Savings Modeling Solution
The impact of savings rate floors on balance sheet management
Low interest rates, decreasing margins and regulatory pressure: banks are faced with a variety of challenges regarding non-maturing deposits. As a result, accurate and robust models for non-maturing deposits are more important than ever. These complex models depend largely on a number of modeling choices. In the savings modeling series, Zanders lays out the main modeling choices, based on our experience at a variety of Tier 1, 2 and 3 banks.
The low or even negative market rates in many Western European countries significantly affect banks’ pricing and funding strategy. Many banks hesitate to offer negative rates on non-maturing deposits (NMD) to retail customers. In some markets, such as Belgium, regulatory restrictions impose a lower limit on the savings rate that a bank can offer. An adverse impact of these developments is that current funding margins for many banks are under pressure.
The flooring effect on variable rate deposits is a hot topic for banks’ Risk Management functions due to its impact on the pricing dynamics and customer behavior. Although it is possible that banks offer negative deposit rates when interest rates continue to decrease (“soft flooring”), banks depend on the pricing strategy of competing banks. Next to that, offering negative rates can cause serious reputational damage, leading to deposit volume outflows. The next paragraphs outline the key focus regarding risk reporting, economic hedges, and risk models for Risk and ALM managers.
Banks are likely to hit the Supervisory Outlier Test (SOT) because of the asymmetric sensitivity of the economic value to interest rate shocks. Banks must inform their supervisor when the Economic Value of Equity change, resulting from specific interest rate scenarios, exceeds certain thresholds. Asymmetric pricing effects on NMD can have substantial impact on economic value and earnings. This is because when NMD rates are close to the floor, the interest rate sensitivity decreases. This effectively makes NMD similar to fixed-rate instruments like bonds.
Risk Management functions need to adjust the Economic hedge to mitigate the typical interest rate gap between assets and liabilities. While NMD are traditionally variable-rate products, they behave more like interest rate insensitive instruments in a low interest environment. Risk managers need to reflect this impact in the economic hedge. It is important to realize that it is difficult to capture the non-linearity of NMD, resulting from the floor, with linear financial instruments such as interest rate swaps. Although some banks are adjusting the hedge on a best-estimate (duration or DV01) basis, the asymmetric pricing effects will largely be left unhedged. Banks can choose to accept and monitor this risk or capitalize for it.
Risk models need to be adjusted to reflect flooring effects on NMD. For most Western European markets, historical data is dominated by higher interest rate levels and does not yield representative behavioral risk estimations. In our article on “Forecasting the retail savings market” we discuss how ALM and Risk managers can address this challenge.
This short article is part of the Savings Modeling Series, a series of articles covering five hot topics in NMD for banking risk management.
The other articles in this series are: ▪ What is core non-maturing deposit volume? ▪ How “hidden savings” dominate the IRRBB profile of current accounts for banks ▪ Non-maturing deposit model concepts for banking risk management ▪ Calibrating non-maturing deposit models: historic data or scenario analysis?
Would you like to read all articles of this series? Or do you have any questions about savings modeling?
Do not hesitate to reach out to Geert Jan den Hertog via +31 35 692 89 89.
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