Chapter12 Chapter 12 Managing and Pricing Deposit Services

Document Sample
Chapter12 Chapter 12 Managing and Pricing Deposit Services Powered By Docstoc
					Chapter 12 - Managing and Pricing Deposit Services

                                              CHAPTER 12


Goal of This Chapter: This chapter has multiple goals. One of the most important is to learn
about the different types of deposits financial institutions offer and, from the perspective of a
manager, to discover which types of deposits are among the most profitable to offer their
customers. We also want to explore how an institution’s cost of funding can be determined and
examine the different methods open to institutions to price the deposits and deposit-related
services they sell to the public.

                                       Key Topics in This Chapter

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

                                              Chapter Outline

I. Introduction: The Importance of Deposits and the Challenge of Managing Deposits
II.Types of Deposits Offered by Banks and Other Depository Institutions
        A. Transaction (Payments or Demand) Deposits
                1. Noninterest-Bearing Transaction Deposits
                2. Interest-Bearing Transaction Deposits
                        a. NOW Accounts
                        b. Money Market Deposit Accounts (MMDAs)
                        c. Super NOWs
        B. Nontransaction (Savings or Thrift) Deposits
                1. Passbook Savings Deposits
                2. Statement Savings Deposits
                3. Time Deposits
        C. Retirement Savings Deposits
                1. Individual Retirement Accounts (IRAs)
                2. Keogh Plans
                3. Roth IRAs

Chapter 12 - Managing and Pricing Deposit Services

III. Interest Rates Offered on Different Types of Deposits
         A. The Composition of Deposits
                 1. Trend toward Interest-Bearing and Nontransaction Deposits
                 2. The Importance of Core Deposits
                 3. Changes in the Relative Importance of Other Types of Deposits
         B. The Ownership of Deposits
         C. Cost of Different Deposit Accounts
IV. Pricing Deposit-Related Services
V. Pricing Deposits at Cost Plus Profit Margin
         A. Estimating Deposit Service Costs
         B. An Example of Pooled Funds Costing
VI. Using Marginal Cost to Set Interest Rates on Deposits
         A. Conditional Pricing
VII. Pricing Based on the Total Customer Relationship and Choosing a Depository
         A. The Role That Pricing and Other Factors Play When Customers Choose a Depository
            Institution to Hold Their Accounts
VIII. Basic (Lifeline) Banking: Key Services for Low-Income Customers
IX. Summary of the Chapter

                                              Concept Checks

12-1. What are the major types of deposit plans that depository institutions offer today?

Deposit plans can be divided broadly into transaction deposits, thrift or nontransaction deposits,
and hybrid deposits. The primary function of transaction deposits is to make payments and these
deposits include regular checking accounts and NOW accounts. The principal function of thrift
deposits is to serve as accumulated savings and include passbook and statement savings
accounts, CDs, and other time deposit accounts. Hybrid deposits combine transactions and thrift
features and include money-market deposit accounts and Super NOWs.

12-2. 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 savings and third-party payments accounts. 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.

12-3. 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.

Chapter 12 - Managing and Pricing Deposit Services

12-4. 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.

12-5. Which deposits are the least costly for depository institutions? The most costly?

Commercial checkable deposits, particularly regular noninterest bearing demand deposits, are
usually the least costly. The most costly deposits are passbook savings accounts having
substantial deposit and withdrawal activity and higher interest-rate time deposits.

12-6. 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. 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. Finally, 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.

12-7. A bank determines from an analysis of its cost-accounting figures that for each $500
minimum-balance checking account it sells account processing and other operating costs will
average $4.87 per month and overhead expenses will run an average of $1.21 per month. The
bank hopes to achieve a profit margin over these particular costs of 10 percent of total monthly
costs. What monthly fee should it charge a customer who opens one of these checking accounts?

The relevant formula is:

                Unit Price        Operating              Overhead      Planned
                 Charged        = Expense            +    Expense   + Profit Margin
                per Month         Per Unit               Per Unit      Per Unit

In this case:

Chapter 12 - Managing and Pricing Deposit Services

        Unit Price Charged Per Month = $4.87 + $1.21 + 0.10 x ($4.87 + $1.21) = $6.69

12-8. To price deposits successfully, service providers must know their costs. How are these
costs determined using the historical average cost approach? The marginal cost of funds
approach? What are the advantages and disadvantages of each approach?

The historical average cost approach looks at the past. It asks the following question:
What funds has the bank raised to date and what did they cost? The marginal cost deposit-pricing
method focuses upon the weighted average cost of new funds raised from all of the different
sources of funds the bank draws upon or plans to draw upon in the current period.
Marginal cost is preferred over historical average cost as frequent changes in interest rates will
make historical average cost a treacherous standard for pricing.

12-9. How can the historical average cost and marginal cost of funds approaches be used to
help select assets (such as loans) that a depository institution might wish to acquire?

The historical average cost rate is called break-even because the institution must earn at least this
rate on its earning assets (primarily loans and securities) just to meet the total operating costs of
raising borrowed funds and the stockholders' required rate of return. Therefore, the institution
will know the lowest rate of return that it can afford to earn on assets it might wish to acquire.
The marginal cost of funds approach can be used as a guide to select loans and other assets
because the institution interested in profit maximizing would want to be sure to cover its fund-
raising costs.

12-10. What factors do household depositors rank most highly in choosing a financial firm for
their checking account? Their savings account? What about business firms?

Studies cited in this chapter indicate that households (individuals and families) appear to
consider, in rank order, the following factors in choosing an institution to hold their checking
account: convenient location, availability of other services, safety, low fees and low minimum
balances, and high deposit interest rates. In selecting an institution to hold their savings account
households appear to consider, in rank order: familiarity, interest rate paid, transactional
convenience, location, availability of payroll deduction, and any fees charged. Business firms, on
the other hand, seem to consider such factors as the financial health of the lending institution,
whether the institution will be a reliable source of credit in the future, the quality of managers,
whether loans are competitively priced, the quality of financial advice given, and whether cash
management and operations services are provided.

12-11. What does the 1991 Truth in Savings Act require financial firms selling deposits inside
the United States to tell their customers?

Chapter 12 - Managing and Pricing Deposit Services

The Truth in Savings Act requires financial firms to fully inform their deposit customers on the
terms offered to each depositor. The customer must be told when a new account is opened or if a
deposit is renewed, what annual percentage yield (APY) is being offered and what minimum
balance is required to receive that yield. Moreover, the depositor must be informed about any
penalties or service fees which could reduce his or her expected yield. If the terms of a deposit
are changed in a way that would reduce the depositor's return advance notice must be given to
the account holder.

12-12. Use the APY formula required by the Truth in Savings Act for the following calculation.
Suppose that a customer holds a savings deposit in a savings bank for a year. The balance in the
account stood at $2,000 for 180 days and $100 for the remaining days in the year. If the Savings
bank paid this depositor $8.50 in interest earnings for the year, what APY did this customer

        The correct formula is:

                           Interest Earned      365               
        APY  100 (1                          ) Day sin Period -1
                       Average Account Balance                    

In this instance,

                         $8.50 365 365 
        APY  100 (1           )     - 1
                       $1036.99          

        APY = 0.82 percent,

Where the average account balance is:

         $2000 x 180 days  $100 x 185 days
                                             $1036.99
                      365 days

12-13. What is lifeline banking? What pressures does it impose on the managers of banks and
other financial institutions?

Chapter 12 - Managing and Pricing Deposit Services

Lifeline banking consists of basic service packages offered by banks to customers not generally
able to afford conventional bank service offerings. The essence of these services is that they
carry low service fees and usually do not offer all of the features of banking services carrying
full service fees. The pressure on managers to offer basic or lifeline services has aroused a big
controversy. From a profit motive point of view banks should not offer unprofitable services. On
the other hand, financial institutions are partially subsidized by government in the form of low-
interest loans and deposit insurance and, therefore, have some public-service responsibilities
which may include providing certain basic services to all potential customers, regardless of their
income or social status.

12-14. Should lifeline banking be offered to low-income customers? Why or why not?

This is not an easy question to answer. One of the most serious problems individuals outside the
financial mainstream face is lack of access to a deposit account. Lifeline banking is providing
basic banking services to these individuals. Most financial-service providers are privately owned
corporations responsible to their stockholders to earn competitive returns on invested capital.
Providing financial services at prices so low, they do not cover production costs interferes with
that important goal. Thus, from a profit motive point of view banks should not offer unprofitable
services. However, it should be considered that depository institutions receive important aid from
the government that grants them a competitive advantage over other financial institutions like
deposit insurance. Therefore, they have some public-service responsibilities which may include
providing certain basic services to all potential customers.


12-1. Rhinestone National Bank reports the following figures in its current Report of

               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

[NOTE: The balance sheet in the Text/PDF does not tally. The error in the value of “Other
Liabilities” has been corrected in the IM.]

a. Evaluate the funding mix of deposits and nondeposit 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?

Chapter 12 - Managing and Pricing Deposit Services

                 Core deposits/Assets                       =   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 54 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

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.

12-2. Kalewood Savings Bank has experienced recent changes in the composition of its deposit
(see the following table; all figures in millions of dollars). What changes have recently occurred
in Kalewood’s deposit mix? Do these changes suggest possible problems for management in
trying to increase profitability and stabilize earnings?

Chapter 12 - Managing and Pricing Deposit Services

                                           One Two Three
                                      This Year Years Years
Types of Deposits Held                Year Ago Ago Ago
Regular and special checking accounts $235 $294 $337 $378
Interest-bearing checking accounts     392 358 329 287
Regular (passbook) savings deposits    501 596 646 709
Money market deposit accounts          863 812 749 725
Retirement deposits                    650 603 542 498
CDs under $100,000                     327 298 261 244
CDs $100,000 and over                  606 587 522 495

Regular and special checking accounts have declined sharply from $378 million to $235 million,
while interest-bearing checking accounts rose from $287 million to $392 million. Passbook
savings deposits have fallen by more than $200 million while money-market deposit accounts,
retirement accounts, and both small and large ($100,000 +) CDs have all risen substantially.
Management has several reasons to be concerned about these developments because the bank’s
funds are shifting into accounts bearing significantly higher interest costs, while the bank is
suffering substantial erosion in its core deposits represented by regular (passbook) savings
deposits and small checking accounts. Thus, more interest-sensitive funds are supplanting
deposits that are more loyal and less interest-elastic. The bank may find its profits are likely to be
squeezed by higher interest costs and its earnings may become more volatile if market interest
rates experience significant changes in the period ahead because a greater portion of the bank’s
funding is coming from more interest-sensitive deposits. A possible offsetting advantage is the
shift away from deposits that can be withdrawn without notice (i.e., regular and special checking
accounts and passbook savings deposits) toward longer-term deposit instruments with fixed
maturities, giving the bank a somewhat longer term and, perhaps, somewhat more predictable
funding base.

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?

Chapter 12 - Managing and Pricing Deposit Services

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.

12-4. Gold Mine Pit Savings Association finds that it can attract the following amounts of
      deposits if it offers new depositors and those rolling over their maturing CDs the interest
      rates indicated below:

                     Expected Volume                   Rate of Interest
                     of New Deposits                  Offered Depositors
                        $10 million                         3.00%
                         15 million                          3.25
                         20 million                          3.50
                         26 million                          3.75
                         28 million                          4.00

Management anticipates being able to invest any new deposits raised in loans yielding 6.25
percent. How far should this thrift institution go in raising its deposit interest rate in order to
maximize total profits (excluding interest costs)?

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

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.

Chapter 12 - Managing and Pricing Deposit Services

12-5. Red Brick Bank plans to launch a new deposit campaign next week in hopes of bringing
in from $100 million to $600 million in new deposit money, which it expects to invest at a 5.5
percent yield. Management believes that an offer rate on new deposits of 2.75 percent would
attract $100 million in new deposits and rollover funds. To attract $200 million, the bank would
probably be forced to offer 3.25 percent. Red Brick’s forecast suggests that $300 million might
be available at 3.75 percent, $400 million at 4.00 percent, $500 million at 4.25 percent, and $600
million at 4.5 percent. What volume of deposits should the institution try to attract to ensure that
marginal cost does not exceed marginal revenue?

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

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.

12-6. Richman 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?

        Following the cost-plus-profit approach, the monthly fee should be:

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

Further analysis of customer accounts reveals that for each $100 above the $500 minimum in
average balance maintained in its transaction accounts, Richman Savings saves about 5 percent
in operating expenses with each account. (Note: If the bank saves about 5 percent in operating
expenses for each $100 held in balances above the $500 minimum, then a customer maintaining
an average monthly balance of $1,000 should save the bank 25 percent in operating costs.) 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?

        The appropriate fee for this customer would be:

Chapter 12 - Managing and Pricing Deposit Services

        [$2.65 -0.25 ($2.65)] + $1.18 + $0.50 = $1.9875 + $1.18 + $0.50 = $3.6675 per month.

12-7. Monica Lane maintains a savings deposit with Monarch Credit Union. This past year
Monica received $10.75 in interest earnings from her savings account. Her savings deposit had
the following average balance each month:

                       January            $400               July        $350
                       February            250               August       425
                       March               300               September    550
                       April               150               October      600
                       May                 225               November     625
                       June                300               December     300

What was the annual percentage yield (APY) earned on Monica’s savings account?

Monica’s account had an average balance this year of:

       [$400 x 31 days + $250 x 28 days + $300 x 31 days + $150 x 30 days
       + $225 x 31 days + $300 x 30 days + $350 x 31 days + $425 x 31 days +
         $550 x 30 days + $600 x 31 days + $625 x 30 days + $300 x 31 days]
                                     365 days

        = $373.56

        Then the APY must be:

                        $10.75 365/365    
        APY = 100 (1          )        1  2.88 percent
                       $373.56            

12-8. The National Bank of Mayville quotes an APY of 3.5 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 $4,500 for the remainder of the
year. How much in total interest earnings did this small business customer receive for the year?

Using the APY formula we can fill in the variables whose values are known and find the
unknown interest earnings. Thus:

                       Interest Earnings 365/365    
        APY = 100 (1                   )         1
                       Average Balance              

                        Interest Earnings 365/365    
        3.5% = 100 (1                   )         1
                             $3267.12                

Chapter 12 - Managing and Pricing Deposit Services

Where the account's average balance is found from:

Average Balance =
                       $2500   x 90 days  $3000 x 180 days  $4500 x 95 days 
                                                365 days

                 = $3267.12


                    Interest Earnings 
        3.5% = 100                      0.030608 x Interest Earnings
                         $3267.12     

        or Interest Earnings = $114.35


Shared By: