Saturday, February 6, 2010

Core Deposits

As promised in the last post, we will be discussing core deposits this time. Let’s begin with what a core deposit is. Core deposit amounts outstanding are stable and dependable. Core deposits can be depended on remaining on the balance sheet for an extended period of time – they are CORE. Depositors are attracted to the deposit for the service and convenience of the institution and not so much by the interest rate. The typical depositor is not really influenced much by the deposit rate. From the institution’s perspective, core deposits have rates that can be changed at any time in either direction often without notice. For this reason, core deposits are also called administered rate deposits.

The fact that they can have almost any rate and yet remain as a stable source of funding tells you that these deposits are extremely valuable to a financial institution. So these deposits are well worth tracking and trying to increase.

Not too surprisingly, the rate on these deposits is often very low, generally from 0%to 0.25%. When rates start rising again from their current floor levels, the rate on these deposits might not rise at all or they might change very slightly.

In essence, core deposits have two main characteristics:

  1. In aggregate, the amount of the deposit is stable over a long period of time.
  2. The rate paid on the deposit is also stable and unlikely to change over a long period of time.

Here’s a useful fact that really helps define a core deposit – core deposits are not variable. Variable deposits and core deposits are opposites of each other. Recall that a variable deposit’s rate is determined by another rate – usually the prime rate. Look at the second characteristic of core deposits and you can see that core deposits and variable deposits have opposite rate characteristics.

Just just because core deposits and variable deposits are opposites doesn’t mean that every account must be either variable or core. Just the opposite is true; most deposit accounts are a combination of the two; partly core and partly variable. A typical savings account will have a low rate today, but when rates start rising again, the savings account rate may go up too. It is very unlikely though, that the rate will go up as fast as the prime rate as it would for an account with a pure variable rate type. More likely, if the prime rate goes up 1%, the rate on a savings account will go up a portion of that 1%, say 0.10%. One useful way to look at this is to say the account is 10% variable. It’s tempting to say that the remainder is core, but be careful. A core deposit is non-variable, but it also has a balance that is stable over a long period. So, the non-variable portion might be core or, it might be non-interest rate sensitive (NIS).

In the last post we discussed how different interest rate types get modelled and interest rate sensitivity. Variable deposits have a straight forward modelling methodology, core deposits actually get modelled as fixed deposits, and NIS deposits are largely ignored - but we’ll talk about NIS accounts some more a little further down.

Here’s how you should determine how much of a deposit account is Core. Take daily or monthly balances for each deposit over two or three years. The very lowest level is definitely core, but that level may be too conservative. Chart the balances on a graph. If the amount has been bouncing around at about the same level, the lowest amount is probably reasonably accurate. If the deposit amount has been growing constantly, you will be better served by choosing a more recent low point; perhaps use the lowest level in the last 6-12 months, or use statistical techniques. Using statistics, you can find the deposit level that you can be 95% certain will be outstanding – that would be the core amount. If the chart is trending downwards, you might pick a core level that is even lower than the lowest point. The important thing to keep in mind is that your model will assume that the core amount will be outstanding for a considerable period of time – a portion of core deposits are assumed to be outstanding for years. You want to make sure that is true.

Take the core amount and divide by the current amount outstanding. Say that’s 75%. We can say the deposit is 75% stable. Now determine how much of the deposit is variable. Ask yourself this question – if rates go up 1%, how much will the rate on this account rise? If the answer is 20 basis points, then it is 20% variable. Remember, if an account is variable, it is not core. So, the most that this account can be is 80% core. You now have two values; the deposit is 75% stable and it is 80% non-variable. The core percent is the smallest value. If the deposit is 75% stable and 80% non-variable, then it is 75% core. So in this case, it is 75% core, 20% variable and 5% NIS.

As another example, say the deposit was 70% non-variable and 90% stable. That would be 70% core and the other 30% is all variable. There is no NIS component in this example.

Let’s look at chequing accounts. Chequing accounts can have very stable balances and the often pay no interest. In fact, some chequing accounts have never paid interest and likely never will pay interest. Are these accounts core or NIS? Recall that an NIS account has no interest rate, will never have an interest rate and is unaffected by changes in rates. It’s actually hard to tell if a chequing account is core or if it is NIS, as these deposits match the definitions for both. The distinction is important though, because the two are modelled very differently for interest rate risk.

Our chequing account example is clearly non-variable; so it might be core. Also, it usually has a balance outstanding that you can depend on lasting for an extended period of time. So, at least a portion of the chequing account meets the requirements to be classified as core. The value of core deposits is that they can be used to finance fixed assets. It seems reasonable to use chequing accounts to do just that. So, it is safe to model these as core.

And you can take that argument further and stretch it to other NIS liabilities. For instance, accounts payable could be core. In this case, as there is no rate involved, the only criterion is whether it has a dependable balance outstanding. If so, interest payable could be modelled as core. Same with accounts payable. And let’s go further still – what about assets? Asset accounts, by definition can never be a deposit, but are they not a perfect offset for a core deposit? For example, to the extent that core assets offset core liabilities, there is no interest rate risk and they can be ignored – effectively treated as NIS. If you are looking at NIS liabilities as possible core deposits, then you should also look at NIS assets.

Let’s step back for a minute and think about this. Core deposits are useful because they are long term sources of funding for fixed assets. We believe that NIS liabilities that have stable balances can also be used to finance fixed assets, so they are also core. Some NIS balances on the asset side are also stable in nature. Since they are on the asset side, they are kind of ‘contra-core’. To the extent that you have the contra-core asset balances, they offset/reduce the core balances. The reduced amounts get treated as NIS and are ignored by the interest rate risk measures.

And clearly, equity can be considered core. In fact, equity is a special case distinct from other core deposits because they have an additional feature that normal core deposits do not have. Equity is stable and has a rate that is controllable by the financial institution and the amount outstanding is completely under the control of the institution. A member can always leave and take their deposits with them, but the member can’t touch retained earnings. So, equity can be reliably used to finance long-term assets. 25-year assets can safely be financed with equity. So if your credit union does not offer mortgages with a term longer than 5 years because there are no deposits with a term longer than 5 years, you might want to reconsider. It is perfectly reasonable (even desirable) to finance long term assets with equity.

The core amounts of your deposits are essentially all the same, even though they originate from very different accounts. All core amounts have constant rates and are stable for extended periods. So, it is perfectly reasonable to lump them all together and model them as a group. This a simple sum for the principal amounts, and it is the weighted average rate for the rates. For example say one deposit has a rate of 0.50% and a $5 million core amount and another has $5 million core and a rate of 0%. Together you have $10 million core deposits with a rate of 0.25%.

So, here’s the process. Examine each variable and NIS account closely to see if it has core component – stable and non-variable. The more important (larger) an account is to your organization the more closely you should examine it. Large accounts might be graphed and perhaps statistically examined. Total all the core liabilities and subtract off total core assets. Now, subtract off core equity accounts as they are modeled differently. The remainder is the amount of core liabilities.

A word on terminology. This post is about core deposits, but clearly we have also included equity, non-deposits, and even assets. Clearly, ‘core deposits’ is a bit of a misnomer. Core liabilities might be better and we’ll use that term too, but we will also refer to them as core deposits as does the rest of the world.

You can see it is an involved process. If your interest rate risk consultant hasn’t taken you through this process, you can be pretty sure that your interest rate model is incorrect, especially for Economic Value at Risk (EVR) measures. And remember, deposit accounts can change over time. What looks completely non-variable today might look quite different tomorrow. You need to repeat the evaluation process- we suggest annually or biannually or on the occasion of extreme events. The recent interest rate crash to historical low levels is an excellent example of an extreme event where core deposits should be re-evaluated.