Controlling interest expense and equity at risk IRR demands an understanding of depositor rate related behaviors and simulation analyses of the interplay of asset and liability side balance sheet responses to changing interest rates. Solutions for both needs rest decisively on fully quantifying all core deposit behaviors, which are by nature indeterminate. But how to control interest expense and equity at risk IRR when key underlying behaviors are uncertain?
To control interest expense and equity at risk IRR, quantify history
The historic record of your depositors paints a detailed picture of their revealed preferences relating to past core deposit supply and retention. Specifically, history tells exactly how depositors have reacted (or not reacted) to changes in financial influences such as rates and rate spreads over time and how long funds are retained in the institution. Your institution's rate paid history does the same for your repricing.
Identifying influences in the historic record that are significant influences on past behavior produces models that can forecast future behavior and value. These models empower financial managers to explore the ranges of core deposit behaviors and values that can be expected across prescribed scenarios. With this information, what once were uncertain balance sheet components can now be managed and controlled effectively.
To control interest expense, the behaviors you need to know are (a) the sensitivity of supply (elasticity) of each deposit category to changes in rates; (b) your institution's typical repricing responses to rate changes, and (c) the repricing behaviors of your market and key competitors. For equity at risk IRR, retention/run off, average life, present value, and duration must be quantified. In addition, your repricing must be quantified.
Quantifying historic core deposit interest expense and value behaviors is not a simple task, however. There are many moving pieces that need to be comprehensively quantified (e.g. baseline supply of funds and sensitivity to changing finance influences, repricing amounts and lag effects, retention over time and sensitivity to changing finance influences, plus seasonality, surge balances, and cannibalization among categories and from CD's).
The bottom line: A high powered and advanced statistical methodology is required to quantify all of the revealed preference information in the historic record of your institution. Half way approaches won't work because they do not capture all of the moving pieces, thus handicapping you in trying to manage your balance sheet.
The MPS solution for quantifying deposit behaviors
Uncertain core deposit behaviors and values are comprehensively quantified in institution-specific applications of the MPS Advanced Assessment Methodology . Forecast outputs from the equation systems estimated using this approach answer all questions relating to controlling interest expense and equity at risk IRR.
The MPS Advanced Assessment Methodology produces:
- High precision quantification of recent historic behaviors that explain the drivers of past trends
- Quantified measures of the rate sensitivity of supply and repricing components of interest expense
- Scenario and time period specific inputs for ALM simulation modeling of equity at risk IRR
MPS services that empower institutions to control interest expense and equity at risk IRR are the Deposit Analysis Service and Deposit Index Report service. Where uncertain loan prepayments or pay downs are a concern see also the MPS Loan Behavior Analysis service.