Chapter-3: Management of Deposits

Deposit: Deposit refers to transfer or place funds for safekeeping or in trust especially in the
bank account. Deposit is the main component of bank’s funds. The existence of a commercial
bank is totally impossible in the absence of deposits. Deposits are the foundation upon which
banks thrive and grow. Deposits significantly influence the magnitude of bank’s loan and
investment activities. It also provides most of the raw material for bank loans and thus
represents the ultimate sources of bank profits and growth.
Deposit management: Deposit management consists of acquisitions of stable and low cost
deposits for the banking business. Deposit management involves the collection of adequate bank
deposits required for the efficient and effective operation of banking business. Deposit
management does not merely concern with the high volume but also with low cost as well and its
stability so as to produce competitive loans product. That is commercial banks deposits
management concentrate on following items:
 Stability (consistence deposits)
 Low cost deposits
 Adequate deposits
 Should produce competitive loans
Objectives of bank deposits: Banks collect deposits from the client in order to accumulate
investable funds. Besides this followings are some other objectives of collecting deposits:
Collection of bank funds: Commercial banks prime responsibility is to collect fund as
deposit and disburse a portion of collected funds as loans or investment. Banks generate
income from sanctioning loan or making investment. To increase such income bank has
to attract deposits as much as it can.
Ensure productive investment of the scattered savings of the clients: Banks collect
scattered savings as deposits from large number of individual in our society and invest
those in the productive fields to facilitate the economic development of the country.
Thus, the small deposits of people, which may be utilized in the day to day activities, are
turned into the profitable investments with the help of bank.
Extending the scope of loan: Banks extend loan by collecting deposits. Sometimes,
banks offer loans to the depositors in various multiplications of their deposited money.
 Thus, many depositors deposit more money with the intention of getting loan facilitates,
which eventually increase the scope of the bank loan.
Fulfilling the excess need for money: Banks provide overdraft facility which means the
opportunity of withdrawing more amounts than deposited. Usually, business persons can
avail of this opportunity to be offered by the banks from the deposits mobilized.
Maintain social responsibility: On behalf of the clients and institutions, banks perform
various service-oriented activities. For example- discounting of bills, payment of
insurance premium, payment of utility bills etc. To avail of these services, people often
keep deposits in the bank. So mobilization of deposits helps banks render some social
responsibility.
Deposits mix: Deposit mix is the combination of total deposits of the bank with different kinds
of deposits. The nature of deposit mixes are mainly of three kinds:
 Ownership mix of deposits
 Types of deposit mix
 Size mix of deposits
Ownership mix of deposits: Individual, business firms, industrial organizations, government, and
foreigners can be the owner of the bank’s deposits. Pattern of deposit and withdrawal of each
owner is different. So it is, risky to maintain the deposit considering only one kind of depositors.
That is, different types of owners help to maintain balance in the deposits transactions towards a
stable fund to be used to profitable utilization. So, banks can minimize the potential risks by
collecting deposits from diversified segment of population.
Types of deposit mix: Deposits are three types such as savings deposits, current deposits and
fixed deposits. In case of savings deposits account, the frequency of deposits and withdrawal is
more in number but the size of amount is usually smaller. It is just reverse of in case of fixed
deposits. But current deposits holders are very frequent in both making deposits and
withdrawals. Their amount of transactions is observed to be relatively larger. Banks may face
problem if they emphasize only on one type of deposit accounts.
Size mix deposits: Deposits may be small, medium, and large. Emphasis on any single size again
may put bank into problem. This is reason for which banks manage deposits on the basis of
deposit-size.
A commercial must manage their deposits by considering all of the above mention three types of
deposits mixes.

Factors determining the level of deposits: Level of deposits means how much deposits are
collected from the clients i.e. the size of deposit amount collected by the bank is known as the
level of deposits. Level of deposit is determined by some internal factors which can be controlled
by the bank or its employees. But there are some other external factors influence on level of
deposits that are not controlled by banks and its employees. These are:
Internal factors:
 Quality of bank personnel: If the bank personnel of a bank utilize their knowledge and
experience properly, depositors will certainly be satisfied with them. Employees with
good communication skill and professionalism can attract more deposit.
 Diversified services: At present, banking businesses are very much competitive. If the
bank takes initiative to implement attractive products both deposits and loans by newer &
acceptable projects, the volume of deposits will increase. So diversified services and
projects are acting as important variable determining the level of deposits.
 Public confidence: Depositors want to deal with such a bank that is worthy of
confidence, reliable and acceptable to all. So, banks should focus on building confidence
of the general members of the public exhibiting financial and professional strength
through which more deposits can be attracted.
 Interest rate: Interest rate may increase or decrease at the end of the financial year.
Public will be interested to deposits if interest rate is high. As a result, volume of deposits
will increase at a higher interest rate. For that reasons, interest rate determination has
strong influence in determining the level of deposits.
External factors:
 State of the national economy: Bank deposit is related economic condition of a country.
If the economic condition is good, volume of deposits will increase and if it is bad, the
reverse effect will occur.
 Characteristics of local economy: The volume of deposits also depends on the location
where the banks or its branches are located. If the region, where the bank is established,
is economically sound, then volume of deposit will increase.
  Role of the government with community: If the government takes initiatives to develop
economic condition by developing and implementing community projects, income of the
people will rise thereby increasing the level of deposit of the bank. In this way, if
government facilitates the business or industrial production, GDP and national income
will increase, which eventually ensure social development. Again, social development
will increase the number of transactions in a bank which will increase the amount of
deposits.
 Relative changes in population:

Deposit insurance: Deposit insurance is a measure to protect bank depositors, in full or in part,
from losses caused by a bank's inability to pay its debts when due. That is, deposit insurance is a
guarantee that a depositor’s debt with a bank will be honored in the event of bankruptcy. Deposit
insurance is a significant aspect of the financial safety net system basically intended to promote
financial stability. The insurance schemes vary with respect to fee structure, degree of coverage,
funding provisions, public/private participation, and compulsory versus voluntary participation.
Explicit deposit insurance measures are implemented in many countries to protect bank
depositors from losses partially or fully due to the inability of a bank to pay its debt. The United
States was the first country to officially enact deposit insurance to protect depositors from losses
by insolvent banks. In 1933, the Glass-Steagall Act established the Federal Deposit Insurance
Corporation (FDIC) to insure deposits at commercial banks. The effect of deposit insurance on
the incentives of the bank depends on the nature of the insurance contract.

Objective of deposit insurance

 Protect small depositors
 Enhance public confidence
 Enhance stability of the financial system
 Increase savings and encourage economic growth
 Enhancing more promising bank services
Deposits Pricing: When commercial banks set fee, commission, charges against deposits related
services then it is called deposits pricing. The main goal of depository institutions especially
bank is to price their deposit services in a way that attracts new funds and makes a profit. The
management faces a difficult decision-making scenario as it has to balance between the
institution’s needs to pay a high enough interest return to attract and hold customer funds, at the
same time, avoid paying an interest rate so costly it erodes any potential profit margin.

Methods of deposits pricing:

 Cost plus profit deposit pricing
 Conditional pricing
 Upscale target pricing
 Market penetration deposits pricing
 Relationship pricing

Cost-plus-profit deposit pricing:

Establishing the rate of return or fees charged on a deposit account based upon the cost of
offering the service plus a profit margin. Cost-plus deposit pricing encourages banks to
determine the costs they incur in labor and management time, materials, among others, in
offering each deposit service. That is, cost-plus pricing typically calls for a bank to charge
deposit service fees enough to cover all the costs of providing the service in addition to a small
margin for profit.

Unit price charged the Operating expense per Estimated overhead Planned profit from
customer for each = unit of deposit service + expense allocated + each deposit service
deposit service to the bank’s unit sold
deposit function
Example 1: ABC savings bank determines that its basic checking account costs the bank $3.00
per month in servicing costs (assume the servicing costs are labor and computer time) and $2.00
per month in overhead expenses. This account requires a $600 minimum balance. Additionally,
the bank also tries to build a $0.60 per month profit margin on these accounts.
Determine the monthly fee that the bank should charge each customer.

Solution:
Operating expense per unit of deposit service = $3.00

Estimated overhead expense allocated to the deposit service function = $2.00

Planned profit margin = $0.60

Following the cost-plus profit pricing formula, the monthly fee is:

Monthly fee=$3.00+$2.00+0.60=$5.60 per month

Example 2: ABC savings bank determines that its basic checking account costs the bank $3.00
per month in servicing costs (assume the servicing costs are labor and computer time) and $2.00
per month in overhead expenses. This account requires a $600 minimum balance. Additionally,
the bank also tries to build a $0.60 per month profit margin on these accounts.
Analysis of ABC Savings Bank Customer accounts reveals that for each $150 above the $600
minimum balance maintained in its checking accounts, the bank saves about 5% in operating
expenses with each customer account.

For a customer who is consistent in maintaining an average monthly balance of $1,200 ($1,000)
how much should the bank charge to protect its profit margin?

400 = 150 + 150 + 100 = (5% + 5% + 5% * 100/150 = 3.33%) = 13.33%

New operating expense = $3 – $0.6 = $ 2.40 / $ .4 ($3 * 13.33%= $ .3999 or $ .40) = $ 2.60
Solution: 5* 100/150 = 3.33% $400= 13.33%
600

Additional balance 600 = 150 (5%) + 150(5%) + 150(5%) +150(5%)

If the bank saves about 5% in operating expenses for each $150 held in balances above the
minimum of $600, then a customer who maintains an average monthly balance of $1,200 saves
the bank (5% *4) 20% in operating expenses.
New operating expenses=$3.00–(20%×$3.00= $0.60) = $2.40
The appropriate amount that the bank should charge to protect its profit margin is therefore
Monthly fee=$2.40+$2.00+$0.60=$5.00 per month
$ 2.60 + 2 + 0.60 = 5.20

Conditional pricing: Conditional pricing is method of pricing deposit services in which the fees
paid by the customer depend mainly upon the account balance and the volume of account
activity. Depository institutions, particularly banks, use conditional pricing as a tool to attract
the kind of depositors they want to have as customers. In this case, a depository institution sets
up a schedule of fees in which the customer pays a low fee or no fee given that the deposit
balance is above some minimum level. However, the customer is liable to higher charges if the
average balance drops below that minimum level. In other words, the customer pays the price
conditional on how they use a deposit account.
Conditional pricing is based on one or more of the following factors:
 The average balance in the account during the period;
 The maturity of the deposit; and/or
 The number of transactions going through the account. For example, the number of
deposits made, or notices of insufficient funds issued.

Example:
Bright Savings bank has posted the following fees schedule for its business checking accounts:

Average Monthly Account Balances

Range Monthly Maintenance Fee Charge Per Check
Over $2000 $0 $0
$1,500–$2,000 $3 $0.20
Less than $1,500 $5 $0.30
= $3+ ($0.20*6) = $ 4.20
If a customer has $1755 in his bank account and check 6 times in a particular month. What is the
amount of Bright’s business pricing over this particular deposit customer?

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.
Upscale target pricing: The setting of prices and fees on deposit accounts in an effort to attract
those customers who hold high balances and purchase other bank services.
Relationship Pricing: Basing prices for deposits and other bank services upon the number of
services purchased and the duration of the bank-customer relationship. Depository institution
prices deposits according to the number of services purchased or utilized. The depositor may be
given lower fees or have a part of the cost waived if they have used two or more services – for
example, having a checking account, a savings account, and his/her mortgage at the same
financial institution. Relationship pricing promotes greater customer loyalty and makes the
customer less sensitive to the interest rates offered on deposits or the prices posted on other
banking services by competing financial service firms.

Marginal cost of deposits: Many financial analysts would argue that the marginal cost, and not
the historical average cost, should be used to price deposits and funding sources. This is because
frequent fluctuations in interest rates make historical average cost an unreliable standard for
pricing. Marginal cost approach provides valuable information to bank manager about deciding
just how far the bank should go in expending its deposits base before the added cost of deposit
growth catches up with additional revenues, and total profits begin to decline. When profit stars
to fall, management needs either to find new sources of funding with lower marginal costs, or to
identify new loans and investments promising greater marginal revenues or both.

The marginal cost formula is as follows:

Marginal cost=Change in total cost=New interest rates × Total funds raised at new rate–Old
interest rate× Total funds raised at old rate
Where,
Marginal cost rate=Change in total cost /Additional funds raised

Example: A bank that has a base amount of savings deposits of $50 million and currently pays
8% rate on these funds. The bank seeks to raise additional funds but will have to increase the
interest rate as the amount of cash raised increases. Management anticipates an investment yield
of 10% after investing deposits.

Fund Average rate Total Marginal Changes in Expected Difference Total

raised paid interest cost total cost/ revenue Expected less additional
marginal cost marginal profit
rate
50 m 8% 4m 4m 8% 10% 2% $1m
100m 8.5% 8.5m 4.5m 9% 10% 1% $1.5m
200m 9% 18m 9.5m 9.5% 10% 0.5% $2m
300m 9.5% 28.5m 10.5m 10.5% 10% -0.5% $1.5m

The calculations are as follows:

Total interest=Funds raised ×Average Rate Paid

=50,000,000×8.0%=4,000,000

Marginal cost=Change in total cost

=New interest rates × Total funds raised at new rate–Old interest rate× Total funds raised at old
rate
=(8.5%×100,000,000)−(8.0%×50,000000)
=4,500,000
For the second case,
Change in Total Cost= 4,500,000 / (100,000000−50,000000)
=9.0%
The bank will, therefore, make a total additional profit of the amounts given in the last column.
Total profit tops out at $200,000,000. It would not pay the bank to go beyond this point. The 9%
deposit rate is, therefore, the best choice, given all the assumptions and forecasts made.

Types of deposits offered by Banks and other depository institutions: There are three broad
categories of deposits offered by banks and other deposit institutions. These include:
 I. Transaction (Payments or Demand) Deposits
II. Non-transaction (Savings or Thrift) Deposits
III. Retirement Savings Deposits

We discuss them in the following sections:

I. Transaction (Payments or Demand) Deposits

A transaction deposit is an account used primarily to make payments for purchases of goods and
services. The financial-service providers must instantly honor whatever withdrawals a customer
makes in person or by a third party chosen by the customer to be the recipient of funds
withdrawn.

Transaction deposits are further divided into noninterest-bearing transaction deposits and
interest-bearing transaction deposits.

 Noninterest-bearing demand deposits: offer customers payment services, safekeeping of

funds, and recordkeeping for any transactions committed by card, check, or an electronic
network. They are the most volatile and unpredictable source of funds.
 Interest-bearing demand deposits: offer all the services provided by interest-bearing demand
deposits and pay interest to the depositor. Additionally, they give the depository institution the
right to ensure a prior notice before any withdrawal of funds by customers. They are subdivided
into:

 Negotiable orders of withdrawal (NOW) accounts;

 Money market deposit (MMDA) account; and
 Super NOW (SNOW) account.

II. Non-transaction (Savings or Thrift) Deposits)

 Savings or thrift deposits have features that attract funds from customers who wish to reserve
money in expectation of future expenditures or for financial emergencies. In other words, a thrift
account is an account whose primary purpose is to encourage the bank customer to save rather
than make payments. Compared to transaction deposits, non-transaction deposits usually pay
substantially higher interest rates and are less costly to process and manage for the offering
institutions.

Non-transaction deposits are split into:

 Passbook savings deposits: pay the depositor a competitive interest rate. A physical notebook,
called a passbook, accompanies the depositor to monitor (track) the flow of funds into and out of
the account.
 Statement savings deposits: include transactions involving deposits, withdrawals, and interest
earned, which are recorded as computer entries. The depositor receives a regular statement of
account, showing all transactions up to the posting date. However, unlike passbook savings
deposits, the depositor does not receive a passbook evidencing ownership of the account.
 A time deposit: also known as a certificate of deposits in the United States, is a bank deposit
that has a specified period to maturity and bears interest. This deposit cannot be withdrawn for a
specific term unless a penalty is paid.

III. Retirement Savings Deposits

Retirement savings deposits can be categorized into three:

 Individual retirement account (IRA): Salaried and wage-earning individuals make tax free and
limited contributions each year to this account type, offered by depository institutions, brokerage
firms, insurance companies, and mutual funds, or by employers with a qualified pension or
profit-sharing plans.
 Keogh Plan: Self-employed individuals or businesses have access to a tax-deferred pension plan
called a Keogh Plan for retirement purposes. It can either be a defined benefit or a defined
contribution plan.
 Roth IRA: This is a retirement savings account that is tax-advantaged. In other words, it permits
an individual to withdraw their retirement savings tax-free.
 The main difference between Roth IRAs and traditional IRAs is that Roth IRAs are financed
with after-tax dollars. This means that the contributions are not liable to tax-deductions, but once
one starts withdrawing funds, the money is tax-free. Conversely, traditional IRA deposits are
made with pre-tax dollars. This implies that an individual is liable to a tax deduction on their
contribution and consequently pays income tax when they take out money from the account
when they retire.
Interest rates on deposits majorly depend on:
 The maturity of the deposit;
 The size of the depository financial institution;
 The risk of the depository institution; and/or
 The marketing philosophy and goals of the depository institution.

Core deposits: Core deposits are a stable base of funds that are not highly sensitive to market
interest rate fluctuations and which tend to remain with the bank. The following figure illustrates
the core deposits.

Problems
12-1. Rhinestone National Bank reports the following figures in its current Report of financial
Condition:
Cash and Interbank Dep 50 Core Deposits 50
S.T. Securities 15 Large Negotiable CDs 150
Total Loans, gross 400 Brokered Deposits 65
L.T. Securities 150 Other Deposits 45
Other Assets 10 Money Mkt. Liabilities 195
Total Assets 625 Other Liabilities 65
Equity Capital 55
Total Liab. & Eq. 625

a. Evaluate the funding mix of deposits and non-deposit sources of funds employed by
Rhinestone. Given the mix of its assets, do you see any potential problems? What changes would
you like to see management of this bank make? Why?
Solution:
Core deposits/Assets (50/ 625) = 8.00%
Large Negotiable CDs/Assets = 24.00%
Brokered Deposits/Assets = 10.40%
Other Deposits/Assets = 7.2%
Money Market Liabilities/Assets = 31.2%
Other Liabilities/Assets = 10.40%
Equity Capital/Assets = 8.80%
The proportion of core deposits at Rhinestone is exceptionally low, while large CDs and other
money-market borrowings make up more than 55.2 percent of the bank’s total funding sources.
This funding mix tends to subject the bank to excessive vulnerability to quick withdrawal of
funds and high interest-rate risk exposure. Rhinestone also appears to be excessively dependent
on brokered deposits which are highly volatile and interest-sensitive. Adding in these brokered
deposits, more than half of Rhinestone’s assets are funded with highly interest-sensitive deposits
and money-market borrowings. Management needs to expand the bank’s core deposits and other
more stable funds sources.
b. Suppose market interest rates are projected to rise significantly. Does Rhinestone appear to
face significant losses due to liquidity risk? Due to interest rate risk? Please be as specific as
possible.
Solution:
If interest rates rise, Rhinestone will experience higher interest costs immediately or within hours
or a few days on at least 50 percent of its funding sources. Unfortunately all but $65 million of
its $625 million in total assets are longer-term, inflexible assets whose interest yields cannot be
adjusted as rapidly as the interest rates to be paid out on the bank’s liabilities. Other factors held
equal, the bank’s earnings will be squeezed. Management needs to do some serious restructuring
work on both sides of the bank’s balance sheet in moving toward more flexible-return assets and
more flexible-cost liabilities, and to move toward greater use of interest-rate hedging techniques.
12-3. First Metrocentre Bank posts the following schedule of fees for its household and small-
business transaction accounts:
 For average monthly account balances over $1,500 there is no monthly maintenance fee
and no charge per check or other draft.
 For average monthly account balances of $1,000 to $1,500, a $2 monthly maintenance
fee is assessed and there is a 10¢ charge per check or charge cleared.
 For average monthly account balances of less than $1,000, a $4 monthly maintenance fee
is assessed and there is a 15¢ per check or per charge fee.
What form of deposit pricing is this? What is First Metrocentre trying to accomplish with its
pricing schedule? Can you foresee any problems with this pricing plan?
Solution: First Metrocentre Bank has posted a schedule of deposit fees that allows the customer
service-charge free checking for average monthly account balances over $1,500. Lower balances
are assessed an inverse monthly maintenance fee plus an increased per-check charge as the
average monthly account balance falls. This is conditional deposit pricing designed to encourage
more stable, larger-denomination accounts which would give the bank more money to use and,
perhaps, a more stable funding base. The fees on under-$1,000 accounts are stiff which may
drive away many small depositors to other banks.