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CHAPTER TWELVEManaging and Pricing Deposit

Services

We will review • the different types of deposits banks offer and,

•which types of deposits are among the most profitable to offer their customers.

We will examine how an institution’s cost of funding can be determined and the different methods of pricing deposits and deposit-related services.

Key Topics

•Types of Deposit Accounts Offered •The Changing Mix of Deposits and Deposit Costs

•Pricing Deposit Services and Deposit Interest Rates

•Conditional Deposit Pricing •Rules for Deposit Insurance Coverage •Disclosure of Deposit Terms •Lifeline Banking

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Composition of Bank Balance Statements(Percentage Mix of Bank Sources and Uses of Funds for 2006)

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?

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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 Nontransaction (Savings or Thrift)

Deposits Longer-Term Higher Interest Rates Than Transaction

Deposits Generally Less Costly to Process and Manage

Most held by private sector

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Transaction Deposit

An account used primarily to make payments for purchases of goods and services

Transaction Deposits

Noninterest-Bearing Demand Deposits Interest prohibited by Glass-Steagall

Most volatile and unpredictable source of funds

Interest-Bearing Demand Deposits Negotiable Orders of Withdrawal (NOW)

Money Market Deposit Account (MMDA)

Super NOW (SNOW) Account

Check ImagingTechnology which allows any depository institution’s staff member to search on screen for a check or other document by account number, date, dollar amount or document number as well as perform other functions

Thrift or Savings Deposit

An account whose primary purpose is to encourage the bank customer to save rather than make payments

Types of Savings or Thrift Deposits

Passbook Savings Account Statement Savings Deposit Time Deposit (CD) Retirement Savings Acct’s

Individual Retirement Account (IRA)Keogh DepositRoth IRA – after taxDefault Option Retirement Plans

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

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

The Changing Composition of Deposits in the U.S.

Core Deposits

A stable base of funds that is not highly sensitive to movements in market interest rates and which tend to remain with the bank

Core DepositsDepos it A mount (Millions o f Do lla rs )

1996

T otal Depos its

Core Depos its

V olat i le Depos its = T otal Depos its - C ore Depos i t s

199519941993199219911990198919881987 19981997T ime

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/

http://www.federalreserve.gov/

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 (temporarily $250,000) for each account holder within the same bank (even if different branches)

Deposits placed in separate institutions are insured separately

Truth in Savings Act 1991

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

Annual Percentage Yield• 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 receive?

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Annual Percentage Yield

The correct formula is: In this instance,

Or, APY = 0.82 percent, Where the average account balance is:

1- )

BalanceAccount Average

EarnedInterest (1 100 APY Periodin Days

365

$1036.99 days 365

days 185 x $100 days 180 x $2000

1 - )

$1036.99

$8.50 (1 100 APY 365

365

Pricing Deposit-Related Services

• The Glass-Steagall Act of 1933 – Federal Limits on Interest Rates Paid on Deposits – why?

• Nonprice Competition• The Depository Institutions Deregulation and

Monetary Control Act of 1980▫ Cost-Plus Pricing▫ Historical Avg Cost Pricing▫ Pooled Funds Approach▫ Marginal Cost of Deposits▫ Conditional Pricing▫ Upscale Target Pricing▫ Relationship Pricing

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Cost Plus Profit Deposit Pricing

Unit Price Charged the

Customer for Each Service

=

Operating Expense

Per Unit of Deposit Service

+

Estimating Overhead Expense

Allocated to the Deposit

Function

+

Planned Profit from

Each Service Unit

Sold

Problem 12- 6 Richman Savings Bank finds that its basic checking

account which requires a $500 minimum balance, costs the bank $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

Problem 12- 6 (continued)

Further analysis of customer accounts reveals that for each $100 above the $500 minimum in average balance maintained in its checking accounts, Richman Savings saves about 5 percent in operating expenses with each account. For a customer who consistently maintains an average monthly balance of $1,000, how much should the bank charge in order to protect its profit margin?

Problem 12- 6 (continued)

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.

The appropriate fee for this customer would be: [$2.65 –(5x0.05)x($2.65)] + $1.18 + $0.50 = $1.9875 + $1.18 + $0.50 = $3.6675 per month.

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.

Pooled Funds 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?


Amount Interest Reserve

Type (millions) Cost Req.

Checkable $10010% 15%Time and Savings 20011 5Money Market 5011 2Equity 5022 0Total $400


float and tsrequiremen reserve Percentage-percent 100

costs raising fundt noninteres &Interest

raised funds Total

equity Owners'



raised funds Total

fundsmarket Money



raised funds Total

deposits savings & Time



raised funds Total

depositsCheckbook

%88.121288.0000.1

22.400$50$

02.00.1

11.400$50$

05.00.1

11.400$200$

15.00.1

10.400$100$

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 CostMarginal cost = Change in Total Cost = New interest rate x Total funds raised – Old interest rate x Total funds raised at

old rate

raised funds Additional

cost in total Change ratecost Marginal

Problem 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 the bank go in raising its deposit rate in order to maximize total profit (excluding interest costs)?

Problem 12-4 (continued)

Problem 12-4

Funds Raised

Avg Rate Paid Total interest

Marginal Cost

Marginal Cost %

Expected Revenue

Difference Expected - Marginal

Total Additional Profits

$ 10,000,000 3.00% $ 300,000 $ 300,000 3.00% 6.25% 3.25% $ 325,000 $ 15,000,000 3.25% $ 487,500 $ 187,500 3.75% 6.25% 2.50% $ 450,000 $ 20,000,000 3.50% $ 700,000 $ 212,500 4.25% 6.25% 2.00% $ 550,000 $ 26,000,000 3.75% $ 975,000 $ 275,000 4.58% 6.25% 1.67% $ 650,000 $ 28,000,000 4.00% $ 1,120,000 $ 145,000 7.25% 6.25% -1.00% $ 630,000

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.

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

Problem 12-3 First Metrocentre Bank posts the following schedule of

fees for its household and small business checking accounts: For average monthly account balances over $1500 there is no

monthly maintenance fee and no charge per check. For average monthly account balances of $1000 to $1500 a $2

monthly maintenance fee is assessed and there is a $.10 charge per check.

For average monthly account balances of less than $1000, a $4 monthly maintenance fee is assessed and there is a $.15 per check 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 schedule?

Problem 12-3 (continued)

First Metrocentre Bank has posted a schedule of deposit fees that allows the customer service-charge free checking for average monthly account balances over $1500. 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-$1000 accounts are stiff which may drive away many small depositors to other banks.

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.

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.

Basic or Lifeline Banking

Some people feel that all individuals are entitled to a minimum level of financial services no matter their income level.

Quick Quiz

• What are the major types of deposit plans offered today?

• What are core deposits, and why are they so important?

• How has the composition of deposits changed in recent years?

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Quick Quiz (cont.)

• 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 earn 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?

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

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Expedited Funds Availability Act 1987

Sets the maximum delay for receipt of deposit credit banks can use and requires the bank to notify customers of their policies for making funds available

Summary Types of Deposits Determinants of interest rate paid Core deposits Deposit pricing methods

Cost plus Marginal Historical Market penetration Pooled

Deposit fee schedules Additional deposit pricing types

Upscale Relationship Lifeline or basic Expedited funds availability act

Economy & Finance

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