Q & A with Emily Hollis

Emily Hollis
November 27, 2007 | COMMENTS

Q: I have recently been requested to place all of my non-maturing deposits at par for purposes of the NEV valuation. What do you think of this practice?

Par values recognize no economic gain or loss in the value of non-maturing deposits. This means, for example, that the results of the model are unaffected whether a credit union pays zero percent or five percent on its share drafts. Obviously, net interest margins (and subsequently net economic values) are grossly affected by such decisions. Industry theory generally holds that if a financial institution attracts funds at lower rates than its borrowing cost it creates economic value in its balance sheet. Par values also embrace the assumption that you will correlate your dividend rate 100 percent to overnight funds. In some rare instances of aggressive, high dollar money market accounts, this indeed is applicable. Otherwise, this method is erroneous.

The greatest weakness of this method is grossly understating liability duration which would cause the analysis to miss the danger of spread compression in downward rate environments. We know that in practice, non-maturing liabilities do have duration as accounts remain with an institution over time, regardless of the prevailing interest-rate environment and dividend paid. We also know in practice, that banks have paid significant premiums for low yielding funds.

As in any ALM analysis (both NEV and NII tests), the assumptions regarding non-maturing liabilities are critical in providing accurate results. In using net economic value analyses, sometimes par values are used as opinions vary as to what weighted average lives and discount rates are appropriate.

We believe that the most critical determinant of value for a non-maturing deposit is the projected dividend rate paid by the credit union. Consider a fixed-rate bullet (a cash flow that has a single maturity, such as a CD) instrument that matures in ten years. It has significant interest rate risk (or price volatility). If we changed the fixed rate to a rate that adjusts monthly with the market, it has no interest rate risk and its duration is zero. Therefore, if your institution has historically changed the interest rate on an account in lockstep with the market, and the market is represented by the effective fed funds rates, the analysis will show little sensitivity in economic value in different interest-rate scenarios, regardless of maturity of decay rate. Thus, it's important to capture the true determinant of economic value in non-maturing liabilities; when and by how much an institution must change its offering rate.

The maturity is secondary. First of all for the reason cited above and second, using a decay rate of 15 percent, remaining balances of shares would be 36 percent at the end of five years and 14 percent at the end of 10, so extending the maturity to say, 15 years, produces only minimal differences of economic value.

Although a statistical analysis gives verification to values, a simple analytical method is to model the dividends in an income simulation for each interest-rate scenario and then present value the cash flows to calculate the economic premiums.

Placing par values on all non-maturing liabilities provides equal modeling results between having 100 percent of funds in money market accounts paying 6 percent, or 100 percent in share drafts paying zero percent. Not only is this erroneous but such an assumption could be dangerous.

Emily Hollis is a CFA and president of ALM First Financial Advisors, LLC in Dallas, Texas. Contact Hollis at 800-752-4628 or ehollis@almfirst.com. Margot Strong, director of business development, may be reached at mstrong@almfirst.com.