The Price of Everything

Another important freebie that falls out of deposit pricing is deposit valuation. Banks often pay hefty fees to value CDI (core deposit intangibles, also called “unrealized gain”). CDI (the value to the bank beyond book value) is important because regulators demand it, but also is the major driver of shareholder value - and higher stock prices.

The figures coming from deposit pricing are more accurate and useful than any static valuation study.

1. The rate-balance models are more robust and can be easily backtested
2. Rate sensitivities capture deeper real world complexities than simple decay rates and runoff assumptions
3. Data oddities have been automatically weeded out in import process
4. Users can drill down in subtype, region, etc.
5. Users can evaluate unrealized gain with only existing balances (useful for regulators) or all balances (needed for running a bank)
6. Numbers tie seamlessly to profits and pricing
7. Figures are automatically displayed graphically and in tables
8. Cash flows can be integrated into ALCO packages

Ultimately, deposit valuation provides answers to important questions:

• How much are my deposits worth?
• How much could they be worth with better rates?
• What is the relationship between balance, rate, and profit?
• What happens to value when external rates change?

Economic value can be calculated for any set of rates, including those projected by today’s forward curve. Essentially, this is a method of boiling down profits over time - and valuing the short-term profits higher.

Bankers need to model economic values in a special way when building numbers for the regulators (existing deposits only). In this case, the bank owes $2.3BN to its depositors (book value, red bar on right). Because the bank is able to repay deposits over a long period of time and at a low rate, the value of these deposits is pretty large - $200MM (green bar on right).

Regulators also need to know how the value of the bank is affected by changes in the external environment. This information is combined with changes in loan and investment value (so regulators know the bank is not assuming outsized interest rate risk). Here, deposits are worth an additional $60MM (green bars on right) when there’s a +100 basis point rate shock. Even though deposits run off quicker, there’s more profit each month.

Bankers value deposits in a different way when they are focused on running the bank than when preparing regulatory reports. Deposit valuation don’t depend solely on existing deposits. Bankers must also price (and value) new deposits coming in to replace deposit runoff. The total unrealized gain (CDI) is $350MM (green bar on right).

Of course, this all ties back to deposit price optimization. Better rates deliver higher CDI. Here, we see an improvement from $350MM to $480MM - because of optimized rates.

Previous: Profitability

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There are many features in deposit pricing software beyond price optimization. For example, check out profitability. Under Funds Transfer Pricing (FTP), profits are the difference between wholesale cost of funds and all-in rate (interest paid to depositors and servicing costs). This makes logical sense, but does not contain the important relationship between rate and balance. Therefore, it misses the time component.

• What happens to profits as balances change?
• What happens to profits when wholesale rates change?

We can look at any set of rates - whether we change what we give customers or if the external economy changes. Let’s look at what happens if rates stay flat, but treasury rates follow the forward rates embedded in today’s yield curve.

These rates will affect balance flows and therefore, profits. The profit graph on the right shows how profits change over time.

Finally, let’s bring this all together by viewing wholesale cost, servicing cost, and interest all in one screen. The difference (profit) is shown in green.

The deposit pricing approach is helpful in a few ways beyond the added accuracy:

1. Provided in a pivot chart - the user can drill down to different regions or account types.
2. Integrated with the other numbers used by the bank - no wasted effort nailing down discrepancies.

Next: Economic Value

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Hidden complexity is an important part of good software design. We often push some functionality towards the background in order to focus on the primary benefits. This makes software easier to use, but runs the risk of appearing incomplete. In the worst case, users will look outside to complete tasks already handled by the software.

Think about a good kitchen faucet. It will be easy to clean, move to where you need it, and remember the last cold/hot mix you used. But most important, it should be easy to turn on. So this feature is made very obvious.

Deposit pricing software is no different. The major reason for using it is optimize rates for higher profits (different from measuring profitability). So this is what is properly emphasized and this is what users think of first.

But it also makes sense to consider some of the secondary features that are integrated into any complete deposit pricing package. Three of the most important are:

1. Profitability - How much is the bank earning from various deposit types and regions?
2. Economic Value - How much are our deposits worth (core deposit intangibles)? What are they worth in different economic scenarios?
3. Rate Exception Monitoring - How much are actual rates deviating from posted rates? Where do these exceptions occur?

The same calculations that are needed for deposit price optimization also let you answer other important questions. And the answers are superior to any external calculations because they are:

1. More accurate - the underlying models are more precise
2. More complete - all relevant factors are included in the numbers
3. More detailed - you can drill down to specific regions, account types, etc.
4. More accessible - output is provided in both Excel charts and tables

The moral of the story: even if necessity drives you to throw in everything including the kitchen sink, put the most important features front-and-center. But make sure the complete feature list is available for everyone, including prospects.

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