Alternative approaches to

modelling Non-Maturing
Deposits

Floris van Diest

Senior Consultant
Zanders Treasury & Finance Solutions
Global Association of Risk Professionals

September 2016
 The views expressed in the following material are the

author’s and do not necessarily represent the views of

the Global Association of Risk Professionals (GARP),

its Membership or its Management.

2
Tuesday, 20 September 2016

GARP Chapter Meeting - Zürich

Alternative approaches to
modelling Non-Maturing Deposits

Floris van Diest

Senior Consultant
Alternative approaches to modelling Non-Maturing Deposits - 3
Introduction to Zanders
• Founded in 1994
• An independent and specialised advisory firm in
o Financial Risk Management
o Treasury Management
o Corporate Finance
• Over 120 qualified consultants operating from
o The Netherlands
o Belgium
o United Kingdom
o Switzerland
• Providing advisory, transactions, interim and outsourcing services
• From strategy and governance to design and implementation
• Strong track record at financial institutions, corporates and public sector

Zanders believes that treasury and risk management solutions should be advised in an independent,
innovative and entrepreneurial manner based on innovative concepts which align with the
constant evolution of the financial markets

Alternative approaches to modelling Non-Maturing Deposits - 4

Zanders’ NMD modelling track record
• Regarding interest rate risk and liquidity risk modelling of
NMD, Zanders has extensive experience in:
o (Re)design
o Implementation
o Validation
• Zanders has gained this experience across:
o 10+ bigger (incl. G-SiB’s) and smaller banks in the
Netherlands and Switzerland
• Projects involved both:
o Replicating portfolio approaches
o Volume/attrition approaches
• Zanders is also engaged in its own research and assessments on
the topic

(Re)design Implementation Validation

Alternative approaches to modelling Non-Maturing Deposits - 5

Agenda

1. Interest rate risk modelling of NMD

2. Market practice in interest rate risk modelling of NMD
3. Impact of environment on interest rate risk modelling
4. Evaluation of alternative calibration techniques

Alternative approaches to modelling Non-Maturing Deposits - 6

Interest rate risk modelling of NMD
NMD Considerations

Behavioural • Client’s option: Clients can withdraw funds at their convenience

optionalities • Bank’s option: Banks can adjust the client rate at their convenience

• Interest rate risk (IRR) measurement and management

Model
• Product pricing and hurdle rates (margin)
applications
• Fund Transfer Pricing

Risk • IR typical and L&F typical behaviour of NMD can be different

measurement • Segregation between interest rate risk and L&F risk is common

Correctly reflecting risks in hurdle rate vital to have a correct view on

Profitability the economic profitability of products and businesses

Alternative approaches to modelling Non-Maturing Deposits - 7

Agenda

1. Interest rate risk modelling of NMD

2. Market practice in interest rate risk modelling of NMD
3. Impact of environment on interest rate risk modelling
4. Evaluation of alternative calibration techniques

Alternative approaches to modelling Non-Maturing Deposits - 8

1. Traditional Replicating Portfolio (RP) approach
Earnings perspective

• Model the joint client’s/bank’s behavioural (IRT) maturity by:

o … replicating its (market) interest rate sensitivity Marginal investment strategy
Goal

Investment notional
o … with an investment portfolio of fixed-rate instruments
o … based on an ‘optimal’ investment strategy

• Static rule stipulating what percentage of volume should be

invested in which tenors
0M 6M 12M 18M 24M 30M 36M
o Marginal investment strategy: monthly ‘investable
Investment
amount’ invested with a fixed rule Portfolio investment strategy
strategy

Investment notional
o Portfolio investment strategy: monthly ‘investable
amount’ invested s.t. total portfolio maturity profile aligns
with fixed (‘optimal’) allocation rule

• ‘Optimal’ investment strategy based on minimizing volatility

of ‘product margin’ in simulation(s): 0M 6M 12M 18M 24M 30M 36M
Strategy
o Coherent set(s) of historic/forward-looking market
calibration
interest rate, client rate and volume scenarios
o Potentially subject to portfolio constraints

Alternative approaches to modelling Non-Maturing Deposits - 9

2. Cash flow modelling approach
Economic value perspective Client rate modelling
6.0%

Interest rate
• Model the joint client’s/bank’s behavioural (IRT) maturity by: 5.0%

4.0%
Goal o … modelling the cash (out)flows
3.0%
o … modelling the client coupon cash flows 2.0%

1.0%
• Two types of models:
0.0%
o Client rate model: models future client rates based on -1.0%
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Cash flow scenarios for the underlying drivers NMD client rate 1M Euribor MA 1Y swap MA 8Y swap

model o Cash (out)flow model: models future NMD volume Vintage modelling
outflow assuming a run-off portfolio (i.e. vintage 180

Volume (in mln.)

modelling) incorporating various drivers 160
140
120
• Parametrization derived from ‘best fitting’ historical time 100

Model series of client rates, outflow rates and underlying drivers 80

60
calibration • Additionally, forward-looking time series might be implied by 40
expert judgement 20
0
2009 2010 2011 2012 2013
NMD volume Vintage run-off

Alternative approaches to modelling Non-Maturing Deposits - 10

Comparison of approaches
Difference in view on interest rate risk

Replicating portfolio approach Cash flow approach

Current account CR modelling
IRR Product margin stabilization Run-off portfolio cash flow model 6.0%

Interest rate
view objective implies earnings view implies economic value view 5.0%

4.0%

• Interest rate risk measurement • Interest rate risk measurement

3.0%

Model 2.0%
• Physical/hypothetical risk transfer • EaR derived from CR model
use 1.0%

• Hurdle rate (IRR FTP) calculation • Easily applied to reg. reporting 0.0%
2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
-1.0%

Difference in approaches
1M Euribor MA 1Y swap MA 8Y swap Current account client rate

Current account outflow modelling

Outcomes of the two approaches can deviate substantially. For example, for 100%

Remaining volume (as% of begin.)

Current Account portfolios: 90%
80%

Replicating portfolio approach Cash flow approach

70%
60%
50%
40%
Given market interest rate Given substantial outflow from 30%

IRR insensitive client rate, margin current account deposits, statistical 20%
10%
view stabilization objective favours long fit will favour short duration 0%
0M 6M 12M 18M 24M 30M 36M 42M
duration investment strategy parametrization Current account Savings account

Alternative approaches to modelling Non-Maturing Deposits - 11

Agenda

1. Interest rate risk modelling of NMD

2. Market practice in interest rate risk modelling of NMD
3. Impact of environment on interest rate risk modelling
4. Evaluation of alternative calibration techniques

Alternative approaches to modelling Non-Maturing Deposits - 12

Market environment
Low/negative interest rates
• Current market environment influences calibration of NMD Historical market interest rates
Replicating portfolio approach 6.0%

Interest rate
5.0%
• Aims to manage earnings risk
4.0%
o Short term view on IRR might disregard long term effects
3.0%
(prone to front-loading of product earnings)
2.0%
• Margin under the current interest rate environment could drive
1.0%
the calibrations towards longer duration strategies
0.0%
o Flooring client rates at 0%: Convergence of market 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
-1.0%
rates and decreasing volatility of short term rates may lead 1M Euribor 1Y swap MA 1Y swap 8Y swap MA 8Y swap
to underestimations of ‘true’ interest rate sensitivity
o Lack of alternative investment opportunities: Inflow Developments call for:
of interest rate sensitive NMD volume into bank’s • Incorporation of both earnings effects and
replicating portfolios is deemed non-stable and might not economic value effects
be captured by existing strategy • Diverse set of forward-looking scenarios (incl.
o Portfolio legacy: Low yielding longer tenor RP steep increases of market interest rates,
outflow of instable volume)
investments may influence future performance in long-run

Alternative approaches to modelling Non-Maturing Deposits - 13

Regulatory environment
IRRBB standards and guidelines
• Both BCBS and EBA hint on a balanced dual view on interest rate risk

 “… where an institution considers calculation of interest rate risk to be based on

EBA impact of future earnings, it should nonetheless also consider the economic
value at risk in its balance sheet position…” - IRRBB guidelines (2015)

• “The Committee observes that most commercial banks primarily utilise earnings-
based measures for IRRBB management…. The Committee acknowledges the
BCBS importance of both economic value and earnings-based measures…”
• “… The banks’ risk appetite for IRRBB should be articulated in terms of the risk
to both economic value and earnings” – IRRBB standards (2016)

Blending earnings risk with economic value risk perspective

• Both market and regulatory environment call for more dual view on interest rate risk
and thereby interest rate risk modelling combining earnings and economic value risk
• Bring together traditional replicating portfolio and cash flow based approach into one

4 alternative techniques across earnings risk vs. economic value risk spectrum
for calibrating replicating portfolios will be presented

Alternative approaches to modelling Non-Maturing Deposits - 14

Agenda

1. Interest rate risk modelling of NMD

2. Market practice in interest rate risk modelling of NMD
3. Impact of environment on interest rate risk modelling
4. Evaluation of alternative calibration techniques

Alternative approaches to modelling Non-Maturing Deposits - 15

Alternative calibration techniques
A. Static approaches
• Approaches calibrate the RP strategy in traditional ‘static’ way:
– Out of 500 possible strategies a strategy is selected satisfying a
given objective function estimated over various scenario triplets
Product line B/S
• Three approaches: Rep. portfolio (RP) NMD portfolio (NMD)
1. Earnings approach:
 Objective: Minimize σ(Product margin) Product margin (Mt) • Return (Rt) • Client rate (CRt)
2. Value approach:
• Notional CF’s (Nt) • Cash outflow (Ot)
 Objective: Minimize σ(Product NPV)
3. Blend approach: Product NPV (NPVt) • PVRP = PV(Rt+Nt) • PVNMD = PV(CRt+Ot)
 Objective: Minimize σ(Portfolio Risk)

• where σ(Portfolio Risk)= 𝑤𝑒2 ∙ 𝜎 2 𝑀𝑡 + 𝑤𝑣2 ∙ 𝜎 2 𝑁𝑃𝑉𝑡 + 2 ∙ 𝑤𝑒 ∙ 𝑤𝑣 ∙ 𝜎 𝑀𝑡 ∙ 𝜎 𝑁𝑃𝑉𝑡 ∙ 1

B. Dynamic approach (delta hedging)

• Dynamic investment strategy with the objective to establish a delta hedge of the NMD portfolio
4. Dynamic value approach:
• Objective: Key Rate PV’01RP= Key Rate PV’01NMD

Alternative approaches to modelling Non-Maturing Deposits - 16

Simulation – Current Accounts
Volume and market interest rate scenario
Simulation 8.0% 400

Market interest rate

Volume (in mln.)

• Performance of different approaches is tested in a 7.0% 350

simulation with an underlying scenario combining: 6.0% 300

5.0% 250
o Market interest rate scenario [*] 4.0% 200
Combined historic (2006-2016) and reverse-historic scenario 3.0% 150
for the Euribor-Swap curve 2.0% 100
o NMD volume scenario [*] 1.0% 50

Increasing volume scenario including shocks coherent with 0.0% 0

the market interest rate scenario

2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026
1M Euribor 1Y swap 10Y swap NMD volume
[*] Note this scenario is chosen purely for hypothetical performance testing of various
NMD cash flow model approaches. It is not a suggested approach for calibration of NMD behavioural models
• Estimation of PVNMD in each step of the simulation requires
a model generating future cash flows used as proxy Cash flow model
100 2.0

Volume/cash outflow (in mln.)

o Client rate model

Coupon cash flow (in mln.)

90 1.8
• Model structure incorporates (moving averages of) 80 1.6
market interest rates as drivers 70 1.4

• Pre-defined parametrization implying low sensitivity to 60 1.2

50 1.0
market environment as expected for current accounts 40 0.8
o Outflow model 30 0.6
• Model structure incorporates interest rate incentives and 20 0.4
aging factors as drivers 10 0.2
• Pre-defined parametrization implying generally high 0
0M 12M 24M 36M 48M 60M 72M 84M 96M 108M 120M
0.0

outflow as expected for current accounts Outstanding NMD volume Cash outflow Client coupon

Alternative approaches to modelling Non-Maturing Deposits - 17

Evaluation of alternative techniques
Product margin Normalized NPV (% of NMD volume)
5% 10%

Product NPV / Volume

Product margin
8%
4%
6%
3%
4%
2% 2%

1% 0%

-2%
0%
-4%
-1%
-6%

-2% -8%
2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026 2006 2008 2010 2012 2014 2016 2018 2020 2022 2024 2026

Volatilities Duration
1.0%

Average product margin

4.0%
σ(Product NPV / Volume)

Earnings approach 0.9%

3.5% Earnings approach
0.8%
3.0%
0.7%
2.5% 0.6%

2.0% 0.5%
Blend approach
1.5% 0.4%
Value approach
Blend approach 0.3%
1.0%
Value approach 0.2%
0.5% Delta hedge approach Delta hedge approach
0.1%
0.0% 0.0%
0.00% 0.25% 0.50% 0.75% 1.00% 1.25% 1.50% 1.75% 2.00% 0 1 2 3 4 5
σ(Product margin) Duration

Alternative approaches to modelling Non-Maturing Deposits - 18

Conclusion
Considerations for future calibration of Non-Maturing Deposits

• Modelling of NMD is currently under scrutiny of regulators

• Current market environment incentivizes banks to rethink NMD modelling approach

• Different calibration techniques result in potentially widely different outcomes

• In order to make an informed decision, ALCO may require transparency on dual risk view
o Balancing act between short-term and long-term risk considerations

• Pure earnings focus may not capture long term effects of strategies once market rates start rising
o Focus on one risk measure disregards the other one
o Front-loading of earnings has a negative impact on NPV in the long-run
o Underestimation of repricing risk

• Blended approach allows for balancing earnings risk vs. economic value risk appetite
o Combining the replicating portfolio approach with a cash flow based approach
o Evaluate outcomes of alternative techniques in terms of earnings risk and economic value risk

Alternative approaches to modelling Non-Maturing Deposits - 19

Agenda

1. Interest rate risk modelling of NMD

2. Market practice in interest rate risk modelling of NMD
3. Impact of environment on interest rate risk modelling
4. Evaluation of alternative calibration techniques
Discussion

Alternative approaches to modelling Non-Maturing Deposits - 20

Contact details

Zanders BV
Brinklaan 134
1404 GV Bussum
The Netherlands
T: +31 35 692 8989

Zanders UK LLP
26 Grosvenor Gardens
SW1W 0GT London
United Kingdom
T: +44 20 7730 2510

Zanders Belgium BVBA

Place de l’Albertine 2 B6
1000 Brussels
Belgium
T: +32 2 213 8400

Zanders GmbH
Gessnerallee 36 Floris van Diest
8001 Zürich f.van.diest@zanders.eu
Switzerland T: +41 76 315 1177
T: +41 44 577 7010

Alternative approaches to modelling Non-Maturing Deposits - 21

Disclaimer

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Although any indicative information is reflective of the terms under which a transaction might
be arranged, no assurance is given that such a transaction will be executed on the specific
terms indicated, due to changes in circumstances or new understanding through further
analyses.

Alternative approaches to modelling Non-Maturing Deposits - 22

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