For banks, using variable savings as a source of financing differs fundamentally from ‘professional’ sources of financing. What risks are involved and how do you determine the return? With capital market financing, such as bond financing, the redemption is known in advance and the interest coupon is fixed for a longer period of time. Financing using variable savings differs from this on two points: the client can withdraw the money at any given time and the bank has the right to adjust the interest rate when it wants to. An essential question here is: why would a bank opt to use savings for financing rather than other sources of financing? The answer to this question is not a simple one, but has to do with the relationship between risk and return.
Determining returns on the savings portfolio
How do you determine the yield on savings? In order to get as accurate an estimate as possible of the return on a balance sheet instrument, the client rate for a product is often compared to what is called the internal benchmark price, also referred to as the ‘funds transfer price’ (FTP). For savings, the FTP represents the theoretical yield achieved from investing these funds. The difference between the theoretical yield and the actual costs (which includes not only the costs of paying interest on savings, but also the operating/IT costs, for instance) can be regarded as the return on the savings. Calculating this theoretical yield is not a simple task, however. It is often based on a notional investment portfolio, with the same interest rate and liquidity periods as the savings. These periods reflect the interest rate and liquidity characteristics of the savings.
"By ensuring that the expected outflow of savings coincides with the expected influx from investments, the liquidity requirements can be satisfied in the future as well."
Managing margin risk
The question that now arises is: what risks do the savings pose for the bank? Fluctuating market interest rates have an impact on both the yields on the investments and the interest costs on the savings. Although the bank has the right to set its own interest rate, there is a great deal of dependency since banks often follow the interest rate of the market (i.e., their competitors) in order to retain their volume of savings. The bank is therefore exposed to margin risk if the income from the investments does not keep pace with the savings rate offered to clients.
The risk-free interest rate is often the biggest driver behind these kinds of movements on the market for savings interest. The dependency between the savings interest and risk-free interest is indicated using the (estimated) interest rate period. This information makes it possible to mitigate the margin risk in two ways. The interest rate period of the investment portfolio can be aligned with the savings, which causes this income to respond to the interest-free interest rate to the same degree as the costs of paying the savings interest rate. It is also possible to enter into interest rate swaps to influence the interest rate period of the investments.
Assessing liquidity risk
The liquidity risk of savings manifests if clients withdraw their money and the bank does not have enough cash/liquid investments to comply with these withdrawals. By ensuring that the expected outflow of savings coincides with the expected influx from investments, the liquidity requirements can be satisfied in the future as well. Consequently a bank will be less likely to find itself forced to raise financing or sell illiquid investments in crisis situations. A bank also maintains liquidity buffers for its liquidity requirements in the short term; the regulator requires it to do this by means of the LCR (Liquidity Coverage Ratio) requirement. Since it is expensive to maintain liquidity buffers, a bank aims for a prudent liquidity buffer, but one that is as low as possible. It is also essential for the bank to determine the liquidity period (how long savings remain in the client’s account). It must do this in order to manage the liquidity risk, but also to determine the right level of cash buffers, which improves the return. Savings modeling is a must In order to get the right insight into savings - and to manage them - it is essential to determine both the interest rate period and liquidity period of those savings. It is only with this information that management can gain insight into how the return on savings relates to the margin and liquidity risk.
Regulators are also putting increasing pressure on banks to have better insight into savings. In interest rate risk management, for instance, DNB requires that the interest rate risk of savings be properly substantiated. There is also increasing attention to this from the standpoint of liquidity risk management, for instance as part of the ILAAP (Internal Liquidity Adequacy Assessment Process). Modeling of savings is therefore an absolute must for banks.
Growing interest in savings
At the end of 2012, approximately EUR 950 million of the total of EUR 2.7 billion on Dutch banks’ balance sheets was financed with private savings. EUR 545 million of this comes from Dutch households and businesses. Given the fact that the credit extended to this sector totals EUR 997 million, the Dutch funding gap is the highest of all the euro-zone countries except for Ireland. Since the start of the financial crisis in 2008, there have been two developments that have contributed to the growing interest in savings on the part of banks. First of all, after the collapse of the (inter-bank) money and capital markets, banks had to seek out alternative stable sources of financing. Secondly, compared to other forms of financing, savings have secured a relatively favourable position in the liquidity regulations under Basel III. This culminated in a price war on the savings market in 2010.