Assumption Overrides: A Cautionary Tale
A few years ago, I was assigned as the analyst and modeler for a new DCG Advisory client. They had been performing their IRR modeling in-house for as long as anyone could remember but decided, for a variety of reasons, to switch to outsourcing. As we started the transition to the new process, we noticed they had been modeling very short average life assumptions (one year) for several core non-maturity deposit accounts. When we asked the CFO for the rationale or support behind such conservative assumptions, he seemed surprised by their existence and unsure why they were in use. After digging around, he discovered these model settings were due to an assumption override made seven years prior!
How could this have happened? Well, seven years prior, the institution had acquired another bank. To account for potential flight risk in the wake of the merger, the modeler decided to assume very conservative average lives for the acquired deposits, which were broken into their own model categories. Unfortunately, no one had documented this override, why it was done, who was responsible, how it would be monitored, or when it would be reversed. Over the course of the next seven years, personnel left, the model changed hands, and this one assumption was completely forgotten but still active in the model. The deposit categories were still in use, but now comprised of growing balances from loyal customers whose relationships had stood the test of time. Even though the flight risk for these deposits had long since passed, the model setting had been continually rolled over without it ever being questioned.
The real tragedy is this bank had been out of policy in its EVE limits for some time, largely because of this outdated assumption, and management had decided to take on expensive long-term funding to ensure they remained within their limits. They had been spending tens of thousands of dollars every year to hedge against a risk that was no longer real!