Modeling CD Deposit Cost by David Farris Asset Management Group, Inc. (AMG) is a wholly owned subsidiary of Country Club Bank and has been serving community banks since 1995.  AMG offers a range of asset/liability management services designed to manage risk and improve margins while also meeting regulatory requirements and expectations.   Over the last several months, there has been increased scrutiny of deposit cost modeling driven by the recent historic rise in interest rates and bank failures.  There have been many questions about the use of deposit betas and also how the use of CD specials can come into play.  This Pro Shop will discuss these issues and AMG’s approach to modeling CD deposit costs. AMG’s BancPath model uses account level data for all calculations.  This includes the calculation of deposit betas that are used to adjust deposit rates for interest rate shifts away from the base scenario.  For time deposit CD pricing, this would include all accounts that are based on standard rate sheet pricing and those accounts that are priced through a CD special.  All accounts are included in the analysis on an account level basis.   The betas are calculated using regression analysis between the short-term treasury rate and the rates on the deposit accounts.  Calculated each reporting period, these betas are updated and changing each period as rates change.   Betas are used to calculate the repricing in the deposit rates for 100 basis point rate shifts in the treasury market.  For example, if a deposit account has a beta of 50%, that means for every 100-basis point change in treasury rates, the rate on the deposit will change by 50 bps when it reprices. In the BASE CASE for CD rates, when CDs mature, the model reinvests that maturing CD into its same original maturity at the banks current Offering Rate for that maturity.  The Offering Rate is calculated by the ACTUAL prior period business booked by the bank.  For example, assume the bank has a CD maturing three months from the current valuation date that was originally a 12-month CD.  The current rate on this CD is 3.00%.  The bank last month put 12-month CDs on the books at 5.00%.  The BancPath model for the upcoming 12 months will assign a cost of 3% for this particular CD for the first 3 months of the year until it matures and then will renew the CD at 5% for the remaining 9 months of year 1 and the first 3 months of year 2.  In the BASE CASE, the cost of this particular CD will remain at 5% for the rest of year 2 and all of year 3 and forward.  This is done for every CD account. Banks do have the option to adjust Offering Rates (reinvestment rates) using the manual override option provided within the model.  One example of how this might be used is with CD specials.  With these, many times the bank usually keeps the standard board CD Offering Rate at 5% for 12-month CDs but the CD special is for 11 or 13 months at a higher rate.  Per the CD contract, which will vary by bank, if the CD investor does not call the bank to renew the CD investment at maturity, CDs booked under the special are usually then automatically renewed at maturity (per the CD contract) at some fixed lower rate or off the bank’s standard board rate for some contractually predetermined maturity.  Banks setting their automatic renewal rates for CDs at rates that are lower than what is currently being advertised is a standard practice.  However, for modeling purposes, when CDs are put on the books due to automatic renewal at a below market rate, that below market rate would then be the Offering Rate for all CDs in that particular term bucket if no new CDs were actually booked in the current prior period.  Applying an override rate here at a higher “market rate” would be more appropriate for projecting cost for the bank on this term bucket going forward assuming that the majority of CD investors will actually call the bank to renew at a higher rate.  For INTEREST RATE SHIFTS, (again using the same 12-month 3% example) the 5% Offering Rate is adjusted for the beta when the CD matures.  For the +100 scenario, assuming a 50% beta, the CD cost would again be 3% for the first 3 months of the analysis (until maturity) but would then be 5.50% for the remaining 9 months of year 1 and forward.  Likewise, in the -100 scenario, the cost would be 3% for the first 3 months and then 4.50% for the final 9 months of year 1 and forward. What if the next month, the bank decided to offer a 6% rate on 12-month CDs as a CD special.  The BancPath model adds in this new, higher rate into the beta calculation, which will begin to increase the beta as this higher rate is added into the calculation.  The model will pick up the new rate, whether it is a CD special or not, and factor that in to the beta calculation.  The point here is that CD specials are factored into the beta calculation in the normal course of the analysis. As mentioned previously, the betas are calculated using regression analysis. This is an accurate method to use except when the regression does not show a correlation (R-squared) that is high enough to merit consideration.  The BancPath model generally sets this cutoff at 65% but this can be adjusted in the model to different levels.  If the correlation is below 65%, the BancPath model reverts to using the average beta for all other BancPath users as a good general proxy.  Banks also have the ability within the model to just input their own betas should they choose to do so.  In addition, the BancPath model provides stress tests on betas and deposit durations in the report each period. The bank can also perform unlimited additional stress tests because the model used to run the stress tests is provided to the bank in excel format for them to use. Banks using deposit betas is an accepted methodology in the market for estimating the change in bank deposit rates as interest rates change because they are statistically generated numbers that represent the historical behavior on actual bank deposit rate changes over time versus treasury rates. However, the need for liquidity and competitive factors in a bank’s market can sometimes throw in wrench into deposit cost as well as deposit balance predictions as we saw in the last interest rate cycle and during the bank failures in the Spring of 2023.  Choosing the best funding strategy is different for every bank and many things factor into these decisions.  When a bank chooses to run a CD special to maintain funding, the fact that actual CD rates are now higher due to these CD specials just implemented is not something that modeling would reasonably be able to pick up, at least right away.  This is especially true in an environment where there was a 525 bp increase in the Fed Funds rate over a less than year and a half time frame. To summarize, all CD deposit accounts are analyzed on an account level basis in the BancPath model.  The rates on CDs that are booked in the prior period by the bank are used as the Offering Rate (reinvestment rate) for all future CD repricing so any increases in cost due to a CD special are picked up immediately at BASE.  Manual overrides can be applied to these offering rates if necessary.  Betas are then applied to the BASE CASE costs for INTEREST RATE SHIFTS away from BASE.  Betas are calculated based on actual historical data and adjust every period over time as new data is added. The functionality of the BancPath model provides for banks to run unlimited stress scenarios to help develop an expected range of outcomes for deposit costs. For further information on our Asset / Liability Management Reporting and Consulting services or any of the other services provided by AMG, please feel free to reach out to your Capital Markets Group Investment Sales Representative.  You may also contact AMG directly at 800-226-1923 or at    AMG@CountryClubBank.com.

This information is intended for institutional investors only. The material provided in this document/presentation is for informational purposes only and is intended solely for private use. Past performance is not indicative of future results. This material is not intended as an offer or solicitation for the purchase or sale of any financial instruments.

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