Lending & Credit Risk

Key Role of Core Deposits in Interest Rate Risk Management – Part 1

August 16, 2013

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One of the most important sources of funding for financial institutions is checking accounts and regular savings accounts. Depending on the institution, such accounts often represent between 10% and 50% of funding. While they are the most basic of deposit services, a great deal of controversy surrounds analyzing the sensitivity of these core deposits to changes in market rates.

This is the first of a series of articles that focus on how you might evaluate the rate sensitivity of your core deposits. It begins by discussing the two markets available to institutions for managing their interest rate risk, retail markets and wholesale markets. The retail market discussion focuses on importance of pricing in controlling demand for products and services and introduces techniques for making pricing decisions. Subsequent articles will build upon the pricing base established in this article by showing you how to use readily available financial information to evaluate the rate sensitivity of core deposits.

How Institutions Manage Interest Rate Risk

Strategies aimed at managing interest rate risk are generally implemented in two markets, wholesale markets and retail markets. The methods used by institutions to modify their interest rate risk are different in each market.

Wholesale Markets

The primary wholesale markets used by financial institutions are the securities markets where financial instruments are bought and sold. Financial instruments offered in the securities markets are underwritten to meet a set of standards that are commonly recognized throughout the market. For example, when a broker attempts to sell an institution a five-year US Treasury bond, the buyer knows by definition how it gives off its cash flows. Once a bond’s issue date and rate is known, comparative prices can readily be obtained from other brokers because their bonds will offer identical cash flow characteristics. Generally, an institution will buy the bond from the bond house offering the best price.

Very few financial institutions are big enough and influential to play a significant role in setting the price of instruments sold in the wholesale markets. Consequently, an institution will either accept the market rate/price offered by the market or not participate in the market. Institutions manage their interest rate risk in the wholesale markets by selling products with undesirable interest rate risk characteristics and purchasing products that have desirable characteristics.

Retail Markets

Retail markets are markets in which an institution negotiates the rate on its products and services with its customers. The customers can be consumers or businesses. The negotiation occurs either across the table from the customer, or through the actions taken by the institution’s pricing committee. An important difference between the retail markets and wholesale markets is that retail products are not standardized, at least not in the eyes of the customer. Retail products have features, rate-related and non-rate related, that differentiate one institution’s products from those offered by the institution down the street, across the state and across the country.

The rate-related features are components of a product’s price related to its rate that are important to the customer. An example would be interest payment frequencies, compounding methods and early withdrawal penalties on CDs. Because institutions often underwrite products that don’t meet national standards, these features vary from institution to institution.

Non-rate related features are components of a product’s price that are not related to its rate. Such factors as location convenience time convenience, other account relationships, safety and soundness and customer loyalty may be as important to a CD customer as rate.

Generally, the greater the value a customer places on a product’s rate-related and non-rate related features, the less sensitive the customer will be to the rate paid on the instrument. Because the values placed on rate-related and non-rate related features will vary from customer to customer, their responses to an institution’s pricing actions will also vary. Financial institutions control the demand for their products and services by varying their rates relative to rates offered by competitors.

Pricing is the primary technique used by institutions in managing interest rate risk in the retail markets. If a deposit account has desirable interest rate risk characteristics, an institution will raise its rates relative to its competitors, bringing in more rate sensitive customers. If a deposit account has undesirable interest rate characteristics, the institution will lower its rates relative to competitors, losing some of its rate sensitive customers in the process. Because pricing is a key tool in managing interest rate risk, it makes sense for institutions to develop a mechanism for evaluating pricing alternatives and making pricing decisions.

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Making Intelligent Pricing Decisions – A Marginal Cost/Benefit Approach

In evaluating pricing alternatives, we suggest that you evaluate the marginal cost or benefit of one pricing alternative as compared to another. This marginal cost concept is best illustrated with an example.

Yesterday ABC Institution had $10 million in passbook savings accounts at an interest rate of 3.0%. As Figure 1 illustrates, annual interest expense is $300,000.

Assume that market rates increase by 0.5% today and that our competitors respond by raising their passbook rates to 3.5%. ABC might consider two alternative responses; raise their rates to 3.5%, or leave them at 3.0%. Of course, ABC has a range of options between the two extremes. For example, it could raise passbook rates by half of the competitive change to 3.25%. While this example only looks at the two extreme options, any other pricing option could be evaluated in the same way.

Pricing option #1 is to raise passbook rates to the competitors’ market rate of 3.5%. It would be reasonable to assume that if ABC’s rate sensitive passbook customers were content at 3.0% yesterday, they’ll be happy with 3.5% today.

Annual interest expense on the $10 million will increase to $350,00O.

Pricing option # 2 is to leave passbook rates at 3.0%. It would be reasonable to assume that ABC’s more rate sensitive customers will move their balances out of passbooks if ABC doesn’t match competitive market rates. Assume that 10% of the passbook customers move their balances leaving $9 million at 3.0%, an annual interest expense of $270,000.

In deciding which alternative to pursue, ABC needs to look at the marginal cost of holding on to ‘the $1 million of rate sensitive funds; ABC determines the marginal cost by examining differences in the results from the two pricing options.

As Figure 1 shows, if ABC doesn’t raise the rates on the passbooks, they will lose $1,000,000 in balances from the service line. It will also save $80,000 in annual interest expense.

The marginal cost of holding on to the $1 million is calculated by dividing the increased interest expense by the increased balances.

80,000 / $1,000,000 = 8%

But how can it cost 8% to hold onto 3.5% passbook money? The answer to the question is the key to making intelligent pricing decisions on retail accounts.

There are actually two different costs associated with raising passbook rates to 3.5%. First, ABC must pay 3.5% to the $1 million of rate sensitive passbook customers at an annual cost of $35,000. If it doesn’t it will lose the balances. In addition, ABC must pay an additional 0.5% to the $9 million of non-rate sensitive passbook customers, at an additional cost of $45,000. This additional cost is incurred even though the customers would have left their funds on deposit at the lower 3% rate.

$1,000,000 x 3.5% $35,000

$9,000,000 x 0.5% $45,000

Total Additional Expense $80,000

Now that ABC knows that the marginal cost of holding on to the $1 million in rate sensitive money is $80,000 in annual interest expense or 8%, how does it use this information in deciding whether to raise the rate?

Using the Marginal Cost/ Benefit in Decision Making

In deciding whether to raise the rate, ABC needs to compare the marginal cost to two other rates; the yield it is receiving on the asset supported by the $1 million and the rate we would have to pay for the funding from some other source.

Comparing to the Yield Received on the Asset

In its first comparison, ABC should determine whether the marginal cost of retaining the rate-sensitive passbooks (8%) is lower than the yield it is receiving on the asset supported by the $1 million. Unless it is earning at least an 8% yield, ABC would be better off selling the asset and using the proceeds to fund the outflow of the rate sensitive passbooks.

The asset yield used in the comparison would be net of any adjustments for the asset’s risks and servicing costs. For example, the yield on a credit card may drop from 14% to 7% after backing out charge-offs and the cost of an institution’s credit card operations.

Comparing to the Alternative Cost of Funding

The second comparison looks at whether ABC can raise the $1,000,000 somewhere else at a marginal cost of less than 10%. For example, it may be able to borrow the funds from a wholesale source like the nearby Federal Home Loan Bank at a cost of 6%. By doing so ABC would lower its cost of funds on the $1,000,000 by 2%. Or possibly, ABC can convince its rate sensitive passbook customers to move their money into some other account at the institution. It can afford to pay up to 8% in the other account and break even.

Say, for example, ABC convinces its rate sensitive passbook customers to move the funds into a 90 day CD costing 4.5%. The customers will be happy because instead of receiving 3.5% on the funds, they will receive 4.5%. ABC will also be happy because instead of incurring a marginal cost of 8% to keep the $1 million in the passbook service line, it instead will pay 4.5%.

Relating the Mix of Rate Sensitive/Non-Rate Sensitive Customers to the Marginal Cost

The win-win situation in the previous example occurs because of the high cost for paying up for non-rate sensitive money to hold onto rate sensitive money. As Figure 2 shows, the greater the percentage of a service line’s customers that are non-rate sensitive, the higher the marginal cost of keeping the rate sensitive customers.

The chart shows that as the percentage of non-rate sensitive customers in a service line increases, so does the marginal cost of paying up to keep rate sensitive customers in the service line.

This explains why a financial institution is more likely to pay up for CDs in a rising rate environment than for passbook accounts. Because the CDs have less rate-related and non-rate related features, the customers in the service line are more rate sensitive. And the more rate sensitive customers in a service line, the less non-rate sensitive customers that will receive a higher rate in order to hold onto the rate sensitive customers.

As this article has illustrated, there are compelling financial reasons for not paying up for checking and savings account money in a rising rate environment given the percentage of the customers in the service line that are non-rate sensitive.

This leads naturally to the conclusion that even though these accounts are contractually both immediately repricable and withdrawable, they aren’t as rate sensitive as instruments with similar repricing characteristics such as fed funds or variable-rate commercial loans. But its one thing to believe transaction money isn’t terribly rate sensitive and it’s another thing to prove it to the satisfaction of your examiner. For information on evaluating, documenting, and supporting your conclusions as to the rate sensitivity of this important source of funding, contact Abrigo Advisory Services.

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Key Role of Core Deposits in Interest Rate Risk Management – Part 1

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