Long-suffering time deposit account holders are hoping for better deals the next time their CDs mature. Bankers anticipate this and model their future interest expense by applying “beta” estimates at the time of deposit maturities in their modeling. “Beta” is the percentage of interest rate changes that must be passed on to the depositors to maintain funding volumes. Although commonly applied to non-maturing deposits, time deposit pre-maturity decay rates have generally been ignored.
Now, bankers are confronted with the possibility of increases in deposit costs and portfolio decay not previously considered. The reason: time deposit customers may soon discover and exploit the options embedded in their time deposit accounts. Simply stated, waiting to maturity may not be the best option for many depositors. Deposit holders may be able to “refinance” their CDs by taking action immediately to withdraw before maturity and improve the value of their portfolio without any risk. Beyond typical beta estimates, this potential depositor action presents a generally unanticipated cost to the financial institution that will have to be addressed to maintain funding volumes as rates rise.
No Longer Punitive
Time deposit early withdrawal penalties are commonly set to be a forfeiture of a specific number of months of interest. In the recent environment of low rates, these penalties have become much less punitive. For example, the owner of a five-year, $100,000 CD opened 12 months ago at an annual percentage yield (APY) of 1.20% with a six-month early withdrawal penalty, would only forfeit approximately $600 of interest if they withdrew it early. By reinvesting the proceeds for the remaining 48 months, the depositor can recover that $600 penalty and increase their value at maturity if they can reinvest at any APY above 1.35%. The benefit to depositors resulting from such a modest interest rate increase from 1.20% to 1.35% (15 basis points) illustrates the potential volatility of deposit refinancing.
As the bank’s Asset-Liability Committee (ALCO) is responsible for managing portfolio risks, including optionality, ALCO’s identification and measurement of depositor refinancing risk is critical. The variables required for this evaluation include three data elements: the current portfolio, early withdrawal penalties and CD offering rates currently available to depositors. The current portfolio data requires current balance, interest rate, date of deposit and maturity date. The early withdrawal penalty structure must be stated for all accounts. Currently available CD offering rates should include the financial institution’s own offerings and competitors’ offerings for comparable remaining terms.
Using the above three data elements, each account is analyzed for the value at maturity if redeemed early and reinvested versus holding to maturity. Results reveal the percentage of the portfolio for which depositors would be wise to refinance, the sum of early withdrawal penalties that should be assessed and the sum of the net benefit to transfer that will be achieved for the depositors’ accounts at maturity.
As an example, consider an analysis of a $150 million CD portfolio with a weighted average interest rate of 0.91% and a weighted average remaining term-to-maturity of 16.6 months. The early withdrawal penalties for the analysis were set at one month interest forfeited for term-to-maturity of less than 12 months; three months forfeited for terms less than 24 months; six months forfeited for terms less than 36 months; and 12 months for longer terms. The replacement CD offering rates were set to equal Federal Home Loan Bank (FHLB) advance rates for the remaining terms of each CD. The results identified a current exposure of $43 million or 29% of the balances benefiting the deposit holder from an immediate refinance. The bank would collect $184,000 in early withdrawal penalties and the aggregate net benefit to all depositors at maturity after paying the penalty would be $174,000.
This approach enables modeling various rate scenarios. Under a scenario of a 100 basis point increase in replacement offering rates for this particular portfolio, $103 million of deposits or 69% of the balances benefit the deposit holder from an immediate refinance. The bank would collect $685,000 in early withdrawal penalties and the aggregate net benefit to depositors at maturity, after paying the penalty, would be $1.7 million.
The benefit to depositors described above is ultimately a cost to the financial institution holding the deposit and expecting to hold it to maturity. Deposit refinancing costs can become a significant financial burden. The analysis above indicates the potential magnitude of unexpected costs to ALCO committees that fail to incorporate deposit refinance analytics in their interest rate risk models.
Naturally, increasing the early withdrawal penalties negates some of the benefit to refinancing. Many bankers have incrementally increased their penalties in recent years. Doubling the penalty from six months to 12 months seems like a big improvement. However, many might be surprised at the risk that remains after this kind of penalty adjustment. A detailed account-level analysis is essential to measuring the risk. Every financial institution needs to promptly perform a portfolio-specific analysis to understand their exposure to this critical and timely issue.
As interest rates rise, therefore, effective executive leadership will use performance analytics to anticipate the costs and prepare their associates to retain deposits at optimal levels as they negotiate with informed depositors.
Mr. Stanley is CEO/founder of The CorePoint, an Omaha, Neb.-based firm offering a web-based retail deposit pricing and sales platform and performance analytics incorporating patent protected solutions. He can be reached atNeil@TheCorePoint.com.