Deposit Drag
Duration matching between a bank’s deposits and asset portfolio is the primary focus for Asset Liability Management Committees (“ALCO”) as they manage their balance sheet. Deposit duration assumptions have been tested in recent years as interest rates have risen rapidly and technology has enabled deposits to move more quickly and with less predictably.
Understanding the duration of deposits becomes even more difficult if a bank’s deposit base is volatile, concentrated, and uninsured. Volatile deposits tend to have no predictable duration and are likely to run off during market uncertainty. A highly concentrated and uninsured deposit base can potentially lead to bank runs as we have seen recently with several institutions. One way ALCOs can protect against deposit runoff or a potential bank run is to hold a larger cash or liquid security buffer, but this limits their ability to allocate funds to higher-yielding asset classes. This results in a performance drag on a bank’s asset portfolio, i.e. “deposit drag” [1].
Faced with deposit uncertainty, we’ve even seen institutions move to shed less valuable deposits in recent weeks to recalibrate their balance sheet. However, ALCOs do have tools at their disposal to reduce deposit drag today, other than just turning away depositors. One solution is to engage in a reciprocal or sweep program, which allows banks to reduce the amount of uninsured and unwanted deposits as well as diversify their deposit base. Banks, however, need more alternatives. Specifically, banks need to be able to precisely calculate the quality of a deposit to understand its duration, its corresponding collateral needs and resulting “drag”, above and beyond the analysis they are able to do today. Technology can help here by potentially analyzing a bank’s deposit base down to the account level and incorporating a variety of customer and market factors. Better deposit products, combined with tech-driven insights to analyze the duration of a bank’s deposit base, will enable ALCOs to reduce deposit drag in the future. With a more diversified deposit base and accurate insights, ALCOs can reduce their cash buffer and improve performance with more confidence.
[1] In a previous newsletter, we spoke about “collateral drag”, the opportunity cost of potential return on assets when posting collateral.
Best,
Adam and the ModernFi Team
Current rates
Change from two weeks ago
Sources: FHLB Advances are an average of FHLB Boston, FHLB Chicago, and FHLB Des Moines. Brokered CDs are an average of Fidelity and Vanguard. Listed CDs provided by National CD Rateline. US Treasurys and LIBOR provided by WSJ. SOFR provided by CME.
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