The Value of Callable CDs That Most All Banks Miss

Lowering Bank Funding Cost

If you handle deposits or look to issue a certificates of deposit special in the near-term, then you should read this because most banks get their callable certificates of deposit (CD) valuation completely wrong and, as a result, underutilize the product to help lower the funding cost of the bank. For the record, we are not advocates of any CD that markets on rate, as a majority of time a customer’s predilection for rate is highly correlated to low or negative lifetime value. Rate, no surprise, attracts rate-sensitive customers and rate-sensitive customers are also likely fee sensitive.  That combination is bad for building long-term franchise value. However, if you have to raise funds quickly and/or are looking to add below market cost of funds, then a callable CD, where your bank retains the option to call, is one of the best CDs a bank can issue and should be in every CFOs / Chief Deposit Officers arsenal. Today, we highlight the missing calculation that most all bank CFOs miscalculate.


How A Callable CD Works


A callable CD is usually 3 to 5 years in length and has a feature that the bank can redeem, or “call” the CD back and return the depositor’s money. In exchange for this option, the bank pays an above average rate to compensate the depositors for the variability of cash flows. Thus, depending on maturity and structure, a callable CD often has rates that are 0.20% to 0.50% higher.


Calling CDs (certificates of deposits)


The Value Of The Option


When it comes to callable CDs, you could sell the option to reduce your funding cost or keep it. The problem is that any counterparty willing to purchase the option will not pass on the full value of that option. That is, that option is worth more to you than a swap dealer or other counterparty. Let’s take a 3-year callable CD as an example that can be called any time after 6 months. Here, the option value, as calculated by a standard Black-Scholes model (the calculator of which is available free on the Internet), is approximately 0.34% per annum. Your bank would likely get 0.22% of value from a third-party counterparty, leaving about 0.12% per annum on the table, or about 35% of the value. 


Thus, by retaining the call option and issuing the CDs yourself in your local market, you can retain the full value of the option. At this point, many bankers would point out that there is a potential for customers to be mad if their CD gets called away. While this is a possibility, it is rare. The public, like most financial professionals, don’t fully value the option. Should the CD get called away, the depositor is only out opportunity cost of that higher CD rate, and while real, isn’t an actual book loss. The depositor is in exactly the same position as a bank that purchases callable agencies for their investment portfolio – few complain since that was the contract. All that said, if your bank is worried about the impact of callable CDs on your customers (either because of the rate or the possibility of call) then using a broker could be a good idea.


Where The Value Is That Most Banks Miss


By an estimated 95% of the market, that call option is valued in the traditional way based on current rates, the expectation of future rates and the expected volatility of rates. Here is the problem – that is just part of the volatility. As can be seen in the graphic above, a bank may choose to call the CD because of a larger than expected inflow of checking balances. This potential balance sheet movement creates additional volatility for the bank that increases the value of that option.  The more dynamic your balance sheet is, the more value you derive from being long that option. This is option value that no counterparty will pay you for since it is just germane to your bank.


To put this in perspective, for the average bank, the compensation of different factors make up almost as much value as the impact of interest rate movement on the option’s value. Thus, if the bank’s intent is to post a 1.05% rate in the 3-year, the net effective cost is closer to 0.40%. 

Callable CD Value

This Special Time


We bring this up today as we are seeing near record volatility in BOTH the interest rate market and on bank’s balance sheets. As such, it makes the value of that call option worth more than ever for banks. The day-to-day movement combined with the uncertainty in the market makes now a great time to issue callable CDs. 


As you can see that call option is very valuable in that it gives you balance sheet flexibility. Another way to look at this is that flexibility has value (65 basis points p.a.) but holders of that CD don’t value that option too much. Thus, you are arbitraging the difference in the option’s real vs. perceived value. This is the exact strategy that Fannie Mae and Freddie Mac do when they sell banks callable agencies. Bankers don’t value the call option on the investment side properly. Thus, Fannie and Freddie enjoy lower cost of funding often than the US Treasury.


Don't let the full value of that CD option go to waste. 30+ basis points in funding cost is significant. If your bank needs funding and feels compelled to pay a higher than market rate to quickly attract deposits, a core callable CD is an excellent vehicle and is unique in the marketplace.