Analyzing Core Deposits and Balance Sheet Risk

May 27, 2005

Many credit unions are conducting studies of their core deposits, in part because of the popularity of the Net Economic Value (NEV) model of asset-liability management.

A credit union’s core deposits are those sources of funds likely to remain in the credit union for an extended period, even if the credit union pays a dividend rate that fails to move with market interest rates. The methods for analyzing core deposits described in this paper are usually applied to nonmaturity accounts, which have no schedule for returning the principal to the owner.

The concepts of decay rate and weighted average life may mean different things to different analysts, yet common definitions are important for an effective discussion of asset-liability management. The decay rate describes the speed at which principal is reduced over time, while the weighted average life measures how long it takes, on average, for cash flows to occur.

While common definitions of terms are important, economic interpretations of what is being measured are as crucial. Several examples of how to calculate effective duration by combining decay rates with dividend and discount rate changes are provided, using the NEV model. The examples are put in an economic context by relating the numerical results to transactions the credit union might peform.

Because the NEV model doesn’t allow for the possibility of new or growing accounts, it doesn’t capture relationships between growth and earnings. Moving away from present value methods allows for the possibility of accounts growing and new accounts being opened. The main questions become:

1. “How will our total deposit balances evolve in the future, under a variety of assumptions about interest rates or other factors that affect consumers’ use of deposit accounts?”
2. “How will our dividend rates evolve in the future?”

Real-life examples from CUNA Credit Union are provided to illustrate how to analzye core deposits for a “going concern” credit union scenario.

All credit unions use income simulation as a planning and risk management tool at least once each year when they write their annual budgets. Credit unions are also expected to perform NEV analysis if they are relatively large or hold fixed-rate mortgages as a significant percent of total assets, so most credit unions use both types of analyses. In considering the two models, the question isn’t which to use, but on which to place the most reliance.

Every credit union needs to decide on the approach that best fits its specific needs and situation. This approach may change in response to market factors and a changing environment. However, a thorough understanding of the different tools and methodologies available, even if they are not used, will benefit all credit unions and analysts.

This is the executive summary from CUNA CFO Council white paper by Keith Peterson entitled, “Analyzing Core Deposits and Balance Sheet Risk.”For the entire paper, visit http://www.cunacfocouncil.org/tools/research.html.

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