It is clear that the outline agreement 2018 (Hoofdlijnen Akkoord 2018) is starting to crack. Slowing down the growth of medical-specialist care expenses to zero percent has not yet proved feasible in practice. Demographic developments, among other things, are causing demand for care to rise, but the parties are unable to realize the intended transition from hospital care to primary care at the same pace. In the mean time, however, insurers want to stick to the zero percent goal while hospitals do not want to turn patients away. In some arrangements, particularly those involving “effective care”, care provided in excess of the agreed amount is still (partly) reimbursed.

NECESSARY INVESTMENTS

As for the hospitals, in addition to the increase in demand for care, more money is needed. The recent CAO agreements are not covered by the regular agreements with the health insurer. Furthermore, it is common knowledge that the level of investment has lagged behind in recent years. Hospitals cannot continue to postpone the necessary investments in renovation, electronic patient files and further automation. Room must be created in operations to be able to bear the extra financing costs (interest and depreciation) in the long run.

"The hospital’s business case, with a projection of new investments, can no longer be made on the basis of the outcome of the negotiations with the health insurer."

Delivering care for the right remuneration has therefore become an increasingly delicate balancing act. The question is how the hospital will succeed in doing this within its operations and continue to comply with its financing ratios. The transition does not result in any cuts. Savings must come from the application of new concepts that lead to greater efficiency and a lower demand for second-line care. However, these developments take place at a slower pace than desired. Until then, hospitals feel, health insurers should step in. At least, as mentioned above, by reimbursing “effective care” above the agreed amount. The alternative is to raise the rates where there is still some room. So P or Q.

FINANCIAL BUSINESS CASE

The hospital’s business case, with a projection of new investments, can no longer be made on the basis of the outcome of the negotiations with the health insurer. Instead, during the negotiation process the person who controls the multi-year budget model – the treasurer – must be involved in the process. This gives the hospital more insight into the financial consequences. Sharing these insights with the health insurer can better substantiate the hospital’s arguments and thus provide more insight during negotiations. This way, the insurer becomes more directly involved in the long-term prognosis and the long-term financial health of the hospital. It thereby becomes a joint objective to achieve affordable care in the long term.

An important part of the financial business case is shaped during negotiations with the insurer. During the negotiations, the hospital wants to be able to steer the long-term impact of the outcomes. This is the only way to ensure that a proposition emerges that is financeable for banks and secure for the WfZ (Guarantee Fund for the Health Care Sector), and that the hospital is able to comply with the financing ratios in the long term. It will remain a balancing act, but one with a more solid basis.

Financial setbacks can occur due to, for example, higher construction costs, inability to invoice due to IT problems, or production falling behind due to staff shortages. Savings, also called liquidity buffer, give you some time in such situations to take measures to resolve the incidents. If these temporary liquidity shortfalls cannot be compensated in time, this may translate into structural problems, deterioration of cash flow ratios, higher risk premiums on loans and, in the long term, perhaps even bankruptcy. A buffer therefore seems logical, but the design of a liquidity buffer is not that easy. After all, how is the amount and form of the buffer determined?

BUFFERING! (OR IS IT?)

Maintaining a liquidity buffer requires reserving available funds, but may be seen as unnecessary and socially undesirable. After all, there seems to be enough liquidity available to compensate setbacks and the public money could be better spent on social purposes. In practice, however, it happens that additional liquidity is not routinely or immediately available, or it is difficult to release funds quickly, or the additional liquidity is insufficient to temporarily compensate deficits.

Banks are also less likely to provide money to cover shortfalls during difficult times. In addition, the application process at a bank can take a relatively long time. To ensure the financial continuity of an institution in both good and bad times, many healthcare and educational institutions therefore feel the need to keep extra liquidity on hand, often encouraged by the accountant or the supervisory board. Next to that, bodies such as the WFZ (Guarantee Fund for the Health Care Sector), the Education Inspectorate and banks also stress the importance of a healthy liquidity buffer.

An important consideration is that the comfort of a liquidity buffer in the event of financial setbacks is only temporary. After all, you can only spend the money set aside once. If liquidity shortages continue and thus become structural in nature, you will have to look at long-term measures. However, using the liquidity buffer for structural deficits can give you more time to take a considered decision on the measures to be taken.

THE THICKER THE PIGGY BANK, THE BETTER?

An unequivocal answer to this question cannot be given. The starting points used differ per sector and per institution. In educational institutions, for example, we often see the current ratio as a yardstick for the buffer to be maintained. The current ratio indicates the relationship between the current assets and the current liabilities. The Education Inspectorate uses a current ratio of at least 0.5 for institutions in higher education and intermediate vocational education, and at least 0.75 for institutions in primary education, as a signaling value. However, many administrators and supervisory boards are comfortable with a higher standard and aim for a minimum ratio of 1.0 or higher.

An advantage of this methodology is that the current ratio does not yet take into account any room under the current account facility. This means that any current account facility can serve as an extra buffer in difficult times. A disadvantage is that the current ratio is generally a snapshot of the end of the year; no account is taken of intra-year developments. In case of an institution with volatile cash flows, guiding buffers by means of the current ratio can also lead to a yearly varying available buffer.

An alternative is to keep the amount of the liquidity buffer constant by steering towards an absolute norm. The WFZ, for example, advises healthcare institutions to use twice their turnover per month as the standard, but states that this is not a universal, objective standard. Zanders also sees many institutions using a standard of twice the monthly salary or 1.5 months' turnover. One point to note is that these standards are often quite high.

Our general advice is to gear the amount of the buffer to the liquidity development in both the short and long term, the risks and factors that play a role in your sector and in your institution. In addition, we recommend that the development of your long-term budget in the event of negative developments, also referred to as scenario analyses, be included in the consideration. Comfort can also play an important role. After all, it is up to you to determine which liquidity buffer is most appropriate and offers most comfort in daily operations.

DIFFERENT COMPONENTS OF YOUR BUFFER

Decisions must be made not only about the amount, but also about how to build up the liquidity buffer. Banks often offer the option of maintaining a liquidity buffer in the form of a current account facility, where the borrower pays commitment fees on the unused proportion and is charged a variable interest rate plus mark-up on the used portion. Generally, the amount of the current account is tailored to the institution's liquidity forecasts.

When deploying the current-account credit, it is important to determine whether it is committed or uncommitted. With an uncommitted overdraft, the bank can unilaterally cancel the facility daily - this is an availability risk. With a committed facility, there is the 'certainty' that the bank may not withdraw the facility during the agreed term. Also for this service, a commitment fee must be paid on the unused portion and the bank may ask for a higher mark-up during bad years when using the current account. In addition, there may be contractual terms that still allow the bank to unilaterally cancel the unused portion.

"An important consideration is that the comfort of a liquidity buffer in the event of financial setbacks is only temporary. After all, you can only spend the money set aside once."

From a risk perspective, it could therefore be argued that credit balances are safer than current account facilities. After all, this money cannot be cancelled unilaterally and there is no commitment fee on the unused portion or interest charges on the used portion. However, due to the low interest rates in recent years, the savings interest rate on credit balances has fallen to such a low level that it is currently even negative. For some banks this means that interest is no longer received on positive balances, but that from a certain size of credit balance onward, interest may have to be paid, also called negative interest. As a result, financing must then also be attracted in order to maintain the liquidity buffer, so there are double costs. In this case you not only pay interest on the credit balance, but also the regular financing costs.

Some institutions see their investment portfolio as an emergency pool they can use in difficult times. The advantage of invested money is that you do not suffer from negative interest rates or commitment fees. You also have a monthly stream of investment income. However, not every institution is allowed to invest money due to laws and regulations. Furthermore, you have to deal with counterparty risk, price risk in case of interim sales, and risk of negative returns. Moreover, the question is whether you can liquidate your investments fast enough to make payments.
The above options provide institutions with the room to have additional funds available during financially challenging times. However, the question remains as to which is the best option. Each option has advantages and disadvantages, and to make the choice even more difficult, a combination of the above options could also be a good solution for you.

CUSTOMIZATION, CUSTOMIZATION, CUSTOMIZATION...

Many institutions see the need to maintain a liquidity buffer either from a risk perspective, because of regulatory requirements, or for having comfort in operational execution. However, there is no simple answer to what the optimum level of a liquidity buffer is and how exactly it should be built. Each institution has its own risks and factors that must be taken into account. Setting up a liquidity buffer therefore requires a thorough analysis of cash flow development in the short and long term, key figures, costs, risks and options available from banks while adhering to legislation and regulations. In short, setting up a liquidity buffer is and remains custom work!

When a positive operating cash flow is realized, it is easier for a company to invest in acquisitions, fixed assets and innovation, for example. On the other hand, a negative operating cash flow can be an indication that the survival of an organization in the long term may be at risk. Therefore, a reliable cash flow forecast is of strategic importance for every organization and deserves attention at board level as well.
In one of our other articles about cash flow forecasting, we focus on information, processes and systems that are needed to come to an accurate cash flow forecast. In this article, we focus on the strategic side; which stakeholders, agreements and steering possibilities play a role to keep a grip on the cash flows in the long run?

STAKEHOLDERS

Having sufficient liquidity in the long run ultimately means continuity for the company. Internally, not only management (Board of Directors) but also the Supervisory Board (SB) is responsible for this. Large investments often have to be approved by both. They will therefore want to be informed well and in time about the expected development of the liquidity position in the short and longer term. After all, if a cash shortage threatens, directors' liability comes into play. The management board may not enter into any new obligations if it can reasonably assume that the current creditors cannot be paid (in the short term).
In some cases there may be a public shareholder. For them, insight into cash flows and the development of liquid assets is of great importance. After all, if a cash shortage is imminent, the shareholder is often the first to be approached to supplement this.
A company also has to deal with external stakeholders. The most important are often the financiers and the auditor. Financiers can be banks, but also ministries (through treasury banking) or care offices (funding). The financiers usually monitor the financial health of the company using various ratios and covenants. The liquidity position is very relevant here because, among other things, it gives an indication of the extent to which the organization is able to repay the outstanding loan(s).
Finally, the auditing external accountant follows the liquidity position with above-average interest, because when auditing the financial statements he must issue a continuity statement, among other things. This is only possible if there are sufficient liquid assets to meet current liabilities for at least 18 months in advance.

APPOINTMENTS

Internal agreements focus mainly on the frequency, timing and type of cash flow forecast. In calm, predictable times with an ample liquidity buffer the demands are different from those in uncertain, turbulent times. This therefore requires a different set-up of the organization. During predictable times and when there are no major investment plans, a good understanding of the liquidity position is still important, because it affects the amount of funding to be raised or the deployment of funds, for example.
However, in that case the frequency of forecasting does not have to be weekly, the timing is less strict and the indirect method suffices (in which the cash flows originate from the P&L account and the balance sheet. This method therefore also includes the cash effects of balance sheet changes). Reporting to management board members also takes place less frequently. However, if the company is in dire straits, this will not be sufficient and the frequency of the forecast and the reports will have to be increased. Moreover, the time horizon will be longer.

"In addition to making arrangements to make cash flows transparent, it is equally important to know what tools a director has to prevent a cash shortage."

The ability to attract additional funding is largely determined by the extent to which the organization is able to provide the necessary insight into, and correct substantiation of, the cash flows, assuming sufficient repayment capacity. This means that extra attention must be paid to the design of the processes, the mutual communication and the quality of the available data. Although these are matters that must be arranged in the operational process, this often does not happen automatically. It is therefore desirable for directors to keep a close eye and at least discuss the progress made in this area with the responsible manager(s).
It is also good for directors to be aware of the most important agreements in the financing contracts. For example: when must the (un)audited annual figures or the calculation of the bank covenants be submitted; what are the consequences of breaching the covenants; what conditions apply to obtaining a waiver? Although there is a whole process involved, it is good to realize that, worst case, failure to meet certain obligations in the contract can lead to an event of default and ultimately even a loan falling due.

CONTROL OPTIONS

In addition to making agreements to provide insight into cash flows, it is at least as important to know which instruments a director has to prevent a shortage of liquid assets. Before discussing this with financiers or possible shareholders, experience shows that they will often first demand that costs and revenues be closely scrutinized. Furthermore, outside the organization additional financing can be sought from banks or a ministry.
If available, a shareholder can be asked for additional capital. Which one should be approached first, again depends on the situation. In times of uncertainty, or when the financiers have financed a large amount (this can be determined using the net debt/EBITDA or Loan to Value), it is common to approach the potential shareholders first.
After all, because of the uncertainty about the future or the size of their current exposure, financiers will be reluctant to put extra money into the company. It is important to inform shareholders during good times and to keep them informed in the regular reporting cycle. To avoid being taken by surprise, they should be informed immediately of any development that could have a major impact. If the company is doing well and investments are needed to facilitate growth, for example, the financiers can be consulted first. Whether they are prepared to provide additional financing depends on several factors (such as the nature of the investment plans and the robustness of the forecasts provided), but the basic attitude will often be positive.

CONCLUSION

The importance of understanding the development of cash flows is not purely an operational matter. Cash flows play an important role in the continuity and flexibility of the business, the ability to invest, the timely identification of risks and the determination of the value of the business. For these reasons cash flows deserve attention at board level. To obtain good insights, the relationship with internal and external stakeholders, the agreements made with financiers and the measures to adjust play an important role. In all these matters, timeliness, predictability and accuracy are key to continuity and therefore important for a director. It is advisable to continuously invest in and pay attention to these issues.

During uncertain times, making a forecast requires extra effort and poses a greater challenge. For example, due to uncertainty, it may be decided to update the liquidity forecast(s) more frequently. The question raised then is what frequency is appropriate and how to deal with the assumptions underlying forecasts made during an economically sound period. In this article we discuss the information, processes and systems that are important for getting (and keeping) a good grip on the development of cash flows. Ultimately, as an organization you want to have a reliable picture at all times of the expected development of the liquidity in the short, medium and long term.

AVAILABILITY OF THE RIGHT INFORMATION

In order to obtain the best possible picture of the liquidity position, the quality of the underlying information is of great importance. The realized and projected profit and loss account, balance sheet, investment plans and transactions form an important part of the input. From a theoretical point of view, there are two methods to translate this input into the calculation of the (expected) cash flows; the direct and the indirect method.

• Under the direct method, cash flows are based on individual incoming and outgoing transactions, such as accounts receivable receipts, accounts payable payments, investments and interest payments.
• Cash flows under the indirect method arise from the P&L account and the balance sheet. Thus, under this method, the cash effects of balance sheet changes are also included.

Which method is appropriate depends in part on the length of the specific forecast. Actual bank movements (or an accurate estimate of these), on which the direct method is based, are often available for a relatively short period of time. This makes this method suitable for a short-term forecast. With the indirect method, the cash flows are derived from the projected P&L account and balance sheet. Because of this combination, this method is ideal for medium and long-term forecasts.
The most appropriate methodology depends partly on the length of the liquidity forecasts. In order to obtain a good picture of the liquidity position in the short, medium and long term, various forecasts must be prepared. These forecasts differ in terms of time units (week, month, quarter and year) and length (quarter, year and > 1 year). The matrix below shows the different time lines again, with the different forecasts shown vertically. To the right of the matrix, the appropriate methods for each forecast are shown.

Here, it is often the case that the longer the period over which the forecast is made, the less accurate the forecast. The choices regarding time units and length of the forecast are related to the phase in which the organization finds itself and the type of sector in which the organization operates. For example, in times of economic uncertainty (such as the current pandemic) or in the case of a weak financial position, it is often chosen - sometimes imposed by external financial stakeholders (e.g. special management of a bank) - to produce a short term forecast on a weekly basis. This should ensure that the financial position is brought into focus on a weekly basis, thereby increasing the grip on cash flows.

"In order to get a good picture of the liquidity position in the short, medium and long term, various forecasts need to be made."

However, this does not mean that the financial position is more accurately portrayed by creating more forecasts of different lengths. Indeed, too many (different) forecasts generate a constant time investment that is too great to keep updating them.
When an organization is in a "quiet" period, a monthly forecast for 12 months rolling, combined with a multi-year (annual) forecast for 5 years rolling, may be sufficient. However, consistency between forecasts is crucial. The inputs provided should be consistent across the different forecasts, and the time units of the different forecasts should overlap. For example, if a 13-week forecast (quarterly) is chosen, it will logically align with the liquidity forecast of at least 12 months rolling on a quarterly basis.

EMBEDDING IN SYSTEMS

One of the tools needed to process and update all information is a system that brings together all cash flow information. In practice, a treasury module in the existing ERP system or an Excel file is regularly used. If Excel is used without a clear format, it often turns out to be too complex, confusing and prone to errors. With a clear format, Excel can certainly be a suitable tool. In addition, one can choose to largely automate the forecasting process by means of an application.
The format of the chosen system will act as a means of creating consensus among internal stakeholders on the approach and principles of forecasting. In addition, it will create clarity towards external stakeholders. In order to maintain an overview, it is advisable to subdivide the cash flows into a limited number of items. The following three types of cash flows provide the basis for this:

• Operating cash flow: all cash flows resulting from operations.
• Investing cash flow: consisting of the investments in fixed assets, investments in the form of acquisitions or revenue sales.
• Financing cash flow: all expenditures and income from financing activities (a different choice can be made with respect to interest).

TREASURYnxt provides organizations with a flexible way to create liquidity forecasts for the above cash flows. To learn more about TREASURYnxt , click here.

GETTING A GRIP ON CASH THROUGH THE RIGHT PROCESSES

Besides information and systems, processes will need to be established within the organization to really get a grip on the cash position. Fixed processes bring structure to the preparation, comparison and updating of forecasts. It must always be possible to answer the question of why a particular cash flow differs from a previously prepared forecast.
It is important to be able to explain the difference between two liquidity forecasts of different times. A clear format can help with this. The challenge lies in constantly updating and reconciling these forecasts. If, for example, an investment is postponed, this will have to be reflected immediately in the investment cash flows of the forecasts. Here, clear communication is crucial. This starts with internal communication, by means of regular meetings or calls (so-called cash calls). By scheduling regular cash calls, during which the cash position and expectations are discussed and analyzed, the forecasts remain up-to-date. It is preferable to align the frequency of these cash calls with the frequency of the relevant forecast. In communications with external stakeholders, it is particularly important to provide insight into the risks and opportunities of the forecasts that have been prepared.
Finally, it is essential to compare the actual realization of the cash flows with the forecast that was prepared for the cash flows. The deviations and insights arising from this must be taken into account in the forecast for the subsequent period. After processing this realization, the length of the relevant forecast will have to remain unchanged, a so-called rolling forecast.
Ultimately, grip on the cash position can only be realized through the combination of information, systems and processes. A clear vision on this helps to structure this interplay.

The low or even negative market rates in many Western European countries significantly affect banks’ pricing and funding strategy. Many banks hesitate to offer negative rates on non-maturing deposits (NMD) to retail customers. In some markets, like in Belgium, regulatory restrictions impose a lower limit on the savings rate that a bank can offer. The adverse impact of these developments is that current funding margins for many banks are under pressure.

The flooring effect on variable rate deposits is a hot topic for banks’ Risk Management functions due to its impact on the pricing dynamics and customer behaviour. Although it is possible that banks offer negative deposit rates when interest rates continue to decrease (“soft flooring”), banks depend on the pricing strategy of competing banks. Next to that, offering negative rates can cause serious reputational damage, leading to deposit volume outflows. The next paragraphs outline the key focus regarding risk reporting, economic hedges, and risk models for Risk and ALM managers.

BREACHING THE SUPERVISORY OUTLIER TEST

Banks are likely to hit the Supervisory Outlier Test (SOT) because of the asymmetric sensitivity of the economic value to interest rate shocks. Banks must inform their supervisor when the Economic Value of Equity change resulting from specific interest rate scenarios exceeds certain thresholds. Asymmetric pricing effects on NMD can have substantial impact on economic value and earnings. This is because when NMD rates are close to the floor, the interest rate sensitivity decreases. This effectively makes NMD similar to fixed-rate instruments like bonds.

"Banks are likely to hit the Supervisory Outlier Test (SOT) because of the asymmetric sensitivity of the economic value to interest rate shocks."

Risk Management functions need to adjust the Economic hedge to mitigate the interest rate typical gap between assets and liabilities. While NMD are traditionally variable-rate products, these behave more like interest rate insensitive instruments in a low interest environment. Risk managers need to reflect this impact in the economic hedge. It is important to realize that it is difficult to capture the non-linearity of NMD, resulting from the floor, with linear financial instruments such as interest rate swaps. Although some banks are adjusting the hedge on a best-estimate (duration or DV01) basis, the asymmetric pricing effects will largely be left unhedged. Banks can choose to accept and monitor this risk, or capitalize for it.

Risk models need to be adjusted to reflect flooring effects on NMD. For most Western European markets, historical data is dominated by higher interest rate levels and does not yield representative behavioural risk estimations.

SAVINGS MODELING SERIES

This short article is part of the Savings Modeling Series, a series of articles covering five hot topics in NMD for banking risk management. The other articles in this series are:

• How to determine core non-maturing deposit volume?
• Non-maturing deposit model concepts for banking risk management
• Calibrating non-maturing deposit models: historic data or scenario analysis?
• How ‘hidden savings’ dominate the risk profile of current accounts for banks

WHAT ARE HIDDEN SAVINGS?

Because the low or zero rates offered by banks provide little motivation to move money to savings accounts, many banking customers use their current accounts as savings account. It is very likely that customers will move part of this money to savings accounts when rates increase again. This ‘hidden savings’ or ‘savings substitution’ volume and savings accounts volume have the same interest rate sensitivity, including the asymmetric ‘flooring’ effect.

SO, HOW DO I DEAL WITH THEM?

Given the existence of these hidden savings, it might be justified to model it with a shorter maturity, thereby increasing funding stability. Because hidden savings proves to be very difficult to quantify and substantiate in practice, its modeling is still not general practice with Risk and ALM managers. The banks that do include the hidden savings effect typically use historical data-based approaches, combined with expert-based guidelines on the measurement approach and significance thresholds. Significance thresholds can be relative (a fixed percentage of total current accounts volume) or absolute amounts (for example 100 million euro of volume).

"Because the low or zero rates offered by banks provide little motivation to move money to savings accounts, many banking customers use their current accounts as savings account."

USING HISTORICAL DATA

Some banks use historical portfolio data to estimate the hidden savings portion of current accounts. Hidden savings is defined as the portion of volume after subtracting the volatile and long-term volume. The volatile (non-stable) volume is estimated based on intra-month (daily) volume fluctuations. The long-term, non-repricing, volume (core volume) can be estimated based on historical minimum volume levels.
Another measurement approach is to use account-level data to estimate the hidden savings volume. The average current account balance development over time is used to identify a trend of accelerating balance levels. Hidden savings is derived as the portion of current account volume above historically identified trends. To identify these historical trends, sufficient historical data on time periods with a significant difference between savings and current accounts rates are required.

SAVINGS MODELING SERIES

This short article is part of the Savings Modeling Series, a series of articles covering five hot topics in NMD for banking risk management. The other articles in this series are:

• How to determine core non-maturing deposit volume?
• Non-maturing deposit model concepts for banking risk management
• Calibrating non-maturing deposit models: historic data or scenario analysis?
• The impact of savings rate floors on balance sheet management

Are you interested in a more in-depth comparison of deposit modeling concepts? Click here.

For banks with significant non-maturing deposits portfolios, Risk Management functions need to have a robust behavioural risk model. This model is required for Interest Rate Risk in the Banking Book reporting, hedge, stress testing, risk transfer, and ad-hoc analyses. Although specific modeling assumptions vary per bank, cashflow-based models, a replicating portfolio model, or a hybrid model are market practice model concepts. The choice for one of these models is strongly linked to model purpose and use. Each concept has its benefits and drawbacks for different purposes and uses.

CASHFLOW-BASED MODELS

Cashflow-based models consist of two sub-models for the deposit rate and volume that forecast coupon and notional cashflows, respectively. Both sub-models measure the relationship between behavioural risk and underlying explanatory factors. Cashflow-based models are suited to include asymmetric pricing effects (such as flooring of rates) in resulting risk metrics. Since the approach captures rate and volume dynamics well, it is also often used for ad-hoc behavioural risk analysis and stress testing.

"The choice for one of these models is strongly linked to model purpose and use."

REPLICATING PORTFOLIO MODELS

Replicating Portfolio models replicate a deposit portfolio into simple financial instruments (e.g., bonds) such that its risk profile matches the risk profile of the underlying deposits. The advantage is that it converts a complex product into tangible financial instruments with a coupon and maturity. This simplified portfolio is well-suited to transfer risk from business units to treasury departments. A disadvantage of the model is that it does not fully capture non-linear deposit behaviour, for example the asymmetric pricing effects resulting from the floor. This makes the approach less suited for stress testing or ad-hoc behavioural risk analysis for senior management.

Read our extensive analysis of replicating portfolio models here.

HYBRID MODELS

Hybrid models, consisting of both a cash flow model and replicating portfolio model, combine the benefits of the other approaches, but at the cost of increased complexity. These models are often used by banks that want to use the model for a wide range of purposes: risk transfer to treasury departments, risk reporting, ad-hoc behavioural risk analysis, and stress testing. To prevent a larger mismatch between the models, most banks ensure that the risk profiles (duration or DV01) of both models align.

SAVINGS MODELING SERIES

This short article is part of the Savings Modeling Series, a series of articles covering five hot topics in NMD for banking risk management. The other articles in this series are:

• How to determine core non-maturing deposit volume?
• Calibrating non-maturing deposit models: historic data or scenario analysis?
• The impact of savings rate floors on balance sheet management
• How ‘hidden savings’ dominate the risk profile of current accounts for banks

Identifying the core of non-maturing deposits has become increasingly important for European banking Risk and ALM managers. This is especially true for retail banks whose funding mostly comprises deposits. The last years, the concept of core deposits was formalized by the Basel Committee and included in various regulatory standards. European regulators consider a disclosure requirement of the core NMD portion to regulators and possibly to public stakeholders. Despite these developments, a lot of banks still wonder: What is core deposits and how do I identify them?

FINDING FUNDING STABILITY: CORE PORTION OF DEPOSITS

Behavioural risk profiles for client deposits can be quite different per bank and portfolio. A portion of deposits can be stable in volume and price where other portions are volatile and sensitive to market rate changes. Before banks determine the behavioural (investment) profile for these funds, it should be analysed which deposits are suitable for long-term investment. This portion is often labelled as core deposits.

Basel standards define core deposits as balances that are highly likely to remain stable in terms of volume and are unlikely to reprice after interest rate changes. Behaviour models can vary a lot between (or even within) banks and are hard to compare. A simple metric such as the proportion of core deposits should make a comparison easier. The core breakdown alone should be sufficient to substantiate differences in the investment and risk profiles of deposits.

"A good definition of core deposit volume is tailored to banks’ deposit behavioural risk model."

Regulatory guidelines do not define the exact confidence level and horizon used for core analysis. Therefore banks need to formulate an interpretation of the regulatory guidance and set the assumptions on which their analysis is based. A good definition of core deposit volume is tailored to banks’ deposit behavioural risk model. Ideally, the core percentage can be calculated directly from behavioural model parameters. ALM and Risk managers should start with the review of internal behavioural models: how are volume and pricing stability modelled and how are they translated into investment restrictions?

SAVINGS MODELING SERIES

This short article is part of the Savings Modeling Series, a series of articles covering five hot topics in NMD for banking risk management. The other articles in this series are:

• Non-maturing deposit model concepts for banking risk management
• Calibrating non-maturing deposit models: historic data or scenario analysis?
• The impact of savings rate floors on balance sheet management
• How ‘hidden savings’ dominate the risk profile of current accounts for banks

One of the puzzles for Risk and ALM managers at banks the last years has been determining the interest rate risk profile of non-maturing deposits. Banks need to substantiate modeling choices and parametrization of the deposit models to both internal and external validation and regulatory bodies. Traditionally, banks used historically observed relationships between behavioural deposit components and their drivers for the parametrization. Because of the low interest rate environment and outlook, historic data has lost (part of) its forecasting power. Alternatives such as forward-looking scenario analysis are considered by ALM and Risk functions, but what are the important focus points using this approach?

THE PROBLEM WITH USING HISTORICAL OBSERVATIONS

In traditional deposit models, it is difficult to capture the complex nature of deposit client rate and volume dynamics. On the one hand Risk and ALM managers believe that historical observations are not necessarily representative for the coming years. On the other hand it is hard to ignore observed behaviour, especially when future interest rates return to historic levels. To overcome these issues, model forecasts should be challenged by proper logical reasoning.

In many European markets, the degree to which customer deposit rates track market rates (repricing) has decreased over the last decade. Repricing decreased because many banks hesitate to lower rates below zero. Risk and ALM managers should analyse to what extent the historically decreasing repricing pattern is representative for the coming years and align with the banks’ pricing strategy. This discussion often involves the approval of senior management given the strategic relevance of the topic.

"Common sense and understanding deposit model dynamics are an integral part of the modeling process."

IMPROVING MODELS THROUGH FORWARD LOOKING INFORMATION

Common sense and understanding deposit model dynamics are an integral part of the modeling process (read our interview with ING experts here). Best practice deposit modeling includes forming a comprehensive set of interest rate scenarios that can be translated to a business strategy. To capture all possible future market developments, both downward and upward scenarios should be included. The slope of the interest rate scenarios can be adjusted to reflect gradual changes over time, or sudden steepening or flattening of the curve. Pricing experts should be consulted to determine the expected deposit rate developments over time for each of the interest rate scenarios. Deposit model parameters should be chosen in such a way that its estimations on average provide a best fit for the scenario analysis.

When going through this process in your own organisation, be aware that the effects of consulting pricing experts go both ways. Risk and ALM managers will improve deposit models by using forward-looking business opinion and the business’ understanding of the market will improve through model forecasts.

SAVINGS MODELING SERIES

This short article is part of the Savings Modeling Series, a series of articles covering five hot topics in NMD for banking risk management. The other articles in this series are:

• How to determine core non-maturing deposit volume?
• Non-maturing deposit model concepts for banking risk management
• The impact of savings rate floors on balance sheet management
• How ‘hidden savings’ dominate the risk profile of current accounts for banks

In some European countries, savings rates appear to have hit a limit where they have stayed at a low level for a few years, despite interest rates moving down. This would suggest a structural shift where the relation between interest rates and savings rates has broken down. How can banks model savings in this unprecedented situation?

Tom Tschirner: “The situation is different everywhere. Within the countries where we are active, the legal and regulatory frameworks are very different. For example, in countries like Italy or Belgium, the law prohibits further decreases in specific interest rates. In Germany, this regulatory restriction is not in place. From a modeling perspective, this introduces a very different dynamic.”

Maarten Hummel: “It seems all banks are struggling with the impact of these low interest rates on the behavior of their customers. There is no real history on these low rates to use in our modeling. To develop forward-looking scenarios and to know how to model these scenarios we therefore work even more closely with the business.”

How do you weigh these expert opinions in unprecedented scenarios versus historic observations?

Tschirner: “The political wind is towards using historic data. It is challenging to substantiate what you have based your expert opinion on with a regulator. Using data-based model decisions is more straightforward from that point of view, as the model is then objectively determined. However, there are situations like the one we have now, when you just have no or very limited data. And then you must use expert judgement.

The question is then: how good can the experts be? We neither have data nor experience with the current situation. What becomes important in that situation is not to do stupid things. It’s important to know what competitors are doing. For example, if you find out that on average their deposits are modeled for the duration of three years and your own model indicates you should use seven years, you should take a break and reconsider. Particularly when you don’t have enough data and experience.”

Maarten Hummel - Financial Risk Officer - ING Group

What is your role in this as a market risk manager?

Tschirner: “Our role is always to make sure that common sense is around the table and that everyone who is somehow affected by the model knows how much it depends on expert opinion, data, competition and common sense.”

Hummel: “We always have to be sure that we understand and can explain the dynamics in the forward-looking scenarios; how the bank reacts, how the clients react, what would happen in the wider savings market and other relevant factors. There needs to be a logic to explain the scenario outcomes, both on the savings portfolio and the overall balance sheet. We always look at what it means for the bank as a whole, for example: how would we manage the total bank in such a situation? It is not just a simple exercise of running a savings model based on historic data to get the answers – more important is that you assess the overall plausibility. Therefore, when calibrating our savings models, we now spend more time discussing the scenarios in-depth with the various stakeholders in the bank.”

Does that mean that both quantitative and qualitative elements are discussed?

Hummel: “The business strategy is leading. We use a global framework for our business strategy to look at how it would play out in a certain environment. Then you need to have discussions on whether that strategy will really hold in the more severe scenarios. We do take scenarios into account in a more qualitative strategy discussion. We have to look at the market, our own balance sheet and how we are positioned. It is an interesting discussion.”

To what extent do you look at the restrictions on the lending side in discussions on savings modeling?

Hummel: “The starting point is to look at the saving portfolio independently, but at some stage you cannot escape the rest of the balance sheet. For example, if I have a 50-year liability, where am I going to invest it and what is my funding value? There needs to be a check to see if the value attached to it exists.”

Tschirner: “At the end of the day, when it comes to modeling savings, the question that we are trying to answer is: how should we invest the money that we get from our clients? And can you do that totally independently of the asset situation? Most likely not. If the model tells you to invest the money for fifty years, but there are no such assets in the economy, the model is not very helpful. I would not say it is the individual situation of the bank that matters, but more the economy or the country. How easy is it to find long-term assets in Germany, Poland, or Belgium? That certainly plays an important role for the modeling of savings. One year ago, I may not have subscribed to this view, but now I’m quite convinced about that.”

Do the low savings rates impact the relation between the balances on payment accounts and the saving accounts?

Hummel: “Before, the idea was that these have different functions; one for the transactions and one to earn interest. The incentive on the savings side has now largely disappeared. Inevitably, we see many more funds staying on the current account. The question is then: how can you separate the two parts? The client does not bother to put it on the savings account, because the interest is the same. But since we have to be prepared for a scenario where interest rates will go up significantly again, we keep identifying that money as savings. You need data to identify the amount of transactional account money and separate that from the savings amount. Rates have been low for a long period already, so for a newly started bank estimating that will be very hard.”

Tom Tschirner - Head of Market Risk - ING Germany

A large portion of German ING clients is relatively new. Is it therefore harder to get the right data?

Tschirner: “There are different ways to look at it, but what we clearly observe is that the average balance of the current accounts is increasing quite significantly. You can relook at history and try to find a trend, to see what the average balances would be if it were not for the low-rate environment. Or you can look at intra-monthly patterns, driven for example by salaries and rents. If there is a threshold above which you do not find a pattern anymore, then it looks more like a savings account. These are two approaches to determine which part should be modeled as true current account money and which part as savings. There is no standard yet, but given the regulatory attention, we will find an industry standard in the coming year.”

Do you think it is a common blind spot that the segmentation between those two is often not explicitly modeled?

Tschirner: “It’s not the biggest issue that we have. But yes, you need a model. If you want a real good model though, you need all legs of the cycle; you would also need an observation from a point in time that rates increase – and you don’t have that.”

Hummel: “I agree, you need a full cycle. The challenge is that for each solution you put on this, you need an exit strategy, so once savings rates go up again and market rates are high, you gradually build down the savings on your current account. In the meantime, every client is different. We have different sets of clients and you need to have data on how your client composition is changing over time.”

Tschirner: “In Germany, ING is growing, and the number of accounts has been increasing a lot. We also know that the average age of our clients has gone up. You could argue that older clients intend to have higher balances on their accounts and that they do not shift it when rates are around zero. But if you look at data, you will not be able to tell the difference. And there is no data-based way of telling this apart. That makes it challenging to model.”