Chapter 3 (cont)

Pricing deposit-related services

 12-2

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
 12-3

Pricing deposit-related services

▪ Cost-plus pricing

▪ Marginal cost of deposits

▪ Conditional pricing

▪ Relationship pricing
 12-4

1. 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-dere
gulation-monetary-control-act/4953012-1.html
)
• → unbundle service pricing: deposits are priced separately
 12-5

Cost plus profit deposit pricing

Deposit services are priced high enough to cover all
costs:
 12-9

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
 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%
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
 12-13

2. 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?

 12-14

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)
 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)
 12-22

3. 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
 12-24

4. 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.

 12-25

Basic or lifeline banking

Some people feel that all individuals are entitled to a minimum level

of financial services no matter their income level

Calculating the Average Net Cost of Deposit
Accounts
 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)