Why It Is Critical to Update Your Core Deposit Study
A financial institution’s internal pricing decisions and strategies are crucial to the safety and the soundness of the organization and to its interest rate risk management process in particular. While it is unclear whether we will remain in a rising wholesale interest rate environment, given some of the Federal Reserve’s recent discussions on the fed funds rates, we all know and expect that in many areas of the U.S., retail rates will probably go higher since we are in a tight liquidity situation. In some markets, retail deposit rates are still catching up to the past increases on the wholesale side. In other areas where loan demand remains healthy and robust, demand for funding may be putting pressure on rates to increase regardless of the Fed’s decision. This leaves many bankers concerned about the potential impact a rising rate environment could have on their cost of funds. Consequently, institutions will most likely be busy with budgeting and financial planning to accurately forecast the impact a rising retail rate scenario will have.
Time to update to the core deposit study?
One of the most critical assumptions in this forecast is what we use for our deposit portfolios, specifically for non-maturity accounts. If you are one of the lucky institutions having already completed a core deposit study, you have your own decay rates (deposit attrition) and repricing coefficients (beta factors), which describe how deposits would behave and reprice in different interest rate scenarios. This is one of the most scrutinized examination topics and you need to be ready to answer for yours.
There are a number of reasons why financial institutions should update their core deposit studies. Here are a few:
- The change in the shape of yield curve will impact the assumptions. Currently, the flat and inverse yield curve makes it harder to improve earnings since the long-end pressures loan rates and rising short-end means higher funding costs. This is especially true for non-maturity deposit accounts, since they are priced on the short end of the yield curve and whole balances are immediately repriceable as rates change. How quickly your financial institution responds to rate changes will also impact your cost of funds. An updated pricing beta can have a huge impact on interest expense and the bottom line with response to market rate changes.
- As economic conditions change, so do the decay rates and betas. The surge balances will leave the institution during economic recovery and flow into the institution during recessions, and this ultimately impacts the cash flow assumptions. How well do you know your surge/volatile funds balances?
- An updated core deposit analysis helps you to better understand your customer base, not just from the historical base but also related to current trends and behaviors that will impact retention and growth. An updated study will give you the latest trends and changes in your customer base, especially new account and balance trends.
- An updated core deposit study can ascertain changes in spread between non-maturity accounts and time deposits. The wider the spread, the more funds flow to time deposits, since customers get enough premium to lock their rates into longer terms. The narrower the spread, the more funds flow to non-maturity accounts and the more likely customers are waiting for rates to rise. The influx of internal flows between non-maturity and time deposits will amplify cost of funds and surge deposits balances.
- The beta lags change; lags are longer in rising rate environments and the opposite is true in declining rate environments, so an updated core deposit study will account for this. Financial institutions generally are reluctant to raise rates during the rising rate environments, however, they are very quick to take down offering rates during declining rate environments.
- Of course, based on an institution’s needs, there may be questions about choosing to be aggressive or non-aggressive with pricing decisions and perhaps overriding actual study results. The institution-specific business strategies and planning will impact the decay rates and betas.
It is very important with the ALM models to calculate and capture all the specific sources of performance and interest rate risk that converge in the institution’s balance sheets. The non-maturity deposit area is one of those closely monitored. The specific management approaches to retain and grow non-maturity retail accounts impact the overall income sensitivity, the new liquidity management guidelines, therefore impacting economic value of equity (EVE) sensitivity and overall risk management strategies.
We recommend annually updating your core deposit study based on your institution-specific strategies, complexity and size. A current core study gives us cash flow details to create a better balance sheet mix and growth strategy, ultimately providing better overall risk management for the financial institution.