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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It was a tough demo. But after the stress of the demo is gone, there’s time to debrief and polish up any aspects that went awry.  Demo in haste, repent in leisure.  And this is how software gets good.

I worked with Ivan and Sergey and realized that our numbers were right. The bank had been locking in 12 month CDs at 4%, but treasury rates have recently plummeted close to 3%. This brings loans from the wholesale market down to about 3.5% - and all of the 4% CDs were earning negative interest.

It takes 12 months for all of these CDs to be replaced at a lower rate. Also, the shape of the yield curve indicates it will be a while before rates come up again.

But even with the calculations working out, I still got pretty sweaty during the demo. It might not be all that different for a user looking at the same information.

We made a few subtle changes that should block surprises from this particular gremlin:

1. Added a note to the user when the wholesale market changes drastically. Drastic changes only happen every few years - and the user may not easily remember the effect on profits and optimal rates.
2. Displayed negative profits (instead of just cutting off the graph at zero). This leaves a constant reminder of deposit profits during the last low rate environment in 2004.

Note that both changes are so subtle you can barely notice them. But the problem disappears and the fix doesn’t create more issues. The last thing we want is software bearing the weight of a thousand error messages and menu choices.

While these changes are pretty minor, it starts adding up after a while. We’ve completed nearly 5,000 cases like this. And the gremlins are getting spread pretty far apart.

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In real life, you never get a do-over.   But software inhabits a cartoon world  where stressing the system and watching for mistakes makes the product better and better.  Do it enough times and you get something really smooth.

I often demo with a version that has not gone through the testing checks applied to software for customers.  This lets me exercise the latest features and also works quality control a little harder.

I demoed SmartRate to a prospect the other day over the net.  We ran into a few glitches with GoToMeeting.  And then the software (seemed to) hit a major bug. CD profits in the demo displayed as negative.

In case you’ve never demoed software as part of a sales call, the experience can be intense. I’d liken it to asking a girl out while drag racing. Adrenalin is coursing through your body and it’s only compounded by your reluctance to visibly break a sweat.

I knew I couldn’t think clearly, but negative profits seemed obviously wrong. Unless Crazy Eddie is running the bank, they probably aren’t losing money by paying out too much on interest.

I latched on to demo rule number one (move past the bugs). Unfortunately, this was right in the heart of the demo, so there was a large portion of the software which I never showed.

Turns out there’s a good reason for negative profits. Wholesale rates have been diving with the subprime mess. This means that CDs which were locked in months ago at pretty high rates are no longer making money (because the bank could get money at lower rates from the wholesale market). Today’s negative profits are a different kettle of fish (to be explained in a different post).

Even though SmartRate worked properly, there was still a problem. If I was flustered during the demo by negative profits, imagine the user hitting this issue during a presentation to the CFO. Good software should not make you sweat. Even if it’s complex.

When gremlins attack, part II

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My buddy Mark measures physical properties like outer diameter, durometer, and Young’s modulus when he builds custom rubber parts for F500 companies. He’s constantly improving quality along whatever dimensions his customers need. That’s life in the ISO-9001 world.

Business took a page from the manufacturing book with an adage from Edward Deming, “you can’t manage what you don’t measure”. Unfortunately, the quality guru never said it - because many important parts of your business can’t be gaged well. This applies most to employees.

Humans are much trickier to measure than rubber boots for submarine telecommunication cables. People game the metrics to look good.

Look at software. Programming managers like to measure software bug counts and lines of code. Coders naturally respond to bug counts by arguing with the testers about bugs instead of fixing them - or even avoid the bug tracking system. If you measure lines of code written, developers will tend to write bloated, unmaintainable code. Either criteria will cause worse performance.

Expect similar fun in banking:

• Measure number of incoming customer calls handled? The call center will cut the customer short.
• Pay branch managers according to deposit growth? They’ll push harder for unprofitable rate exceptions.
• Pay tellers on customer satisfaction? They’ll waive fees too easily.

Employees are a little like subatomic particles - the very act of measurement will change them. Even if the yardstick is not explicitly linked to pay, people know that you are measuring because it’s important.

So what’s left?

• Make the measurements ungameable: combine multiple measures together to make sure there’s no way to adversely affect the numbers. For example, profits measured with funds transfer pricing are much less vulnerable to bad rate exceptions than deposit growth. Or just stop using rate exceptions completely. Note: Fair Isaac’s James Taylor rightly points out that decision automation has side benefits of reducing gamesmanship while focusing employees on the customer.
• Allow your employees to skew their outlook: it may not be a bad thing if tellers are solely focused on the customer - even if this drops fee income a little.
• Manage subjectively: Throw out the worst metrics and replace them with good judgement.
• Inspire your employees: Most people want to do the right thing. Make sure everyone understands how important banking is to the rest of society - a world without mortgages or savings accounts puts people in worse homes and keeps money hidden under the mattress. Explain how better customer service lets someone’s grandmother relax a little when worrying about money; higher profits allow the bank to help more people. Listen to their own ideas for how to improve.

Bankers: We rely heavily on yardsticks - and even more since SarbOx came along. Take the time to ensure these measures clearly transmit the right information and help the business.

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Bankervision analyzes customer feedback about overall bank satisfaction and comes up with some interesting clues. Of particular interest:

• Customers care most about good rates - People who rate their bank well also rate the prices well.

I think James’ analysis is correct, but I draw different conclusions. In experience with more extensive data, some customers (and deposit products) are more rate-sensitive than others, but many customers barely care about rate. How can the data sets be resolved?

1. Customers may care most about service, but falsely remember a poor rate when surveyed. This may be because interest rates are the most easily quantified component of customer value. I suspect a low correlation between rate satisfaction (and perceived rates) and actual interest rates.
2. Poor rates may be a problem customers live with (much like certain cancers are often discovered after people die of old age). The majority of reviews are from current customers, so they are describing issues they would like changed, but not enough to switch for.
3. Customers lie. They (correctly) view rates as easily modified and service, convenience as nearly immutable. Customers get better service quickly only by switching banks and better rates by convincing bankers to give better rates. Banks can only change service and convenience levels through glacial change.

Bank customers hope that if they say they care most about rate, all banks will give better rates. In reality, customers are best served in the long term by matching prices to true rate sensitivity. This rewards banks which have dropped their depositors’ rate sensitivity (through convenience, service, etc.). Ultimately, customers that care about rates get good rates. But everyone receives maximized value.

No matter what your customers’ price sensitivity, it’s important to correctly measure and then build into correct equations for total long-term profitability. If bank customers are very price-sensitive, your prices should approach the wholesale alternative cost of funds. If customers don’t care, rates should approach the “embarrassment” rate.

Update: Financial services marketing guru Ron Shevlin advances the argument that bank customers are only inadvertently misleading (in comments).

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Remember when Bono advised Treasury Secretary O’Neill on debt relief? We bankers have been plotting revenge ever since.

Listen to the stylish rhythms of the MBNA/BoA merger set to U2’s One. This catchy ditty may never make it to the top of the charts. Still, over 100,000 people have watched it already.

We’ve got Bank One on the run
What’s in your wallet? It’s not Capital One

Bankers: If you want to preserve your reputation for probity, check your videocameras at the door.

Update: The original was pulled from YouTube.  Here’s a cover from a comedy club with the same words:

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Banking used to be a pretty simple game. Take in deposits from some customers and loan the same money to other customers. And earn your profit on the difference.

The last 30 years have changed the game. Deposit gathering is now divorced from smart investing. If your deposits aren’t enough to fund your loans and investment portfolio, you can make up the shortfall on the wholesale market.

Why is this such a big deal?

Extra investments let the bank increase its risk and returns. If you are following solid risk management strategies (diversification and careful analysis of the risks in your portfolio), the bank is far safer than during the old days. The extra boost in risk lets the bank make more money, but still prevent meltdowns.

More important from a pricing perspective, balance level no longer must be a goal in itself. The deposit pricing committee can focus on optimal rates (high enough to keep balances around, low enough to increase profit margin) and let the treasurer ensure the bank is fully funded.

The bank doesn’t have to pay up for local balances. Of course, the rest comes at higher, wholesale rates. But the bank can keep its total costs lower than if the bank raised all the deposits locally.

The FDIC Banking Review comes through again. The Liability Structure of FDIC-Insured Institutions: Changes and Implications:

The study gives terrific information about the wholesale market. It outlines the major funding strategies and shows how important wholesale funds have become.

I would only disagree with the authors on the impact of the structural changes. I think the increased reliance on wholesale funds has a lot more to do with rate strategy than risk.

Hat tip: Steve Janaszak

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Fair Isaacs has seen it all.  FICO’s James Taylor takes off from a recent piece from TowerGroup’s Kathleen Khirallah by placing it in a larger context. 

The key element to get started is that Banks need more finely grained segmentation for their pricing. Most of them already do a great job of segmentation for risk, credit line management and so on but they lack this approach in pricing. They don’t have a comprehensive pricing strategy that reflects the sensitivities and desires of customers.

While traditional segmentation works pretty well for loans (customers expect individualized pricing), this can be tricky in deposits - and banks should tread carefully.  Read more »

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