Pub 2 2013 Issue 7

September 2013 27 l e a d i n g a d v o c a t e f o r t h e b a n k i n g i n d u s t r y i n k a n s a s Using Tablets in the Cloud By Nathan Dahlstromof CoNetrix Stress Testing Non-Maturnity Deposits By Jeffrey F. Caughron The Baker Group LP A Focus on Non-Maturity Deposits A notable trend in bank balance sheets over the past few years has been the steady growth of non-ma- turity deposits, or NMD. Much of this growth has been a result of greater risk-aversion on the part of depositors who now view liquidity and protection of principal as key considerations. The increased FDIC insurance threshold of $250K has likely played a part in this trend as well. In any case, the growth of these deposits raises questions about interest rate risk in the balance sheet in the event of a change in economic conditions or the rate envi- ronment. Historically, NMD balances are extremely stable and the rates paid on those deposits change infrequently. In other words, they are normally not very rate sensitive. However, from a risk management standpoint, we cannot assume that past behavior will necessarily hold true in the future. The regulatory agencies are concerned that the “surge balanc- es” of non-maturity deposits that flowed into bank balance sheets in recent years may leave the bank at least as quickly, or that banks may find themselves having to compete more aggressively from a pricing standpoint in order to keep these balances in the bank. This concern points to the need for stress testing of non-maturity deposits. Developing NMD Assumptions The Interest Rate Risk Monitor (IRRM) is designed to capture fluc - tuations in non-maturity deposit balances and changes in pricing that occur in different interest rate environments. This requires a set of assumptions about how reactive the bank’s deposit pricing will be. In developing a reasonable set of assumptions, we first do an analysis of the actual observed behavior of each bank’s NMD. The deposit pricing analysis looks at how closely correlated the pricing of NMD has been in relation to changes in market interest rates such as the fed funds rate or the six month T-Bill rate. We can look at the actual history of the bank’s NMD pricing to determine how sensitive the bank’s pricing has been, including time lags between a given move in market rates and the reactive pricing on the part of bank management. This analysis is necessary to derive reasonable shift sensitivities (betas) and time lags to be used in the model. Stress Testing NMD Assumptions The analysis of NMD pricing behavior described above is based on institution-specific historical data and gives us a good base-case assumptions set. But what if future behavior is different? What if depositors don’t act like they have in past cycles? It’s entirely possible that the next rising rate cycle will result in much more rate sensitive deposits than our base case assumptions imply. This is why a stress test is necessary. We conduct a stress test on non-maturity depos- its by aggressively ratch- eting up the shift sensitivi- ties (betas) and simultaneously collaping the time lags in order to mimic a situation where the bank must aggressively compete on price in order to keep the deposits in the bank. For example, consider a modeling assumption where a 100bps rise in the fed funds rate will result in a 35bps increase in money market rates after a three-month time lag. Perhaps that’s the most likely behavior based on past history, and therefore these should be our base-case modeling assumptions. However, we need to also model potential behavior in an unusual environment where rate sensitivity is much greater for these money market balances. We would therefore crank the beta up to 75% rather than 35%. At the same time, we would re-set the time lag to one month rather than three months. If we re-run the model using these more aggressive assumptions, the unsurprising result is that interest expense rises much faster and by a greater degree. Although we may not anticipate rising rates in the near future, prudent risk management requires that we have on file a study of how our earnings might be affected by a sudden ramping-up of rate sensitivity on core deposits and the necessity of aggressive pricing. This is an im- portant risk management exercise for community banks, and one that becomes even more necessary as we move toward an eventual change in the rate environment. Since 1979, we’ve helped our clients improve decision-making, man- age interest rate risk, and maximize investment portfolio performance. Our proven approach of total resource integration utilizing software and products developed by Baker’s Software Solutions* — combined with our solid investment experience and advice — makes us the investment firm of choice for many community financial institutions. For more information, contact Jeff Caughron at The Baker Group: 800-937-2257, www.GoBaker.com, or email: jcaughron@GoBaker.com . The Baker Group LP is the sole authorized distributor for the products and services developed and provided by The Baker Group Software Solutions, Inc. Jeffrey F. Caughron Associate Partner The Baker Group LP