The Price of Everything

A stable banking system is the bedrock of the US and global economies. While airlines have operated at a net loss over their entire history, banks have always been out for profits. And while there’s an occasional rough patch - like the current subprime mess - over time, we’re solidly in the black.

Yet despite our long-term financial acumen, sometimes we give the store away. What’s that about?

One reason is that deposit prices are simply counter-intuitive. When prices go up in the supermarket, the souk, or on the web site, profit margins normally follow. Our pricing brains are wired this way and bankers must constantly tune out the the siren song of higher rates. In other words, there’s very little “gut-check” in sound deposit pricing.

A second problem is that the other side of the banker’s profit calculus, wholesale rates, moves much quicker than retail prices. This is typical historically but especially so in modern times (check out The Economist (sub. reqd.) for a few helpful papers in this area).

Generally speaking, the greater the share of raw materials in a product, the more often its price moves: petrol prices change, on average, in five months out of six in both America and Europe; the prices of fresh food are altered far more frequently than those of processed goods.

This effect applies not only in physical raw inputs like crude oil, but also notional inputs such as wholesale borrowing costs. While depositor satisfaction, good branch networks, friction and other factors allow us a high profit margin, we can’t lose sight of one important fact: almost all the marginal costs in taking in the next dollar are related to the cost of wholesale borrowing.

Consumers (and bankers) recognize that with oil prices doubling over the last year, gas price rises at the pump quickly follow. But are bankers as aware that Fed Funds halved in the last six months? A rate that was profitable in September bleeds red ink today. A nimble approach is needed in order to avoid being caught flat-footed.

Unfortunately, bankers often are not constitutionally prepared to move quickly. Changing rates requires analysis, decision-making, and implementation, and by the time a new strategy reaches the customer, it may already need to be changed. Simply streamlining the time to bring rates to market can have the same outsized benefits in retail banking that process reengineering has brought to manufacturing industries.

The final issue is the massive complexity of setting the right rate. The best rates are determined by many factors, among them wholesale costs, competitive rates, and consumer behavior. To find all the rates at a large bank, this exercise must be repeated hundreds of times. It’s easy to get stuck in the weeds of managing rates while hacking through them, leaving unprofitable rates unchanged.

Bankers, it’s time for a pledge: Leave the unprofitable business on the table. If the rest of the industry is acting irrationally, let them. Gather in profitable deposits and finance your shortfalls in the wholesale market. When rates come up again, you’ll be better placed to build your deposit base. In the meantime, stop the bleeding while the patient is still relatively healthy.

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Ever notice prices so strange, you couldn’t believe your eyes? When I was a kid, Crazy Eddie advertised how insane his prices were. Today, it’s the “fiscally conservative” banking industry instead.

While the subprime mess has captured all the recent headlines, the distortions in retail deposit pricing are just as striking. A recent WSJ article points out that today’s astronomical rates are beginning to come back to earth. It also gives an indication for how out of orbit prices have been.

According to the article, consumers can still buy a 4 year CD from a nationally-respected institution at 5%; this isn’t just a great retail rate - this is better than banks pay wholesale.

So let’s do the numbers. Wholesale rates for four-year money are currently 3.88% at the FHLB. This means the bank in the article is paying 1.12% above wholesale. Even at the $10,000 account minimum, the bank pays the consumer $510 above cost over 4 years. Put another way, for every $1MM of deposits the bank accepts, it loses at least $50,000.

Leaving aside complications like servicing cost, marketing fees, and cannibalization of existing customers, this practice still costs beaucoup bucks. Maybe there’s a little profit in cross-selling other accounts or in higher-profit renewals later, but nowhere near enough to claw back the losses on the front end.

Solid deposit pricing can be tricky. Often, a bank needs to predict customer behavior and run tricky mathematics to find the most profitable price. Sometimes, though, the answers are clear even without the statistical crystal orb. As one deposit pricer recently summed it up to me, “If you can’t profit on a single account, how are you going to make it up on volume?”

Next: How banks went crazy

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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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We all still miss traveling down US 1 and thumping Princeton - a tradition since 1869. But it’s pretty exciting watching Rutgers beat Louisville from Tumulty’s in New Brunswick. Upstream, red team!

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I used to be a banker.  Now, I make software for banks.  This weblog covers both worlds, banking and software. 

Software, good software, the kind of software that makes you stronger at your job, is not easy to build.  The software industry has wasted billions, accidentally shot a spacecraft into the surface of Mars, and killed patients with lethal doses of radiation.  And then there’s Windows Vista (currently at 5 years and $6 BN in development costs).

Banking is well past the bad old days of the 1980s S&L crisis.  There were 534 bank failures in 1989; these days you can count the year’s failures on one hand.  Plus, we bankers are no longer famous for supplying credit cards to US senators.  But, banking is still more bureaucratic than it could be.  And bankers know it.

Finance and software are the twin foundations of a modern economy.  America thrives in both.  Google, swaptions, RSS feeds, FICO scores - the level of innovation in either industry is staggering. 

I’m wowed by it all.  But I’ll try to show some of the hidden flaws in each industry as well.  The mistakes are almost as valuable as the successes.

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