By: Tom Hannagan
Apparently my last post on the role of risk management in the pricing of deposit services hit some nerve ends. That’s good. The industry needs its “nerve ends” tweaked after the dearth of effective risk management that contributed to the financial malaise of the last couple of years. Banks, or any business, can prosper by simply following their competitors’ marketing strategies and meeting or slightly undercutting their prices. The actions of competitors are an important piece of intelligence to consider, but not necessarily optimal for your bank to copy.
One question is regarding the “how-to” behind risk-based pricing (RBP) of deposits. The answer has four parts. Let’s see. First, because of the importance and size of the deposit business (yes, it’s a line of business) as a funding source, one needs to isolate the interest rate risk. This is done by transfer pricing, or in a sense, crediting the deposit balances for their marginal value as an offset to borrowing funds. This transfer price has nothing to do with the earnings credit rate used in account analysis – that is a merchandising issue used to generate fee income. Fees, resulting from account analysis, when not waived, affect the profitability of deposit services, but are not a risk element.
Two things are critical to the transfer of funding credit: 1) the assumptions regarding the duration, or reliability of the deposit balances and 2) the rate curve used to match the duration. Different types of deposit behave differently based on changes in rates paid. Checking account deposit funds tend to be very loyal or “sticky” – they don’t move around a lot (or easily) because of rate paid, if any. At the other extreme, time deposits tend to be very rate-sensitive and can move (in or out) for small incremental gains. Savings, money market and NOW accounts are in-between.
Since deposits are an offset (ultimately) to marginal borrowing, just as loans might (ultimately) require marginal borrowing, we recommend using the same rate curve for both asset and liability transfer pricing. The money is the same thing on both sides of the balance sheet and the rate curve used to fund a loan or credit a deposit should be the same. We believe this will help, greatly, to isolate IRR. It is also seems more fair when explaining the concept to line management.
Secondly, although there is essentially no credit risk associated with deposits, there is operational risk. Deposit make up most of the liability side of the balance sheet and therefore the lion’s share of institutional funding. Deposits are also a major source of operational expense. The mitigated operational risks such as physical security, backup processing arrangements, various kinds of insurance and catastrophe plans, are normal expenses of doing business and included in a bank’s financial statements. The costs need to be broken down by deposit category to get a picture of the risk-adjusted operating expenses.
The third major consideration for analyzing risk-adjusted deposit profitability is its revenue contribution. Deposit-related fee income can be a very significant number and needs to be allocated to particular deposit category that generates this income. This is an important aspect of the return, along with the risk-adjusted funding value of the balances. It will vary substantially for various deposit types. Time deposits have essentially zero fee income, whereas checking accounts can produce significant revenues.
The fourth major consideration is capital. There are unexpected losses associated with deposits that must be covered by risk-based capital – or equity. The unexpected losses include: unmitigated operational risks, any error in transfer pricing the market risk, and business or strategic risk. Although the unexpected losses associated with deposit products are substantially less than found in the lending products, they needs to be taken into account to have a fully risk-adjusted view. It is also necessary to be able to compare the risk-adjusted profit and profitability of such diverse services as found within banking.
Enterprise risk management needs to consider all of the lines of business, and all of the products of the organization, on a risk-adjusted performance basis. Otherwise it is impossible to decide on the allocation of resources, including precious capital. Without this risk management view of deposits (just as with loans) it is impossible to price the services in a completely knowledgeable fashion. Good entity governance, asset and liability posturing, and competent line of business management, all require more and better risk-based profit considerations to be an important part of the intelligence used to optimally price deposits.