Modeling Non Maturity Deposits

Modeling Non Maturity Deposits

Robert J. Wyle, CFASenior Director, Moody’s Analytics

April 11, 2023

Agenda

» 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 FTP

2

April 11, 2023

Introduction

» Non maturity deposits include demand deposit accounts (DDAs), negotiable order of withdrawal (NOW) accounts, money market deposit accounts (MMDAs), and passbook type accounts.

» These deposits play and important role in the profitability and interest rate risk management of depository institutions.

» The term non maturity arises form the fact that these deposits, unlike other types of bank funds, such as CDs, carry no explicit maturity date.

» The lack of a contractual maturity for NMD necessitates the development of behavioral models based on time series analysis.

» NMD behavioral models are needed for the estimation of deposit decay/runoff, interest cash flows, and balance projections needed to calculate market value, earnings, and funds transfer pricing

» Macro economic variables play an important role in terms of runoff and the cannibalization of existing deposits into different deposit categories and cash.

» It is critical that the NMD modeling assumptions between NII forecasting, market valuation, and FTP functions be consistent.

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NMD CHARACTERISTICS AND BEHAVIOR

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April 11, 2023

Data Sources

5

» 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

April 11, 2023

6

Funding Sources by Liability Type

2001Q4

2002Q3

2003Q2

2004Q1

2004Q4

2005Q3

2006Q2

2007Q1

2007Q4

2008Q3

2009Q2

2010Q1

2010Q4

2011Q360

62

64

66

68

70

72

74

76

15

16

17

18

19

20

21

Retail funding (left axis) Wholesale funding (right axis)Re

tail

(%)

Who

lesa

le (%

)

April 11, 2023

Y-variables

» Cross-sectional means’ of individual banks’ funding source time-series

» Modeled as relative % change

Models

Some 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 growth rate

» Higher consumer credit is followed by higher wholesale CDs, fed funds and repos

7

A Simple Time-Series Analysis of Funding Sources

𝛥𝑆𝑎𝑣𝑖𝑛𝑔𝑠𝑡 = 1.08+ 0.56∗𝛥𝑆𝑎𝑣𝑖𝑛𝑔𝑠𝑡−1 + 0.08∗𝛥𝑉𝐼𝑋𝑡−1 𝛥𝐶ℎ𝑒𝑐𝑖𝑛𝑔𝑠𝑡 = 1.22− 3.24∗𝛥𝐿𝑂𝐶𝑠𝑡−1 𝛥𝑆𝑚𝑎𝑙𝑙𝐶𝐷𝑠𝑡 = 3.54+ 3.82∗𝛥𝑇𝑟𝑠𝑦2𝑌𝑡−1 − 1.05∗𝑉𝑜𝑙𝑇𝑟𝑠𝑦2𝑌𝑡−1 + 4.02∗𝛥𝑆𝑝𝑟𝑒𝑎𝑑3𝑀𝐶𝑜𝑟𝑝𝐵𝐵𝐵𝑡−1 𝛥𝐽𝑢𝑚𝑏𝑜𝐶𝐷𝑠𝑡 = −3.44+ 3.42∗𝛥𝑇𝑟𝑠𝑦2𝑌𝑡−1 + 0.63∗𝛥𝐶𝑜𝑛𝑠𝐶𝑟𝑒𝑑𝑖𝑡𝑡−1 + 0.24∗𝛥𝐿𝑜𝑎𝑛𝑠𝑡−1 𝛥𝐹𝑒𝑑𝐹𝑢𝑛𝑑𝑠𝑡 = −2.32+ 4.98∗𝛥𝐿𝐼𝐵𝑂𝑅3𝑀𝑡−1 + 0.86∗𝛥𝐶𝑜𝑛𝑠𝐶𝑟𝑒𝑑𝑖𝑡𝑡−1 + 0.28∗𝛥𝐹𝑒𝑑𝐹𝑢𝑛𝑑𝑠𝑇𝑜𝑡𝑎𝑙𝑡−1 𝛥𝑂𝑡ℎ𝑒𝑟𝑆𝑇𝐵𝑤𝑖𝑛𝑔𝑠𝑡 = −5.91+ 1.93∗𝛥𝐶𝑜𝑛𝑠𝐶𝑟𝑒𝑑𝑖𝑡𝑡−1

April 11, 2023

Modeling Funding Cost Dynamics

8

– 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 t

l m

r r X Checking rate Savings rate CD Retail rate CD Wholesale

rateFed Funds And Repo rate

# of lags in Y 1 2 3 3 1

Adj-R2 (%) 30.54 60.73 62.06 64.07 80.51

significant variables

FedFund_ChGDP_Ch_lag1

LIBOR1M_ch T2Y_ch_lag1

LIBOR3M_ch T2Y_ch_lag2

LIBOR3M_ch T2Y_ch_lag2

FedFunds_ch

April 11, 2023

Deposit Modeling and Stress Testing Conclusions

» Macro economic variables matter when constructing stress testing assumptions because macro economic exogenous variables influence retail consumer and institutional behavior.

» Whereas most banks do not have experience with bank runs, there are a wealth of banks who have. All of these banks must file FDIC call reports. Therefore, banks can construct stress testing scenarios based on publicly available time series data.

» Surge deposits need to be removed from the modeling of NMD and model based upon macro economic models.

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April 11, 2023

NMD MODELING BASICS

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11

Interest Rate Risk – Review» The market value (price) of an interest earning asset or liability is the

present value of all future cash flows.

» In the case of a fixed rate, fixed maturity ,option free bond (i.e. 10-Year Treasury bond), the future cash flows are known with certainty. In this instance, changes in the bond price are driven by changes in market/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 the bond/asset.

» Similarly, the above also applies to liabilities where the future cash flows represent payments versus receipts.

» As many of the Bank’s loan and security positions are fixed rate, these positions gain in value with falling rates and fall in value with rising rates. Whereas, fixed rate liability positions (CDs) gain in value in rising rates and decline in value in falling rates.

April 11, 2023

12

Interest Rate Risk - Duration

» The most often used metric to quantify the interest rate sensitivity of an asset or liability is duration. Duration in this context does not simply mean average life, but rather refers to the change in the market value of an asset or liability for a change in 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 the market value of the asset to decline by 5%.

» For a fixed rate instrument, the longer the maturity of a fixed rate instrument the higher the duration. Floating rate instruments have durations that are limited to the reset period of the index rate, provided they do not contain embedded caps, floors, or other rate provisions.

» The duration of a financial institution’s equity is a function of the asset/liability mismatch scaled by the institutions leverage; consider the following example:

Amount Duration Weighting FactorAssets 10 B 2.00 20Liabilities 9 B 1.50 13.5Equity 1 B 6.50 6.5

April 11, 2023

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Interest Rate Risk – Equity at Risk• The net change in the Market Value of the Bank’s asset, liability and derivative

portfolio is the interest rate risk exposure to the Bank’s equity or Equity at Risk. Typically, the Market Value sensitivity of the Bank’s assets will exceed the Market Value sensitivity of the Bank’s liabilities. The resulting exposure is then hedged to be within policy limits by the derivative portfolio.

Change in Market Value by Parallel Rate Shock 1/31/05

Assets (Long)Market Value -100 -50 -25 +25 +50 +100 +200

Investment 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 +200

Retail 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) 72 142 276 529

HedgingMarket Value -100 -50 -25 +25 +50 +100 +200

Derivatives 33 -302 -152 -76 75 151 307 629

Equity at Risk 1/31/05 1,769 -193 -68 -27 15 19 8 -62

April 11, 2023

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Interest Rate Risk - Modeling Assumptions

» While there are numerous modeling assumptions used in estimating Equity at Risk, many of these assumptions can be validated by looking to market prices for liquid securities (prepayment rates on a mortgage loan portfolio).

» However, in some cases the assumptions behind the valuation cannot be validated from market data. In these cases the asset or liability is institution specific. This is either due to unique contractual features or specific customer preferences and behavior.

» When evaluating the market value sensitivity of Non-maturity deposit accounts, evaluating account specific customer behavior is necessary to draw inference as to the price sensitivity of the account. Furthermore, evaluating account specific institution behavior is necessary if product strategy is shifting over time or is likely to shift in the future.

April 11, 2023

15

Deposit Modeling - Summary

» In order to calculate the market value of a deposit account, the cash flows that the account generates must be modeled. The discounted present value of these cash flows against the current curve generates the market value.

» The two critical items to be determined in modeling the cash flows of a Non-maturity account, and therefore the interest rate sensitivity, are:

– Deposit balance retention - the decay of deposits in existing accounts over time.

– The degree of correlation (pricing coefficient) between the rate paid to the customer (offered rate) on the account and short term interest rates.

April 11, 2023

Retention Rate

» The retention rate is defined as the percentage of balances retained from a certain point in time forward for a constant set of accounts. This includes both attrition and churn.

» Balances are assumed to undergo a natural decay as existing accounts run off over time

16

1t

Retention

tBalance

BalancesNewAccounttBalance

April 11, 2023

17

Non-Maturity Deposit Balance Survival/Decay Function, by Category, 01/2002-12/2004

0

10

20

30

40

50

60

70

80

90

1001 9 17 25 33 41 49 57 65 73 81 89 97 105

113

121

129

137

145

153

161

169

177

185

193

201

209

217

225

233

Age, in month

Su

rviv

al R

ate,

%

Checking Saving MM1 MM2 MM3 MM4 MMP1 MMP2 MMP3

April 11, 2023

18

Market Value and Duration

» Identifying balance retention (balance decay) allows for the modeling of principal cash flows, while the correlation of offered rates to market rates allows for the modeling of interest cash flows.

» Determining a set of principal and interest cash flow for a given yield curve 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 the change in market value (price), where market value was determined from a given pricing coefficient, retention and yield curve.

V0 = initial price

V- = price if yield changes by -y

V+ = price if yield changes by +yΔi = change in yield

De =V- - V+

2(V0)(Δi )

April 11, 2023

19

Effect of Model Inputs on Duration

• Accounts that exhibit low correlation with movements in short rates will exhibit higher duration for 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 market rates, high retention will result in higher duration.

Low Retention High Retention

Low Correlation to Market Rates

Medium Duration High Duration

High Correlation to Market Rates

Low Duration Medium Duration

April 11, 2023

20

Estimated Duration Sensitivity

Retention 85.00% 80.00% 75.66% 70.00% 60.00%100.0% 0.84 1.22 1.57 2.02 2.85

90.0% 0.63 0.88 1.10 1.39 1.91 83.4% 0.54 0.73 0.90 1.12 1.52 80.0% 0.50 0.67 0.82 1.01 1.36 70.0% 0.41 0.53 0.64 0.78 1.02 60.0% 0.35 0.44 0.52 0.62 0.80

Retention 45.00% 35.00% 30.00% 25.00% 20.00%100.0% 4.08 5.16 5.71 6.28 6.87

90.0% 2.61 3.21 3.52 3.83 4.14 80.0% 1.82 2.20 2.36 2.58 2.78 70.0% 1.35 1.61 1.74 1.87 2.00 60.0% 1.04 1.23 1.32 1.42 1.51 50.0% 0.83 0.97 1.04 1.11 1.18

Money Market Plus Tier 3 DurationRate Coefficient

Sweep DurationRate Coefficient

April 11, 2023

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Estimated MVPE/P&L Impact

Retention 85.00% 80.00% 75.66% 70.00% 60.00% Retention 85.00% 80.00% 75.66% 70.00% 60.00%100.0% (2,761) 14,583 29,911 50,295 87,440 100.0% (373) 1,972 4,044 6,800 11,822 90.0% (12,009) (792) 9,043 22,011 45,322 90.0% (1,624) (107) 1,223 2,976 6,128 83.4% (16,199) (7,556) - 9,929 27,684 83.4% (2,190) (1,022) - 1,342 3,743 80.0% (17,946) (10,332) (3,685) 5,040 20,611 80.0% (2,426) (1,397) (498) 681 2,787 70.0% (21,872) (16,470) (11,765) (5,604) 5,346 70.0% (2,957) (2,227) (1,591) (758) 723 60.0% (24,568) (20,594) (17,137) (12,617) (4,602) 60.0% (3,322) (2,784) (2,317) (1,706) (622)

Retention 45.00% 35.00% 30.00% 25.00% 20.00% Retention 45.00% 35.00% 30.00% 25.00% 20.00%100.0% 212,416 344,817 413,512 483,956 556,215 100.0% 28,719 46,619 55,907 65,431 75,200 90.0% 30,480 104,765 142,613 181,105 219,765 90.0% 4,121 14,164 19,281 24,485 29,712 80.0% (66,738) (19,860) - 27,164 51,431 80.0% (9,023) (2,685) - 3,673 6,953 70.0% (124,724) (92,771) (76,697) (60,945) (44,625) 70.0% (16,863) (12,543) (10,369) (8,240) (6,033) 60.0% (162,208) (139,248) (128,011) (116,400) (104,760) 60.0% (21,931) (18,826) (17,307) (15,737) (14,164) 50.0% (188,136) (171,068) (162,671) (154,070) (145,455) 50.0% (25,436) (23,128) (21,993) (20,830) (19,666)

1EAR sensitivity assumes $1.35 million of 10 year equivalence per $10 million of risk.

Sweep - +200 MVPE Sweep - P&L Impact ($Thous$)1

Rate Coefficient Rate Coefficient

Money Market Plus Tier 3 - +200 MVPE Money Market Plus Tier 3 - P&L Impact ($Thous$)1

Rate Coefficient Rate Coefficient

April 11, 2023

NMD VINTAGE METHODOLOGY – MORE ADVANCED

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Fundamentals

» What is a vintage methodology?

» What are the components of a vintage methodology?

How do I characterize

NMD maturities?

April 11, 2023

Vintage Runoff Methodology Defined

» A vintage runoff methodology seeks to segregate balances based on historical tranches called vintages.

» A vintage consists of all of the individual accounts for a non-maturity deposit account type that are opened in a particular month.

» Cash flow behavior characteristics are applied to each vintage by calculating the monthly runoff within each vintage.

» Therefore, the vintage account runoff model characterizes the manner in which accounts close over time.

April 11, 2023

January 2005 Vintage Decay

1/31/2005 2/28/2004 3/31/2004 4/30/2004 5/31/2004 3/27/2003 4/23/2002

1 `23456789

10

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Key Challenges

» How long and why?

» How to determine repricing assumptions and separate them from maturity assumptions if possible – rate risk vs. term risk

» How to segment portfolios to capture the key behavior characteristics defining cash flow

» Locking in profit

April 11, 2023

Balances

» Fixed Core Balances

– Long term stable source of funding

– Accounts where repricing characteristics don’t entail significant interest rate risk.

» 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 to the next.

April 11, 2023

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Core and floating balance decomposition

» The core volatile split may be determined in a number of ways:

– The difference between a moving average and the actual balance (not recommended)

– The lower bound for the 95% confidence leverage average monthly balances at the deal level. That is to say, next month, there is a 95% possibility that the average balance per account will be greater than the core balance.

– Linear regression

» The fixed core/floating core split can either be a negotiated rate or is the beta of the offered rate function.

April 11, 2023

Different Lives

» Liquidity Term

– Term corresponding to which cash flows are truncated

» Reprice Term

– Frequency with which the funds transfer credit for interest bearing accounts is repriced

» Re-Strip Term

– Term corresponding to how often the surviving balances within a vintage will be re-stripped

» Weighted average Life

– Term corresponding to the observed liquidity premium

April 11, 2023

NMD RETENTION AND OFFERED RATES

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April 11, 2023

Retention Rate Example

31

Jan 31, 20xxFeb 28 20xx

Vintage Vintage Vintage VintageAge Balance Age Balance SMM = (Feb Bal - Jan Bal)/Jan Bal

00 $ 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.

April 11, 2023

Runoff Example

32

Exponetial Model Piece-wise linear model  Start End % of OriginalConstant SMM Period Period Balance

5.00% 0 3 4.75%  3 7 3.98%

  7 10 3.32%       

Period Balance Balance  

0 $ 100.00 $ 100.00  

1 $ 95.00 $ 95.25  

2 $ 90.25 $ 90.49  

3 $ 85.74 $ 85.74  

4 $ 81.45 $ 81.76  

5 $ 77.38 $ 77.79  

6 $ 73.51 $ 73.81  

7 $ 69.83 $ 69.83  

8 $ 66.34 $ 66.51  

9 $ 63.02 $ 63.19  

10 $ 59.87 $ 59.87    

Here 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.

April 11, 2023

More Realistic Runoff Example

» In actuality, any deposit decay study should be a cross section of a homogeneous pool of NMDs.

33

Time0 1 2 3 4 5 6 7 8 Total

Vintage 1 Avg SMM1

2 1 Avg SMM2

3 2 1 Avg SMM3

4 3 2 1 Avg SMM4

5 4 3 2 1 Avg SMM5

6 5 4 3 2 1 Avg SMM6

7 6 5 4 3 2 1 Avg SMM7

8 7 6 5 4 3 2 1 Avg SMM8

9 8 7 6 5 4 3 2 1 Avg SMM9

10 9 8 7 6 5 4 3 2 Avg SMM10

11 10 9 8 7 6 5 4 3 Avg SMM11

12 11 10 9 8 7 6 5 4 Avg SMM12

13 12 11 10 9 8 7 6 5 Avg SMM13

c

c

April 11, 2023

Typical 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 behavior

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35

Offer Rate Functions

» The offered rate or paid rate function quantifies the correlation between the offered rate and benchmark short term interest rates.

» Generally, the offered rate in each future period is correlated with some market rate(s) in that period and the offer rate in

the previous period.

)1

(*1

t

LIBORt

LIBORt

OfferRatet

OfferRate

April 11, 2023

FUNDS TRANSFER PRICING NMD

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April 11, 2023

Intro 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 risk management system is translated into financial incentives for large and diverse organizations rooted in financial accounting systems. As such, the FTP concept 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 with suspicion by line unit managers. Borrowers from the book feel rates are too high and lenders to the book feel rates are too low. If large interest rate risk positions are taken within the book in an attempt to make profits, any resulting gains 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 transactions with the transfer pricing book. If there are losses, the transfer pricing book manager will be regarded as incompetent.”

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Why do we need Funds Transfer Pricing?

» Funds transfer pricing (FTP) is an internal measurement and allocation process that assigns a profit contribution value to funds gathered and lent or invested by the bank. It is a critical component of the profitability measurement process, as it allocates the major contributor 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 funding unit

» Evaluate the attractiveness of asset based activities separately from liability based activities to support ongoing pricing decisions

April 11, 2023

39

A Simple Example of FTP

Balance Sheet

Loan 5 Y

Customer PositionMarket Rate

2.1%3.0%

Contribution Margin

Assets: 0.9%

Position Customer

Deposit 2 Y

Market Rate

1.8% 1.6%

Contribution Margin

Liabilities: 0.2%

Treasury Contribution

0.3%

Interest Margin

1.4%

April 11, 2023

40

Creation of Profit Centers

Profit Center “Asset” Profit Center “Liability”

Deposit 2Y1.6%

Profit Center “Treasury”

Loan 5Y 2.1%

Financing 5Y 2.1%

Loan 5Y3%Client Client

Investment 2Y 1.8%

Deposit 2Y1.8%

asset / liability contribution is not affected by interest rate risk

Asset Contribution 0.9%

Liability Contribution 0.2%

Treasury Contribution 0.3%

interest rate risk is solely managed in the Treasury

total margin = asset contribution + liability contribution + treasury contribution

April 11, 2023

41

Calculation of the Three Components

t

Interest rate

Liabilities (Deposits)

Assets (Loans)

3.0%

5.0%

asset contribution

liability contribution

treasury contribution

Inte

rest

mar

gin

4.5%

3.5%

April 11, 2023

42

Common 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 to individual pools is derived either internally, based on actual rates earned or paid, or alternatively, 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 transfer rates to each source and use of funds at the time of origination. But rather than use a discrete series of pools, matched-term methods derive transfer rates from continuous term structure pricing curves that represent prevailing rates for wholesale investment/borrowing alternatives available to the institution.

April 11, 2023

FTP Methods – Strip Funding

» Strip funding is similar to the concept of replicating portfolios. That is, one can model any stream of cash flows with a portfolio of zero coupon bonds. Therefore, one can value that stream of cash flows by adding together the market values of each of the component zero coupon instruments. Similarly, if each cash flow of an instrument were match funded at the prevailing cost of funds, the discounted cash flow of the constituent strip of zero coupons should equal the price of the instrument.

» Strip funding is defined as the transfer spread that equates the price of an instrument with 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 points above the cost of funding.

» The transfer spread never changes once it is assigned unless there is a change in contractual 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 solving for the average transfer spread that equates the price at origination with the sum of the average discounted cash flows. Stochastic strip funding is typically used for instruments with embedded options like mortgages.

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April 11, 2023

Other FTP Methods

There are many other different types of transfer pricing methodologies used around the world besides strip funding.

» Average Rate Method

» Rate Index Method

» Weighted Average Life Method

» Duration Method

» Maturity Method

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April 11, 2023

Calculating 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 at least one of the core components.

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April 11, 2023

Calculating a Monthly FTP Rate

» The monthly FTP rate is the sum of the following three components:– 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.

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April 11, 2023

Calculating a Monthly FTP Rate

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Business DDA, December 2001

Vintage Vintage Vintage Vintage WeightedDate Age Balance FTP Rate Contribution

Jan-92 120 mo. $12,559,070 * 6.759% = 848,868Feb-92 119 mo. $9,677,942 * 6.713% = 649,680Mar-92 118 mo. $17,362,906 * 6.107% = 1,060,353Apr-92 117 mo. $16,821,151 * 6.026% = 1,013,643

. . . . .

. . . . .Sep-01 4 mo. $55,733,943 * 5.079% = 2,830,727Oct-01 3 mo. $97,694,409 * 4.686% = 4,577,960Nov-01 2 mo. $98,597,449 * 4.722% = 4,655,772Dec-01 1 mo. $91,699,526 * 5.031% = 4,613,403

+ $4,220,116,540 + 268,779,222

Fixed-Core FTP Rate: 268,779,222 / $4,220,116,540 = 6.369%

Fixed Core FTP Rate

April 11, 2023

Calculating a Monthly FTP Rate

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Floating Core FTP Rate

Business DDA, December 2001

Vintage Vintage Vintage Vintage WeightedDate Age Balance Liquidity Prem. Contribution

Jan-92 120 mo. $12,559,070 * 0.045% = 5,689Feb-92 119 mo. $9,677,942 * 0.321% = 31,095Mar-92 118 mo. $17,362,906 * 0.028% = 4,862Apr-92 117 mo. $16,821,151 * 0.256% = 43,012

. . . . .

. . . . .Sep-01 4 mo. $55,733,943 * 0.672% = 374,365Oct-01 3 mo. $97,694,409 * 0.695% = 678,488Nov-01 2 mo. $98,597,449 * 0.712% = 702,211Dec-01 1 mo. $91,699,526 * 0.624% = 572,572

+ $4,220,116,540 + 16,964,868

Months Liq. Premium: 16,964,868 / $4,220,116,540 = 0.402%

3-month moving average 3-mo. FTP rate: + 2.247%

Floating-Core FTP Rate: 2.649%

April 11, 2023

Calculating a monthly FTP rate- Vintage Runoff Model

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Volatile Balance $855,818,200 Volatile Balance Fraction 13.94%Fixed-core Balance $4,226,899,040 Fixed-core Balance Fraction 68.85%Floating-core Balance $1,056,724,760 Floating-core Balance Fraction 17.21%Total Balance $6,139,442,000 (20% of total core balance)

Over-night rate 1.930% Volatile FTP Component 0.269%Fixed-core FTP rate 6.369% Fixed-core FTP Component 4.385%Floating-core FTP rate 2.649% Floating-core FTP Component 0.456%

Monthly FTP rate 5.110%

Business DDA December 2001

Balances Balance Fractions

Rates FTP Components

April 11, 2023

Simpler Methods - Vintage Method Approximation

» Lock in the current FTC or a reasonable proxy. A good rule of thumb is to use an FTC that 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 to the current duration assumption per product or tier.

» The impact of new volumes and decay can be approximated by adjusting the initial FTC using a forward-looking moving average over time. This moving average is rolled forward over an assumed weighted average life equal to twice the existing duration per product category or tier. For example, The FTC0+1 would be 119/120th of FTC0 and 1/120th of the FTC0+1 spot rate for a 5 yr duration product. This growing average is then rolled forward using the same methodology.

» The balance used to calculate the dollar value for the FTC should be based on a core balance and a volatile balance. The core balance can be estimated using a number of approaches. The volatile balance is calculated as the difference between the month end balance and the core balance. The volatile balance is credited using a short term index i.e. one month LIBOR plus the term liquidity premium.

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Example

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Acctg Avg Vintage InterestBalance Duration Approx. FTP Expense NIM

Checking 375,918,649 5.00 4.95% 1,529,211 205,146 1,324,065Savings 189,990,316 1.05 1.77% 275,118 167,137 107,981Regular Money Market 550,133,781 2.87 3.01% 1,358,340 438,876 919,464Money Market Plus 2,776,755,694 1.04 1.78% 4,064,181 2,698,064 1,366,117

Total Transactional Deposits 3,892,798,440 1.68 2.26% 7,226,851 3,509,223 3,717,628CDs 2,274,740,044 n.a. 3.31% 6,178,520 6,090,546 87,974

Total Retail Deposits 6,167,538,484 2.65% 13,405,370 9,599,769 3,805,601Misc 5,589,761,271 2.36 2.52% 11,566,995 1,833,906 9,733,089

Total Deposits 11,757,299,755 2.59% 24,972,366 11,433,675 13,538,691

60 Day Avg Vintage InterestBalance Duration Approx. FTP Expense NIM

Checking 369,988,403 5.00 4.95% 1,502,136 205,146 1,296,990Savings 191,390,153 1.05 1.77% 276,952 167,137 109,815Regular Money Market 549,041,228 2.87 3.01% 1,354,027 438,876 915,151Money Market Plus (Ending Balance) 2,732,816,145 1.04 1.78% 3,997,043 2,698,064 1,298,979

Total Transactional Deposits 3,843,235,929 1.68 2.26% 7,130,157 3,509,223 3,620,934Misc 5,401,062,316 2.36 2.52% 11,165,354 1,833,906 9,331,448

Total Transactional and SDA 9,244,298,245 2.41% 18,295,511 5,343,129 12,952,382

CDs (Ending Balance) 2,250,118,608 n.a. 3.31% 6,103,635 6,063,529 40,106Total Deposits 11,494,416,854 2.59% 24,399,146 11,406,658 12,992,488

Over / (Under) Spot Product60 Day Avg Swap (1ML) Yield Spread NIM

Checking 11,020,513 1.78% 0.68% 1.11% 9,994Savings (3,235,743) 1.78% 1.07% 0.72% (1,903)Regular Money Market (1,681,138) 1.78% 0.98% 0.81% (1,113)Money Market Plus 0 1.78% 1.20% 0.58% 0

Total Transactional Deposits 6,103,633 1.78% 1.11% 0.67% 6,978Misc 207,764,395 1.78% 0.40% 1.38% 235,344

Total Deposits 213,868,028 1.78% 0.70% 1.09% 242,323

NIM, netNet NIM by Product:

Checking 1,306,984Savings 107,912Regular Money Market 914,038Money Market Plus 1,298,979

Total Transactional Deposits 3,627,913Misc 9,566,792

Total Transactional and SDA 13,194,705

CDs 40,106Total Retail Deposits 13,234,811

April 11, 2023

Simpler Methods - Moving Average Method

» Calculate all NMD FTCs using a moving average rate. The term of the moving average should correspond to the product level or tier level deposit duration. The point on the yield curve used to calculate the moving average should correspond to the duration as well.

» The balance used to calculate the dollar value for the FTC should be based on a core balance and a volatile balance. The core balance can be estimated using a number of approaches. The volatile balance is calculated as the difference between the month end balance and the core balance. The volatile balance is credited using a short term index i.e. one month LIBOR plus the term liquidity premium.

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April 11, 2023

Example

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Acctg Avg Moving InterestBalance Duration Avg Swap FTP Expense NIM

Checking 375,918,649 5.00 4.95% 1,529,211 205,146 1,324,065Savings 189,990,316 1.05 1.77% 275,118 167,137 107,981Regular Money Market 550,133,781 2.87 3.01% 1,358,340 438,876 919,464Money Market Plus 2,776,755,694 1.04 1.78% 4,064,181 2,698,064 1,366,117

Total Transactional Deposits 3,892,798,440 1.68 2.26% 7,226,851 3,509,223 3,717,628CDs 2,274,740,044 n.a. 3.31% 6,178,520 6,090,546 87,974

Total Retail Deposits 6,167,538,484 2.65% 13,405,370 9,599,769 3,805,601Misc 5,589,761,271 2.36 2.52% 11,566,995 1,833,906 9,733,089

Total Deposits 11,757,299,755 2.59% 24,972,366 11,433,675 13,538,691

60 Day Avg Moving InterestBalance Duration Avg Swap FTP Expense NIM

Checking 369,988,403 5.00 4.95% 1,502,136 205,146 1,296,990Savings 191,390,153 1.05 1.77% 276,952 167,137 109,815Regular Money Market 549,041,228 2.87 3.01% 1,354,027 438,876 915,151Money Market Plus (Ending Balance) 2,732,816,145 1.04 1.78% 3,997,043 2,698,064 1,298,979

Total Transactional Deposits 3,843,235,929 1.68 2.26% 7,130,157 3,509,223 3,620,934Misc 5,401,062,316 2.36 2.52% 11,165,354 1,833,906 9,331,448

Total Transactional and SDA 9,244,298,245 2.41% 18,295,511 5,343,129 12,952,382

CDs (Ending Balance) 2,250,118,608 n.a. 3.31% 6,103,635 6,063,529 40,106Total Deposits 11,494,416,854 2.59% 24,399,146 11,406,658 12,992,488

Over / (Under) Spot Product60 Day Avg Swap (1ML) Yield Spread NIM

Checking 11,020,513 1.78% 0.68% 1.11% 9,994Savings (3,235,743) 1.78% 1.07% 0.72% (1,903)Regular Money Market (1,681,138) 1.78% 0.98% 0.81% (1,113)Money Market Plus 0 1.78% 1.20% 0.58% 0

Total Transactional Deposits 6,103,633 1.78% 1.11% 0.67% 6,978Misc 207,764,395 1.78% 0.40% 1.38% 235,344

Total Deposits 213,868,028 1.78% 0.70% 1.09% 242,323

NIM, netNet NIM by Product:

Checking 1,306,984Savings 107,912Regular Money Market 914,038Money Market Plus 1,298,979

Total Transactional Deposits 3,627,913Misc 9,566,792

Total Transactional and SDA 13,194,705

CDs 40,106Total Retail Deposits 13,234,811

April 11, 2023

Evaluating both Methods

» Both methods are easy to implement and maintain

» The moving average method benefits the business unit when rates are 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 harder to game because it uses current spot rates to approximate the FTC for new vintages.

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Conclusion» There are linkages between the framework for the valuation, interest rate risk

quantification, and performance measurement for non-maturing deposits (NMD).

» Despite the fact that there is a wide range of practice and sophistication across the globe, the underlying deposit modeling assumptions for net interest income (NII) simulation, valuation, risk measurement, and performance management must be consistent. Otherwise, inconsistent and perhaps naïve decision making may result.

» Bottom up analysis of the data must be performed in order to understand the various behavior factors that drive cash flows under various interest rate and economic scenarios.

» NMD behavior models will more accurately quantify the risk of the balance sheet and can be a source of value creation and return enhancement for a financial institution.

» The impact of macro economic factors on deposit retention and decay must be analyzed and modeled independently.

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The End

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