DESIGN AND PRICING OF DEPOSIT SERVICES

IMPORTANCE OF MANAGING
LIABILITIES
 Liabilities play a critical role in the risk return
profile of banks
 While deciding liability mix, banks have to
balance profitability with risks
 Liabilities are the basis for asset creation, and
hence, banks’ profitability and growth
LIABILITY MANAGEMENT & PRIMARY
SOURCES OF FUNDS
 Primary sources of fund (Liabilities)
 Deposits- representing the savings of the economy
 Equity & Reserves and surplus
 Borrowings

 Improper liability management of above sources can

lead to many risks such as below;
 Interestrate risk
 Liquidity risk
 Refinancing risk….etc.
LIABILITY MIX -FACTORS TO BE
CONSIDERED
 Maturity
 Cost
 Regulatoryframework
 Market conditions……etc.
BANK DEPOSITS
 Deposits are differentiated by type of customer, tenure
of deposit and cost to bank.

Classification of
deposits

Transaction
account / Payment Term deposits
deposits

Non-interest
Interest bearing
bearing demand
demand deposits
deposits (Current
(Savings a/c)
a/c)
BANK DEPOSITS
 Transaction deposits can be interest bearing or non
interest bearing.
 Interest-bearing deposits:
 Saving a/c preferred by individuals and certain organizations.
These deposit pays low rate of interest.
 It can have condition of minimum balance & transaction
charges.
 Non- interest bearing deposits :
 Current a/c where in corporate customers park their money. It
can be highly volatile source of fund for a bank.
BANK DEPOSITS
 Term deposits:
Form of ‘debt instrument’, called ‘fixed
deposit’
Here, customer is wiling to lend money to a
bank for specified time period.
Customer receive stream of cash inflow as an
interest on the deposit.
It has higher interest rate.
DEPOSIT INSURANCE
 USwas the first country to set up a deposit insuring
agency, post the great Depression in 1934.

 Most of the deposit insuring agencies of the world

are members of International Association of Deposit
Insurers [IADI].
 IADI - PARTICIPANTS

 International Association of Deposit Insurers (IADI)

is established in 2002.

 India is a member of IADI.

 Members are entities/countries that, under law or

agreement, have a deposit insurance system and have
been approved for membership by IADI.
DEPOSIT INSURANCE
 India was the second country in the world to introduce
the scheme – in operation since 1962.
 Operated by the government.

 A protection for depositors in most countries against non

repayment of deposits by banks.
 Used by governments to enhance the stability of the
banking system, and minimize losses to depositors in
case of bank failure.
DEPOSIT INSURANCE
 The Deposit Insurance Corporation (DIC), was created under the
Deposit Insurance Act,1961.
 Later on it is renamed as Deposit Insurance and Credit Guarantee
Corporation (DICGC)
 Since 1st, May, 1993 the amount covered under DICGC was Rs.
1,00,000 for the deposit parked at banks, but as per 2020 year’s budget
announcement now the amount covered by DICGC is Rs. 5,00,000.
 All kind of deposits like; fixed deposit, current deposit, recurring
deposit, Saving deposit, Inter-bank deposits are covered under deposit
insurance.
 Banks are included: Commercial banks, PSBs, State & urban co-op.
banks, local area banks, regional rural banks.
 Certificates of deposit and illegal deposits are not covered.

 Information regarding DICGC can be looked at :

https://m.rbi.org.in/Scripts/FAQView.aspx?Id=64
 DEPOSIT INSURANCE FUND
 The deposit insurance fund (DIF) is built through transfer
of the Deposit insurance Corporation’s surplus – excess of
income.

 This
fund is used for settlement of claims of depositors of
banks going into liquidation/ reconstruction/
amalgamation, etc.
PRICING DEPOSITS
 Assumes importance in present deregulated and
competitive environment.
 Banks should have a pricing policy to take into account
cost and availability of funding sources, and banks’
profitability.
 Better informed deposit pricing for identified customer
segments would generate positive effect on Net interest
margin and Net interest income of banks
 Shift from Supply-side pricing: simply matching
competitors & what bank itself could afford.
 To Demand-side pricing: focusing on demand elasticity
of deposits. Beside interest rate, customer segments
became important.
CONSIDERATIONS FOR PRICING
 servicing costs versus minimum balance requirements
 deposit volumes and their costs in relation to profits
 lending and investment avenues and compensating
balances
 relationship with customers
 promotional pricing, if new products are being considered
 product differentiation in a competitive market
 Explicit & Implicit Prices and their impact on bank revenue and cost

Bank cash flows Explicit prices Implicit prices

Bank costs Interest payments Below cost services [eg: free

cheque book issue etc.]

Gifts to customers More convenience to customers

– branch offices, ATMs,
business hours etc.

Bank revenues Service fees – eg, charges Minimum balance

per cheque issued requirements

Other fees- such as on Restrictions – such as limited

overdrafts cheque writing privileges
COMMON PRICING METHODOLOGIES

Cost plus
margin
pricing

Market
Relationsh penetratio
ip pricing n deposit
Deposits pricing
pricing
Methods

Upscale
target Condition
pricing al pricing
COST PLUS MARGIN DEPOSIT
PRICING

 Establishing the rate of return or fees charged on

a deposit account based upon the cost of offering
the service plus a profit margin.
 Personnel and management time, automation and
material spent in offering deposit service is
added as a cost.
 Unit price charged from the customer
for
each deposit service

Operating Estimated overhead Planned profit

expense per unit expense allocated to from each
of deposit service the bank’s deposit deposit service
function unit sold
MARKET PENETRATION DEPOSIT
PRICING
 Focuses on high growth markets in order to cover larger
market share.
 To penetrate in the market bank may offer low or zero
customer fees/charges than the prevailing market
standard OR offer higher deposit rate above the market
level.
 Bank believes that by adopting this pricing, it can attract
larger share of deposits and pitch for other related
business products which will compensate for the lower
profit margin.
CONDITIONAL PRICING
 It is used as a tool to attract a specific type of customers
segments only.
 Features such as
 Larger amount of deposit will fetch higher interest rate or lower
fees.
 Minimum balance amount for savings a/c.
 Limit or no limit on No. of cheques can be issued free.
 Promos/offers based on No. of transactions done in specific time
period.
 Charges/ penalties for more withdrawals, no transactions fees etc.

 Eg. MNC banks like Citi bank, Deutsche bank etc. have
relatively high minimum balance requirement Rs. 25,000
and upward.
EXAMPLE OF PENETRATION PRICING &
CONDITIONAL PRICING BY KOTAK
BANK

Note : W.e.f. October 18, 2019,earn 6% p.a. interest on

Savings Account balance over Rs. 1 lakh and up to Rs 10
lakhs.
Earn 4% p.a. interest on Savings Account balance up to
Rs. 1 lakh and 5.5% p.a. interest on Savings Account
balance above Rs. 10 lakhs. Applicable for Resident
Accounts only.

Source: https://www.kotak.com/en/rates/interest-
rates.html
UPSCALE TARGET PRICING
 This pricing
 Customizes the terms of standardized products.
 Is carefully and aggressively design deposit advertising
programs and pricing schemes for specify set of customers
only.
 Eg. Special deposit schemes for business owners, Doctors,
HNIs etc.
RELATIONSHIP PRICING
 This pricing works on the basis that
 Bank’s best customers get the best possible pricing for
deposits and other services.
 Waivers, premium promos/offers, exclusive deals are
constructed as part of rewarding the strong relationship
with customers.
 Relationship pricing is based on promoting the customer
loyalty in order to build long, trustworthy and fulfilling
relationship.
PRE-PRICING ANALYSIS
 Quantify the actual cost of new deposits
 Quantify the cost of protecting existing deposits

 The quantification is commonly done through two

approaches
 The marginal cost of funds approach
 The new cost of funds approach (Optimum level)
WORKING : MARGINAL COST OF FUND
 Assume, ABC bank has deposit base of Rs. 1,000 cr. of
which Rs. 250 cr. are considered to be premium deposits
who are rate sensitive. The bank pays 5% interest rate.
 Now bank XYZ comes up with offer that it will pay 6%
interest on premium deposits.
 It is estimated that if ABC bank does not raise the
interest rate for premium deposit category it may loose
Rs. 50 cr. Worth of deposit to competitor.
 ABC bank has option of raising 1% interest rate to retain
Rs. 50 cr. worth of deposit OR keeping interest rate of
5% only and risking the deposit worth of Rs. 50 cr.
WORKING : MARGINAL COST OF FUND
Likely position of ABC bank:

Balance Interest rate% Interest

expense

Option -1 (Increasing rate by Rs. 250 cr. 6% 15 cr.

1%)

Option -2 (No change in rate Rs. 200 cr. 5% 10 cr.

& losing Rs.50 cr. Deposit)
WORKING : MARGINAL COST OF FUND
 Marginal cost of holdings the fund

 = change in interest expenditure

change in holdings of the deposit

= Rs. 5 cr. / Rs. 50 cr.

= 0.1 or converting into % it is 10 %.

So, Marginal cost of holdings the fund is 10% in this

particular case.
EXERCISE : MARGINAL COST OF FUND
 Suvidha Bank Ltd.is facing intense competition from
Amenity Bank Ltd., due to increase in deposit rate by
125 BPS to prime depositors. It is estimated by Suvidha
Bank that out of total deposit of Rs. 1,500 cr., Rs.600 cr.
belongs to prime deposit category of which Rs.125 cr.
deposit is rate sensitive and can shift to competitor.
 Prevailing deposit rate = 5.50%

 New deposit rate offer by Amenity Bank = 6.75%

 Calculate the marginal cost of fund if Suvidha Bank

increase deposit rate by 125 BPS for prime deposit
category & if doesn’t there will be loss of Rs.125 cr.
worth of deposit.
EXERCISE : MARGINAL COST OF FUND

Balance Interest rate% Interest

expense

Option -1 (Increasing rate by Rs. 600 cr. 6.75 % 40.50 cr.

1.25%)

Option -2 (No change in rate Rs. 475 cr. 5.50% 26.12 cr.
& losing Rs. 125 cr. Deposit)
EXERCISE : MARGINAL COST OF FUND
 Marginal cost of holdings the fund

 = change in interest expenditure

change in holdings of the deposit

= Rs. 14.38 cr. / Rs. 125 cr.

= 0.1150 or converting into % it is 11.50 %.

So, Marginal cost of holdings the fund is 11.50% in this

particular case.
WORKING: NEW COST OF FUNDS
(OPTIMUM LEVEL)
 Assume: Solid Bank Ltd. estimates that it can raise new
deposits of Rs. 25 cr. by offering 6% which is also
offered by competitor. Bank also estimates that if it
beats the competitor’s offering by giving 6.5%, it can
have Rs.50 cr. deposit. Likewise Solid Bank can keep on
increasing interest rate by 50 bps (0.5%) and can get
extra Rs. 25 cr. as a deposit.
 These new deposits can be used by bank to invest in
assets which has average yield of 10%.
 WORKING: NEW COST OF FUNDS (OPTIMUM LEVEL)
Expected Interest Interest Marginal Marginal cost Margina MR-MC
new rate expense cost of new as a % of l
deposit deposit incremental revenue
inflow fund (MC) (MR)
25 cr. 6% 1.5 cr. 1.5 cr. 6% 10% 4%

50 cr. 6.5% 3.25 cr. 1.75 cr. 7% (1.75/25) 10% 3%

75 cr. 7% 5.25 cr. 2 cr. 8% (2/25) 10% 2%

Optimum
100 cr. 7.5% 7.5 cr. 2.25 cr. 9% (2.25/25) 10% 1% level is
MR=MC

125 cr. 8% 10 cr. 2.50 cr. 10% (2.5/25) 10% 0%

150 cr. 8.5% 12.75 cr. 2.75 cr. 11%(2.75/25) 10% -1 %

EXERCISE: NEW COST OF FUNDS
(OPTIMUM LEVEL)
 Assume: Super Bank Ltd. estimates that it can raise new
deposits of Rs. 12 cr. by offering 5% which is also
offered by competitor. Bank also estimates that if it beat
the competitor’s offering by giving 5.5%, it can have
Rs.17 cr. deposit. Likewise Super Bank can keep on
increasing interest rate by 50 bps (0.5%) and can get
extra Rs. 5 cr. as deposit.
 These new deposits can be used by bank to invest in
assets which has average yield of 8%.
MEASURING DEPOSIT INTEREST
RATE RISK
 Till 1990s, it was believed that bank deposits are not
prone to interest rate risk emerging from unanticipated
change in interest rate.
 With the passage of time, it was accepted that bank
deposits may also encounter with the interest risk.
 Measuring interest rate risk for bank deposits is similar
to measuring interest rate risk for bond by factoring
forecasted cash flows and change in interest rate.
NON DEPOSIT FUNDING SOURCES
 Alsocalled ‘wholesale funding sources’
 Examples
 Money market sources
 Long term sources
 International market sources
 Loan sale and securitizations
 ‘Funding gap’ is calculated as the difference
between current and projected deposit flows and
credit flows, and funded through deposit or non
deposit sources
 SOURCES OF FUNDS- INDIA
 DEPOSITS categorized as
 Savings
 Current, and
 Term
 Certificate of deposit (CD)

 Bankscan design customized deposit schemes for their

customers

 Banking regulation Act, 1949 specifies that accepting and

maintaining deposit accounts are the core activities of banks in
India.
SOME COMMON NON-DEPOSIT FUNDING
SOURCES IN INDIA

 Call / notice money (Money market)

 External commercial borrowing [ECBs]

 Foreign currency convertible bonds [FCCBs]

 Capital market sources (Bond issuance, Equity capital

infusion etc.)