Hiding software complexity: Economic Value
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.
- The rate-balance models are more robust and can be easily backtested
- Rate sensitivities capture deeper real world complexities than simple decay rates and runoff assumptions
- Data oddities have been automatically weeded out in import process
- Users can drill down in subtype, region, etc.
- Users can evaluate unrealized gain with only existing balances (useful for regulators) or all balances (needed for running a bank)
- Numbers tie seamlessly to profits and pricing
- Figures are automatically displayed graphically and in tables
- 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.
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