​Case Study: Deposit Valuation Analysis Overview

Transcript

Case Study: Deposit Valuation Analysis Overview

0:00 
Hey everybody. Welcome to the first of our two-part case study on valuing non-maturity deposits, and, moreover, using that information to think about making better funding decisions.0:20 First, a quick introduction of myself.
0:22 
My name is Sean Carraher, and I'm the Senior Financial Strategist here at the Home Loan Bank.
0:27 
I just started in May of 2022, and as I record this in mid-July of 2022, I've been here just about two months.
0:34 
I have more than 20 years’ experience in banking and financial services and have been the treasurer of two different member banks of the Home Loan Bank Boston --
0:45 
two multi-billion dollar banks here in Boston and the immediate area.

0:49 
I've chaired ALCO committees, created and managed risk and profitability frameworks, and identified and executed a number of different funding and derivative strategies over the years.
1:00 
So, why should we take a swing at valuing our non-maturity deposits?
1:04 
And perhaps evenmoreover, why is somebody from the Home Loan Bank leading a discussion around valuing non-maturity deposits?

1:11 
Well, there's a few different reasons, but probably the headline reason of which is to enable better funding decisions.
1:18 
If we understand the value of customer deposits, we can make better overall funding decisions, including the appropriate use of wholesale funding on our overall balance sheet.
1:29 
It also helps determine the value of products and general business strategy.
1:33 
So, we could figure out the value of particular product types such as DDAs, relative to savings, or whether a particular branch is profitable or not,
1:43 
and ultimately would help … determine the value of customer relationships.
1:49 
There are different parts of a relationship, of course, but we might want to value the non-maturity deposit relative to a lending relationship or relative to fee income associated with a particular deposit.
2:01 
But how do we go about thinking about valuing a non-maturity deposit, because if we just put it in the context of accounting, non-maturity deposits look like they are a source of expense.
2:12 
Literally, they're a source of expense on our P&L, and they're also a liability on our balance sheet.
2:18 
They come at operational costs, and they come with attendant costs such as deposit insurance.
2:23 
And yet, I think everybody would agree that non-maturity deposits are a major source of economic profitability for our financial institution.
2:32 
They fund the asset base.
2:34 
They have attractive relative pricing, relative, usually, to other funding sources.
2:39 
They have a long life. They have limited volatility, and they're generally uncollateralized.
2:44 
And so, we can see this sort of tension that exists on the balance sheet between the fact that these liabilities incur expenses and yet economically seem to have a reality that's very much at odds with the accounting constructs.
2:59 
So, if we think about a fixed-income security that would live on the asset side of our balance sheet,
3:04 
we realize that the valuation of it, it's pretty straightforward, even if we didn't have access to a Bloomberg Terminal, or we didn't have a quote from a custodian or a broker dealer, we could estimate the value of any given bond.
3:22 
Pretty well, especially if it's just a bullet structure with determined cashflows.
3:26 
So, in this example, on the left-hand side of this slide, um, we assume that there's a bullet bond with 2% annual coupons and three years remaining to maturity.
3:38 
And I can observe through, just market observations, what the discount rate should probably be for each one of those years, apply that to the cash flows,
3:49 
figure out the present value of each one of those cash flows, and then just add up the present value of those cash flows. And in this example, you'd come to a value of the bond of about 96.36.
3:58 
But in non-maturity deposits, we don't have the benefit of any one of those parameters.
4:03 
There's no contractual pricing, there's no contractual term.
4:06 
And even the very liquidity is not guaranteed.
4:10 
If we all agree that non-maturity deposits have significant economic value, then how can we go about quantifying that value?
4:19 
If it's got significant economic value to start with, we know that there must be a way to put some numbers around this that value it in a way that's a little bit more than the abstract.
4:29 
Taking a step back, there's some intuition that goes into figuring out the value of our deposits that
4:36  
I think most people listening would share.
4:40 
If you're thinking about the four major non-maturity types, DDAs, NOWs, savings, money markets, which do you think is most valuable?
4:50 
If we think about the way that different accounts within product types behave, do they all exhibit the exact same behaviors?
4:58 
Does an individual have the same behaviors as a business? That somebody who has had an account for five years have the same behaviors as somebody who's just opened up an account a couple of months ago?
5:07 
And does the interest-rate environment matter? If rates are up, are deposit accounts worth more or less than if the interest-rate environment is a zero-rate environment?
5:18 
So, to start to answer some of those rhetorical questions on the prior slide, I think most listening to this call would agree that DDAs have the highest value of the four major non-maturity types.
5:28 
Certainly, a higher value than money market accounts, and I think we'd all agree that not every account is created equal.
5:36 
That different types of accounts exhibit different types of behaviors and that in a different interest-rate environment,
5:42 
non-maturity deposits are worth more or less as we were in a zero interest rate environment in recent years,
5:49 
deposit valuations were simply worthless because it was everything was a zero rate or close to it.
5:55 
And now as deposit rates rise, the overall interest-rate environment is rising even more rapidly.
6:01 
And so those non-maturity deposits are actually worth more.
6:06 
And as we think about what's informing our intuition, what are the qualities that are informing our natural intuition about the value of our deposit base,
6:15 
we can start to think about quantifying each one of those attributes.
6:21 
And when we think about why do we think that DDAs are worth more than MMDAs?
6:25 
First, it's lower price sensitivity.
6:28 
DDAs simply don't pay interest or very much interest compared to money market accounts
.6:32 
And usually in part because of that, DDAs have longer lives than other types of accounts.
6:40 
And they also typically have lower aggregate volatility
6:43 
because those funds are typically used for day-to-day income and expenses and not for extraordinary activity.
6:50 
They're not things that are here waiting for investment somewhere else.
6:53 
They’re ongoing accounts that are going to have naturally inflows and outflows, but the overall balances in aggregate are likely to stay very similar.
7:03 
So, as we start to think about what our intuition is for the attributes that ascribe economic value to deposits, we can then think about if we have any metrics that are associated with those attributes.
7:17 
And the good news is, as you can see on the slide, and, as we'll, we'll talk about in more depth in Part 2, we already have those metrics.
7:25 
It's just assembling those metrics in a framework that will allow us to more discretely quantify the value of the deposit.
7:32 
So first, what are the attributes?
7:34 
It's the degree to which pricing adjusts with market changes, and that metric is a beta. It's a deposit beta.
7:40 
If money market accounts go up 60% relative to the Fed Funds rate, that's the deposit beta, and that's the degree to which the pricing will adjust.
7:50 
It's the speed with which pricing will adjust, and that's usually a lag term that we might have in an NII model.
7:56 
Are those prices going to change in two months, three months, six months, maybe more, maybe less.
8:02 
But the speed with which the pricing will adjust will inform the value of the deposit.
8:07 
It's the volatility of the balances at any given time.
8:10 
And in our eve, or any of our modeling, there's some decay rate that's being used in order to value the long-term value of our liabilities. And it's the amount of time over which a deposit is expected to remain outstanding.

8:24 
That's the average life.
8:27 
And then, finally, there's an opportunity benefit of maintaining client funds relative to wholesale funding.
8:32 
And we can estimate that through a concept called term liquidity premium.
8:36 
And as we think about putting together a framework that will value our deposits in a more rigorous, quantitative manner, that framework should use some combination of all of these economic attributes.
8:50 
So, in part two of this case study around deposit valuation, we'll introduce the specifics of that framework,
8:58 
building off all the ALM
8:59 
metrics identified on the prior slide, to discreetly value our deposits.
9:05 
And then we'll think about a way to combine those valuations of our deposit types and our overall funding mix to make decisions around introducing deposit specials or taking advances from the Home Loan Bank.
9:22 
Thanks for your time and hearing this introductory case study today.
9:27 
And please feel free to reach out to me with any questions or concerns that you have.

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