tool 2: developing a core funding strategy through an ... · step 5: document strategies 26...

Tool 2:Developing a Core Funding Strategy Through an Initial Strategic Review

ABAToolb x on LiquidityABA Members Only

Dear Reader,Welcome to Tool 2 of the ABA Liquidity Toolbox. In this Tool, you will be introduced to a process you can use to develop a plan to grow your institution’s Core Funding. While the Interagency Guidance on Liquidity and Funds Management (Guidance) identifies Core Funding as the most important non-capital source of a financial institution’s funding, the document does not address the importance of developing a Core Funding strategy. We thought it was important to address this strategy in Tool 2.

A Core Funding strategy should address the following:

• Revising and upgrading internal processes

• Using appropriate analytics as decision making tools

• Developing of effective segmentation strategies

Tool 2 lays out those three key implementation components, and provides examples through the XYZ Bank case study.

Many of the figures created for the XYZ Bank case study in Tool 2 are screen shots from the software component of Farin & Associates iPrice service. (To learn more, please visit www.farin.com/pricing/.)

Tom Farin, FARIn & Associates, Lead AuthorMr. Farin is the author of three separate books on financial institution asset-liability management, as well as a popular asset-liability newsletter. FARIn & Associates is best known for using technology and education to help community banks develop and implement retail strategies.

About American Bankers Association

The American Bankers Association represents banks of all sizes and charters and is the voice for the nation’s $13 trillion banking industry and its two million employees. The majority of ABA’s members are banks with less than $165 million in assets. ABA’s extensive resources enhance the success of the nation’s banks and strengthen America’s economy and communities.

© 2011 American Bankers Association, Washington, D.C.

This publication was paid for in part with the dues of ABA member financial institutions and is intended solely for their use. Please call 1-800-BAnKERS if you have any questions about this resource, ABA membership or would like to copy or license any part of this publication.

This publication is designed to provide accurate information on the subject addressed. It is provided with the understanding that neither the authors, con-tributors nor the publisher is engaged in rendering legal, accounting, or other expert or professional services. If legal or other expert assistance is required, the services of a competent professional should be sought. This guide in no way intends or effectuates a restraint of trade or other illegal concerted action.

Banker Reviewers

Steven W. Corrie Senior Vice President Security National Bank Sioux City, Iowa

Phil Emma CFO Merrimack County Savings Bank Concord, New Hampshire

J. Robert Kelly

Troy K. Lewis, CPA Vice President Heritage Bank St. George, Utah

ABA Staff Contributors

Mary Frances Monroe

Deanne Johnson de Mariño

Susan Einfalt

Mark Tenhundfeld

James Chessen

Ryan Zagone

Mako Parker

Keith Leggett

Donna Fisher

Ellen Collier

Rachaell Davis

Lisa Gold Scheier

Robin Gordon

Core Funding Growth and Retention 1

Initial Strategic Review of Core Funding 3

Step 1: Divide Core Funding into Sectors and Subsectors 6

Step 2: Review Products by Sectors 10

Step 3: Develop Product Plans to Achieve Funding Goals 16

Step 4: Design Products to Implement Product Plans 20

Step 5: Document Strategies 26

Developing a Core Funding Strategy Through an Initial Strategic Review 2

IntroIntroduction to the ABA Toolbox

on Liquidity

1Developing an

Effective Capital/Liquidity Plan

2Developing a Core Funding Strategy Through an Initial Strategic Review

3Integrating

Near-Core and Non-Core Sources Into Bank Funding

4Measuring Asset Based Liquidity

with the Liquidity Coverage Ratio

5Developing a Liquidity Plan

Glossary Benchmark rates – The interest rates on alternative funding sources that are used to determine whether deposits are well or poorly priced; most common benchmark used by community banks is FHLB Bullet Advance rates

Decay rate – The annual speed at which balances in a specific group of non-maturity deposits decline over time

Deposit Sector – A group of deposit accounts that are considered to functionally equivalent by customers

Initial Strategic Review (ISR) – A process in which an institution’s initial core funding strategy is developed and documented

Inter-Sector Segmentation – A segmentation strategy that divides customers between different products offered in a deposit sector

Marginal Cost of Funds – The effective cost of new funds raised as part of a pricing strategy; considers both the cost of new funds acquired and the additional cost of higher rates paid to existing customers in order to attract new funds

Segmentation technique – A deposit strategy that attempts to categorize customers by classes, so products can be designed for specific classes; also used to separate rate-sensitive from non-rate-sensitive funds, enabling the institution to attract and retain rate-sensitive funds without incurring a higher cost for non-rate-sensitive funds

Target audience – A class of customers that have been identified for which a pricing strategy or product is designed

ABA Toolbox on Liquidity — Tool 2: Developing a Core Funding Strategy | 1

Core Funding Growth and RetentionCore Funding is the most favored, lowest cost and most stable source of funding for a financial institution. However, most regulatory guidance addressing balance sheet management focuses on managing asset-based liquidity and near-Core and non-Core Funding. Consequently, few small- to medium-sized financial institutions have a Core Funding plan. Tool 2 of this ABA Toolbox on Liquidity will help institutions develop and document that plan.

For the purposes of this Toolbox on Liquidity, we divided non-capital funding into three classes: Core, near-Core, and non-Core. Although Tools 2 and 3 will discuss these in detail, here is a brief review of the distinction between these three classes.

• Core Funding Deposit funding considered to be Core by regulators. Generally this includes all customer deposits except CDs with balances over $250,000.

• Near-Core Funding Deposit funding from customers not considered to be Core by regulators. This includes CDs over $250,000, deposits placed in reciprocal deposit networks, and other sources of customer deposits that may not meet regulatory definitions of Core Funding.

• Non-Core Funding Funding from a variety of sources other than customers including FHLB advances, brokered CDs, Internet CDs, brokerage firm deposit sweeps, etc.

Actions taken as part of a Core Funding strategy might raise near-Core Funding. For example, a strategy aimed at raising CD funding as part of a Core Funding strategy will probably also attract CD deposits greater than $250,000.

The Core Funding Plan is an ongoing process with both strategic and tactical components. This process interlinks with many other processes within an institution, especially the plans generated by the asset/liability committee (ALCO), and the most important of these, the capital liquidity plan (CLP).

It is uncommon for regulators to use the terms Core, Near-Core and Non-Core Funding. Instead, regulators view sources of funds on a scale from less risky (Core) to more risky (Non-Core).

2 | American Bankers Association

In order to go through the thought process required for a Core Funding Plan, Tool 2 presents a number of tools:

• Conducting deposit audits

• Using benchmark rates

• Making runoff assumptions

• Using marginal cost analysis (MCA)

As you use these tools and techniques, you will realize that there are changes you want to make in your product offerings. You may wish to design new products and terminate others. To do this, you will want to use segmentation techniques, and erect barriers to entry. Tool 2 will discuss how to use these tools to create plans and achieve goals related to specific constituencies.

Finally, once the products are reorganized to achieve the goals laid out in the capital/liquidity plan, you can establish pricing rules for the various account offerings in the sector.

• Savings products and money market accounts

• Short-term CDs

• Long-term CDs

• Checking accounts

Tool 2 covers the Initial Strategic Review in detail, a process that will aid you in creating a plan to implement strategies designed to reach the financial goals you developed in Tool 1. We will see these strategies in practice through our case study institution, XYZ Bank.


Initial Strategic Review of Core FundingIn an Initial Strategic Review (ISR), senior management develops an understanding of product pricing, how products impact the institution’s liquidity risk and interest rate risk, and how changes in products that help to achieve liquidity goals affect the institution’s customer base. For example, new products may better meet the needs of particular constituencies that are not well-served by existing offerings. The ISR is conducted in five steps:

Step 1 Divide core funding into sectors and subsectors

Step 2 Review products by sector

Step 3 Develop product plans to achieve funding goals

Step 4 Design products to implement the product plans

Step 5 Document strategies

STEP 1Divide CoreFunding

STEP 2Review Products

STEP 3Develop Product Plans

STEP 4DesignProducts

STEP 5Document


XYZ BANK CASe STuDy

As XyZ prepares to begin its ISR, senior management looks back to the financial goals it established with the ALCO. These strategic goals are shown in Figure 2-1. XyZ set both loan and Core Funding growth rates at an 8% annual rate.

This would result in an 8% asset growth rate. However, Core Funding growth rate goals vary materially from year to year as XyZ works through its performance problems and as the balance sheet mix moves in the direction of the mix specified in the strategic financial goals. Figure 2-2 compares the annual growth rate goals for Core Funding to the goals for loan growth.

The Core Funding annual growth rate goals step up gradually over the 5 years of the forecast, reaching the strategic goal of 8% in the fourth year. In years 1-4 of the forecast, the Core Funding growth goals exceed the loan growth goals, converging at 8% in year 5 of the forecast.

How will XyZ succeed in growing Core Funding faster than loans? XyZ plans to outgrow its competitors while effectively managing funding costs by having a more effective Core Funding strategy in place. Senior management may also consider limiting its loan growth and/or selling a portion of its loan production in the secondary markets.

Developing Core Funding Objectives

About This Case StudyThe ISR helps to create the plans that will enable an institution to accomplish its goals. The following case study reviews XyZ’s goals, which form a base for the plans it will soon develop to achieve those goals.

XyZ would like to reduce its reliance on Near-Core and Non-Core Funding. Many institutions would like to grow Core Funding faster than loans. However, in a healthy economy, industry loans are likely to outgrow Core Funding, as has been demonstrated in 13 of the last 18 years. The answer to this conundrum will come from the planning accomplished in the ISR.

Figure 2-1 Strategic Financial Goals

Strategic Financial Goals Curr/Rct Goal BalancedROE -10.75% 12.00%Capital/Assets 8.70% 9.00%ROA -1.00% 1.08% 1.08%Dividends/Income -13.33% 33.33%Organic Capital Growth -12.18% 8.00%Loan Growth Rate 0.00% 8.00% 8.00%Investments/Assets 6.50% 12.00%Non-Earning Assets/Assets 8.67% 7.00%Regulatory Core Growth 2.00% 8.00% 8.00%Non-Regulatory Fund/Assets 35.91% 20.00%Other Liab/Assets 0.20% 0.20%


Figure 2-2 Annual Growth Goals for Core Funding and Loans

Loan Growth Ending Ending AssetYear Rate Loans Assets Growth

Dec-09 0.00% 249,218 300,000 0.00%Dec-10 -12.00% 219,312 269,094 -10.30%Dec-11 -4.00% 210,539 261,215 -2.93%Dec-12 2.00% 214,750 267,102 2.25%Dec-13 6.00% 227,635 281,031 5.21%Dec-14 8.00% 245,846 303,514 8.00%

SFG 8.00%

-15%-10%

-5%0%5%

10%15%20%25%

2007 2008 2009 2010 2011 2012 2013 2014

Core Growth EndingRate Core

Dec-09 2.00% 164,980 Dec-10 2.00% 168,280 Dec-11 5.00% 176,694 Dec-12 7.00% 189,062 Dec-13 8.00% 204,187 Dec-14 8.00% 220,522 Strat Goal 8.00%

Year

0%

2%

4%

6%

8%

10%

20142013201220112010200920082007


STEP 1 Divide Core Funding into Sectors and SubsectorsTo begin the ISR, institutions should take a good look at the product mix and breaks it down into sectors and subsectors. Sectors are groupings of accounts with similar levels of utility to a customer, and subsectors further refine these offerings. A sample sector/subsector division follows:

Savings Products

• Savings • Money Markets

Short-term CDs

• 1-4 month CDs• 5-9 month CDs • 10-12 month CDs

Long-term CDs

• 13-29 months• 30-40 months• 41-53 months• 54+ months

Checking

• Business• Personal

Savings Both savings and money market account types meet the same basic need – to set aside a portion of a customer’s liquidity, keeping it out of the velocity of daily transactions moving through the customer’s checking account. Institutions separate customers into two behavior classes, those that are relatively rate-insensitive and those that are relatively rate-sensitive.

CDs Institutions use CDs with different rates and terms to compete for rate-sensitive customers.

Checking The primary customer need met by the account is to conduct daily transactions. However, within the checking sector, customers have a variety of needs and priorities. Institutions address the varying needs and priorities with different consumer and business checking products.

Funding Trend: CDs Decline as Percent of FundingOne long-term trend affecting the industry is the decline of CDs as a percent of funding. That decline is likely to continue as wealth passes from seniors to Baby Boomers, Generation Y, and Generation X.



STEP 5Document



The regulatory definition for a long-term CD is anything with a maturity longer than 12 months, which is the breakdown that should be used for call report purposes. This Tool reviews segmentation strategies, so our definition of short-term CD reaches a bit longer into the maturity range, because as consumers perceive a 13-15 month CD special as being functionally equivalent to a 12 month CD.


Divide Core Funding into Sectors and Subsectors

Once XyZ has outlined specific Core Funding growth objectives senior management examines the composition of its Core Funding. Figure 2-3 breaks the XyZ Core Funding into sectors and subsectors. XyZ’s Core Funding is displayed in thousands of dollars as of 12/31/09 and as a percent of Core Funding. CDs represent 54.6% of Core Funding. The remaining 45.4% is in non-maturity deposits. This mix is fairly typical for the industry. Although XyZ’s management is tempted to keep the mix constant, it recognizes that CDs are declining as a percent of Core Funding. Therefore, its plan will have to reflect this trend.

XYZ BANK CASe STuDy

There are two primary reasons CDs may be declining as a percent of funding. First, seniors historically found it more convenient to invest ‘risk free’ money in FDIC-insured bank CDs than in U.S. Treasuries. This came about because of the relative inconvenience of Treasury purchases relative to opening a CD with a local institution. Today, it is much more convenient to move funds over the web from an equity mutual fund into a short-term Treasury fund. Convenience has swung away from bank CDs and in the direction of Treasuries.

Second, most younger people have little knowledge of bank CDs. Ask a Gen Y customer about bank CDs. In response to your question, the customer is most likely to open the disk drive on a laptop, pull out the gold disk and ask, “Is this what we are talking about?”

Two ways that banks have tried to manage this trend are to educate customers as to the advantages offered by CDs, in an attempt to turn the trend around and focus on growing non-maturity deposits.

Figure 2-3 Core Funding by Sector and Subsector

Month/Year Dec-09 Risk AssetsCore Funding 164,980

Balances Risk Wt. Mix %Business Ckg 6,580 0.0% 4.0%Personal Ckg 13,238 0.0% 8.0%Savings 5,819 0.0% 3.5%MMDA 49,202 0.0% 29.8%0-4 Month CDs 496 0.0% 0.3%5-9 Month CDs 12,371 0.0% 7.5%10-15 Month CDs 47,103 0.0% 28.6%16-29 Month CDs 20,047 0.0% 12.2%30-40 Month CDs 4,883 0.0% 3.0%41-53 Month CDs 393 0.0% 0.2%54+ Month CDs 4,848 0.0% 2.9%Total 164,980 0.0% 100.0%


YZ BANK CASe STuDy

XyZ is concerned about its reliance on CDs as a funding source. In addition, it has a significant portfolio of CDs over $250,000, which count as Near-Core Funding, and brokered CDs, which are Non-Core.

Overall, the goal for 2010 is to maintain a Core Funding growth rate of 2% in 2010 and shift 5.2% of Core Funding from short-term CDs into MMDAs. Meanwhile, the ALCO also wishes to reduce XyZ’s cost of funds in the process. These goals translate into the balance sheet targets for 2010 shown in Figure 2-4.

In setting goals for Core Funding, the ALCO took the following issues into consideration:

• Concern about interest rate risk in rising rate environments for the first 200 bp of market rate movements: XyZ’s variable rate commercial loans and HeLOCs have floors of 5%. Rates will need to rise 200 basis points before loan rates exceed the floors. The ALCO feels that

it would be better to fund the variable-rate loans with MMDAs rather than short-term CDs, since MMDA rate increases can be more readily contained in the first part of a rising rate environment.

• Desire to be less reliant on CDs: XyZ management would prefer to be less reliant on CDs and have more funding in non-maturity deposits.

• Beneficial effects on Near-Core CDs: Actions taken to reduce reliance on CDs would also reduce reliance on Near-Core CDs (those with balances in excess of $250,000).

As XyZ increases the percentage of MMDAs in its Core Funding portfolio over the next year, XyZ expects corresponding reductions in 5-9 and 10-15 month CDs as a percent of funding. Successful execution of this strategy will bring XyZ to a Core Funding mix of 50/50 between non-maturity deposits and CDs within one year.

Regulatory Core Mix

About This Case StudyIt would be fairly simple to ignore long-term industry trends and plan for more of the same. But this will not enable XyZ to achieve its goal of increasing Core Funding. In the following case study, XyZ senior management struggles with the kinds of changes it can make in its Core Funding Mix in order to increase Core Funding even faster than its loans.


Figure 2-4 2010 Core Funding Balance Sheet Targets

Core Funding Balances Dec-09 Jan-10 Feb-10 Mar-10 Jun-10 Sep-10 Dec-10Business Ckg 6,580 6,591 6,602 6,613 6,646 6,679 6,712Personal Ckg 13,238 13,260 13,282 13,304 13,370 13,437 13,503Savings 5,819 5,829 5,838 5,848 5,877 5,906 5,935MMDA 49,202 49,284 50,321 51,234 54,321 56,600 58,8980-4 Month CDs 496 497 498 498 501 503 5065-9 Month CDs 12,371 12,392 11,918 11,606 11,331 11,387 11,44310-15 Month CDs 47,103 47,182 46,845 46,425 44,157 42,366 40,55516-29 Month CDs 20,047 20,080 20,114 20,147 20,247 20,348 20,44830-40 Month CDs 4,883 4,891 4,899 4,907 4,932 4,956 4,98141-53 Month CDs 393 394 394 395 397 399 40154+ Month CDs 4,848 4,856 4,864 4,872 4,896 4,921 4,945Total 164,980 165,255 165,576 165,851 166,676 167,501 168,326

Liquidity risk tolerances or limits should be appropriate for the complexity and liquidity risk profile of the institution and should employ both quantitative targets and qualitative guidelines.

FDIC Financial Institution Letter FIL-84-2008: Liquidity Risk Management


STEP 2 Review Products by SectorsOnce the products have been organized, offerings are reviewed in detail at the sector and subsector level. This analysis forms the basis for strategy ideas that become plans in Step 3.

There are many tools that institutions can use to conduct this review. Three primary tools are covered in detail on the facing page:

• Deposit Audits

• Benchmark Rates

• Runoff Analysis

In practice, these tools interlock. As an institution reviews each sector, product by product, it begins to imagine strategies that would help achieve its goals. It chooses a benchmark rate and then compares strategies by conducting a runoff analysis to see which might be better in a given sector.

The following three case studies put these tools into practice as XYZ Bank conducts a detailed analysis of its short-term CDs.


STEP 5Document





ANALYSIS STRATeGY 1: Deposit Audits

A deposit audit reviews balances and rates for the sector being analyzed and compares those rates with market data. Competitive survey data can be obtained in-house or by contracting with a survey firm to conduct offering rate surveys for the competitors you wish to use in your comparisons.

As an institution begins to formulate strategies, it should assess its competitive position carefully. Some institutions compete with regular accounts and others with premium or promotional accounts like premium MMDAs or off-maturity CD specials. Unless an institution incorporates data on premium accounts in its analysis it will not effectively evaluate its true competitive position.

ANALYSIS STRATeGY 2: Using Benchmark Rates

In deciding between two alternative strategies, it makes sense to use rates on read-ily available Non-Core Funding as a benchmark to determine whether Core Funding is well- or poorly-priced. Under most circumstances, financial institutions have a number of choices in funding their balance sheet. They can fund with Core Funding or they can fund with Near-Core and Non-Core Funding. Clearly, regulators would prefer that banks fund their balance sheets with Core Funding. It is the least rate sensitive and most stable source of funding available. Yet there are circumstances in which Core Funding may be far more expensive than Non-Core Funding. For example, in the past two years, some troubled institutions aggressively priced insured deposits to maintain funding. This made insured deposits, a Core Funding source, more expensive than other funding alternatives, such as FHLB advances.

Decisions as to which funding source to use should not be based solely on which fund-ing source is cheaper. Other customer relationships come with changes in Core Funding strategy. And, of course, an institution needs to manage its overall level of Near-Core and Non-Core Funding.

ANALYSIS STRATeGY 3: Runoff Analysis

To understand which product subsector to target for higher or lower retention, an institution can use a worksheet that looks at runoff assumptions. For CDs, runoff assumptions are based on maturity schedules and generally focus on CDs maturing in the next quarter, as these are the CD balances that will be exposed to whatever CD pricing strategy is deployed based on the results of the analysis.


XYZ BANK CASe STuDy

Figure 2-5 is a deposit audit for XyZ’s short-term CD sector. As you can see, XyZ offers standard term CDs at 3, 6, and 12 months. They are also offering an aggressively-priced, 14-month CD Special. Balances shown include Near-Core CDs of $12.2 million with balances in excess of $250,000.

XyZ’s rates on regular CDs are well above market median and the special rates approach the top rates paid in the market.

XyZ’s short-term CD pricing strategy has resulted in significant growth in short-term CDs. This includes both the Core portion and the Near-Core (>$250,000) portion of these balances. XyZ’s desire to raise CDs is understandable. Institutions feeling regulatory pressure to reduce their heavy reliance on Non-Core Funding may find it relatively easy to grow Core Funding by aggressively pricing short-term CDs. But before doing so, it is important to understand just how much such a strategy is costing.

Conducting Deposit Audits

Figure 2-5 XyZ Short-term CD Audit

Balances and Rates As Of Nov-12-2009

Values in ThousandsMarket Balance Offer Rate Tier Term

Short Term CD All 721700-4 Month CD All 6713 Mo CD - 1K All 162 0.90 33 Mo CD - 25K All 334 0.92 25,000 33 Mo CD - 50K All 175 0.98 100,000 35-9 Month CD All 137076 Mo CD - 1K All 2515 1.11 1,000 66 Mo CD - 25K All 9856 1.17 25,000 66 Mo CD - 50K All 1336 1.27 100,000 610-15 Month CD All 5779212 Mo CD - 1K All 4915 1.23 1,000 1212 Mo CD - 25K All 13565 1.38 25,000 1212 Mo CD - 50K All 4035 1.46 100,000 1214 Mo CD Special All 7508 1.60 1,000 1414 Mo CD Special All 21115 1.70 25,000 1414 Mo CD Special All 6654 1.80 100,000 14

A deposit audit reviews balances and rates for the sector being analyzed and compares those rates with market data.


XYZ BANK CASe STuDy

Using Benchmark RatesXyZ must choose a benchmark rate to use as a comparison for the MCA they will be carrying out as they consider potential strategies. To qualify, a benchmark needs to meet the following criteria:

• Can be used as a true alternative source of funding

• Data is readily available when decisions are made

• Complete funding curve, since it is used in pricing a variety of deposit terms

Given that XyZ purchases both brokered CDs and FHLB advances, either interest rate curve would be appropriate to use as a benchmark. Some institutions might compromise by averaging the two as illustrated in figure 2-6.

In making the decision between the two, management might consider:

• Whether XyZ is close to its collateralized borrowing limits on FHLB advances

• Whether concentration of either source of Non-Core Funding approaches concentration limits in XyZ’s liquidity policy

• Which is the cheaper Non-Core Funding source at the present time

• Whether the level of advances or brokered CDs would trigger additional FDIC premium expense

XyZ has sufficient collateral for additional FHLB borrowings, and neither brokered CDs nor FHLB advances are reaching a concentration policy constraint. The FHLB advance curve is the most commonly used benchmark for community banks, as it is the most commonly used source of Non-Core funding by community banks. Therefore, it makes sense to use FHLB advances as a benchmark.

Figure 2-6 Benchmark Rate Curves

Term (mo) Brokered FHLB Average3 0.60 0.25 0.436 0.85 0.35 0.60

12 1.40 0.96 1.1824 2.10 1.94 2.0236 2.75 2.89 2.8260 3.50 4.62 4.06

There are circumstances in which Core Funding may be far more expensive than Non-Core Funding.


XYZ BANK CASe STuDy

XyZ’s goal is to shrink short-term CD balances. Senior management wants to know what pricing strategy to pursue to accomplish this goal. First, they look at runoff cash flows, which can be seen in Figure 2-7.

In completing Figure 2-7, XyZ started with the actual deposit balances for December, 2009, and set a goal to hit forecast deposit balances for January, 2010 from Figure 2-4.

Then, XyZ senior management added the annualized cash flow runoff (AnCF) percentage. This is the percentage of the balances assumed to mature per year. The assumption used by XyZ for 0-4 month CDs is 400%. That portfolio is assumed to roll over completely four times in the next year. The assumption for 5-9 month CDs is 200%. That portfolio is assumed to roll over completely two times in the next year. The assumption for 10-15 month CDs is 100%. That portfolio is assumed to roll over completely one time in the next year. Immediately to the right is the

assumed dollar cash flow (CshFlw$) during the period. Because this period is one month, assumed cash flow is 1/12 of the annual cash flow. New Orig is the amount of new balances that must be booked in January to hit XyZs Balances goals at the end of January 2010.

Figure 2-8 summarizes the results from the runoff analysis for the next two months in 2010 (February and March). In Figure 2-9, periods shift to quarters and show the runoff analysis for the remaining three quarters of 2010.

Finally, XyZ senior management compared maturities (CshFlw$) to New originations (New Orig) for 2010 (Figures 2-7, 2-8, and 2-9), which led to the conclusion that a pricing strategy needs to be implemented that will retain approximately 80-90% of maturing CDs during the quarter for 5-9 and 10-15 month CDs.

Review Runoff Assumptions

Month/Year Jun-10 Sep-10 Dec-10Core Funding 0 165,530 0 165,805 0 165,805

Mix% AnCF% CshFlw$ New Orig Balances Mix% AnCF% CshFlw$ New Orig Balances Mix% AnCF% CshFlw$ New Orig BalancesBusiness Ckg 4.0% 15% 252 281 6,646 4.0% 15% 249 282 6,679 4.0% 15% 250 283 6,712Personal Ckg 8.0% 15% 506 565 13,370 8.0% 15% 501 568 13,437 8.0% 15% 504 570 13,503Savings 3.5% 15% 223 248 5,877 3.5% 15% 220 249 5,906 3.5% 15% 221 251 5,935MMDA 35.0% 25% 3,681 6,290 54,321 33.8% 25% 3,395 5,673 56,600 35.0% 25% 3,537 5,836 58,8980-4 Month CDs 0.3% 400% 506 501 501 0.3% 400% 501 503 503 0.3% 400% 503 506 5065-9 Month CDs 6.8% 200% 5,722 5,528 11,331 6.8% 200% 5,665 5,722 11,387 6.8% 200% 5,693 5,750 11,44310-15 Month CDs 24.1% 100% 10,139 9,338 44,157 25.3% 100% 11,039 9,248 42,366 24.1% 100% 10,592 8,781 40,55516-29 Month CDs 12.2% 50% 2,556 2,619 20,247 12.2% 50% 2,531 2,631 20,348 12.2% 50% 2,543 2,644 20,44830-40 Month CDs 3.0% 30% 374 392 4,932 3.0% 30% 370 394 4,956 3.0% 30% 372 396 4,98141-53 Month CDs 0.2% 25% 25 27 397 0.2% 25% 25 27 399 0.2% 25% 25 27 40154+ Month CDs 2.9% 20% 247 268 4,896 2.9% 20% 245 269 4,921 2.9% 20% 246 270 4,945Total 100.0% 61% 25,231 20,056 166,676 100.0% 59% 24,742 25,567 167,501 100.0% 58% 24,488 25,313 168,326

Figure 2-9 Cash Flows in 2010 ($000)


Figure 2-8 Cash Flow/Retention ($000)

Month/Year Feb-10 Mar-10Core Funding 0 165,530 0 165,805

Mix% AnCF% CshFlw$ New Orig Balances Mix% AnCF% CshFlw$ New Orig BalancesBusiness Ckg 4.0% 15% 82 93 6,602 4.0% 15% 83 93 6,613Personal Ckg 8.0% 15% 166 188 13,282 8.0% 15% 166 188 13,304Savings 3.5% 15% 73 83 5,838 3.5% 15% 73 83 5,848MMDA 30.4% 25% 1,027 2,064 50,321 30.9% 25% 1,048 1,961 51,2340-4 Month CDs 0.3% 400% 166 166 498 0.3% 400% 166 167 4985-9 Month CDs 7.2% 200% 2,065 1,592 11,918 7.0% 200% 1,986 1,675 11,60610-15 Month CDs 28.3% 100% 3,932 3,595 46,845 28.0% 100% 3,904 3,484 46,42516-29 Month CDs 12.2% 50% 837 870 20,114 12.2% 50% 838 871 20,14730-40 Month CDs 3.0% 30% 122 130 4,899 3.0% 30% 122 131 4,90741-53 Month CDs 0.2% 25% 8 9 394 0.2% 25% 8 9 39554+ Month CDs 2.9% 20% 81 89 4,864 2.9% 20% 81 89 4,872Total 100.0% 62% 8,559 8,879 165,576 100.0% 61% 8,476 8,751 165,851

Month/Year Jun-10 Sep-10 Dec-10Core Funding 0 165,530 0 165,805 0 165,805

Mix% AnCF% CshFlw$ New Orig Balances Mix% AnCF% CshFlw$ New Orig Balances Mix% AnCF% CshFlw$ New Orig BalancesBusiness Ckg 4.0% 15% 252 281 6,646 4.0% 15% 249 282 6,679 4.0% 15% 250 283 6,712Personal Ckg 8.0% 15% 506 565 13,370 8.0% 15% 501 568 13,437 8.0% 15% 504 570 13,503Savings 3.5% 15% 223 248 5,877 3.5% 15% 220 249 5,906 3.5% 15% 221 251 5,935MMDA 35.0% 25% 3,681 6,290 54,321 33.8% 25% 3,395 5,673 56,600 35.0% 25% 3,537 5,836 58,8980-4 Month CDs 0.3% 400% 506 501 501 0.3% 400% 501 503 503 0.3% 400% 503 506 5065-9 Month CDs 6.8% 200% 5,722 5,528 11,331 6.8% 200% 5,665 5,722 11,387 6.8% 200% 5,693 5,750 11,44310-15 Month CDs 24.1% 100% 10,139 9,338 44,157 25.3% 100% 11,039 9,248 42,366 24.1% 100% 10,592 8,781 40,55516-29 Month CDs 12.2% 50% 2,556 2,619 20,247 12.2% 50% 2,531 2,631 20,348 12.2% 50% 2,543 2,644 20,44830-40 Month CDs 3.0% 30% 374 392 4,932 3.0% 30% 370 394 4,956 3.0% 30% 372 396 4,98141-53 Month CDs 0.2% 25% 25 27 397 0.2% 25% 25 27 399 0.2% 25% 25 27 40154+ Month CDs 2.9% 20% 247 268 4,896 2.9% 20% 245 269 4,921 2.9% 20% 246 270 4,945Total 100.0% 61% 25,231 20,056 166,676 100.0% 59% 24,742 25,567 167,501 100.0% 58% 24,488 25,313 168,326

Figure 2-7 December 2009 - January 2010 Runoff Cash Flows ($000)

Month/Year Dec-09 Jan-10Core Funding 164,980 0 165,255

Balances Mix % Mix% AnCF% CshFlw$ New Orig BalancesBusiness Ckg 6,580 4.0% 4.0% 15% 82 93 6,591Personal Ckg 13,238 8.0% 8.0% 15% 165 188 13,260Savings 5,819 3.5% 3.5% 15% 73 82 5,829MMDA 49,202 29.8% 29.8% 25% 1,025 1,107 49,2840-4 Month CDs 496 0.3% 0.3% 400% 165 166 4975-9 Month CDs 12,371 7.5% 7.5% 200% 2,062 2,082 12,39210-15 Month CDs 47,103 28.6% 28.6% 100% 3,925 4,004 47,18216-29 Month CDs 20,047 12.2% 12.2% 50% 835 869 20,08030-40 Month CDs 4,883 3.0% 3.0% 30% 122 130 4,89141-53 Month CDs 393 0.2% 0.2% 25% 8 9 39454+ Month CDs 4,848 2.9% 2.9% 20% 81 89 4,856Total 164,980 100.0% 100.0% 62% 8,544 8,819 165,255

Figure 2-9 Cash Flows in 2010 ($000)


XYZ BANK CASe STuDy

STEP 3 Develop Product Plans to Achieve Funding GoalsAfter reviewing the sectors and subsectors in detail and beginning to think through possible strategies, it is time to make a plan. This will entail choosing between several options. In order to understand the potential impact of various options, institutions often conduct MCA. This Analysis Tool is discussed in detail below. In the next case study, XYZ Bank will consider a strategy to limit growth on some of its CDs.

XyZ senior management has determined the need to implement a pricing strategy that will retain 80-90% of maturing CDs during 2010 for 5-9 and 10-15 month CDs. A common approach to limiting growth in a sector is to discontinue premium accounts. To determine whether this strategy should be employed, institutions should use MCA. This example looks at implementation of the strategy for the first quarter of 2010.

It makes good sense in implementing strategies to devise a strategy, test it for a quarter, evaluate the success of the strategy and tune the strategy for the next quarter. As a result, the marginal cost analysis we will be reviewing looks out one quarter at a time.

The following is a MCA for the 14-month special.

Strategy 1 Continue the existing strategy; continuing to pay top rates results in a 10% growth (110% retention of maturing funds).

Strategy 2 Discontinue the 14-month special by setting rates equal to 12-month CD rates. Rates on all CDs are reduced to the market median or below. This strategy assumes 10% shrinkage (90% retention of maturing funds).

The lower portion of Figure 2-10 shows total balances (thousands) maturing in the next quarter for XyZ’s various tiers for its 6-month, 12-month, and 14-month CD special in the far left column. The next four columns show projected results for Strategy 1, a continuation of XyZ’s existing pricing strategy. The first column lists current offering rates, and the second assumed retention percentages of renewing funds. The overall average cost of retained funds is 1.459% and overall retained balances are 110.2% of maturities or $23.5 million. Those two numbers also appear in the summary area for Strategy 1 at the top of Figure 2-10.

The four detailed columns that follow are the results for Strategy 2. In this strategy, the 14 month special is effectively discontinued by reducing offering rates to the same as offered on 12 month CDs. At the same time, all rates are dropped to the median of the market. The pricing changes are assumed to reduce retention percentages to 90% resulting in $19.2 million in balances rebooked at a weighted cost of 0.7%. These weighted costs and balances appear in the summary area for Strategy 2.

In the summary area, retained balances are multiplied by weighted average costs to calculate the annual interest expense on the rebooked funds, which is $342,560 under Strategy 1, while for Strategy 2 is $150,300. The marginal effect line looks at the difference between the two strategies.

Approach 1: Discontinuing the Premium Account


STEP 5Document





ANALYSIS STRATeGY 4: Marginal Cost Analysis

As institutions consider options for achieving goals, it is critical to consider the potential impact of various options. The tool used to model these options is marginal cost analysis. MCA compares the cost effectiveness of multiple potential pricing strategies. When an institution desires to raise new funding, marginal cost considers both the cost increases to existing balances as well as the cost of new funds raised. When an institution desires to drive off funds, marginal cost considers the cost reductions on deposits that stay as well as the savings on the funds that leave.

under Strategy 2, balances are reduced by $4,308,010 and interest expense by $192,260. Dividing the change in expense by the change in balances results in a marginal savings of 4.5% on the funds leaving the institution.

Marginal Savings $192,260 / $4,308,000 = 4.463%

XyZ saves an average cost of 1.5% on $4.3 million that leaves under strategy 2. It also saves the reduction in average cost from 1.4% to 0.7% on the $19.2 million that

stays under the revised pricing. If XyZ needs the funds, the Investment Retail Benchmark (Rtl Bench) column indicates the funds could be replaced with comparable maturity FHLB advances at a cost of 0.6%, saving 4.1%.

XyZ hopes to replace the funding with MMDAs. It will need to raise the replacement MMDA funding at a marginal cost of 4.4% or less in order to accomplish the shift of funds from CDs into MMDAs and reduce its cost of funds in the process.

Figure 2-10 Discontinue 14 Month Special and Drop Below Median

Marginal Cost AnalysisStrategy Name: Discontinue 14 Mo Special - Drop below median Date:

Strat Sumry Investment FTP

Balance Wtd Cost Duration Int Expense Rtl Bench Spread Income ROEStrategy 1 23,479.36 1.459% 0.92 342.56 0.624% 0.835% (74.70) 0.00%Strategy 2 19,171.35 0.784% 0.90 150.30 0.621% 0.153% (22.59) 0.00%Marginal Effect (S2 - (4,308.01) 4.463% 0.99 (192.26) 0.795% 3.624% 52.11 0.00%Deposit Detail Strategy 1 Strategy 2Deposit Type Maturities Rate Ret % Balance Duration Rate Ret % BalanceSummary 21,301.50 1.459% 110.22% 23,479.36 0.92 0.784% 90.00% 19,171.35 Detail6 Mo CD - 1K 1,257.50 1.110% 105.00% 1,320.38 0.50 0.500% 90.00% 1,131.75 6 Mo CD - 25K 4,928.00 1.170% 105.00% 5,174.40 0.50 0.550% 90.00% 4,435.20 6 Mo CD - 50K 668.00 1.270% 105.00% 701.40 0.50 0.600% 90.00% 601.20 12 Mo CD - 1K 1,228.75 1.230% 95.00% 1,167.31 0.99 0.800% 90.00% 1,105.88 12 Mo CD - 25K 3,391.25 1.380% 95.00% 3,221.69 0.99 0.900% 90.00% 3,052.13 12 Mo CD - 50K 1,008.75 1.460% 95.00% 958.31 0.99 1.000% 90.00% 907.88 14 Mo CD Special - 1,877.00 1.600% 124.00% 2,327.48 1.16 0.800% 90.00% 1,689.30 14 Mo CD Special - 5,278.75 1.700% 124.00% 6,545.65 1.16 0.900% 90.00% 4,750.88 14 Mo CD Special - 1,663.50 1.800% 124.00% 2,062.74 1.16 1.000% 90.00% 1,497.15

11/20/09 0:00


Using SegmentationSegmentation strategies are used in developing Core Funding strategies in two different ways:

1. Separate rate sensitive from non-rate sensitive customers so the institution can afford to compete for rate sensitive funds.

2. Attract a particular customer constituency by delivering a product aimed at that constituency.

The application of product design aimed at a particular constituency will be dealt with later in this Tool.

Inter-sector SegmentationInter-sector segmentation separates rate sensitive from non-rate sensitive customers. Financial institutions exploit this difference in rate-sensitivity by aggressively raising rates on products like CDs in rising rate environments while moving rates on products like savings accounts only moderately. This encourages customers to give up some liquidity. There are some limitations. For example, younger customers don’t understand and use CDs. So if an institution communicates to younger customers that they should move funds into a CD, they may search out better rates elsewhere.

Intra-sector SegmentationAn intra-sector segmentation strategy, illustrated in the following case study, is one that attempts to separate rate-sensitive from non-rate sensitive funds within a sector. Intra-sector segmentation strategies do not require that customers trade accounts with one form of liquidity for another.

The limitation of intra-sector segmentation is that there is often very little differentiation in features between regular and premium products, other than the interest paid. Therefore, customers can easily take advantage of the opportunity to gain a better rate.

Customers with higher balances may move beyond price considerations if offered reciprocal deposits, where accounts over $250k can still receive FDIC coverage.


XYZ BANK CASe STuDy

As an alternative to the strategy of discontinuing premium accounts, XyZ might consider implementing an intra-sector segmentation strategy that separates rate-sensitive money from non-rate sensitive money.

Strategy 1 Continue the existing strategy, assuming that continuing to pay the top of rate in the market results in a 10% growth (110% retention of maturing funds).

Strategy 2 The offensive CD special in Strategy 1 is converted into a defensive CD special that is priced near market midpoint. Keeping the special allows further reductions in rates on regular CDs.

The following chart shows the results of the MCA. Marginal savings on the deposit outflow is 4.8% rather than the 4.4% savings in the scenario in Figure 2-10 on page 17. If the segmentation scenario in Figure 2-11 is executed, XyZ would reduce its funding cost by replacing the outgoing CDs with FHLB advances at a marginal cost of less than 4.8%.

It may not seem that retaining the special in Figure 2-14 is worth the additional effort required. One of the reasons the differential between the results of the scenarios in Figures 2-9 and 2-10 is small is that the difference between regular CD and special rates tends to be compressed at

the bottom of the rate cycle. Keep in mind that in an economic recovery scenario where rates rise, XyZ is likely to raise its special rates more aggressively than rates on regular CDs. As a result, XyZ will see an increase in the differential between a strategy of not employing specials (Figure 2-9) versus one employing specials (Figure 2-10 ).

With the intense regulatory pressure on reducing reliance on Near-Core and Non-Core Funding, marginal cost can be a very effective tool in explaining and supporting decisions to examiners. To see the value, turn scenario 2-11 around. What if Strategy 2 represented XyZ’s current pricing strategy? XyZ needs to grow funding by $4.4 million to fund existing loan demand. Its two alternatives could be raising rates on existing CDs or borrowing the funds from the FHLB. The analysis shows that the increase in funds of $4.4 million in Strategy 1 would incur a marginal cost of 4.8%. As an alternative, similar term funding could be borrowed from the FHLB at 0.6%. An examiner would be hard-pressed to argue you should have raised the funds in the retail markets at a marginal cost of 420 basis points above the Non-Core Funding alternative.

We will revisit this issue in Tool 3, where we will consider the use of Near-Core and Non-Core Funding.

Approach 2: Segmentation

Figure 2-11 Convert Offensive to Defensive Special and Cut Regular Rates

Marginal Cost AnalysisStrategy Name: Offensive to Defensive Special - Cut regular rates Date:

Strat Sumry Investment FTPBalance Wtd Cost Duration Int Expense Rtl Bench Spread Income ROE

Strategy 1 23,479.36 1.459% 0.92 342.56 0.581% 0.878% (74.70) 0.00%Strategy 2 19,124.10 0.709% 0.93 135.50 0.590% 0.119% (15.92) 0.00%Marginal Effect (S2 - S1) (4,355.26) 4.754% 0.85 (207.06) 0.581% 4.173% 58.78 0.00%

Deposit Detail Strategy 1 Strategy 2Deposit Type Maturities Rate Ret % Balance Duration Rate Ret % BalanceSummary 21,301.50 1.459% 110.22% 23,479.36 0.92 0.709% 89.78% 19,124.10 Detail6 Mo CD - 1K 1,257.50 1.110% 105.00% 1,320.38 0.50 0.450% 80.00% 1,006.00 6 Mo CD - 25K 4,928.00 1.170% 105.00% 5,174.40 0.50 0.450% 80.00% 3,942.40 6 Mo CD - 50K 668.00 1.270% 105.00% 701.40 0.50 0.500% 80.00% 534.40 12 Mo CD - 1K 1,228.75 1.230% 95.00% 1,167.31 0.99 0.500% 70.00% 860.13 12 Mo CD - 25K 3,391.25 1.380% 95.00% 3,221.69 0.99 0.600% 70.00% 2,373.88 12 Mo CD - 50K 1,008.75 1.460% 95.00% 958.31 0.99 0.700% 70.00% 706.13 14 Mo CD Special - 1K 1,877.00 1.600% 124.00% 2,327.48 1.16 0.800% 110.00% 2,064.70 14 Mo CD Special - 25K 5,278.75 1.700% 124.00% 6,545.65 1.16 0.900% 110.00% 5,806.63 14 Mo CD Special - 50K 1,663.50 1.800% 124.00% 2,062.74 1.16 1.000% 110.00% 1,829.85

11/20/09 0:00


STEP 4 Design Products to Implement Product PlansSometimes, small changes in strategy with a particular product are not enough to accomplish the goal at hand. In these cases, new products may need to be developed. Effective design of customer deposit products is made up of three interacting pieces:

• Identifying the target audience

• Designing the product to admit the target audience

• Setting rates in a way to attract a target audience

Identifying Target AudienceDemographic information for potential target audiences is helpful in product design, because these statistics provide insight into the differences in behaviors for the demographic groups. Figure 2-15 identifies six demographic groups and compares their market composition and customer composition. This kind of information shows the percentages of customers using CDs, savings accounts, money market accounts and checking; average balances by demographic group for the products are also provided; and, for checking customers, average debit transactions per month, and percentages using Internet banking and bill pay.

Institutions can use information like this to target products at specific audiences.

STEP 5Document





Figure 2-12 Sample Demographic Study

Various government agencies, such as the U.S. Census Bureau, are repositories of demographic information. For example, the Federal Reserve’s Survey of Consumer Finances is a triennial survey of the balance sheet, pension, income, and other demographic characteristics of U.S. families. Additionally, consulting firms survey consumers about their financial habits.

Demographic Group Market % Inst % % CDs Avg CD($) % Sav Avg Sav($)% MM Avg MM($) % Ckg Avg Ckg($)Deb/Mo % IB % BPHS/College 15% 10% 1% 1.0$ 30% 0.5$ 1% 0.5$ 10% 0.5$ 25 85% 15%

Paycheck-to-Paycheck 25% 20% 2% 5.0$ 15% 1.0$ 1% 0.5$ 35% 1.0$ 8 15% 8%

CG < 30 Years 15% 10% 5% 5.0$ 5% 5.0$ 10% 5.0$ 20% 8.0$ 25 75% 65%

CG 30-50 Years 10% 10% 15% 15.0$ 10% 15.0$ 20% 10.0$ 35% 10.0$ 15 55% 45%

Affluent 50-65 (Boomers) 15% 20% 40% 25.0$ 30% 25.0$ 40% 20.0$ 45% 15.0$ 8 35% 25%

Affluent Seniors 20% 30% 50% 50.0$ 50% 50.0$ 15% 65.0$ 55% 20.0$ 2 10% 6%


Using Rates to Attract Target AudiencesOften, premium or promotional products are designed to attract audiences from particular sources. Examples include the following:

• Minimum balance requirements or tiered pricing blocks entry from customers in certain balance ranges while admitting customers in other balance ranges.

• Geographic segmentation strategies offer more aggressive pricing in one market or channel than in others. A grand opening special is a common example of a geographic segmentation strategy.

• New money requirements reward existing or new customers bringing in new balances with a more aggressive rate. A rate 25 basis points higher to a renewing or new CD customer bringing $25,000 in new balances is an example of a new money barrier to entry.

• Relationship incentives pay higher rates to customers who meet individual, household, or business relationship criteria. Paying a rate 35 basis points higher to retain a renewing CD customer who has a $5,000 average collected balance in checking is an example of a relationship barrier to entry.

• Channel barriers to entry admit customers using one transaction or delivery channel while blocking those not using that transaction or delivery channel. An internet-only savings account that offers a materially higher rate than paid on regular savings, but prohibits the customer from conducting transactions in a branch is an example of a channel barrier to entry.

• Transaction barriers offer aggressive rates to customers meeting certain transaction criteria while paying lower rates to customers not meeting the transaction criteria. A reward checking account that pays a 3 percent rate in any month in which a customer conducts at least 15 debit card transactions is an example of a transaction barrier to entry.


Using Inter-sector Segmentation Strategies used to attract a target audience can be a very effective segmentation tool. These strategies raise new funds from customers willing to meet the product requirements by the product while reducing cannibalization from customers who do not.

For example, if you wanted to design a product aimed at Generation Y that didn’t attract affluent seniors, you might focus on debit card, Internet banking, and bill payment usage requirements. All three are much higher for Generation Y than for affluent seniors. (See Figure 2-12 on page 20.) Checking accounts that pay a high rate might be appealing to Generation Y customers who may not carry high balances in savings products. In order to attract Generation Y and not older more affluent high balance customers, you may create a checking product that requires monthly Internet banking log-ons and has a minimum debit card transaction cut-off.

XYZ BANK CASe STuDy

Approach 3: Tiered Barrier to entry with Segmentation

One of the objectives of the ALCO was to grow money market accounts. The balances are concentrated in the Generation X, Boomer and Senior populations. XyZ senior management wants to admit those customers while blocking cannibalization from other customers. They decided to try a tiered barrier to entry.

See Figure 2-13, the deposit audit for the XyZ Money Market sector. XyZ offers both a regular and a premium money market. It introduced the premium money market account 3 years ago, and priced it slightly more aggressively than the regular account. Of the $49.2 million in money markets, just over 50%, $25.8 million, is in the premium account.

XyZ premium money market rates are in the top 1/3 of the market, but well below the top rates paid in the market. The regular account rates are in the bottom 1/3 of the market. XyZ is currently seeing no money market

balance growth based on this pricing. But the plan calls for significant money market growth over the next quarter. In fact, management has determined that it will need to add $1.9 million in newly opened MMDA balances in March in order to hit its target of $51.2 million by the end of March.

The annual decay rate for MMDAs is assumed to be 25%. In March, on a beginning balance of $50.3 million, a 25% decay rate translates into $12.6 million per year or $1.0 million a month. This means that if XyZ is going to meet its goal of raising $1.9 million in new MMDAs, then for each dollar of MMDAs XyZ loses, it will need about two dollars of new money. Senior management is tasked with finding a way to accomplish this at a reasonable marginal cost.

$1 million growth in a month on a $50 million base is about 2% a month or about 6% a quarter, XyZ’s goal for

These strategies raise new funds from customers targeted by the product while reducing cannibalization from customers who are blocked by the barrier.


ANALYSIS STRATeGY 5: Decay Rates

The decay rate can be calculated by noting all of the non-maturity deposits at a point in time, say December 31, 2007. Then watch what happens to the balances in that set of accounts over a period of time, until December 31, 2009. Some accounts will close in that two-year period and balances in others will change. Overall, the balances are likely to be lower. Convert the balance change as a percent of the beginning balance into an annual decay rate.

Once a decay rate for a deposit account has been established it can be used in projecting future cash flows from the same account or a similar account. Decay rates are commonly used in projecting cash flows for market value calculations, such as economic value of equity or net present value. They are also useful in liquidity analysis. And in the XYZ case studies, they will help us project how much cash flow from non-maturity deposits we need to replace to maintain constant balances.

MMDA growth. This translates into 24% MMDA growth a year. It will take aggressive pricing to reach that goal.

The natural tendency by most pricing committees will

be to look to the premium MMDA and raise rates there. Figure 2-14 shows how this plays out in the MCA.

Figure 2-13 XyZ Money Market Audit

XYZ Money Market AuditBalances and Rates As Of Nov-12-2009

Values in Thousands Market Balance Offer Rate TierMMDA All 49,202MM - 2.5K All 793 0.34 2,500MM - 25K All 2,773 0.51 25,000MM - 50K All 3,591 0.66 50,000MM - 100K All 8,956 0.75 100,000MM - 250K All 4,925 0.86 250,000MM - 500K All 2,325 1.05 500,000Premium MM - 50K All 6,872 0.80 50,000Premium MM - 100K All 5,456 0.90 100,000Premium MM - 250K All 7,575 1.00 250,000Premium MM All 5,936 1.25 500,000


XYZ BANK CASe STuDy

Strategy 1 With a continuation of existing MMDA pricing, MMDA growth stalls at its current level. No additional cannibalization from regular MMDA accounts into premium accounts is assumed. The premium account has been on the books for 3 years. If customers were going to move for a slightly higher rate they would have moved by now.

Strategy 2 Rates on Premium MMDA accounts are raised by 30 bp. Resulting rates are near the top of the market. Note that this account has a barrier to entry at $50,000. Additional cannibalization of 5% is assumed from the regular MMDA customers eligible for the premium account because of the additional rate differential.

under Strategy 2, balances grow by just under 6%, so raising the rates on the premium money market achieves balance goals. However, the marginal cost of the new $2.9 million in new money is 4.1%, 0.5% above the FHLB benchmark. The marginal cost is also just under the marginal savings from the CD strategy which was either 4.4% (Figure 2-10, page 17) or 4.8% (Figure 2-11, page 19) depending on which of the two CD strategies was deployed.

upon seeing this analysis, senior management thinks that XyZ can do better. They decide to try another approach, shown in Figure 2-15. They create a new premium money market with barriers that would limit cannibalization from the current premium money market.

Strategy 1 As before, with a continuation of existing MMDA pricing, MMDA growth stalls at its current level. No additional cannibalization from regular MMDA accounts into premium accounts is assumed. The premium account has been on the books for 3 years. If customers were going to move for a slightly higher rate they would have moved by now.

Strategy 3 Rates on the existing premium money market are reduced to rate paid on the existing money market account. The new premium money market is priced identical to rates paid on the existing account in Strategy 2 in Figure 2-14.

Figure 2-15 shows the effect of introducing a new premium money market as opposed to raising rates on the existing account.

Figure 2-14 Pay up on existing Premium MMDA

Strategy Name: Pay up on Premium MM Date:

Strat Sumry Investment FTP

Balance Wtd Cost Duration Int Expense Rtl Bench Spread Income ROEStrategy 1 49,202.00 0.871% 4.14 428.51 3.672% -2.801% 7,505.95 0.00%Strategy 2 52,088.00 1.052% 6.22 547.87 3.696% -2.644% 7,673.49 0.00%Marginal Effect (S2 - S 2,886.00 4.136% 41.68 119.37 3.672% 0.464% 167.54 0.00%

Deposit Detail Strategy 1 Strategy 2Deposit Type Maturities Rate Ret % Balance Duration Rate Ret % BalanceSummary 49,202.00 0.871% 100.00% 49,202.00 4.14 1.052% 105.87% 52,088.00 DetailMM - 2.5K 793.00 0.340% 100.00% 793.00 4.12 0.340% 100.00% 793.00 MM - 25K 2,773.00 0.510% 100.00% 2,773.00 4.17 0.510% 100.00% 2,773.00 MM - 50K 3,591.00 0.660% 100.00% 3,591.00 4.16 0.660% 95.00% 3,411.45 MM - 100K 8,956.00 0.750% 100.00% 8,956.00 4.16 0.750% 95.00% 8,508.20 MM - 250K 4,925.00 0.860% 100.00% 4,925.00 4.16 0.860% 95.00% 4,678.75 MM - 500K 2,325.00 1.050% 100.00% 2,325.00 4.16 1.050% 95.00% 2,208.75 Premium MM - 50K 6,872.00 0.800% 100.00% 6,872.00 4.12 1.100% 115.00% 7,902.80 Premium MM - 100K 5,456.00 0.900% 100.00% 5,456.00 4.12 1.200% 115.00% 6,274.40 Premium MM - 250K 7,575.00 1.000% 100.00% 7,575.00 4.11 1.300% 115.00% 8,711.25 Premium MM 5,936.00 1.250% 100.00% 5,936.00 4.11 1.550% 115.00% 6,826.40

11/17/09

Approach 3, Continued


As expected, balances grow by just under 6%, so raising the rates on the premium MMDA achieves balance goals. However, the marginal cost of the new money comes in at 1.3% (Marginal effect, Figure 2-15) rather than 4.1% (Marginal effect, Figure 2-14), an interest expense savings of $82,000 per year resulting from raising $2.88 million of new funds at a 285 bp lower marginal cost. even better, $7.5 million of CDs run off at a savings of at least 4.5%. (See Figure 2-10, page 17). These will be replaced with MMDAs at a marginal cost of 1.3%. That translates into a marginal savings of at least 3.2% on all balances shifted. Senior management expects the pricing committee to ask a question: Why would 70% of premium money market customers stick with the old account rather than moving to the new account?

Management is prepared with answers:

• The existing premium money market account is three years old.

• Front line people put all the qualifying accounts opened in the last three years in the premium service line whether they were rate sensitive or not.

• If the customers were very rate sensitive, they would be at another institution by now, since we currently pay rates well below the top of the market.

Figure 2-15 New Premium MMDA

Strategy Name: New Premium MMDA Date:Strat Sumry Investment FTP

Balance Wtd Cost Duration Int Expense Rtl Bench Spread Income ROEStrategy 1 49,202.00 0.871% 4.14 428.51 3.672% -2.801% 7,508.91 0.00%Strategy 2 52,085.45 0.894% 4.13 465.58 4.002% -3.108% 12,541.11 0.00%Marginal Effect (S2 - S 2,883.45 1.286% 4.08 37.07 3.672% -2.387% 5,032.20 0.00%

Deposit Detail Strategy 1 Strategy 3Deposit Type Maturities Rate Ret % Balance Duration Rate Ret % BalanceSummary 49,202.00 0.871% 100.00% 49,202.00 4.14 0.894% 105.86% 52,085.45 DetailMM - 2.5K 793.00 0.340% 100.00% 793.00 4.12 0.340% 100.00% 793.00 MM - 25K 2,773.00 0.510% 100.00% 2,773.00 4.17 0.510% 100.00% 2,773.00 MM - 50K 3,591.00 0.660% 100.00% 3,591.00 4.16 0.660% 95.00% 3,411.45 MM - 100K 8,956.00 0.750% 100.00% 8,956.00 4.16 0.750% 95.00% 8,508.20 MM - 250K 4,925.00 0.860% 100.00% 4,925.00 4.16 0.860% 95.00% 4,678.75 MM - 500K 2,325.00 1.050% 100.00% 2,325.00 4.16 1.050% 95.00% 2,208.75 Premium MM - 50K 6,872.00 0.800% 100.00% 6,872.00 4.12 0.660% 70.00% 4,810.40 Premium MM - 100K 5,456.00 0.900% 100.00% 5,456.00 4.12 0.750% 70.00% 3,819.20 Premium MM - 250K 7,575.00 1.000% 100.00% 7,575.00 4.11 0.860% 70.00% 5,302.50 Premium MM 5,936.00 1.250% 100.00% 5,936.00 4.11 1.050% 70.00% 4,155.20 New Prem MM - 50K 0.00 0.000% 0.00% - 4.11 1.100% 0.00% 2,850.00 New Prem MM - 100K 0.00 0.000% 0.00% - 4.11 1.200% 0.00% 2,750.00 New Prem MM - 250K 0.00 0.000% 0.00% - 4.11 1.300% 0.00% 3,350.00 New Prem MM - 500K 0.00 0.000% 0.00% - 4.11 1.550% 0.00% 2,675.00

11/17/09


STEP 5 Document StrategiesOnce core funding strategies have been developed and modeled, the documentation of strategies and conclusions should be included in your institution’s overall liquidity plan. A blank Core Strategy Worksheet is provided at the end of this section and is also available at www.aba.com/LiquidityToolbox.

Overall Strategic GoalsThe long-term strategic goal worksheet in the capital planning model can be included with documentation for this section.





STEP 5Document

XyZ’s strategic goal is to grow capital through retained earnings, loans, and core funding at the annual rate of 8% per year. These goals should synchronize asset growth, capital growth, loan/investment mix, and Core to Near-Core and Non-Core Funding mix over the long haul.

Strategic Financial Goals

XY

Z

Strategic Financial Goals Curr/Rct Goal BalancedROE -10.75% 12.00%Capital/Assets 8.70% 9.00%ROA -1.00% 1.08% 1.08%Dividends/Income -13.33% 33.33%Organic Capital Growth -12.18% 8.00%Loan Growth Rate 0.00% 8.00% 8.00%Investments/Assets 6.50% 12.00%Non-Earning Assets/Assets 8.67% 7.00%Regulatory Core Growth 2.00% 8.00% 8.00%Non-Regulatory Fund/Assets 35.91% 20.00%Other Liab/Assets 0.20% 0.20%


Goals for Core Funding GrowthThe Annual Growth Goals for Core Funding from the capital planning model can provide the documentation for this section.

XyZ plans to grow Core Funding faster than loans in the 2010-2012 years in order to:

1. Increase the level of highly liquid unencumbered marketable securities in order to better serve potential liquidity needs; and

2. Reduce the reliance on Near-Core and Non-Core funding to a level more in line with its long-term goals.

In 2013 and 2014, growth rates for both Core Funding and loans will be brought into line with the speed of capital accumulation through retained earnings as XyZ’s earnings are brought toward their long-range goals.

XY

Z

Annual Growth Goals for Core Funding and Loans

Core Growth EndingRate Core

Dec-09 2.00% 164,980 Dec-10 2.00% 168,280 Dec-11 5.00% 176,694 Dec-12 7.00% 189,062 Dec-13 8.00% 204,187 Dec-14 8.00% 220,522 Strat Goal 8.00%

Year

0%

2%

4%

6%

8%

10%

20142013201220112010200920082007


Goals for Core Funding Mix

Core Funding Strategy – Short-Term CDs

As part of its overall core funding strategy, XyZ plans to reduce its reliance on short-term CDs and increase its level of money market accounts so that by the end of 2010, non-maturity deposits will be at a 50%-50% balance with CDs.

Core Funding Mix

XY

Z

Non-Maturity Dep Dec-09 Jan-10 Feb-10 Mar-10 Jun-10 Sep-10 Sep-10 Dec-10Business Ckg 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0%Personal Ckg 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0% 8.0%Savings 3.5% 3.5% 3.5% 3.5% 3.5% 3.5% 3.5% 3.5%MMDA 29.8% 29.8% 30.4% 30.9% 32.6% 33.8% 35.0% 35.0%0-4 Month CDs 0.3% 0.3% 0.3% 0.3% 0.3% 0.3% 0.3% 0.3%5-9 Month CDs 7.5% 7.5% 7.2% 7.0% 6.8% 6.8% 6.8% 6.8%10-15 Month CDs 28.6% 28.6% 28.3% 28.0% 26.5% 25.3% 24.1% 24.1%16-29 Month CDs 12.2% 12.2% 12.2% 12.2% 12.2% 12.2% 12.2% 12.2%30-40 Month CDs 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0% 3.0%41-53 Month CDs 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2% 0.2%54+ Month CDs 2.9% 2.9% 2.9% 2.9% 2.9% 2.9% 2.9% 2.9%… 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%… 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%Total 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

Products: XyZ offers 3, 6, and 12 month tiered regular CDs. We also offer a 14 month tiered CD special. XyZ contemplates no changes in these product offerings over the next 12 months other than a possible term change for the specials.

Pricing Rules: Pricing strategies will make use of defensively priced CD specials. The general strategy will be to price regular CDs at or below the 50th percentile based on survey data. CD specials will be priced at the 60th to 70th percentile based on survey data.

XY

Z


Core Funding Strategy – Long-Term CDs

Core Funding Strategy – Savings/Money Market

Core Funding Strategy – Checking

Products: XyZ offers 24, 36, and 48 and 60 month tiered regular CDs. At this point no changes are contemplated in these product offerings.

Pricing Rules: XyZ has priced long-term CDs generally in the 75th percentile based on survey data. No change is currently contemplated for this pricing strategy.

XY

Z

Products: XyZ offers a tiered regular money market and a tiered premium money market. Approximately 65% of balances are in the premium service line. XyZ contemplates introduction of a new premium money market account with a $50,000 barrier to entry.

Pricing Rules: Once the new premium money market is introduced, it will be priced at the 75th to 85th percentile based on survey data. Rates on the existing premium money market account will be reduced to the 50th percentile of the market depending on tier. The current regular money market will be priced in the 33rd percentile of the market depending on tier.

XY

Z

Products: XyZ offers a free checking account and a tiered NOW account to consumers. XyZ feels a rewards-style checking account might be used in the future to go after Gen y customers. However, with limited needs for core funding growth it makes sense for XyZ to hold off on introducing such a product until needs for core funding growth develop.

Pricing Rules: The current pricing rule is to price the NOW account in the bottom 1/3 of the market based on survey data. At this point XyZ contemplates no change in this strategy.

XY

Z


The following page contains a blank worksheet for you to use in documenting your Core Funding strategy. The blank worksheet is also available at www.aba.com/LiquidityToolbox.

As we move forward, Tool 3 will address the use of near-Core and non-Core Funding as part of your liquidity plan. We will also discuss changes in the Core Funding strategy that might be made to deal with liquidity stress events.


ABA Toolbox on Liquidity

Core Funding Strategy Worksheet

Institution: Date Completed:

Completed By:

Overall Strategic Goals Goals for Core Funding Growth

Goals for Core Funding Mix

Core Funding Strategy Short-Term CD Sector

Products: Pricing Rules:

Long-Term CD Sector

Products: Pricing Rules:

Savings/Money Market Sector Products: Pricing Rules:

Checking Sector Products: Pricing Rules:

Core Funding Strategy Worksheet is available for download at www.aba.com/LiquidityToolbox

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tool 2: developing a core funding strategy through an ... · step 5: document strategies 26...

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