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All written content on this site is for informational purposes only. Opinions expressed herein are solely those of Asset Management Group, Inc. Any material presented is believed to be from reliable sources and we make no representations as to its accuracy or completeness. All information and ideas should be discussed in detail with your individual advisor prior to implementation. Links to other sites should not be construed as endorsement of that site's advice and/or products. Although Asset Management Group, Inc. is a subsidiary of Country Club Bank, nothing presented here should be construed as either an offer to buy or sell securities, and does not represent a guarantee by the bank, implied or otherwise, of any financial asset.
Disclaimer

Disclaimer

All written content on this site is for informational purposes only. Opinions expressed herein are solely those of Asset Management Group, Inc. Any material presented is believed to be from reliable sources and we make no representations as to its accuracy or completeness. All information and ideas should be discussed in detail with your individual advisor prior to implementation. Links to other sites should not be construed as endorsement of that site's advice and/or products. Although Asset Management Group, Inc. is a subsidiary of Country Club Bank, nothing presented here should be construed as either an offer to buy or sell securities, and does not represent a guarantee by the bank, implied or otherwise, of any financial asset.

Tuesday, September 27, 2022 Deposit Decay Rates

by Sean Doherty

There is an ongoing debate within the industry (both financial and regulatory) about the validity of using Decay Rates to calculate the value of Non-Maturing Deposits (NMD) in the required Economic Value of Equity analysis from the 2010 Interagency Advisory on Interest Rate Risk.

Decay Rates imply that a certain amount of a financial institutions deposits will mature or "disappear" from the balance sheet over a period of time. While this may be true of any specific account, it cannot be said to be true for balances as a whole. In fact, a look at deposit trends for the industry would indicate that overall deposit balances are increasing, not declining.
 

So where did this assumption come from? Back in the day, when the first models were being developed (OTS and others), there was an attempt to value these deposits in an effort to more fully understand the long term sensitivity of a balance sheet. This was both a necessary and valuable contribution to our understanding of these deposit relationships.
During this time, a theory began to be discussed as how to best measure these deposits, and it appears that one of the classic mistakes in statistics was made, extrapolating to the general population the characteristics of a specific case. Since Deposit Studies were rare and expensive, this seemed to be a good compromise, and over time, this thinking has become the standard. Some will even refer to this as "best practice", however, "saying so doesn't make it true". Oftentimes, this is an excuse for the vendor to throw a number into their model to get a value, any value.

Further, as rates became volatile, and valuations using this methodology became volatile as well, the issue of deposit life began to take center stage. Modelers and regulators had difficulty in accepting the fact that any NMD could have a life beyond "x" years, and so "Truncation" became the buzzword. Truncation is an arbitrary number of years, after which ALL NMD are said to disappear. This is typically done so that the valuations generated from the analysis fit into the real world deposit premiums being paid in acquisitions. As rates have generally declined over the last two decades, these "deposit premiums" have declined as well. Non Maturing Deposits are simply not as valuable in a low rate environment as they are in a high rate environment, and acquirers rightly justify these lower premiums using this logic.

Having said this, Deposit Premium is NOT what is required to be calculated in the 2010 Advisory. As modelers, and as bankers, in order to comply with this requirement, we are asked to value the "Replacement Value" of these liabilities, not the value that another institution places on them. And this is where we believe much of the misunderstanding resides. Accountants, model validators, auditors and many examiners (because they have been taught the "best practices" sited above) confuse Deposit Premium with Replacement Value. There are many things that go into the Deposit Premium including, franchise value, expected credit losses, OREO, fixed assets, depreciation costs, non-interest income sources, expense management, etc. So in essence, the value of the entire organization, both tangible and intangible, is encapsulated in the Deposit Premium calculation.

Replacement Value, on the other hand, is the value of any particular asset or liability at today's rates (and shocked rates as well). So each component part of the balance sheet is valued on its own merits, without regard to credit risk on assets. To measure this, an institution must be able to accurately measure the amount of time current NMD deposits have been in the bank, as well as the ability of the institution to retain these deposits over a number of years. So "industry standards"  do not apply. If you are currently using some made up numbers, or numbers that are not specific to your institution, then be prepared to explain their relevance to your organization. In most cases this is a futile effort.

We all understand that these deposits have value beyond the one day contractual obligation of the depositor. We have spent many years and an incredible amount of resources to ensure that our clients get this correct. including a detailed Deposit Study and Retention Analysis to determine at which point on the curve your particular liabilities should be valued. Don't take  "Best Practices" as the answer for your institution. More on this in a our next post...
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Note: All written content on this site is for informational purposes only. Opinions expressed herein are solely those of Asset Management Group, Inc. Any material presented is believed to be from reliable sources and we make no representations as to its accuracy or completeness. All information and ideas should be discussed in detail with your individual advisor prior to implementation. Links to other sites should not be construed as endorsement of that site's advice and/or products. Although Asset Management Group, Inc. is a subsidiary of Country Club Bank, nothing presented here should be construed as either an offer to buy or sell securities, and does not represent a guarantee by the bank, implied or otherwise, of any financial asset.

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Disclaimer

All written content on this site is for informational purposes only. Opinions expressed herein are solely those of Asset Management Group, Inc. Any material presented is believed to be from reliable sources and we make no representations as to its accuracy or completeness. All information and ideas should be discussed in detail with your individual advisor prior to implementation. Links to other sites should not be construed as endorsement of that site's advice and/or products. Although Asset Management Group, Inc. is a subsidiary of Country Club Bank, nothing presented here should be construed as either an offer to buy or sell securities, and does not represent a guarantee by the bank, implied or otherwise, of any financial asset.