C. Myblog

Cost of Funds: Pulling Together Deposit Assumptions

May 29, 2014

There is a lot of debate on the mathematics and methodology for deposit withdrawal speed and deposit pricing assumptions in different rate environments. Let’s step back for a moment and first ask the question: What is the objective of developing the deposit assumptions? Ultimately, the end objective of these assumptions is to arrive at a projected cost of funds (COF).

From a risk perspective, the projected COF should be in line with, or more conservative than, what the credit union has experienced historically. Some credit unions may choose to model a projected COF that is lower than their historical experience and, in those cases, it is especially important that decision-makers document their rationale.

There are a couple of ways to compare the projected and experienced COF. One approach is to compare the projected and experienced COF at the high point in the previous rate cycle; in this case, short- and long-term rates at 5%. For example, the credit union’s COF on the June 2007 call report was 2.00%, while the projected COF increases to 2.10% by the end of the second or beginning of the third year of the simulation. This provides support that the assumptions are reasonable.

For models that are unable to simulate a +500 basis point (bp) rate environment, another way credit unions can compare the projected and experienced COF is to look at the percent movement of the COF in comparison to the market rate. For example, if the COF moved 30% of the market when short-term rates went from 5% to 0%, then the projected COF should move minimally 30% of the market in a simulated +300 bp rate environment.

It is important to evaluate the individual withdrawal speed and deposit pricing assumptions and determine an approach that matches the credit union’s strategy. However, comparing the projected COF to history can help decision-makers pull together the assumptions to understand the impact of each on the end results and ensure their reasonability.

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