-1a) assess the sensitivity of the institution to changes in market rates and

important assumptions underlying the metrics used stress testing, which includes both scenario and sensitivity analysis, is

an integral component of IRR management stress testing should include a sensitivity analysis to help determine

which assumptions have the most influence on model output. sensitivity analysis can be used to determine the conditions under

which key business assumptions and model parameters break down institutions should ensure the reasonableness of asset prepayments,

non-maturity deposit price sensitivity and decay rates sensitivity testing of key assumptions that exert the greatest impact on

measurement results. When actual experience differs significantly from past assumptions and expectations, institutions should use a range of assumptions to appropriately reflect this uncertainty.

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sensitivity analysis: industry and better practices Interagency Advisory on Interest Rate Risk Management

(OCC 2010-1a) notes many better practices large bank presents sensitivity analysis and earnings impact

of key assumptions monthly for community banks, we recommend that:

ALCO review and approve key assumptions at least annually When significant change occurs, for example:

– Core Deposit study – New pricing strategy

Sensitivity analysis assists with an intuitive understanding of the affect of key assumptions

MMDA example Sensitivities of 25%, 50%, 85%

CD example Sensitivities of 75%, 85%, 100%

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liquidity concerns

normal “business as usual” scenarios Base case rate cash flow assumptions by product May have scenario-specific flows based on difference from market rate

Analogous to prepays

liquidity scenario analysis & stress testing Define base congruent with IRR analyses Core Deposit flows vary by:

scenario type (credit, fraud, systemic risk, etc.) stress level (mild, moderate, severe, extreme)

Liquidity stress tests demonstrate another value of core deposits

Liquidity Funds Transfer Pricing (Liquidity FTP) Required of large banks per Interagency Policy Statement on Funding

and Liquidity Risk Management (OCC 2010-27a) Better practice for all banks Remember to consider in pricing and valuation

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core deposit studies and behavioral inputs: regulatory and accounting compliance (1) Data requirements

Request account level detail for 10 years Realistically need for an entire rate cycle to observe rate & balance

behaviors

Data aggregation Product mapping & account type consistency over time frame Consider ALM model set up

Draw curves for balance behaviors (we use JMP/SAS) Life distribution (Excel example next page) Fit life by econometric factor x,y,z Degradation (decay) Survival (retention)

Parametric Non-parametric

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core deposit studies and behavioral inputs : regulatory and accounting compliance (2)

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core deposit studies and behavioral inputs : regulatory and accounting compliance (3) Rates paid by account type

Realistically need for an entire rate cycle to observe rate & balance behaviors

Product mapping & type consistency over time frame Consider ALM model set up

Analyze rates vs. market rates & economic factors Single factor LIBOR or Fed Funds great starting point

80/20 principle at work here Easy to understand, explain, and model Initial and lag effects (Arnold & Hawkins 1999, Poorman & Hawkins

2001) Step-wise multi-factor model

May have greater explanatory power (R2) May be difficult to understand, explain, and model Initial and lag effects

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core deposit studies and behavioral inputs: better practices Integrate rate and balance behaviors at product level

Need entire rate cycle & complete data set Need well-defined behavioral equations (“Valuing Core Deposits”,

Sheehan, 2004) Validation issues (out of sample & back testing)

Use customer data to understand depositor behaviors Issue: Customer A has 5 products, how does the customer manage his

portfolio? Customer moves money between products; looks like savings goes

down but actually moving money to MMDA or Promo CDs. Data and analytical complexity.

May need to integrate with CRM system & customer demographics balance migration between accounts balance changes within accounts new & closed accounts

Drives pricing decisions, need management/organizational buy in

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is there a “best” theoretical approach to core deposits? Jarrow model is most often cited:

The arbitrage-free valuation and hedging of demand deposits and credit card loans”, Robert A. Jarrow, Donald R. van Deventer, 199

Using a market-segmentation argument, core deposits are equated with an exotic interest-rate swap and valued via an arbitrage-free valuation methodology. In this model, balances “change randomly based on both the level and average of past market rates” (rates=Treasury rates).

They due note valuation is firm-specific

Valuation of deposit is:

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is there a “best” theoretical approach to core deposits? Short answer is “No”. Longer answer is that the usually cited, theoretically correct

academic articles with closed form solutions may result in nonsensical durations and values However, there have recently (2007-2010) been Core Deposit articles

that make sense from both a theoretical and practical perspective. There are primarily from Europe.

My favorite title is: “Optimal Deposit Pricing: There is no ‘One-Size-Fits-All’’ Valuation Approach” Blochlinger and Zurcher, 2010 “The resulting Nash equilibria agree with the empirical finance

literature on deposit pricing: size matters.” “We show that there is no ‘one-size-fits-all’ approach, that is, the

valuation for deposit accounts must be bank-specific.” Three bank strategies are noted for pricing & valuation.

However, FASB has spoken!

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Economy & Finance

Fiserv risk core poorman 2011