Friday, January 21, 2005

Value and Duration in Retail Financial Markets: The Economics of Bank Deposits

Value and Duration in Retail Financial Markets: The Economics of Bank Deposits

David Hutchinson in Bquest provides an interesting look at bank deposits and the economics of the retail banking industry. (Yeah I know, some of you doubt whether bank deposits can be interesting. Well surprisingly enough, they can be!)

For instance on the role of the FDIC

"Perhaps the most fundamental difference between banks and other financial firms is that under deposit insurance, banks issue a class of liabilities for which most balances are fully insured by the U.S. government. The resulting market structure creates several complications for the implementation of internal profitability and duration models. First, deposit insurance separates the deposit investor from the credit risks of the bank, which are assumed by the FDIC. In essence, when a bank issues a deposit it engages in two transactions: it issues a risk-free (government insured) liability to a depositor and it purchases an insurance contract from the FDIC to cover the credit risks associated with the priority position of the deposit claim"

On duration analysis for retail deposits (and probably the core of the paper):

"Much of the difficulty experienced by bankers and bank economists in measuring value and duration results from the use of analytic tools poorly designed for these markets. Standard valuation/duration models...implicitly assume a competitive market in which a shock to current market interest rates impacts only the economic value of the existing assets and liabilities of the institution. Future bank activity is implicitly assumed to be competitively priced (zero net present value), or at a minimum it is assumed that the profitability of future lending and deposit business is unrelated to current levels of interest rates. In this framework, maturing deposits essentially are assumed to fully re-price to competitive market rates. Thus, determining the value and duration of deposits is simply a matter of determining the maturity of the current deposit liabilities and discounting them at competitive market rates before and after an interest rate shock.

However, because demandable deposits can be redeemed at par at any point in time, they effectively mature and are implicitly re-priced continuously. In the traditional valuation framework, the duration and interest rate risk of these deposits is, therefore, zero .... Yet...neither demandable deposits quantities nor rates respond fully to changing market yields, and thus their behavior is inconsistent with the traditional valuation model."

Now this is not ground breaking news so far and there are proprietary software packages available to analyze this duration, but as Hutchinson points out:
"Although more sophisticated, commercially-available value-added and asset/liability models have become more common, most depositories still depend on traditional modeling techniques. Even among those institutions using more sophisticated methods, frequently the models are a "black box" not well understood by the analysts using them. As will be shown, many of the problems encountered by practitioners result from the inappropriate application of traditional valuation and duration tools that were built for highly competitive markets"

All in all the article is well worth your time and a virtual must for any Money and Banking or Financial Instititutions student/teacher!

In the interest of full disclosure, I am on the editorial board for this journal, but did not review this article for publication nor have any input into the decsion process. Nor for the choice of website format ;)

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