Chapter 12 - Managing and Pricing Deposit Services

CHAPTER 12

MANAGING AND PRICING DEPOSIT SERVICES

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
II. Types of Deposits Offered by Depository Institutions
A. Transaction (Payments or Demand) Deposits
1. Noninterest-Bearing Transaction (Demand) Deposits
2. Interest-Bearing Transaction Deposits
a. Negotiable Order Of Withdrawal (NOW) Accounts
b. Money Market Deposit Accounts (MMDAs)
c. Super NOWs (SNOWs)
3. Mobile Apps—Impact on Transaction Deposits and Potential Customers
B. Nontransaction (Savings or Thrift) Deposits
1. Passbook Savings Deposits
2. Time Deposits
C. Retirement Savings Deposits
1. Individual Retirement Accounts (IRAs)
2. Keogh Plans
3. Roth IRAs
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 Mix of Deposits

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B. The Ownership of Deposits

C. The Cost of Different Deposit Accounts
IV. Pricing Deposit-Related Services
V. Pricing Deposits at Cost Plus Profit Margin
A. Estimating Deposit Service Costs
VI New Deposit Insurance Rules–Insights and Issues
VII. Using Marginal Cost to Set Interest Rates on Deposits
A. Conditional Pricing
VIII. 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
IX. Basic (Lifeline) Banking: Key Services for Low-Income Customers
X. Summary of the Chapter

Problems and Projects

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

Assets (millions) Liabilities and Equity (millions)

Cash and interbank $50 Core deposits $50
deposits
Short-term security 15 Large negotiable CDs 150
investments
Total loans, gross 400 Deposits placed by brokers 65
Long-term securities 150 Other deposits 45
Other assets 10 Money market liabilities 195
Other liabilities 65
Equity capital 55
Total assets $625 Total liabilities and equity capital $625

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?

Core deposits/Assets = 8.00 percent

Large Negotiable CDs/Assets = 24.00 percent
Deposits placed by Brokers/Assets = 10.40 percent
Other Deposits/Assets = 7.20 percent
Money Market Liabilities/Assets = 31.20 percent
Other Liabilities/Assets = 10.40 percent
Equity Capital/Assets = 8.80 percent

The proportion of core deposits at Rhinestone is exceptionally low, while large CDs and other
money-market borrowings make up more than 55 percent of the bank’s total funding sources.

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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 having less sensitive interest rates.

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
possible.

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
deposits (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?

This One Year Two Years Three

Types of Deposits Held Year Ago Ago Years 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

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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, passbook savings deposits, and money market deposit accounts) toward longer-term
deposit instruments (i.e., retirement deposits and CDs) with fixed maturities, giving the bank
longer term, and perhaps a 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?

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. Although, the monthly maintenance fees on under $1,000
accounts are stiff, and may drive away many small depositors to other banks.

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

Expected Volume of New Rate of Interest Offered

Deposits Depositors
$10 million 2.00%
15 million 2.25
20 million 2.50
24 million 2.75
26 million 3.00

Management anticipates being able to invest any new deposits raised in loans yielding 5.50
percent. How far should this thrift institution go in raising its deposit interest rate in order to
maximize total profits (excluding interest costs)?

Rate Exp. Diff.

Total Marginal Marginal Total
Expected Offered Marginal In Marg.
Interest Interest Revenue Profits
Inflows on New Cost Rate Rev and
Cost Cost Rate Earned
Funds Cost
$10 2.00% 0.2000 0.2000 2.00% 5.50% +3.50% $0.3500
$15 2.25% 0.3375 0.1375 2.75% 5.50% +2.75% $0.4875
$20 2.50% 0.5000 0.1625 3.25% 5.50% +2.25% $0.6000
$24 2.75% 0.6600 0.1600 4.00% 5.50% +1.50% $0.6600
$26 3.00% 0.7800 0.1200 6.00% 5.50% −0.50% $0.6500

Fine-Tuned Savings Association should raise its deposit rate to 2.75 percent, attracting $24
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 3.0 percent, the marginal cost rate is greater
than the marginal revenue rate and total profits fall from a high of $0.66 million back down to
$0.65 million.

12-5. New Day 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 4.25
percent yield. Management believes that an offer rate on new deposits of 2 percent would attract
$100 million in new deposits and rollover funds. To attract $200 million, the bank would
probably be forced to offer 2.25 percent. New Day’s forecast suggests that $300 million might be
available at 2.50 percent, $400 million at 2.75 percent, $500 million at 3.00 percent, and $600
million at 3.25 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 2.00% 2.00 2.00 2.00% 4.25% +2.25% $2.25
$200 2.25% 4.50 2.50 2.50% 4.25% +1.75% $4.00

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$300 2.50% 7.50 3.00 3.00% 4.25% +1.25% $5.25

$400 2.75% 11.00 3.50 3.50% 4.25% +0.75% $6.00
$500 3.00% 15.00 4.00 4.00% 4.25% +0.25% $6.25
$600 3.25% 19.50 4.50 4.50% 4.25% −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 4.50 percent is greater than the marginal
revenue rate of 4.25 percent. Therefore, New Day Bank should try and attract $500 million in
new deposits.

12-6. R&R Savings Bank finds that its basic transaction account, which requires a $1,000
minimum balance, costs this savings bank an average of $3.25 per month in servicing costs
(including labor and computer time) and $1.25 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?
Further analysis of customer accounts reveals that for each $100 above the $1,000
minimum in average balance maintained in its transaction accounts, R&R 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 $1,000 minimum, then a customer
maintaining an average monthly balance of $1,500 should save the bank 25 percent in operating
costs.) For a customer who consistently maintains an average balance of $1,200 per month, how
much should the bank charge in order to protect its profit margin?

Following the cost-plus-profit approach, the monthly fee to be charged by the bank should be:

Planned profit
Unit price charged Operating Estimated overhead
margin from
the customer for = expense per unit + expense allocated to the +
each service
each deposit service of deposit service deposit-service function
unit sold

= $3.25 + $1.25 + $0.50 = $5.00 per month.

The appropriate fee for a customer maintaining an average balance of $1,200 per month would
be:

[$3.25 – {0.10 × ($3.25)}] + $1.25 + $0.50 = $2.925 + $1.25 + $0.50 = $4.675 per month.

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

January $450 July $450

February 350 August 425
March 300 September 550
April 550 October 600
May 225 November 625

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June 400 December 500

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

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

[$450 × 31 days + $350 × 28 days + $300 × 31 days + $550 × 30 days + $225 × 31 days
+ $400 × 30 days + $450 × 31 days + $425 × 31 days + $550 × 30 days + $600 × 31 days
+ $625 × 30 days + $500 × 31 days] ÷ 365 days

= $452.055

Then the APY must be:

= 2.38 percent.

12-8. The National Bank of Mayville quotes an APY of 2.75 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 $3,700 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:

Where the account's average balance is found from:

= $3,058.904

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Then:

Interest earned = $84.12.

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