Low interest rates, decreasing margins and regulatory pressure: banks are faced with a variety of challenges regarding non-maturing deposits. Accurate and robust models for non-maturing deposits are more important than ever. These complex models depend largely on a number of modeling choices. In the savings modeling series, Zanders lays out the main modeling choices, based on our experience at a variety of Tier 1, 2 and 3 banks.
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For banks with significant non-maturing deposits portfolios, Risk Management functions need to have a robust behavioural risk model. This model is required for Interest Rate Risk in the Banking Book reporting, hedge, stress testing, risk transfer, and ad-hoc analyses. Although specific modelling assumptions vary per bank, cashflow-based models, a replicating portfolio model, or a hybrid model are market practice model concepts. The choice for one of these models is strongly linked to model purpose and use. Each concept has its benefits and drawbacks for different purposes and uses.
Cashflow-based models consist of two sub-models for the deposit rate and volume that forecast coupon and notional cashflows, respectively. Both sub-models measure the relationship between behavioural risk and underlying explanatory factors. Cashflow-based models are suited to include asymmetric pricing effects (such as flooring of rates) in resulting risk metrics. Since the approach captures rate and volume dynamics well, it is also often used for ad-hoc behavioural risk analysis and stress testing.
"The choice for one of these models is strongly linked to model purpose and use."
Replicating Portfolio models
Replicating Portfolio models replicate a deposit portfolio into simple financial instruments (e.g., bonds) such that its risk profile matches the risk profile of the underlying deposits. The advantage is that it converts a complex product into tangible financial instruments with a coupon and maturity. This simplified portfolio is well-suited to transfer risk from business units to treasury departments. A disadvantage of the model is that it does not fully capture non-linear deposit behaviour, for example the asymmetric pricing effects resulting from the floor. This makes the approach less suited for stress testing or ad-hoc behavioural risk analysis for senior management.
Read our extensive analysis of replicating portfolio models here.
Hybrid models, consisting of both a cash flow model and replicating portfolio model, combine the benefits of the other approaches, but at the cost of increased complexity. These models are often used by banks that want to use the model for a wide range of purposes: risk transfer to treasury departments, risk reporting, ad-hoc behavioural risk analysis, and stress testing. To prevent a larger mismatch between the models, most banks ensure that the risk profiles (duration or DV01) of both models align.
Savings modelling series
This short article is part of the Savings Modelling Series, a series of articles covering five hot topics in NMD for banking risk management. The other articles in this series are: