Term Advances: The Foundation of Funding Diversification

posted on Tuesday, August 15, 2017 in Advances

Many members are aware of available multiple-term advance types ranging from straight-forward short-term bullets to longer-term advances with symmetrical and forward settlement features.  However, for now, we'll confine this discussion to the role that “non-structured” or “standard” term advances can play in: enhancing balance sheet liquidity, enhancing net interest margin and managing interest rate risk.  Finally, we'll highlight the role that term advances can play in diversifying a financial institution's liability structure.

Once the properties of liability diversification are appreciated, balance sheets can be enhanced via executing laddered, blended funding strategies.  In the past, these blended funding strategies have focused on static approaches: simply identifying assets that require funding and apportioning funding mixes without regard for future changes in rates or deposit behavior. More effective usage of term advances requires an understanding of blended funding strategies that take into account deposit rate sensitivity under varying scenarios.

Term Advances:  Multiple Purposes

Applications of term advances can generally fall into three frequently overlapping categories: liquidity management, interest rate risk management and capital management.  Liquidity management is not unlike a manufacturer that employs just-in-time inventory. A manufacturer would rather not carry the burden of underutilized, non-cash-generating assets.  It's the same concept as effectively managing a balance sheet. With interest rate risk, it's understood that term advances represent a quick and effective means of adjusting liability duration.

In an October 2013 Financial Institutions Letter, referring to “diversification of funding sources strengthening an institution's ability to withstand idiosyncratic and market-wide liquidity shocks,” institutions were advised to consider “rebalancing asset and liability durations.”  On the capital management side, term advance availability allows an institution to support strategically optimized levels of capital – levels that are not purely guided by the availability of deposits. Market conditions change. Is it necessarily desirable to turn away loans when deposits dry up?

Building a Case of Term Advance Blended Funding Strategies: Diversification

There is a key reason that deposits and term advances are so different and require complementarity on a balance sheet: deposits lack duration-certainty, whereas non-structured term advances are duration-certain.  Within the FHLBDM district, some members make a viable case for seven-year durations on their DDA's while others assign two years to the same account type.  Many, including those in the regulatory community, cite subjective descriptors when categorizing deposit types.  There can be a lot that we don't know about “core,” “volatile” or “retail” sources of funding, as referenced in Figure 1What are the prepayment characteristics?  Duration uncertainties of deposits can be prompted by changing demographics, markets or yields in other markets. On the other hand, duration uncertainty might be tempered by “sticky” products such as online bill pay, direct deposits or remote capture.

Figure 1. Example of Classifications of Funding Diversification

Classifications of Funding Diversification

Diversifying a Balance Sheet with Blended Funding Strategies

The blended funding concept involves using term advances that can support either bullet or amortizing structures; and supplementing them with low-cost, albeit duration-uncertain deposits.  The objective is to create some partially-matched funding flows with advances in order to build in some prepayment protection against asset prepayments.  Deposits would then act as supplements due to their low cost and because of their value in the event that funded assets extend.

The impact on net interest margin from the assessment of different term advance/deposit mixes can be approached in one of two ways:  1) static interest rate assumptions, or 2) dynamic rate scenarios that test different rate and deposit and beta assumptions.  In the theory, the dynamic approach to developing blended funding strategies can help address the unpredictable nature of asset pay downs, deposit funding costs and interest rates.

Figure 2 demonstrates a simple example of a community financial institution that is looking to fund a $5 million, 10-year commercial real estate loan on behalf of a customer.  In this instance, with the help of some dynamic tools that modeled the impact of different funding scenarios on net interest income, the institution decided to fund the asset via two $1.15 million ($3.3 million total) advances – one a five-year bullet at 2.20% and the other a six-year bullet at 2.37%.  Initially, the remaining funding requirement would be covered by $1.7 million in deposits.  It was further assumed that after the laddered advances had matured, deposits would then take on the role of supporting the remaining tail balances.  Further analysis of this suggested funding combination could then be used to focus on the impact of varying interest rate shifts on net interest income and market value of equity.  

Figure 2. Example of a Laddered, Term Blended Funding Strategy

Example of a Laddered, Term Blended Funding Strategy

Digging Deeper by Developing a Dynamically-Modelled Blended Funding Strategy

Dynamic modeling requires several steps:  1) a complete assessment of the deposit mix, including allocation and assumed beta (projected deposit category's proportional response to general rate changes); 2) setting prepayment assumptions about the funded assets (Figure 3), 3) testing pre-set funding mixes (Figure 4), and 5) analyzing the net interest income and market value of equity under varying rate scenarios (Figure 6 and 7).

Consider the case of a financial institution that would like to evaluate funding $5 million of mortgages either entirely via deposits or via a blend of deposits and laddered advances.  Figure 3 represents how each deposit category is broken down and allocated in constructing an overall blended funding case. The current weighted average deposit rate is 0.40% and would be anticipated to increase to 2.12% in a +300 bps rate shock. The betas of each deposit category are overlaid against possible rate outcomes. Weighted-average beta of the portfolio is 57.5%. We then look at the possible characteristics of the asset that is being funded and make some assumptions about their prepayment speeds under different rate scenarios (Figure 4).

Figure 5 demonstrates how we would construct a funding mix allocation.  In this case, we would be looking at a 50/50 deposit and term advance mix. Advances would consist of laddered term advances over one to seven years, totaling $2.5 million, with a weighted average cost of 2.07%.

Figures 6 and 7 demonstrate that once we model a blended funding strategy against varying deposit assumptions and rate scenarios, we can get a better picture of how funding diversification can play a positive role in a rising rate environment.  In examining net interest income scenarios, the cross-over point in favor of the blended funding scenario is a rate move of approximately +1.75%.  If we were to examine rate scenarios and their impact upon market value of equity, the cross-over point in favor of the blended funding strategy occurs at an unchanged rate scenario. A 100%-deposit scenario shows an under performing result in a higher rate environment.  Why?  Deposits bear uncertain durations.  Under rising rates, the increased sensitivity of higher-beta deposit categories kicks in and margin contracts. The certain duration of term advances is preserved, while formerly low-cost deposits (particularly those with higher betas) increasingly add to cost of funds.

Figure 3. Example of a Summary Asset/Liability Assumption Set

Example of a Summary Asset/Liability Assumption Set

Figure 4. Example of Inputs of Funding Mix Allocation for Deposits and Assets

Example of Inputs of Funding Mix Allocation for Deposits and Assets

Figure 5. Example of Inputs for Advance Ladder Detail

Example of Inputs for Advance Ladder Detail  

Figure 6. Example of Changes in Net Interest Income Resulting from 100% Deposit-Funded and 50/50 Blended Funded Mortgages

Example of Changes in Net Interest Income Resulting from 100% Deposit-Funded and 50/50 Blended Funded Mortgages

Figure 7. Example of Changes in Market Value of Equity Resulting from 100% Deposit-Funded and 50/50 Blended Funded Mortgages

Example of Changes in Market Value of Equity Resulting from 100% Deposit-Funded and 50/50 Blended Funded Mortgages

In the words ascribed to Mark Twain, “20 years from now, you will be more disappointed by the things you didn't do than by the ones you did do.” Now may very well be the time to add some duration certainty to your funding base via dynamic modeling of blended funding scenarios that include term advances.  We welcome you to consult your Federal Home Loan Bank of Des Moines balance sheet expert for assistance in identifying term funding strategies that can prudently diversify your interest rate exposure.  

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