Value and Duration in Retail Financial Markets The Economics of Bank Deposits

Measuring value and interest rate risk in retail financial markets such as the market for consumer deposits has proven to be a very difficult problem for financial firms. Standard models of value and interest rate risk (duration), based on the competitive market paradigm, are inappropriate in retail markets characterized by sluggish price and quantity behavior. Although the penetration of sophisticated shareholder value-added models within the banking industry has increased markedly, the shortcomings of standard valuation models have not been well understood. In this applied paper, we analyze the economics of retail deposit markets in the context of valuation/duration practices employed by bank asset-liability managers. Using simple illustrative models of deposit market value, we find that factors typically ignored in bank duration modeling such as the dynamics of interest rates and deposit market growth are potentially significant components of retail deposit market interest rate exposure.