Chapter 4

Managing and Pricing

Deposit services

Peter Rose, Chapter 12

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 Content

• The nature of commercial bank products

• Types of Deposit Accounts Offered
• The Changing Mix of Deposits and Deposit Costs
• Pricing Deposit Services and Deposit Interest Rates
• Conditional Deposit Pricing
• Rules for Deposit Insurance Coverage
• Disclosure of Deposit Terms
• Lifeline Banking

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 The nature of banking products
• Banking products are not really like Apple products.
• To a great extent, most of the main products can be
obtained (provided the specific customer is acceptable to
the bank in question) from most banks.
• Banking and financial services are a commoditised product.
• With commoditized products, much of the “unique selling
point” for an individual bank comes from superior customer
service, the attitude and customer friendliness of its staff,
and efficient operations, rather than anything exotic about
the product itself.

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Commercial banking products

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 Commercial banking products
• It is well to remember that every financial services product
is, simply a series of cash flows.
• At the same time, most banks are price takers and the
external market is the most influential price driver.

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 Types of Deposit Accounts
• Transaction (Payment or Demand) Deposits
• Making Payment on Behalf of Customers
• One of The Oldest Services
• Provider is Required to Honor Any Withdrawals
Immediately
• Nontransaction (Savings or Thrift) Deposits
• Longer-Term
• Higher Interest Rates Than Transaction Deposits
• Generally Less Costly to Process and Manage

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 Types of Transaction Deposits
• Noninterest-Bearing Demand Deposits
▫ Interest Was Prohibited by Glass-Steagall Act
▫ One of the Most Volatile and Unpredictable Sources of
Funds
▫ Most Deposits are Held by Business Firms
• Interest-Bearing Demand Deposits
▫ Negotiable Orders of Withdrawal (NOW)- hybrid savings
instrument
▫ Money Market Deposit Account (MMDA) and Super
NOW due to Garn-St Germain Depository Institution Act
of 1982

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 Types of Savings
or Thrift Deposits
• Passbook Savings Account
• Statement Savings Deposit
• Time Deposit (CD)
• Individual Retirement Account (IRA) - The Economic
Recovery Tax Act of1981
• Keogh Deposit – have tax benefits
• Roth IRA – The Tax Relief Act of 1997 Allows Non-Tax-
Deductible Contributions
• Default Option Retirement Plans – The Pension Protection
Act of 2006
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 Popular Types of CDs
• Bump-Up CD – Allows a Depositor to Switch to a Higher
Interest Rate if Market Rates Rise
• Step-Up CD – Permits Periodic Upward Adjustments in the
Promised Interest Rate
• Liquid CD – Permits the Depositor to Withdraw Some or All
of Their Funds Without a Withdrawal Penalty

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 Factors affecting Interest Rates
on Deposits
• The Maturity of the Deposit

• The Size of the Offering Institution

• The Risk of the Offering Institution

• Marketing Philosophy and Goals of the Offering Institution

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 Key Issues Depository Institutions
Are Faced With

1. Where can funds be raised at lowest possible cost?

2. How can management ensure that there are enough

deposits to support lending and other services the public
demands?

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The Changing Composition of
Deposits in the US

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 Core Deposits
• A Stable Base of Funds that is Not Highly Sensitive to
Movements in Market Interest Rates (Low Interest-Rate
Elasticity) and Which Tend to Remain with the Bank

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 Check 21 and Substitute
Checks
• Effective October 28,2004 – Permits Depository Institutions
to Electronically Transfer Check Images
• The Images are Called Substitute Checks and is a Legal
Copy of the Check
• Protects Depositors Against Loss
• Benefits Institutions by Reducing the Cost of Check
Clearing
• Substitute Checks Can Be Sent Electronically Instead of
Sending Bundles of Checks
• More Information: http://www.federalreserve.gov/

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 FDIC Insurance Coverage
• Banks Insured Through Bank Insurance Fund (BIF)
• Savings and Loans Insured Through Savings Association
Insurance Fund (SAIF)
• Covers Only Those Deposits Payable in the U.S.
• Many Types of Accounts are Covered Up To $100,000
(increased to $250,000 until year-end 2009 by the
Emergency Economic Stabilization Act of 2008) for Each
Account Holder within the Same Bank (Even if Different
Branches)
• Deposits Placed in Separate Institutions are Insured
Separately

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 Truth in Savings Act
• Consumers Must be Informed of the Deposit Terms Before They a
New Account
• Depository Institutions Must Disclose:
• Minimum Balance to Open
• Minimum to Avoid Fees
• How the Balance is Figured
• When Interest Begins to Accrue
• Penalties for Early Withdrawal
• Options at Maturity
• And the APY

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 APY
• The National Bank of Taraville quotes an APY of 5 percent
on a one-year money market CD sold to one of the small
businesses in town. The firm posted a balance of $2,500 for
the first 90 days of the year, $3,000 over the next 180 days,
and $5,000 for the remainder of the year. How much in total
interest earnings did this small business customer receive
for the year?

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 Deposit product pricing
• Customer deposit rates are strongly influenced by overall
market rates. There are also two additional factors to
consider:
• The cost of providing the product and the cost of customer
transactions: a current account generally pays no interest
because there is the high transaction cost incurred by the
bank given the number of frequent withdrawals.
• The desire for retail and small business funding: the
customer funding model is a common one for many banks
and so here there is an imperative to pay a high deposit rate
to attract customer funds.

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 Pricing Deposit-Related Services
• The Glass-Steagall Act of 1933 – Federal Limits on Interest
Rates Paid on Deposits – why?
• Nonprice Competition
• The Depository Institutions Deregulation Act of 1980
▫ Cost-Plus Pricing
▫ Marginal Cost of Deposits
▫ Conditional Pricing
▫ Relationship Pricing

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Cost Plus Profit Deposit Pricing

Estimating
Unit Price Operating Planned
Overhead
Charged the Expense Profit from
Expense
Customer = Per Unit of + + Each
Allocated to
for Each Deposit Service Unit
the Deposit
Service Service Sold
Function

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 The Marginal Cost
Approach: Historical
Average Cost Approach
• Determines the Bank’s Const of Funds by Looking at the
Past. It Looks at What Funds the Bank Has Raised to Date
and What those Funds Have Cost

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 Pooled Funds COST Approach
• Determine the Bank’s Cost of Funds by Looking at the
Future. What minimum Rate of Return is the Bank Going to
Have to Earn on Any Future Loans and Securities to Cover
the Cost of all New Funds Raised?
• A CB raised totally 400$mil
• $100 mil in checkable deposit (IR = 10%, RR = 15%)
• $200 ml in time and saving deposit (IR= 11%, RR = 5%)
• $50 mil from MM (IR = 11%, RR = 2%)
• $ 50 mil equity raising (IR = 22%)
• Weight average cost of funds:
= (100/400)*10%/85% + (200/400)*11%*95%+
(50/400)*11%*98% + (50/400)*0.22=12.88%
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The manager should earns a rate of return more than 12.88%
 Using Marginal Cost to Set
Interest Rates on Deposits
• Many Financial Analysts Would Argue That the Added Cost
(Not Weighted Average Cost) of Bringing New Funds into
the Bank Should Be Used to Price Deposits.

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 Market Penetration
Deposit Pricing

• The Method of Selling Deposits That Usually Sets Low

Prices and Fees Initially to Encourage Customers to Open
an Account and Then Raises Prices and Fees Later On.

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 Conditional Pricing
• Schedule of Fees were Low If Customer Stayed Above
Some Minimum Balance - Fees Conditional On How the
Account Was Used
• Conditional Pricing Based On One or More Of the Following
Factors
• The Number of Transactions Passing Through the
Account
• The Average Balance Held in the Account During
the Period
• The Maturity of the Deposit

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 Conditional Pricing
• (1) flat-rate pricing
• (2) free pricing
• (3) conditionally free pricing

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 Conditional Pricing
• Conditionally free pricing also allows the offering institution
to divide its deposit market into high-balance, low-activity
accounts and low-balance, high-activity accounts.

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 Upscale Target Pricing
• Bank Aggressively Goes After High-Balance, Low-Activity
Accounts.
• Bank Uses Carefully Designed Advertising to Target
Established Business Owners and Managers and Other
High Income Households.
• 1. The types of customers each depository institution plans
to serve—.
• 2. The cost that serving different types of depositors will
present to the offering institution—.

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 Problem
• Bender Savings Bank finds that its basic transaction
account, which requires a $400 minimum balance, costs this
savings bank an average of $2.65 per month in servicing
costs (including labor and computer time) and $1.18 per
month in overhead expenses.
• The savings bank also tries to build in a $0.50 per month
profit margin on these accounts. What monthly fee should
the bank charge each customer?
• Further analysis of customer accounts reveals that for each
$100 above the $400 minimum in average balance
maintained in its transaction accounts, Bender Savings
saves about 5 percent in operating expenses with each
account. For a customer who consistently maintains an
average balance of $1,000 per month, how much should the
bank charge in order to protect its profit margin?
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 Relationship Pricing
• The Bank Prices Deposits According to the Number of
Services Purchased or Used. The Customer May Be
Granted Lower Fees or Have Some Fees Waived If Two or
More Services are Used.

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 Conditions for relationship banking
• Three conditions are met when relationship banking is
present (see Berger (1999)):
• 1. The intermediary gathers information beyond readily
available public information;
• 2. Information gathering takes place over time through
multiple interactions with the borrower, often through the
provision of multiple financial services;
• 3. The information remains confidential (proprietary).

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 Cost of Relationship Banking
• 1. the soft-budget constraint problem
The key question is whether a bank can credibly deny
additional credit when problems arise.
• 2. the hold-up problem

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 The Role That Pricing and Other
Factors Play When Customers Choose

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 Basic or Lifeline Banking
• Some People Feel That All Individuals Are Entitled to a
Minimum Level of Financial Services No Matter Their
Income Level

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