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Dynamic Pricing On Retail Term Deposits of A Bank
Dynamic Pricing On Retail Term Deposits of A Bank
Dynamic Pricing On Retail Term Deposits of A Bank
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Igor Voloshyn
Lviv Banking Institute of University of Banking (Kyiv)
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October 2013
Version 1
The article “An estimation of optimal interest rates on retail term deposits of a bank” by Voloshyn, І.V.,
Voloshyn, M.І. has been published in “Herald of National Bank of Ukraine”, 2009, No 12 (166).
http://archive.nbuv.gov.ua/portal/soc_gum/vnbu/2009_12.pdf
Key words: dynamic pricing, retail, term deposit, automatic control, interest expense, net
interest income, optimal interest rate, optimization, variational method
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A balance interest rate R(t) on the deposit portfolio at a certain time t is an
average-weighted interest rate on all deposits in the bank’s portfolio. Note that the
balance interest rate varies continuously due to cash flows through deposit accounts.
An interest rate on new deposits attracted in the bank is a flow interest rate.
To estimate optimal interest rates on deposits the most investigators use a
balance interest rate (Sealey and Lindley, 1977; Enzo Dia, 2004). According to the
approach, for example, proposed by Sealey and Lindley (1977), Enzo Dia (2004), the
optimal interest rates are obtained for the balance interest rates by optimization of
interest expense over a certain control period of time:
T
IE B(t ) R(t ) t min , (2a)
t 0
where IE is interest expense on deposits over the time period T, B(t) is deposit
balances, R(t) is the balance interest rate of the bank .
In this approach, the supply of new deposits is assumed to be proportional to the
balance interest rate of the bank. In our view, such a supply model is not clear enough
to reflect the economic sence of this phenomenon.
Surely, there is a correlation between the deposit supply and the balance interest
rate. However, the balance interest rate on existing deposits can not directly affect on
the deposit supply. It may influence on the deposit supply only through the flow interest
rate on the new deposits. In fact, depositors see only interest rates on the new deposits,
i.e. the flow interest rates.
The balance interest rate can vary through deposit repayment while the flow
interest rate on the new deposits can remain without changes.
According to the flow approach by Tsirlin and Kazakov (2003), the deposit supply
is supposed to be proportional to the difference between the flow interest rate offered by
the bank and the market interest rate on the new deposits.
In our opinion, such a supply model much more precisely matches the economic
sence of interaction between the bank and the retail deposit market (Fig. 1). The bigger
this difference, the bigger new deposit inflow. And vice versa.
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Retail market for deposits
with typical interest rate u0
on deposits
Cash flows of
deposits or credit
turnover Ct(t) ~
(u(t)- u0)
Fig. 1. Scheme of interaction between the bank and the retail deposit market.
However, Tsirlin and Kazakov (2003) found the optimal flow interest rates
through the following way of optimization:
T
Ct (t ) R
t 0
Ct (t ) t min (2b)
and not through optimization of the interest expense (2a). In the expression (2b) RCt(t) is
the bank interest rate on deposit cash flow.
The approach by Tsirlin and Kazakov (2003) is based on application of the
thermodynamic principles to description of micro-economical processes. That is why the
criterion of optimization (2b) is chosen. Note that the criterion (2b) expresses the
principle of minimal capital dissipation.
It should be observed that for the bank it is more important to optimize interest
expense, instead of capital dissipation (2b). As a result of the approach (2b), central
information for the bank about the duration of new deposits staying on accounts is lost
while this duration directly affects on the bank interest expense.
Thus, from one side, it is necessary to minimize namely the interest expense
over the control period. From other side, the interest expense is needed to express
through the flow interest rates on the new deposits, because the deposit control is
realized by them.
To express the interest expense through the flow interest rates consider Figure 2
where it is shown how to define the duration of the new deposits’ remaining on accounts
over the control period of time.
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Credit
turnover T-t1
T-t2
Ct(t1) Ct(t2)
0 t1 t2 T Time
Fig. 2. The durations of the new deposits’ remaining on accounts over the control period
of time
As it is shown on Figure 2, the cash flow amount Ct(t1) of the new deposits
attracted at time moment t1 stays on accounts for T-t1 until to the end of control period
T. Correspondingly, the cash flow amount Ct(t2) of the new deposits collected at time
moment t2 remains on accounts for T-t2 until to the end of control period T, and so on.
Taking into account it write the interest expense on the new attracted deposits over the
control period:
T
IE Ct (t ) RCt (t ) T t dt (3)
0
Further use the expression (3) to define an objective function for automatic
control.
3. ASSUMPTIONS
Let there is the national currency retail deposit market. And the alternative ones do not
exist. Thus, it is no need to take into account cash transfer from one market to other.
The deposit market is assumed to be unlimited. Consequently, deposit operations of a
bank do not influence on the level of market interest rates.
Banks in this market offer only one a fixed interest rate deposit with one term to
maturity. The investigated bank is a market-taker. It has a stable credit rating and does
not extend its branch network. Thus, parameters of a supply model are not changed in
time.
The bank controls its deposits over a chosen control period of time T.
Suppose that the existing and new deposits do not mature during the control
period of time T. It means that the existing and new deposits are matured after time T.
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Besides, the new and existing deposits are not withdrawn until to time T. Thus, debit
turnovers do not exist. Over all the control period of time the bank only collects the new
deposits.
Assume that the deposit market is characterized with a certain market interest
rate u0 on deposits that is not changed during all the control period of time. The deposit
supply is proportional to a difference between the bank interest rate u(t) and the market
interest rate u0 on deposits (Fig. 1) as following by Tsirlin and Kazakov (2003). The
movement of interest rate u(t) affects on the deposit supply immediately without any
delay.
For simplicity ignore the effects of seasonality and periodicity of depositing.
Note that the assumptions made are not critical and can be weakened.
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5. A MODEL FOR AUTOMATIC CONTROL
Consider the problem of depositing control in continuous time. For convenience of
subsequent exposition, enter the following new variables:
x(t ) B(t ) , u(t ) RCt (t ) , (5)
where x(t) is the deposit balance on accounts at the time t. It is the state variable. u(t),
RCt(t) are the offered flow interest rates on new deposits. It is the control variable.
Examine the simplest model of deposit supply that describes the dependence of
cash flows on change of flow interest rates in the form (Tsirlin and Kazakov, 2003):
x(t ) Ct (t ) u(t ) u0 , (6)
where u0 is the market interest rate, θ is the dynamic parameter of the model, x’(t) is a
credit turnover of deposits Ct(t). Dash in equation (6) is marked the first derivative with
respect to time.
It will be recall that the existing and new deposits do not mature in the control
period T. Thus, the debit turnover Dt(t) is equal to zero.
To estimate the dynamic parameter θ, the transient response analysis is an
acceptable method. In accordance with this method, the dynamics of the deposit
balances caused a stepwise change of the offered interest rate that then remains
constant is explored. Such a situation is characteristic for the term deposits with fixed
interest rates. The bank makes immediately decision to change interest rate on deposits
and its supply curve response on it. Therefore, from the such deposit dynamics it is
possible to define the dynamic parameter θ (Voloshyn, 2008).
The equation (6) has the following boundary conditions or budget constraints:
x(0) B0 , x(T ) BT , (7)
where B0 and BT are the volumes of deposit portfolio at the beginning and at the end of
the control period of time, respectively.
Taking into consideration the new variables (5) and the expression (6) for credit
turnover, write down the objective control function (4) in the following form:
T
NII u (t ) u 0 R u (t ) T t dt max , (8)
0
where R is the bank interest rate on interest-bearing assets, for example, loans. This
interest rate considers to be constant.
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6. THE SOLUTION OF PROBLEM
To solve the problem of synthesis of optimal deterministic control, use the variational
method (Kim, 2007). The Hamiltonian function of the problem (6-8) is the following:
H u(t ) u0 R u(t ) T t (t ) u(t ) u0 , (9)
where ψ(t) is Lagrange multiplier that can depend on time.
Then, write down the Euler-Lagrange equations:
H
0 , (10)
x
H
2 u (t ) R u0 T t (t ) 0 . (11)
u
The equation (11) determines the optimal control for deposits by means of the
interest rate.
From the equation (10), it is followed:
C1 . (12)
Substituting the expression (12) in the equation (11), define the optimal interest
rate on deposits:
1 C
u (t ) R u0 1 . (13)
2 T t
Note that according to equation (13) the interest rate on deposits during the
control period decreases (C1>0). At t=T it tends to minus infinity, i.e. the control is
unrestricted. Therefore, it needs to lay down the following restriction: the bank interest
rate can not be less than the market one:
u (t ) u0 .
Substituting the solution (13) in the equation (6) and integrating the got
expression, obtain:
x(t ) R u0 t C1 ln( T t ) C2 , (14)
2
where the constants of integration C1 and C 2 are found from the boundary conditions
(7):
2 B / R u0 t *
C1
ln 1 t * / T
, (15)
C2 x(0) C1 ln( T ) ,
2
B x(T ) x(0) ,
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where t* is the time from the beginning of the control period until to moment of time
when the bank interest rate becomes equal to the market one, i.e. u(t*) = u0. This time t*
is defined from equation (13) with taking into account the expression (15):
1 C
u0 R u0 1 * . (16)
2 T t
It should be observed, that it is needed to change the upper limit of the integral
(8). Instead T, write down t*:
t*
NII u (t ) u0 R u (t ) T t dt . (17)
0
Thus, from a moment of time by t t* the bank stops to attract the new
deposits, because the budgeted volume of deposits x(T)= BT has been achieved.
In practice, there are possible cases when it is necessary to restrict the bank
interest rate from above:
u (t ) umax ,
where umax is the given maximal interest rate of the bank that the market participators
interpret as suitable.
10
150
100
75
50
25
t*
0
0 1 2 3 4 5 6
Time, months
21.5
21.0
Optimal interest rate on deposits,
20.5
20.0
% per year
19.5
19.0
18.5
18.0 t*
17.5
0 1 2 3 4 5 6
Time, months
11
8. CONCLUSION
Thus, the proposed approach to estimation of optimal interest rate on retail term
deposits ensures maximal net interest income and achievement of the budgeted volume
of deposit portfolio. Although in this article, it is developed a very simple model for
depositing control, the similar more complicated models seem to be perspective for
usage in sophisticated automatic control of depositing. For this, it is necessary to
consider additionally the following:
1) portfolio of deposits with different terms to maturity;
2) cash flows from contractual repayments of matured deposits;
3) rollover and early withdrawal cash flows;
4) behaviour of market interest rates;
5) uncertainty about deposit supply, and;
6) move from continuous to discrete framework of this problem.
The following should also be noted. To take into consideration a deposit product
line (for example, deposits in foreign currencies, with different schedules of interest
payments, etc.), it is needed to build the corresponding supply models for every deposit
product.
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LITERATURE
Enzo Dia (2004). “Monopolistic Pricing in the Banking Industry: and Dynamic Model”.
Working paper series. Department of Economics University of Milan. Bicocca. No 73:
http://dipeco.economia.unimib.it/web/pdf/pubblicazioni/wp73_04.pdf retrieved on
18.10.13.
Sealey, C.W., Lindley, J.T. (1977) “Inputs, Outputs, and Theory of Production and Cost
at Depositary Financial Institutes”. The Journal of Finance. Vol. XXXII. No 4.
Voloshyn, І.V. (2008) “Automatic Control for Term Deposits of Individuals” Financial
Risks. No. 2(51):
www.securities.com retrieved on 18.10.13.
Voloshyn, І.V., Voloshyn, M.І. (2009) “An estimation of optimal interest rates on retail
term deposits of a bank”. Herald of National Bank of Ukraine. No 12 (166).
http://archive.nbuv.gov.ua/portal/soc_gum/vnbu/2009_12.pdf retrieved on 18.10.13.
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