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Chapter 12 - Managing and Pricing Deposit Services

Goal of This Chapter: This chapter has multiple goals. ne of the most important is to learn
a!out the different t"pes of deposits financial institutions offer and# from the perspective of a
manager# to discover $hich t"pes of deposits are among the most profita!le to offer their
customers. %e also $ant to e&plore ho$ an institution's cost of funding can !e determined and
e&amine the different methods open to institutions to price the deposits and deposit-related
services the" sell to the pu!lic.
(e" Topics in This Chapter
T"pes of Deposit )ccounts ffered
The Changing Mi& of Deposits and Deposit Costs
Pricing Deposit Services
Conditional Deposit Pricing
*ules for Deposit +nsurance Coverage
Disclosure of Deposit Terms
Chapter utline
+. +ntroduction: The +mportance of Deposits and the Challenge of Managing Deposits
++.T"pes of Deposits ffered !" -an.s and ther Depositor" +nstitutions
). Transaction /Pa"ments or Demand0 Deposits
1. 1oninterest--earing Transaction Deposits
2. +nterest--earing Transaction Deposits
a. 1% )ccounts
!. Mone" Deposit )ccounts /MMD)s0
c. Super 1%s
-. 1ontransaction /Savings or Thrift0 Deposits
1. Pass!oo. Savings Deposits
2. Statement Savings Deposits
2. Time Deposits
C. *etirement Savings Deposits
1. +ndividual *etirement )ccounts /+*)s0
2. (eogh Plans
2. *oth +*)s
Chapter 12 - Managing and Pricing Deposit Services
+++. +nterest *ates ffered on Different T"pes of Deposits
). The Composition of Deposits
1. Trend to$ard +nterest--earing and 1ontransaction Deposits
2. The +mportance of Core Deposits
2. Changes in the *elative +mportance of ther T"pes of Deposits
-. The $nership of Deposits
C. Cost of Different Deposit )ccounts
+3. Pricing Deposit-*elated Services
3. Pricing Deposits at Cost Plus Profit Margin
). 4stimating Deposit Service Costs
-. )n 4&ample of Pooled 5unds Costing
3+. 6sing Marginal Cost to Set +nterest *ates on Deposits
). Conditional Pricing
3++. Pricing -ased on the Total Customer *elationship and Choosing a Depositor"
). The *ole That Pricing and ther 5actors Pla" %hen Customers Choose a Depositor"
+nstitution to 7old Their )ccounts
3+++. -asic /,ifeline0 (e" Services for ,o$-+ncome Customers
+8. Summar" of the Chapter
Concept Chec.s
12-1. %hat are the ma9or t"pes of deposit plans that depositor" institutions offer toda":
Deposit plans can !e divided !roadl" into transaction deposits# thrift or nontransaction deposits#
and h"!rid deposits. The primar" function of transaction deposits is to ma.e pa"ments and these
deposits include regular accounts and 1% accounts. The principal function of thrift
deposits is to serve as accumulated savings and include pass!oo. and statement savings
accounts# CDs# and other time deposit accounts. 7"!rid deposits com!ine transactions and thrift
features and include mone" deposit accounts and Super 1%s.
12-2. %hat are core deposits# and $h" are the" so important toda":
Core deposits are the most sta!le components of a depositar" institution's funding !ase and
usuall" include smaller-denomination savings and third-part" pa"ments accounts. The" are
characteri;ed !" relativel" lo$ interest-rate elasticit". 7olding a su!stantial proportion of core
deposits has an advantage in having access to a sta!le and cheaper source of funding $ith
relativel" lo$ interest-rate ris..
12-2. 7o$ has the composition of deposits changed in recent "ears:
There has !een a shift in the pu!lic's holdings of deposits to$ard greater relative proportions of
the highest-"ielding time deposits and to$ard h"!rid accounts that ma&imi;e depositor returns#
$hile still giving them access to deposited funds to ma.e pa"ments.
Chapter 12 - Managing and Pricing Deposit Services
12-<. %hat are the conse=uences for the management and performance of depositor"
institutions resulting from recent changes in deposit composition:
%hile depositor" institutions $ould prefer to sell onl" the cheapest deposits to the pu!lic# it is
predominatel" pu!lic preference that determines $hich t"pes of deposits $ill !e created.
+nstitutions that do not $ish to conform to customer preferences $ill simpl" !e out!id for
deposits !" those $ho do. Managers $ho fail to sta" a!reast of changes in their competitors'
deposit pricing and mar.eting programs stand to lose !oth customers and profits.
12->. %hich deposits are the least costl" for depositor" institutions: The most costl":
Commercial chec.a!le deposits# particularl" regular noninterest !earing demand deposits# are
usuall" the least costl". The most costl" deposits are pass!oo. savings accounts having
su!stantial deposit and $ithdra$al activit" and higher interest-rate time deposits.
12-?. Descri!e the essential differences !et$een the follo$ing deposit pricing methods in use
toda": cost-plus pricing# conditional pricing# and relationship pricing.
Cost-plus deposit pricing encourages !an.s to determine $hat costs the" are incurring in la!or
and management time# materials# etc.# in offering each deposit service. Cost-plus pricing
generall" calls for a !an. to charge deposit service fees ade=uate to cover all the costs of offering
the service plus a small margin for profit. Conditional pricing is used toda" as a tool !" !an.s to
attract the .inds of depositors the" $ant to have as customers. %ith this pricing techni=ue a !an.
$ill post a schedule of offered interest rates or fees assessed for deposits of var"ing si;es and
!ased on account activit". Generall" larger volume deposits carr" higher interest returns to the
depositor or are assessed lo$er service charges# encouraging customers to hold a high average
deposit !alance $hich gives the !an. more funds to invest in earning assets. 5inall"# relationship
pricing involves !asing fees charged a customer on the num!er of services and the intensit" of
use of services the customer purchases from a !an..
12-@. ) !an. determines from an anal"sis of its cost-accounting figures that for each A>BB
minimum-!alance account it sells account processing and other operating costs $ill
average A<.C@ per month and overhead e&penses $ill run an average of A1.21 per month. The
!an. hopes to achieve a profit margin over these particular costs of 1B percent of total monthl"
costs. %hat monthl" fee should it charge a customer $ho opens one of these accounts:
The relevant formula is:
6nit Price perating verhead Planned
Charged D 4&pense E 4&pense E Profit Margin
per Month Per 6nit Per 6nit Per 6nit
+n this case:
Chapter 12 - Managing and Pricing Deposit Services
6nit Price Charged Per Month D A<.C@ E A1.21 E B.1B & /A<.C@ E A1.210 D A?.?F
12-C. To price deposits successfull"# service providers must .no$ their costs. 7o$ are these
costs determined using the historical average cost approach: The marginal cost of funds
approach: %hat are the advantages and disadvantages of each approach:
The historical average cost approach loo.s at the past. +t as.s the follo$ing =uestion:
%hat funds has the !an. raised to date and $hat did the" cost: The marginal cost deposit-pricing
method focuses upon the $eighted average cost of ne$ funds raised from all of the different
sources of funds the !an. dra$s upon or plans to dra$ upon in the current period.
Marginal cost is preferred over historical average cost as fre=uent changes in interest rates $ill
ma.e historical average cost a treacherous standard for pricing.
12-F. 7o$ can the historical average cost and marginal cost of funds approaches !e used to
help select assets /such as loans0 that a depositor" institution might $ish to ac=uire:
The historical average cost rate is called !rea.-even !ecause the institution must earn at least this
rate on its earning assets /primaril" loans and securities0 9ust to meet the total operating costs of
raising !orro$ed funds and the stoc.holdersG re=uired rate of return. Therefore# the institution
$ill .no$ the lo$est rate of return that it can afford to earn on assets it might $ish to ac=uire.
The marginal cost of funds approach can !e used as a guide to select loans and other assets
!ecause the institution interested in profit ma&imi;ing $ould $ant to !e sure to cover its fund-
raising costs.
12-1B. %hat factors do household depositors ran. most highl" in choosing a financial firm for
their account: Their savings account: %hat a!out !usiness firms:
Studies cited in this chapter indicate that households /individuals and families0 appear to
consider# in ran. order# the follo$ing factors in choosing an institution to hold their
account: convenient location# availa!ilit" of other services# safet"# lo$ fees and lo$ minimum
!alances# and high deposit interest rates. +n selecting an institution to hold their savings account
households appear to consider# in ran. order: familiarit"# interest rate paid# transactional
convenience# location# availa!ilit" of pa"roll deduction# and an" fees charged. -usiness firms# on
the other hand# seem to consider such factors as the financial health of the lending institution#
$hether the institution $ill !e a relia!le source of credit in the future# the =ualit" of managers#
$hether loans are competitivel" priced# the =ualit" of financial advice given# and $hether cash
management and operations services are provided.
12-11. %hat does the 1FF1 Truth in Savings )ct re=uire financial firms selling deposits inside
the 6nited States to tell their customers:
Chapter 12 - Managing and Pricing Deposit Services
The Truth in Savings )ct re=uires financial firms to full" inform their deposit customers on the
terms offered to each depositor. The customer must !e told $hen a ne$ account is opened or if a
deposit is rene$ed# $hat annual percentage "ield /)PH0 is !eing offered and $hat minimum
!alance is re=uired to receive that "ield. Moreover# the depositor must !e informed a!out an"
penalties or service fees $hich could reduce his or her e&pected "ield. +f the terms of a deposit
are changed in a $a" that $ould reduce the depositorGs return advance notice must !e given to
the account holder.
12-12. 6se the )PH formula re=uired !" the Truth in Savings )ct for the follo$ing calculation.
Suppose that a customer holds a savings deposit in a savings !an. for a "ear. The !alance in the
account stood at A2#BBB for 1CB da"s and A1BB for the remaining da"s in the "ear. +f the Savings
!an. paid this depositor AC.>B in interest earnings for the "ear# $hat )PH did this customer
The correct formula is:

+ 1 - 0
-alance )ccount )verage
4arned +nterest
/1 1BB )PH
Period in Da"s
+n this instance#

+ 1 - 0
/1 1BB )PH
)PH D B.C2 percent#
%here the average account !alance is:
da"s 2?>
da"s 1C> & A1BB da"s 1CB & A2BBB

12-12. %hat is lifeline ! %hat pressures does it impose on the managers of !an.s and
other financial institutions:
Chapter 12 - Managing and Pricing Deposit Services
,ifeline ! consists of !asic service pac.ages offered !" !an.s to customers not generall"
a!le to afford conventional !an. service offerings. The essence of these services is that the"
carr" lo$ service fees and usuall" do not offer all of the features of ! services carr"ing
full service fees. The pressure on managers to offer !asic or lifeline services has aroused a !ig
controvers". 5rom a profit motive point of vie$ !an.s should not offer unprofita!le services. n
the other hand# financial institutions are partiall" su!sidi;ed !" government in the form of lo$-
interest loans and deposit insurance and# therefore# have some pu!lic-service responsi!ilities
$hich ma" include providing certain !asic services to all potential customers# regardless of their
income or social status.
12.1<. Should lifeline ! !e offered to lo$-income customers: %h" or $h" not:
This is not an eas" =uestion to ans$er. ne of the most serious pro!lems individuals outside the
financial mainstream face is lac. of access to a deposit account. ,ifeline ! is providing
!asic ! services to these individuals. Most financial-service providers are privatel" o$ned
corporations responsi!le to their stoc.holders to earn competitive returns on invested capital.
Providing financial services at prices so lo$# the" do not cover production costs interferes $ith
that important goal. Thus# from a profit motive point of vie$ !an.s should not offer unprofita!le
services. 7o$ever# it should !e considered that depositor" institutions receive important aid from
the government that grants them a competitive advantage over other financial institutions li.e
deposit insurance. Therefore# the" have some pu!lic-service responsi!ilities $hich ma" include
providing certain !asic services to all potential customers.
12-1. *hinestone 1ational -an. reports the follo$ing figures in its current *eport of
Cash and +nter!an. Dep >B Core Deposits >B
S.T. Securities 1> ,arge 1egotia!le CDs 1>B
Total ,oans# gross <BB -ro.ered Deposits ?>
,.T. Securities 1>B ther Deposits <>
ther )ssets 1B Mone" M.t. ,ia!ilities 1F>
Total )ssets ?2> ther ,ia!ilities ?>
4=uit" Capital >>
Total ,ia!. I 4=. ?2>
[NOTE: The balance sheet in the Text/PDF does not tally. The error in the value of Other
iabilities! has been corrected in the "#.$
a. 4valuate the funding mi& of deposits and nondeposit sources of funds emplo"ed !"
*hinestone. Given the mi& of its assets# do "ou see an" potential pro!lems: %hat changes $ould
"ou li.e to see management of this !an. ma.e: %h":
Chapter 12 - Managing and Pricing Deposit Services
Core depositsJ)ssets D C.BBK
,arge 1egotia!le CDsJ)ssets D 2<.BBK
-ro.ered DepositsJ)ssets D 1B.<BK
ther DepositsJ)ssets D @.2K
Mone" ,ia!ilitiesJ)ssets D 21.2K
ther ,ia!ilitiesJ)ssets D 1B.<BK
4=uit" CapitalJ)ssets D C.CBK
The proportion of core deposits at *hinestone is e&ceptionall" lo$# $hile large CDs and other
mone" !orro$ings ma.e up more than >< percent of the !an.'s total funding sources.
This funding mi& tends to su!9ect the !an. to e&cessive vulnera!ilit" to =uic. $ithdra$al of
funds and high interest-rate ris. e&posure. *hinestone also appears to !e e&cessivel" dependent
on !ro.ered deposits $hich are highl" volatile and interest-sensitive. )dding in these !ro.ered
deposits# more than half of *hinestone's assets are funded $ith highl" interest-sensitive deposits
and mone" !orro$ings. Management needs to e&pand the !an.'s core deposits and other
more sta!le funds sources.
!. Suppose interest rates are pro9ected to rise significantl". Does *hinestone appear to
face significant losses due to li=uidit" ris.: Due to interest rate ris.: Please !e as specific as
+f interest rates rise# *hinestone $ill e&perience higher interest costs immediatel" or $ithin hours
or a fe$ da"s on at least >B percent of its funding sources. 6nfortunatel" all !ut A?> million of
its A?2> million in total assets are longer-term# infle&i!le assets $hose interest "ields cannot !e
ad9usted as rapidl" as the interest rates to !e paid out on the !an.'s lia!ilities. ther factors held
e=ual# the !an.'s earnings $ill !e s=uee;ed. Management needs to do some serious restructuring
$or. on !oth sides of the !an.'s !alance sheet in moving to$ard more fle&i!le-return assets and
more fle&i!le-cost lia!ilities# and to move to$ard greater use of interest-rate hedging techni=ues.
12-2. (ale$ood Savings -an. has e&perienced recent changes in the composition of its deposit
/see the follo$ing ta!leL all figures in millions of dollars0. %hat changes have recentl" occurred
in (ale$ood's deposit mi&: Do these changes suggest possi!le pro!lems for management in
tr"ing to increase profita!ilit" and sta!ili;e earnings:
Chapter 12 - Managing and Pricing Deposit Services
Types of Deposits Held
*egular and special accounts A22> A2F< A22@ A2@C
+nterest-!earing accounts 2F2 2>C 22F 2C@
*egular /pass!oo.0 savings deposits >B1 >F? ?<? @BF
Mone" deposit accounts C?2 C12 @<F @2>
*etirement deposits ?>B ?B2 ><2 <FC
CDs under A1BB#BBB 22@ 2FC 2?1 2<<
CDs A1BB#BBB and over ?B? >C@ >22 <F>
*egular and special accounts have declined sharpl" from A2@C million to A22> million#
$hile interest-!earing accounts rose from A2C@ million to A2F2 million. Pass!oo.
savings deposits have fallen !" more than A2BB million $hile mone" deposit accounts#
retirement accounts# and !oth small and large /A1BB#BBB E0 CDs have all risen su!stantiall".
Management has several reasons to !e concerned a!out these developments !ecause the !an.'s
funds are shifting into accounts !earing significantl" higher interest costs# $hile the !an. is
suffering su!stantial erosion in its core deposits represented !" regular /pass!oo.0 savings
deposits and small accounts. Thus# more interest-sensitive funds are supplanting
deposits that are more lo"al and less interest-elastic. The !an. ma" find its profits are li.el" to !e
s=uee;ed !" higher interest costs and its earnings ma" !ecome more volatile if interest
rates e&perience significant changes in the period ahead !ecause a greater portion of the !an.'s
funding is coming from more interest-sensitive deposits. ) possi!le offsetting advantage is the
shift a$a" from deposits that can !e $ithdra$n $ithout notice /i.e.# regular and special
accounts and pass!oo. savings deposits0 to$ard longer-term deposit instruments $ith fi&ed
maturities# giving the !an. a some$hat longer term and# perhaps# some$hat more predicta!le
funding !ase.
12-2. 5irst Metrocentre -an. posts the follo$ing schedule of fees for its household and small-
!usiness transaction accounts:
5or average monthl" account !alances over A1#>BB there is no monthl" maintenance fee
and no charge per chec. or other draft.
5or average monthl" account !alances of A1#BBB to A1#>BB# a A2 monthl" maintenance
fee is assessed and there is a 1BM charge per chec. or charge cleared.
5or average monthl" account !alances of less than A1#BBB# a A< monthl" maintenance fee
is assessed and there is a 1>M per chec. or per charge fee.
%hat form of deposit pricing is this: %hat is 5irst Metrocentre tr"ing to accomplish $ith its
pricing schedule: Can "ou foresee an" pro!lems $ith this pricing plan:
Chapter 12 - Managing and Pricing Deposit Services
5irst Metrocentre -an. has posted a schedule of deposit fees that allo$s the customer service-
charge free for average monthl" account !alances over A1#>BB. ,o$er !alances are
assessed an inverse monthl" maintenance fee plus an increased per-chec. charge as the average
monthl" account !alance falls. This is conditional deposit pricing designed to encourage more
sta!le# larger-denomination accounts $hich $ould give the !an. more mone" to use and#
perhaps# a more sta!le funding !ase. The fees on under-A1#BBB accounts are stiff $hich ma"
drive a$a" man" small depositors to other !an.s.
12.<. Gold Mine Pit Savings )ssociation finds that it can attract the follo$ing amounts of
deposits if it offers ne$ depositors and those rolling over their maturing CDs the interest
rates indicated !elo$:
4&pected 3olume
of 1e$ Deposits
*ate of +nterest
ffered Depositors
A1B million 2.BBK
1> million 2.2>
2B million 2.>B
2? million 2.@>
2C million <.BB
Management anticipates !eing a!le to invest an" ne$ deposits raised in loans "ielding ?.2>
percent. 7o$ far should this thrift institution go in raising its deposit interest rate in order to
ma&imi;e total profits /e&cluding interest costs0:
on 1e$
Cost *ate
4&p. Diff.
+n Marg.
*ev and
A1B 2.BK B.2BBB B.2BBB 2.BBBK ?.2>K E2.2>BK AB.22>B
1> 2.2> B.<C@> B.1C@> 2.@>B ?.2> E2.>BB AB.<>BB
2B 2.>B B.@ B.212> <.2>B ?.2> E2.BB AB.>>BB
2? 2.@> B.F@> B.2@> <.>C2 ?.2> E1.??@ AB.?>BB
2C <.BB 1.12 B.1<> @.2>B ?.2> -1.BB AB.?2BB
Gold Mine Pit Savings )ssociation should raise its deposit rate to 2.@>K# attracting A2? million
in ne$ depositsL !ecause up to that point the marginal revenue rate is greater than the marginal
cost rate and total profits are also rising. )t <.BK# the marginal cost rate is greater than the
marginal revenue rate and total profits have fallen from a high of AB.?> million !ac. do$n to
AB.?2 million.
Chapter 12 - Managing and Pricing Deposit Services
12$>. *ed -ric. -an. plans to launch a ne$ deposit campaign ne&t $ee. in hopes of !ringing
in from A1BB million to A?BB million in ne$ deposit mone"# $hich it e&pects to invest at a >.>
percent "ield. Management !elieves that an offer rate on ne$ deposits of 2.@> percent $ould
attract A1BB million in ne$ deposits and rollover funds. To attract A2BB million# the !an. $ould
pro!a!l" !e forced to offer 2.2> percent. *ed -ric.'s forecast suggests that A2BB million might
!e availa!le at 2.@> percent# A<BB million at <.BB percent# A>BB million at <.2> percent# and A?BB
million at <.> percent. %hat volume of deposits should the institution tr" to attract to ensure that
marginal cost does not e&ceed marginal revenue:
on 1e$
Cost *ate
4&p. Diff.
+n Marg.
*ev and
A1BB 2.@>K 2.@> 2.@> 2.@>K >.>BK E2.@>K A2.@>
A2BB 2.2>K ?.>B 2.@> 2.@>K >.>BK E1.@>K A<.>B
A2BB 2.@>K 11.2> <.@> <.@>K >.>BK EB.@>K A>.2>
A<BB <K 1?.BB <.@> <.@>K >.>BK EB.@>K A?.BB
A>BB <.2>K 21.2> >.2> >.2>K >.>BK EB.2>K A?.2>
A?BB <.>K 2@.BB >.@> >.@>K >.>BK -B.2>K A?.BB
The marginal revenue rate is greater than the marginal cost rate up to A>BB million in ne$
deposits. )t A?BB million# the marginal cost rate of >.@>K is greater than the marginal revenue
rate of >.>BK. Therefore# *ed -ric. -an. should tr" and attract A>BB million in ne$ deposits.
12-?. *ichman Savings -an. finds that its !asic transaction account# $hich re=uires a A<BB
minimum !alance# costs this savings !an. an average of A2.?> per month in servicing costs
/including la!or and computer time0 and A1.1C per month in overhead e&penses. The savings
!an. also tries to !uild in a AB.>B per month profit margin on these accounts. %hat monthl" fee
should the !an. charge each customer:
5ollo$ing the cost-plus-profit approach# the monthl" fee should !e:
Monthl" fee D A2.?> E A1.1C E AB.>B D A<.22 per month.
5urther anal"sis of customer accounts reveals that for each A1BB a!ove the A>BB minimum in
average !alance maintained in its transaction accounts# *ichman Savings saves a!out > percent
in operating e&penses $ith each account. /1ote: +f the !an. saves a!out > percent in operating
e&penses for each A1BB held in !alances a!ove the A>BB minimum# then a customer maintaining
an average monthl" !alance of A1#BBB should save the !an. 2> percent in operating costs.0 5or a
customer $ho consistentl" maintains an average !alance of A1#BBB per month# ho$ much should
the !an. charge in order to protect its profit margin:
The appropriate fee for this customer $ould !e:
Chapter 12 - Managing and Pricing Deposit Services
NA2.?> -B.2> /A2.?>0O E A1.1C E AB.>B D A1.FC@> E A1.1C E AB.>B D A2.??@> per month.
12-@. Monica ,ane maintains a savings deposit $ith Monarch Credit 6nion. This past "ear
Monica received A1B.@> in interest earnings from her savings account. 7er savings deposit had
the follo$ing average !alance each month:
Panuar" A<BB Pul" A2>B
5e!ruar" 2>B )ugust <2>
March 2BB Septem!er >>B
)pril 1>B cto!er ?BB
Ma" 22> 1ovem!er ?2>
Pune 2BB Decem!er 2BB
%hat $as the annual percentage "ield /)PH0 earned on Monica's savings account:
Monica's account had an average !alance this "ear of:
NA<BB & 21 da"s E A2>B & 2C da"s E A2BB & 21 da"s E A1>B & 2B da"s
E A22> & 21 da"s E A2BB & 2B da"s E A2>B & 21 da"s E A<2> & 21 da"s E
A>>B & 2B da"s E A?BB & 21 da"s E A?2> & 2B da"s E A2BB & 21 da"sO
2?> da"s
D A2@2.>?
Then the )PH must !e:
percent 2.88 1 )


12-C. The 1ational -an. of Ma"ville =uotes an )PH of 2.> percent on a one-"ear mone" CD sold to one of the small !usinesses in to$n. The firm posted a !alance of A2#>BB for
the first FB da"s of the "ear# A2#BBB over the ne&t 1CB da"s# and A<#>BB for the remainder of the
"ear. 7o$ much in total interest earnings did this small !usiness customer receive for the "ear:
6sing the )PH formula $e can fill in the varia!les $hose values are .no$n and find the$n interest earnings. Thus:
)PH D 1BB 1

+ 1 )
Balance Average
Earnings Interest
2.>K D 1BB

+ 1 )
Earnings Interest
Chapter 12 - Managing and Pricing Deposit Services
%here the accountGs average !alance is found from:
)verage -alance D
[ ]
das 365
das !5 " $#500 das 180 " $3000 das !0 " $2500 + +
D A22?@.12
2.>K D 1BB
Earnings Interest " 0.030608
Earnings Interest


or +nterest 4arnings D A11<.2>