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Chapter 03: Managing and Pricing Deposit Services

Lectured by: Mr. Rithjayasedh PEOU, MFin (Melb)

Content
!! Types of Deposits

!! Pricing Deposit-Related Services !! Cost Plus Profit Margin !! Marginal Cost Pricing Method !! Conditional Pricing Method !! Total Customer Relationship Method
Lectured by: Mr. Rithjayasedh PEOU 2 10/27/13

Introduction
!! Barney Kilgore, one of the most famous presidents in the history of Dow Jones & Company and publisher of The Wall Street Journal, once cautioned his staff:

Dont write banking stories for bankers. Write for the banks customers. There are a hell of a lot more depositors than bankers.

Lectured by: Mr. Rithjayasedh PEOU

10/27/13

Introduction
!! Deposit accounts are a bankers number one source of funds. !! The ability of management an staff to attract checking and savings deposits from businesses and consumers is an important measure of a depository institution's acceptance by the public. !! Moreover, deposits provide most of the raw material for making loans and, thus, usually represent the ultimate source of profits and growth for a bank or thrift institution. !! Important indicators of managements effectiveness are whether or not funds deposited by the public have been raised at the lowest possible cost and whether sufficient deposits are available to fund all those loans the management of a bank or thrift wishes to make.
Lectured by: Mr. Rithjayasedh PEOU 4 10/27/13

Types of Deposits
!! Transaction (Payment) Deposits This transaction deposit service requires the bank to honor immediately any withdrawals made either in person by the customer or by a third party designated by the customer to be the recipient of the funds withdrawn. !! Noninterest-Bearing Demand Deposits !! Interest payments have been prohibited on regular checking accounts in the United States since passage of the GlassSteagall Act of 1933. !! Demand deposits are among the most volatile and least predictable of a depository institutions' sources of funds, with the shortest potential maturity. !! Most noninterest-bearing demand deposits are held by business firms.
Lectured by: Mr. Rithjayasedh PEOU 5 10/27/13

Types of Deposits
!! Transaction Deposits (contd) !! Interest-Bearing Demand Deposits !! Negotiable Order of Withdrawal Accounts !! Beginning in New England during the 1970s, hybrid checking-savings deposits began to appear in the form of NOWs. !! NOWs were permitted nationwide beginning in 1981 as a result of passage of the Depository Institutions Deregulation Act of 1980. !! The interest rate earned on NOWs roughly equals to that of a savings account. !! However, NOWs can be held only by individuals and nonprofit institutions.
Lectured by: Mr. Rithjayasedh PEOU 6 10/27/13

Types of Deposits
!! Transaction Deposits (contd) !! Interest-Bearing Demand Deposits (contd) !! Super NOW Accounts !! Created in 1982 as a result of passage of the Garn-St Germain Depository Institutions Act, SNOWs may be held only by individuals and nonprofit institutions. !! The number of checks the depositor may write is not limited by regulation. !! However, banks and thrift institutions post lower yields on SNOWs than on MMDAs because the former can be drafted more frequently by clients.
Lectured by: Mr. Rithjayasedh PEOU 7 10/27/13

Types of Deposits
!! Transaction Deposits (contd) !! Interest-Bearing Demand Deposits (contd) !! Money Market Deposit Accounts !! Authorized at about the same time as SNOWs, (MMDAs) are short-maturity depsits that may have a term of only a few days, weeks or months. !! The bank or thrift institution can pay any interest rate that is competitive enough to attract and hold the customers deposits. !! Unlike NOWs and SNOWs, MMDAs can be held by businesses as well as individuals.
Lectured by: Mr. Rithjayasedh PEOU 8 10/27/13

Types of Deposits
!! Nontransaction (Savings or Thrift) Deposits These deposits generally pay significantly higher interest rates than transaction deposits do. !! Passbook Savings Deposits !! Passbook savings deposits were sold to customers in small denominations, and withdrawal privileges were unlimited. !! While legally a bank or other depository institution could insist on receiving prior notice of a planned withdrawal from a passbook savings deposit, few institutions have insisted on this technicality. !! Individuals, nonprofit organizations, governments and businesses can hold savings deposits.
Lectured by: Mr. Rithjayasedh PEOU 9 10/27/13

Types of Deposits
!! Nontransaction Deposits (contd) !! Statement Savings Deposits !! Unlike passbook savings deposits, the statement savings deposits are evidenced only by computer entry. !! The customer can get monthly printouts showing deposits, withdrawals, interest earned, and the balance in the account. !! However, many banks and thrift institutions still offer the more traditional passbook savings deposits, and customers must present the passbook to a teller in order to make deposits or withdrawals.
Lectured by: Mr. Rithjayasedh PEOU 10 10/27/13

Types of Deposits
!! Nontransaction Deposits (contd) !! Statement Savings Deposits !! Unlike passbook savings deposits, the statement savings deposits are evidenced only by computer entry. !! The customer can get monthly printouts showing deposits, withdrawals, interest earned, and the balance in the account. !! However, many banks and thrift institutions still offer the more traditional passbook savings deposits, and customers must present the passbook to a teller in order to make deposits or withdrawals.
Lectured by: Mr. Rithjayasedh PEOU 11 10/27/13

Types of Deposits
!! Nontransaction Deposits (contd) !! Time Deposits !! Time deposits carry fixed maturity dates with fixed interest rates. !! More recently, time deposits have been issued with interest rates that are adjusted periodically (such as every 90 days, know as leg or roll period). !! Time deposits must carry a minimum maturity of seven days and cannot be withdrawn before that. !! The most popular time deposits are negotiable and nonnegotiable certificate of deposits (CDs).
Lectured by: Mr. Rithjayasedh PEOU 12 10/27/13

Types of Deposits
!! Nontransaction Deposits (contd) !! Time Deposits (contd) !! Negotiable CDs Negotiable CDs are the $100,000-plus instruments bought principally by corporations and wealthy individuals. !! Nonnegotiable CDs Nonnegotiable CDs are the $100,000-minus instruments bought principally by individuals. !! Callable CDs Callable CDs were introduced in the late 1990s, and their value fluctuates with market conditions and may be retired if interest rates fall significantly.
Lectured by: Mr. Rithjayasedh PEOU 13 10/27/13

Pricing Deposit-Related Services


!! In pricing deposit services, management is caught between the horns of an old dilemma. !! It needs to pay a high enough interest return to customers to attract and hold their funds, but must avoid paying an interest rate that is so costly. !! Intense competition in todays markets compounds this dilemma because competition tends to raise deposit interest costs while lowering expected returns from putting deposits and other funds to work. !! In fact, in a financial marketplace that closely approaches perfect competition, the individual bank or other depository institution has little control over its prices in the long run.
Lectured by: Mr. Rithjayasedh PEOU 14 10/27/13

Pricing Deposit-Related Services


!! It is the marketplace, not the individual financial firms, that ultimately sets all prices. !! In such a market, management must decide if it wishes to attract more deposits and hold all those it currently has by offering depositors at least the market-determined price, or whether it is willing to lose funds by offering customers terms different from what the market requires. !! Often managers must choose between growth and profitability. !! Aggressive competition for costly deposits and other sources of funds will help the depository institution grow faster, but often at the price of severe profit erosion.
Lectured by: Mr. Rithjayasedh PEOU 15 10/27/13

Cost Plus Profit Margin


!! Until several years ago the notion that customers should receive most deposit related services free of charge was hailed a a wise innovation one that responded to the growing challenge posed by other financial intermediaries that were invading traditional deposit markets. !! Many of the new entrants into the market moved aggressively to capture a major share of the customers through below-cost pricing. !! Customer charges were set below the true level of operating and overhead costs associated with providing checkable deposits and other deposit plans. !! The result was substantially increased rate of return to the customer, known as implicit interest ratethe difference between the true cost of supplying fund-raising services and the services charges actually assesses the customer.
Lectured by: Mr. Rithjayasedh PEOU 16 10/27/13

Cost Plus Profit Margin


!! In the United States, variation in the implicit interest rate paid to the customer were the principal way most banks competed for deposits over the 50 years stretching from the Great Depression to the beginning of the 1980s. !! This was due to the presence of regulatory ceiling on deposit interest rates, beginning in 1933 with passage of the Glass-Steagall Act. !! Unfortunately, such forms of nonprice competition tended to distort the allocation of scarce resources in the banking and thrift sector. !! Therefore, a gradual phaseout of deposit interest-rate ceilings was introduced with passage of the Depository Institutions Deregulation Act of 1980.
Lectured by: Mr. Rithjayasedh PEOU 17 10/27/13

Cost Plus Profit Margin


!! Deregulation has brought more frequent use of unbundled service pricing as greater competitions has raised the average real cost of a deposit for bankers and other deposit-service providers. !! This means, for example, that deposits are usually priced separately from loans and other services. !! And each deposit service is often priced high enough to recover all or most of the cost of providing that service. !! Thus, the price of deposit services would conform to the cost-plus pricing formula.
Unit Price Charged the Customer for Each Deposit Service = Operating Expense per Unit of Deposit Service Estimated Overhead + Expense Allcated to the Deposit-Service Function
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Planned Profit from + Each Deposit Service Unit Sold


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Lectured by: Mr. Rithjayasedh PEOU

Cost Plus Profit Margin


!! Tying deposit pricing to the cost of deposit-service production has encouraged bankers and other deposit providers everywhere to match prices and costs more closely and to eliminate many formerly free services. !! In the United States, more and more depositories are now levying fees for excessive withdrawals from savings deposits, charging for customer balance inquiries, increasing fees on bounced checks and stop-payment orders, assessing charges on cash withdrawal and balance inquiries made through ATM, charging maintenance fees even small savings deposits, and raising required minimum deposit balances.
Lectured by: Mr. Rithjayasedh PEOU 19 10/27/13

Cost Plus Profit Margin


!! Estimating Average Deposit Service Costs !! Cost-plus pricing demands an accurate calculation of the cost of each deposit service. !! One popular approach is the pooled-funds approach which bases deposit prices on the estimated cost of raising funds. !! This requires the banker: !! To calculate the cost rate of each source of funds (adjusted for reserves required by the central bank, deposit insurance fees, and float); !! To multiply each cost rate by the relative proportion of all funds coming from that particular source; !! To sum all resulting products to derive the weighted average cost of all funds raised.
Lectured by: Mr. Rithjayasedh PEOU 20 10/27/13

Cost Plus Profit Margin


!! Estimating Average Deposit Service Costs (contd) !! An example of Pooled-Funds Costing !! Suppose a commercial bank has raised a total of $400M, including $100M in checkable deposits, $200M in time and saving deposits, $50M borrowed from the money market, and $50M from its owners in the form of equity capital. !! Suppose that interest and nonintterest costs spent to attract the checkable deposits and money market borrowings each cost the bank 11 percent of funds raised in interest and noninterest expenses. !! Assume also that equity capital costs the bank an estimated 22 percent of any new equity raised.
Lectured by: Mr. Rithjayasedh PEOU 21 10/27/13

Cost Plus Profit Margin


!! Estimating Average Deposit Service Costs (contd) !! An example of Pooled-Funds Costing (contd) !! Suppose reserve requirements, deposit insurance fees, and uncollected balance (float) reduce the amount of money actually available to the bank for investing in interest-bearing assets by 15 percent for checkbook deposits, 5 percent for thrift deposits, and 2 percent for borrowings in the money market. !! Therefore, this banks weighted average before-tax cost of funds would be as shown in follows: = ($100M / $400M) * (10% / (100% - 15%)) + ($200M / $400M) * (11% / (100% - 5%)) + ($50M / $400M) * (11% / (100% - 2%)) + ($50M / $400M) * (22%/100%) = 0.1288 or 12.88%
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Lectured by: Mr. Rithjayasedh PEOU

Marginal Cost Pricing Method


!! Many financial analysts would argue that, whenever possible, marginal costthe added cost of bringing in new fundsand not weighted average cost, should be used to help price deposits and other funds sources for a financial-service institution. !! The reason is that frequent changes in interest rates will make average cost a treacherous and unrealistic standard for pricing. !! For example, if interest rates are declining, the marginal cost of raising new money may fall well below the average cost over all funds raised. !! Some loans and investments that looked unprofitable when compared to average cost will now look quite profitable when measured against the lower marginal interest cost we must pay today to make those new loans and investments, and vice versa.
Lectured by: Mr. Rithjayasedh PEOU 23 10/27/13

Marginal Cost Pricing Method


!! Example of Marginal Cost Pricing Method !! Suppose a commercial bank expects to raise $25M in new deposits by offering its depositors an interest rate of 7 percent. Management estimates that if the bank offers a 7.5 percent interest rate, it can raise $50M in new deposit money. At 8 percent, $75M is expected to flow in, while a posted deposit rate of 8.5 percent will bring in a projected $100M. Finally, if the bank promises an estimated 9 percent yield, management projects that $125M in new funds will result from both new deposits and existing deposits that customers will keep in the bank to take advantage of the higher rates offered. !! Lets assume as well that management believes it can invest the new deposit money at a yield of 10 percent. This mean loan yield represents marginal revenue, the added operating revenue the bank will generate by making new loans from the new deposits.
Lectured by: Mr. Rithjayasedh PEOU 24 10/27/13

Marginal Cost Pricing Method


!! Example of Marginal Cost Pricing Method !! Based on marginal cost pricing method, we need to know at least two crucial items to answer this deposit rate question !! Marginal cost of moving the deposit rate from one level to another 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 !! !! The marginal cost rate. Marginal Cost Rate = Change in Total Cost / Additional Funds Raised For example, if the bank raises its offer rate on new deposits from 7 percent to 7.5 percent. Marginal Cost = $50M X 7.5% - $25M X 7% = $2M Marginal Cost Rate = $2M / $25M
Lectured by: Mr. Rithjayasedh PEOU 25 10/27/13

Marginal Cost Pricing Method


Expected Average Amounts Interest the Bank of Deposits Will Pay That Will on New Funds Flow in $25 $50 $75 $100 $125 7.0% 7.5% 8.0% 8.5% 9.0% Total Interest Cost of New Funds Raised $1.75 3.75 6.00 8.50 11.25 Marginal Cost of New Deposit Money $1.75 2.00 2.25 2.50 2.75
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Marginal Cost Rate

Expected Marginal Revenue

Difference between Marginal Revenue and Marginal Cost Rate +3% +2% +1% +0% -1%

Total Profits Earned (after Interest Cost) $0.75 1.25 1.50 1.50 1.25
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7.0% 8.0% 9.0% 10.0% 11.0%

10.0% 10.0% 10.0% 10.0% 10.0%

Lectured by: Mr. Rithjayasedh PEOU

Marginal Cost Pricing Method


!! Example of Marginal Cost Pricing Method (contd) !! Scanning down the Table in the previous slide, we note that total profit tops out at $1.5 million, and the bank would not pay the bank to go beyond this point. !! The marginal cost approach provides valuable information to the managers of banks and other depository institutions, not only about setting deposit interest rates, but also about declining just how far the institution should go in expanding its deposit base before added cost of deposit growth catches up with additional revenues, and total profits begin to decline. !! When profits start to fall, mgt needs either to find new sources of funding with lower marginal costs, or to identify new loans and investments promising greater marginal revenues, or both.
Lectured by: Mr. Rithjayasedh PEOU 27 10/27/13

Conditional Pricing Method


!! Conditional pricing is a method where a bank or other depository sets up a schedule of fees in which the customer pays a low fee or even no fee if the deposit balance remains above some minimum level, but faces a higher fee if the average balance falls below that minimum. !! Thus, the customer pays a price conditional on how much he or she uses the deposit. !! Conditional pricing techniques vary deposit prices according to one or more of these factors: !! The number of transactions passing through the account. !! The average balance held in the account over a designated period (usually month). !! The maturity of the deposit in days, weeks, or months.
Lectured by: Mr. Rithjayasedh PEOU 28 10/27/13

Conditional Pricing Method


!! Economist Constance Dunham classified checking account conditional price schedules observed in the New England area into three categories: !! Flat-rate pricing of which the depositors cost is fixed charge per check, per time period or both. Thus, there may by a monthly account maintenance fee of $2, and each check written against that account may cost the customer 10 cents, regardless of the level of account activity. !! Free pricing refers to the absence of a monthly account maintenance fee or per-transaction charge. However, the customer may incur an implicit fee in the form of lost income (opportunity cost), because the effective interest rate paid on the deposit may be less than the going rate on investment of comparable risk. !! Conditionally free pricing favors large-denomination deposits because services are free if the account balance stays above some minimum figure.
Lectured by: Mr. Rithjayasedh PEOU 29 10/27/13

Total Customer Relationship Method


!! Related to the idea of targeting the best customers for special treatment is the notion of pricing deposits according to the number of services the customer uses. !! Customers who purchase two or more services may be granted lower deposit fees or have some fees waived compared to the fees charged customers having only a limited relationship to the offering institution. !! The idea is that selling a customer multiple services increases the customers dependence on the institution and makes it harder for that customer to go elsewhere because of the strong relationship between customer and depository institution. !! Thus, relationship pricing promotes greater customer loyalty and makes the customer less sensitive to the interest rates offered on deposits or the prices posted on other services offered by competing financial-service firms.
Lectured by: Mr. Rithjayasedh PEOU 30 10/27/13

In Choosing a Bank to Hold Their Checking Accounts, Households Consider Convenient location Availability of many other services Safety Low fees and low minimum balance High Deposit interest rates

In Choosing a Bank to Hold Their Savings Deposits, Households Consider Familiarity Interest rate paid Transactional convenience Location Availability of payroll education Fees charged

In Choosing a Bank to Supply Their Deposits and Other Services, Business Firms Consider Financial health of lending institution Whether bank will be reliable source of credit in the future Quality of bank officers Whether loans are competitively priced Quality of financial advice given Whether cash management and operation services are provided

Lectured by: Mr. Rithjayasedh PEOU

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End of Chapter 03!!!


Lectured by: Mr. Rithjayasedh PEOU, MFin (Melb)