When it comes to determining the value of a deposit base, there are three major components that drive franchise value: effective cost of funds, interest rate sensitivity (duration and convexity) and volatility. It is a rare bank that can manage all three dimensions of deposit performance and one that stands out is Citibank as they have been good at proactively taking steps to increase deposit performance. Since cost of funds and interest rate sensitivity is widely understood, today we highlight how to create value by measuring and managing deposit volatility.
A non-interest bearing operating account of a business is usually the most valuable account at the bank. Not only are costs low, but balances are larger. Most importantly, balances are usually inversely correlated to rates so that higher rates usually mean businesses are doing better and cash flow is increasing. On average, a good business account has a risk-adjusted return of approximately 40%. As rates go higher, a properly structured business account will skyrocket in value approaching an average of greater than 300% return on equity.
The downside of an operating account is volatility. Large daily swings in balances place stress on a bank’s liquidity and limit the amount of funds a bank can invest in longer duration investments. The image below shows the volatility of checking (top in red), money market accounts (blue), time deposits (black) and savings (green).
As can be seen with the red checking line, this bank has some accounts that have large swings in balances due to payroll, mortgage and tax payments. For deposits, we measure volatility by looking at the aggregate standard deviation of balances, which gives us a picture of how balances change day to day. The greater the standard deviation, the more volatile the account and the less it can be leveraged.
The Low Volatility Savings Account
For comparison, the average community bank has a business checking account volatility of around $10,000. That means that most accounts (68%) vary plus or minus $10,000 on any given day. The savings account, on the other hand, has the lowest volatility in banking and usually has a volatility of around $250.
For this bank in our case study, the volatility of their checking is about 2.5 times the average due to their account composition. For the record, this case study bank has one of the lowest cost of funds in the industry, but our point is that even a top performing bank can still have room for improvement. In this particular case, these volatile accounts can change in balance by about a 14% variance. This compares to money markets, time deposits and savings that usually exhibit rock solid stability and have a variance of about 3%.
Understanding account volatility is important to at least have a feel for the risk. However, this data now allows a bank to get proactive in account management so that it can undertake several tactics to optimize deposit value. At a minimum, more resources can be put into sales and marketing to bring in accounts that have different cash flow profiles. For example, some payroll companies require funds two days in advance while some require five days in advance. Having a diversified portfolio helps smooth out cash volatility. Further, being able to bank different industries also provides deposit diversification. Banks that go after homeowners associations have a much different set of balance fluctuations as those that bank auto dealers. Industries that are heavy on labor such as some forms of manufacturing or that have high commission payouts monthly, tend to be more volatile. Allocating resources and proactively managing the deposit sales effort is one way to build a diversified deposit base in order to better optimize deposit value.
Along those lines, this is another reason why we heavily advocate dynamic pricing for bank products. Those more volatile accounts can have a higher fee structure to offset the risk. In this manner, resources are efficiently allocated, deposit balances better managed and fee income increased.
Putting This Into Action
In the graph above, this bank employed several tactics and, as can be seen highlighted in the blue rectangle, has successfully limited volatility. Volatility for their business checking product is now back down to normal as they have a more diversified deposit base. The net result is 7% of its checking account base (in this case this equated to about $14mm) can be invested in loans or longer term securities. This helps increase the interest earnings from 25 basis points to between 1% and 3%. In other words, through proactive deposit management, earnings efficiency was increased.
Managing deposits is often thought of as more art than science. However, deposit management is rapidly changing and by monitoring the data and applying basic management techniques such as focused sales and dynamic pricing, a bank can become more profitable.
Submitted by Chris Nichols on December 22, 2016