Retail components of the balance sheet sometimes seem to have a mind of their own. For loans, prepayments and pay downs are controlled by borrower decisions, not strict contract terms. Uncertainty is even greater for core deposits, where actual behaviors normally bear almost no resemblance to contract terms. How to manage your balance sheet when so many behavior dimensions are uncertain?
To manage around uncertain behaviors, you need to quantify history
The historic record of your borrowers and depositors paint a detailed picture of their revealed preferences relating to loan prepayments, core deposit supply and retention, and other behaviors. Specifically, history tells exactly how borrowers and depositors have reacted (or not reacted) to changes in financial influences such as rates and rate spreads over time. 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. These models empower financial managers to explore ranges of loan prepayment and core deposit behaviors that can be expected across prescribed scenarios. With this information, what once were uncertain balance sheet behaviors can now be anticipated and managed effectively.
Quantifying historic retail balance sheet behaviors is not a simple task, however. There are many moving pieces in loan prepayment and pay down decisions that need to be fully quantified (e.g. current loan rate, your new loan rate and competitive rates, echo prepayments flowing from 1-4 family mortgage loans to HELOC and other loans, seasonal influences, and special effects such as Y2K and 9/11). Core deposit behaviors have even more complex behaviors that need to be comprehensively quantified (e.g. baseline supply of funds and its sensitivity to rate changes and spreads, repricing amounts and lag effects, retention over time and its sensitivity to rate changes and spreads, 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 the uncertain elements of your balance sheet.
The MountainView-McGuire solution for quantifying the historic record
Uncertain balance sheet behaviors are comprehensively quantified in institution-specific applications of the patented McGuire Advanced Assessment MethodologyTM. This patent pending, advanced econometric approach analyzes historic loan and deposit data as a simultaneous equations system that reflects banking practice and consumer decision theory. It produces high precision forecasts that quantify scenario specific loan prepayments and pay downs and deposit total balances supplied, rates paid, and retention behaviors, plus identifies inter-category dependencies. As unambiguous linkages are maintained from the data to all applications, audit trails are clear and complete.
The McGuire Advanced Assessment MethodologyTM produces:
- High precision quantification of historic behaviors that explain the drivers of past trends
- Scenario and time period specific forecasts that define direct inputs into financial models
- Defensible regulatory compliance inputs that free managers to add earnings performance
MountainView-McGuire Deposit Analysis and Loan Prepayment/Paydown services directly utilize the McGuire Advanced Assessment MethodologyTM. Forecasts derived from the methodology are also used in core deposit index reports and FAS-related valuations.