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Valuing Core Deposits

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Abstract

While the financial crisis has brought to the fore valuation of bank assets, equally important to a bank’s long-term health is the quality of its deposits. This paper employs bank-specific data on total and retained balances to value so-called core deposits: checking and savings and money market accounts. The empirical results indicate that core deposits have considerable value to financial institutions, often dramatically more than regulators have allowed. The empirical results also indicate that the value of core deposits varies substantially by institution. For some institutions the value of core deposits approaches the total value of the institution. I am grateful to Rob Battalio, Tom Cosimano, Dave Hutchison, Bill McGuire and seminar participants at the University of Notre Dame for their comments on earlier drafts. I am particularly grateful to an anonymous referee whose suggestions substantially improved the paper. Any remaining limitations are entirely my responsibility.

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Notes

  1. “Housing Lenders Fear Bigger Wave of Loan Defaults,” Vikas Bajaj, New York Times, August 4, 2008.

  2. “U.S. to Examine Actions of Washington Mutual,” Erik Dash, New York Times, October 16, 2008.

  3. “Before You Sell Your Bank Stocks …” Business Week, page 76, May 24, 2004.

  4. The valuation of deposits potentially plays a major role in a number of bank-related areas. For example, the Financial Accounting Standards Board issued an opinion for comment that financial institutions will be required to “mark to market” all assets in their portfolios in all financial reports. (“Value Judgment. New Rules Roil Banks,” Wall Street Journal, page C1, October 11, 2000). However, marking assets to market and not also marking liabilities to market need not present the desired financial clarity that FASB seeks, especially when an institution has attempted to match the maturity structure of assets and liabilities. Marking both assets and liabilities to market potentially reduces the regulatory costs imposed on financial institutions while at the same time generally increases the financial clarity of the accounting statement.

  5. OTS became part of the Office of the Comptroller of the Currency in July 2011. OTS values are employed in the following analysis because they have been published in detail and because other regulators’ procedures are very similar.

  6. Basel III’s 85% assumed retention rate under the NSFR guideline implies an average life of over 6 years assuming that retention rate remains constant as accounts age.

  7. Flannery and James (1984) examine stock market reactions to bank funding risk and find result consistent with those here.

  8. See also Hutchison (1995), Jarrow and van Deventer (1998), Selvaggio (1996), Ellis and Jordan (2001), the Office of Thrift Supervision (2001).

  9. While markets for the sale or lease or securitization of core deposits do not exist, this example indicates that core deposits may carry a positive price. In contrast, the OTS allowed lives would not imply a positive price.

  10. Looking only at the liability side of the balance sheet may overstate - or understate - the amount of risk facing a financial institution. While an institution faces interest rate risk both in terms of its liabilities and its assets, it also may attempt to match the durations of assets and liabilities and by so doing reduce the overall interest rate risk to the institution. See also Board of Governors of the Federal Reserve System. Joint policy statement on interest rate risk. Supervisory Letter SR 96-12 page 9 and Kaufman (1984) for further discussion on interest rate risk.

  11. Consistency here means that an institution did not change its pricing strategy during the sample period.

  12. Tests for whether it is appropriate to combine MMDA categories uniformly reject the hypothesis that they can be combined.

  13. For institutions where all accounts were available, the estimation results below were unaffected using deposits in all accounts retained rather than only deposits in a sample of accounts.

  14. These results are not driven by institutions with shorter sample periods. The institution with the longest sample period, 73 months, had 96% retention at the end of the sample period. That is, 96% of the savings deposits in accounts open at the beginning of the period were still with the institution 73 months later.

  15. Data on non-interest costs like labor and facility costs also are required. They are assumed fixed and are unlikely to change appreciably from month-to-month.

  16. DUMk also includes Y2K and 9/11 dummy variables.

  17. Deposit rates are assumed stationary. Including a time trend in the deposit equations together with a lagged dependent variable assumes that these variables are trend stationary rather than difference stationary. Augmented Dickey-Fuller tests support all assumptions.

  18. The Final Prediction Error (FPE) criterion was employed as an alternative to the BIC. The results were robust to this change. The results also were robust to the inclusion/exclusion of the insignificant variables. The equations also were estimated using OLS and the results were substantially the same as those reported here.

  19. For example, Bank B’s personal checking has an own lag that is positive but insignificant while the trend term appears relatively small. These results would appear to suggest that personal checking balances at Bank B will not grow appreciably. However, if the equation were re-estimated excluding the own lag, the trend coefficient increases substantially and the adjusted R2 falls only slightly. Alternately, if the trend is excluded, the own lag’s coefficient increases and is close to one with virtually no change in the adjusted R2. These two results may appear more intuitive but the estimated equations have econometric problems. The moral is that the individual coefficients in a VAR system must be interpreted with extreme care.

  20. Bank A emphasizes to its tellers cross-selling different deposit categories, consistent with its emphasis on service.

  21. One may be concerned that the analysis omits estimation of non-price competition. While non-price competition is potentially important, there is no evidence that those factors are readily changed from month to month. ATM networks and hours of operation undoubtedly influence the size and retention rates of institutions. Those items cannot be readily changed on a short term basis to attract or retain funds. In addition, there is no ready method to measure those items. The trend term could pick up their significance, but many other factors can also impact the coefficient on the trend term.

  22. There also remains a question about the ability to use a 5 or 6 year window of observations as the basis on which to forecast for 20 years. A detailed examination of the confidence intervals is the subject of continuing research. That analysis suggests that the width of the confidence intervals increases with the length of the forecast, but the increases also become smaller over time. That is, the width of the confidence intervals reaches an upper limit.

  23. The run off rates are available in OTS (2001) and the lives are calculated as the weighted averages of those rates. The other regulatory agencies, the Office of the Controller of the Currency (OCC) and the Federal Reserve (Fed), have similarly structured retention rates and average lives.

  24. In addition to the core deposit results presented here, equations were estimated for CD’s where that data was available. CD’s of length up to 2 years virtually never have an average life exceeding 3 years. Thus, the value to the institution of CD’s appears to be near zero, consistent with the perspective that the market for CD’s is competitive.

  25. There are alternative rate changes that may appear more reasonable to consider than a simple and immediate fixed rate increase or decrease. For example, one might ask what would happen if interest rates change consistent with a yield curve approach, for example with short term rates increasing or decreasing more than long term rates. Regulators have not adopted this approach and consider only an immediate and fixed rate change, and that is the reason for the structure of the rate change scenarios presented here. The results from the yield curve approach are similar to those presented in Table 5. Considering the term structure of interest rates complicates the analysis substantially and does not alter the basic results.

  26. It should be emphasized that both credit union’s approaches may be correct for the institution. For example, D could have assets that increase in value when rates rise while E has assets that decrease in value when rates rise. Both would be hedging the asset side of their portfolio.

  27. While the SNL data provides a very useful corroboration of the results here, that data also needs to be interpreted with care. For example, some branch sales stem from antitrust considerations, with banks being required to divest some branches before a merger is allowed. Others are driven by weak profits of branches not in an institution’s primary market. Both these types of sales may lead to relatively low reported deposit premiums.

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  1. Department of Finance, University of Notre Dame, Notre Dame, IN, 46556, USA

    Richard G. Sheehan

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Correspondence to Richard G. Sheehan.

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Sheehan, R.G. Valuing Core Deposits. J Financ Serv Res 43, 197–220 (2013). https://doi.org/10.1007/s10693-012-0130-6

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