MANAGING AND PRICING

DEPOSIT SERVICES

Chapter 3

William Chittenden edited and updated the PowerPoint slides for this edition.
 12-2

Key topics

• 1. Types of deposit accounts offered

• 2. The changing mix of deposits and deposit
costs
• 3. Pricing deposit services and deposit interest
rates
• 4. Conditional deposit pricing
• 5. Rules for deposit insurance coverage
• 6. Disclosure of deposit terms
• 7. Lifeline banking
 12-3

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?
 12-4

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
 Non-transaction (savings or thrift) deposits
 Longer-term
 Higher interest rates than transaction deposits
 Generally less costly to process and manage
Transaction accounts

 Although the interest cost of transaction

accounts is very low, the non-interest costs can
be quite high
 Generally, low balance checking accounts are
not profitable for banks due to the high cost of
processing checks
Transaction accounts
 Most banks offer three different transaction
accounts
 Demand deposits
 DDAs (Demand Deposit Accounts)

 Negotiable Order of Withdrawal

 NOWs

 Automatic Transfers from Savings

 ATS
 12-7

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 since
Regulation Q prohibits banks from paying explicit
interest on for-profit corporate checking accounts
Regulation Q: http://www.bankersonline.com/regs/217/217-3.html
Transaction accounts

Interest-bearing demand deposits with limited or no

check-writing privileges
 Negotiable Orders of Withdrawal (NOW)- hybrid
savings instrument – pay interest
 ATS (Automatic Transfers) Accounts
 Customer has both a DDA and savings account

 The bank transfers enough from savings to DDA

each day to force a zero balance in the DDA
account
 For-profit corporations are prohibited from owning
NOW and ATS accounts
 Transaction accounts
 Money market deposit accounts

 Short-maturity deposit (a few days, weeks, months)

 Pay interest but holders are limited to 6 transactions
per month, of which only three can be checks
 Attractive to banks because they are not required to
hold reserves against MMDAs
 Held by both individuals and businesses
 12-10

Non-transaction (savings or thrift) deposit

An account whose primary purpose is to

encourage the bank customer to save rather
than make payments.
 Non-transaction accounts

 Savings accounts: Have no fixed maturity

 Denomination from $5
 Withdrawal privileges are unlimited, without prior notice
 Stable fund to banks with little interest rate sensitivity
 Low interest rate
 For individuals, non-profit organization, businesses,
governments (firms cannot put > $150,000 in saving
deposits)
 In form of
 Passbook savings account

 Statement savings account

Non-transaction accounts

 Time deposits (CD is most popular type): Have a

specified maturity ranging from 7 days on up
 Large time deposits (Jumbo CDs):
 for corporation & wealthy individuals
 in negotiable form CDs of $100,000-plus
 Typically can be traded in the secondary market
many times before reaching maturity
 Small time deposits:
 Usually acquired by individuals
 nonnegotiable form CDs with smaller denomination
 Cannot be traded before reaching maturity
 12-13

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
 12-14

Non-transaction accounts
 Retirement savings deposits
 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
Non-transaction accounts

 Individual Retirement Accounts

 Each year, a wage earner can make a tax-

deferred investment up to $3,000 of earned
income
 Funds withdrawn before age 59 ½ are subject to
a 10% IRS penalty
 This makes IRAs an attractive source of long-
term funding for banks
 12-16

Interest rates on deposits depend on:

 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
 12-17

The changing composition of deposits in the US

* Saving deposits include MMDAs

 12-18

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.

 12-19

Core deposits
 A large proportion includes transaction deposits and
low-yielding time & savings deposits.
 Small time and savings deposits can be withdrawn
immediately, their effective maturity spans over years
 Increase bank’s liability duration and reduce interest
rate vulnerability
 Share in total deposits in small banks (80%) higher
than in large banks (63%) (FDIC: 2007)
 Declining trend due to inflation, deregulation, stiff
competition and better educated-customers.
Holders of deposits

 Private sector: individuals, partnership and

corporation (75%)
 State and local government (4%)

 Foreign governments, businesses, individuals,

mostly in off-shore offices

 Other financial institutions (correspondent deposits)
Cost of deposits
 Checkable deposits (checking accounts, special
checkbook deposits and interest-bearing checking
accounts)
 Thrift deposits (money market accounts, time
deposits and savings accounts)
 Business transaction accounts are more
profitable than personal checking accounts
 Deposits are determined by public preferences
and competition
 Cost and revenue accounting data for
deposit accounts at FirstBank
Unit Cost
Demand Savings Time
Income
Interest income (estimated earnings credit) 2.6% 2.5% 3.0%
Noninterest income (monthly estimates per account)
Service charges $ 2.80 $ 0.44 $ 0.11
Penalty fees $ 4.32 $ 0.28 $ 0.27
Other $ 0.63 $ 0.16 $ 0.05
Total noninterestiIncome $ 7.75 $ 0.88 $ 0.42
Expenses
Activity charges (unit costs per transaction)
Deposit—electronic $ 0.0089 $ 0.0502 $ 0.1650
Deposit—nonelectronic $ 0.2219 $ 0.7777 $ 3.1425
Withdrawal—electronic $ 0.1073 $ 0.4284 $ 0.5400
Withdrawal—nonelectronic $ 0.2188 $ 0.7777 $ 1.4933
Transit check deposited $ 0.1600 $ 0.5686
Transit check cashed $ 0.2562
On-us check cashed $ 0.2412
Official check issued $ 1.02
Monthly overhead expense costs
Monthly account maintenance (truncated) $ 2.42 $ 4.10 $ 1.99
Monthly account maintenance (nontruncated) $ 8.60
Net indirect expense $ 4.35 $ 1.81 $ 18.38
Miscellaneous expenses
Account opened $ 9.46 $ 33.63 $ 5.78
Account closed $ 5.67 $ 20.18 $ 3.38
 12-23

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/
Substitute check authorized by Check 21
 12-25

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
 12-26

Truth in Savings Act

 Consumers must be informed of the deposit terms
before they open 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 (average yields)
 12-27

Pricing deposit-related services

 Banks need to pay high enough to attract

depositors
 Banks should avoid costly interest rate to protect

potential profit margin

 Banks are price takers, not price maker

 Banks must decide to pay market-determined

price to attract and hold depositors or lose funds

 12-28

Pricing deposit-related services

 Cost-plus pricing

 Marginal cost of deposits

 Conditional pricing

 Relationship pricing
 12-29

Cost plus profit deposit pricing

• - The Glass-Steagall Act of 1933 – Federal limits on
interest rates paid on deposits – why?
• → protect banks from “excessive” interest rate
competition for deposits
• → non-price competition as free-of-charge deposit-
related services or below-cost pricing
• → implicit interest rate
• → fund allocation distortion
• - The Depository Institutions Deregulation Act of
1980 gradually phases out federal limits on deposit
interest rate (
http://www.allbusiness.com/glossaries/depository-institutions-deregulation-monetary-control-act/49
53012-1.html
)
• → unbundle service pricing: deposits are priced
separately
 12-30

Cost plus profit deposit pricing

Deposit services are priced high enough to cover all

costs:

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
 12-31

Historical average cost approach

Determines the bank’s cost of funds by looking

at the past. It looks at what funds the bank has

raised to date and what those funds have cost.

 Calculating the average net cost of deposit
accounts
 Average historical cost of funds
Measure of average unit borrowing costs for
existing funds
 Average interest cost
 Calculated by dividing total interest expense
by the average dollar amount of liabilities
outstanding

Average Net Cost of Bank Liabilities 

Interest Expense  Noninterest Expense - Noninterest Income
Average Balance x [1 - (Required Reserve Ratio  Float ratio)]
Calculating the average net cost of deposit
accounts
 Example:
 Every month, a demand deposit account that
does not pay interest has $20.69 in
transaction costs charges, $7.75 in fees, an
average balance of $5,515, and 5% float plus
10% required reserve would have a yearly
net cost of 3.31%
Average Net Cost of Demand Deposit 
$0  $20.69 - $7.75
 12  3.31%
$5,515  (1 - .15)
Measuring the cost of funds

 Average historical cost of funds

 Many banks incorrectly use the average historical

costs in their pricing decisions
 The primary problem with historical costs is that
they provide no information as to whether future
interest costs will rise or fall.
 Pricing decisions should be based on marginal
costs compared with marginal revenues
 12-35

The marginal 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?

 12-36
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.
Marginal cost rate

Marginal cost = Change in total cost

= (New interest rate x total funds raised at new rate) –

(Old interest rate x total funds raised at old rate)

Change in total cost

Marginal cost rate 
Additional fund raised
 Measuring the marginal cost rate

 Costs of independent sources of funds

 Example:
 Market interest rate is 2.5%
 Servicing costs are 4.1% of balances
 Acquisition costs are 1.0% of balances
 Deposit insurance costs are 0.25% of balances
 Net investable balance is 85% of the balance
(10% required reserves and 5% float)

0.025  0.041 0.01 0.0025

Marginal Cost   0.0924  9.24%
0.85
 12-39

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.

 12-40

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
 12-41

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.
 12-42

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.

 12-43

Basic or lifeline banking

Some people feel that all individuals are entitled

to a minimum level of financial services no

matter their income level

 Medium Balance,
Low Balance, Low High Activity,
Activity, Truncated Nontruncated High Balance
Calculating the Average Net Cost of
Monthly Monthly Monthly
Income / Income / Income /
Activity Expenses Activity Expenses Activity Expenses
Income
Interest income $ 500 $ 0.93 $ 4,589 $ 8.50 $11,500 $ 21.30
on average monthly balance (after float)
Noninterest income (average montly estimates)
Service charges $ 2.80 $ 2.80 $ 2.80
Penalty fees (estimated for account) $ 8.56 $ 6.32 $ 2.01
Other $ 0.63 $ 0.63 $ 0.63
Total noninterest income $ 11.99 $ 9.75 $ 5.44
Total revenue $ 12.92 $ 18.25 $ 26.74
Expenses
Activity charges
Deposit—electronic 1 $ 0.01 2 $ 0.02 2 $ 0.02
Deposit—nonelectronic 1 $ 0.22 3 $ 0.67 3 $ 0.67
Withdrawal—electronic 15 $ 1.61 12 $ 1.29 10 $ 1.07
Withdrawal—nonelectronic 3 $ 0.66 14 $ 3.06 8 $ 1.75
Transit check deposited 1 $ 0.16 2 $ 0.32 2 $ 0.32
Transit check cashed 1 $ 0.26 2 $ 0.51 2 $ 0.51
On-us checks cashed 2 $ 0.48 3 $ 0.72 3 $ 0.72
Official check issued $ - $ - $ -
Deposit Accounts

Total activity expense $ 3.40 $ 6.59 $ 5.06

Monthly expenses
Monthly account maintenance (truncated) 1 $ 2.42 $ - $ -
Monthly account maintenance (nontruncated) - $ - 1 $ 6.60 1 $ 6.60
Net indirect expense $ 4.35 $ 4.35 $ 4.35
Total reoccurring monthly expenses $ 6.77 $ 10.95 $ 10.95
Interest expense $ - $ - $ -
Total expense $ 10.17 $ 17.54 $ 16.01

Net revenue per month $ 2.75 $ 0.71 $ 10.73

Average percentage cost (net of service charges and fees) -5.12% 2.38% 1.29%
Average interest cost 0.00% 0.00% 0.00%
Average noninterest cost 28.53% 5.36% 1.95%
Average noninterest income 33.66% 2.98% 0.66%
Average account balance $ 500 $ 4,589 $ 11,500
Required reserves 10% 10% 10%
Float 5% 5% 5%
 Questions & Problems

1. What are core deposits, and why are they so important

today?
2. How has the composition of deposits changed in recent
years? What are the consequences for the management
and performance of depository institutions resulting from
recent changes in deposit composition?
3. Describe the essential differences between the following
deposit pricing methods in use today: cost-plus pricing,
conditional pricing, and relationship pricing.
4. Problem 1, 4, 5 and 6 (page 411-3)
 Answers

1. What are core deposits, and why are they so important

today?

Core deposits are the most stable components of a

depositary institution’s funding base and usually include
smaller-denomination transaction deposits and low-yielding
time & savings deposits. They are characterized by relatively
low interest-rate elasticity. Holding a substantial proportion of
core deposits has an advantage in having access to a stable
and cheaper source of funding with relatively low interest-rate
risk.
 Answers
2. How has the composition of deposits changed in recent
years?

There has been a shift in the public’s holdings of deposits

toward greater relative proportions of the highest-yielding
time deposits and toward hybrid accounts that maximize
depositor returns, while still giving them access to
deposited funds to make payments.
 Answers
2. What are the consequences for the management and
performance of depository institutions resulting from recent
changes in deposit composition?
While depository institutions would prefer to sell only the
cheapest deposits to the public, it is predominately public
preference that determines which types of deposits will be
created. Institutions that do not wish to conform to customer
preferences will simply be outbid for deposits by those who
do. Managers who fail to stay abreast of changes in their
competitors’ deposit pricing and marketing programs stand
to lose both customers and profits.
 Answers

3. Describe the essential differences between the following

deposit pricing methods in use today: cost-plus pricing,
conditional pricing, and relationship pricing.
Cost-plus deposit pricing encourages banks to determine
what costs they are incurring in labor and management
time, materials, etc., in offering each deposit service.
Cost-plus pricing generally calls for a bank to charge
deposit service fees adequate to cover all the costs of
offering the service plus a small margin for profit.
 Answers
3. Describe the essential differences between the following
deposit pricing methods in use today: cost-plus pricing,
conditional pricing, and relationship pricing.
Conditional pricing is used today as a tool by banks to attract
the kinds of depositors they want to have as customers. With
this pricing technique a bank will post a schedule of offered
interest rates or fees assessed for deposits of varying sizes
and based on account activity. Generally larger volume
deposits carry higher interest returns to the depositor or are
assessed lower service charges, encouraging customers to
hold a high average deposit balance which gives the bank
more funds to invest in earning assets.
 Answers

3. Describe the essential differences between the following

deposit pricing methods in use today: cost-plus pricing,
conditional pricing, and relationship pricing.

Relationship pricing involves basing fees charged a

customer on the number of services and the intensity of
use of services the customer purchases from a bank.
 Answers
4. Problem 1 (page 411-3)
Item Amt Item Amt %
Cash and Interbank
Deposit 50 Core Deposits 50 8,00%

S.Term Securities 15 Large Negotiable CDs 150 24,00%

Total Loans, gross 400 Brokered Deposits 65 10,40%

L. Term Securities 150 Other Deposits 45 7,20%
Money Market
Other Assets 10 Liabilities 195 31,20%
    Other Liabilities 65 10,40%
    Equity Capital 55 8,80%

Total Assets 625 Total Liab. & Eq. 625  

 Answers
4. Problem 1 (page 411-3)
- The proportion of core deposits is exceptionally low, while
large CDs and other money-market borrowings make up more
than 55% of 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.
- The bank also appears to be excessively dependent on
brokered deposits which are highly volatile and interest-
sensitive.
- More than half of 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.
 Answers
4. Problem 1 (page 411-3)
b. If interest rates rise, the bank 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 (Chapter 7 - P.Rose)
 Answers
4. Problem 4 (page 411-3)
Expected Rate Total Marginal Marginal Marginal Exp. Diff. Total
Inflows Offered Interest Interest Cost Rate Revenue In Marg. Profits
on New Cost Cost Rate Rev and Earned
Funds Cost

$10 3.0% 0.3000 0.3000 3.000% 6.25% 3.250% $0.3250

15 3.25 0.4875 0.1875 3.750 6.25 2.500 $0.4500

20 3.50 0.7 0.2125 4.250 6.25 +2.00 $0.5500

26 3.75 0.975 0.275 4.583 6.25 1.667 $0.6500

28 4.00 1.12 0.145 7.250 6.25 -1.00 $0.6300

 Answers

4. Problem 4 (page 411-3)

- Gold Mine Pit Savings Association should raise its deposit rate
to 3.75%, attracting $26 million in new deposits; because up to
that point the marginal revenue rate is greater than the marginal
cost rate and total profits are also rising.

- At 4.0%, the marginal cost rate is greater than the marginal

revenue rate and total profits have fallen from a high of $0.65
million back down to $0.63 million.
 Answers
4. Problem 5 (page 411-3)
Expected Rate Total Marginal Marginal Marginal Exp. Diff. Total
Inflows Offered Interest Interest Cost Rate Revenue In Marg. Profits
on New Cost Cost Rate Rev and Earned
Funds Costs

$100 2.75% 2.75 2.75 2.75% 5.50% +2.75% $2.75

$200 3.25% 6.50 3.75 3.75% 5.50% +1.75% $4.50

$300 3.75% 11.25 4.75 4.75% 5.50% +0.75% $5.25

$400 4% 16.00 4.75 4.75% 5.50% +0.75% $6.00

$500 4.25% 21.25 5.25 5.25% 5.50% +0.25% $6.25

$600 4.5% 27.00 5.75 5.75% 5.50% -0.25% $6.00

 Answers

4. Problem 5 (page 411-3)

- The marginal revenue rate is greater than the marginal

cost rate up to $500 million in new deposits.

- At $600 million, the marginal cost rate of 5.75% is

greater than the marginal revenue rate of 5.50%.

- Therefore, Red Brick Bank should try and attract $500

million in new deposits.
 Answers

4. Problem 6 (page 411-3)

a. Following the cost-plus-profit approach, the monthly fee

should be:

Monthly fee = $2.65 + $1.18 + $0.50 = $4.33 per month.

b. The appropriate fee for this customer would be:

[$2.65 -0.25 ($2.65)] + $1.18 + $0.50

= $1.9875 + $1.18 + $0.50

= $3.6675 per month.

 MANAGING AND PRICING
DEPOSIT SERVICES

Chapter 3

William Chittenden edited and updated the PowerPoint slides for this edition.