Echo Partners Community Bank Blog

The Core Asset Liability Assumption

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As you may well know, it's not so much the asset liability model as it is the assumptions behind that model that determine the accuracy of your asset liability results. For example, changing the prepay speeds on securities or loans can increase or decrease the accuracy of your results. Similarly increasing or decreasing the runoff of your liabilities can have the same result. But the most powerful assumption in your asset liability model concerns non-maturity deposits (NMDAs).

Increasing or decreasing the decay rate will lead directly to a decreased or increased average life of these deposits. But given the size of the NMDAs, this assumption has an outsized impact on your total asset liability position. So how then do you select the proper assumptions for your NMDAs? When you get right down to it, there are only four methods available.

1.  Use the contract terms.  By contract, depositors may withdraw these accounts at any time. Therefore, some banks place these deposits in the overnight pocket. However, as experienced bankers, we know that this sort of behavior is not representative of these deposits. Placing these deposits in the overnight pocket will greatly reduce your reported asset sensitivity. Bankers who did this found out the hard way when rates fell that they were really much more asset sensitive than they thought.
   
2. Use your experience.  Using the sum total of all of your banking experience, your top management team probably has a good idea of average life behavior for these deposits. The second method uses this experience to select an appropriate average life or decay rate. This method probably results in an asset liability report that accurately reflects behavior at your bank. Unfortunately, when the regulators ask to see the backup for your assumptions there is none to show.
   
3. You could perform a deposit study. Generally, deposit studies are more complex and expensive than Community Banks wish to undertake.
   
4. Use the regulators own safe harbor. As an outgrowth of FDICIA 305, an industry standard regulatory asset liability model was proposed. While the proposal failed for a variety of reasons, the process included the disclosure of the regulators' acceptable average lives for non-maturity deposits.

Method 4 combines the accuracy of method 2 with the backup that regulators crave.

Photo provided by roger.karlsson.

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