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 and Deposit Interest Rates
 Conditional Deposit Pricing
 Rules for Deposit Insurance Coverage
 Disclosure of Deposit Terms
 Lifeline Banking

Chapter Outline

I. Introduction: The Importance of Deposits and the Challenge of Managing Deposits

II. Types of Deposits Offered by Banks and Other Depository Institutions
A. Transaction (Payments) Deposits
1. Noninterest-Bearing Demand Deposits
2. Interest-Bearing Demand Deposits
a. NOW Accounts
b. Money Market Deposit Accounts (MMDAs)
c. Super NOWs
B. Nontransaction (Savings or Thrift) Deposits
1. Passbook Savings Deposits
2. Statement Savings Deposits
3. Time Deposits
4. Individual Retirement Accounts (IRAs)
5. Keogh Plans
6. Roth IRAs
Ill. Interest Rates Offered on Different Types of Deposits
A. The Composition of Bank Deposits
1. Trend Toward Interest-Bearing and Nontransaction Deposits
2. The Importance of Core Deposits
3. Changes in the Relative Importance of Other Types of Deposits

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 B. Cost of Different Deposit Accunts
IV. Pricing Deposit-Related Services
V. Pricing Deposits at Cost Plus Profit Margin
A. Estimating Deposit Service Costs
B. An Example of Pooled Funds Costing
VI. Using Marginal Cost to Set Interest Rates on Deposits
A. Conditional Pricing
VII. Pricing Deposits Based on the Total Customer Relationship
A. The Role That Pricing and Other Factors Play When Customers Choose a
Depository Institution to Hold Their Accounts
VIII. Basic (Lifeline) Banking: Key Services for Low-Income Customers
IX. Summary of the Chapter

Concept Checks

12-1. What are the major types of deposit plans depository institutions offer today?

Deposit plans can be divided broadly into transaction deposits, thrift or nontransaction deposits,
and hybrid deposits. The primary function of transaction deposits is to make payments and these
deposits include regular checking accounts and NOW accounts. The principal function of thrift
deposits is to serve as accumulated savings and include passbook and statement savings
accounts, CDs, and other time deposit accounts. Hybrid deposits combine transactions and thrift
features and include money-market deposit accounts and Super NOWs.

12-2. What are core deposits and why are they so important today?

Core deposits are the most stable components of a depositary institution’s funding base and
usually include smaller-denomination savings and third-party payments accounts. They are
characterized by relatively low interest-rate elasticity. Holding a substantial proportion of core
deposits has an advantage in having access to a stable and cheaper source of funding with
relatively low interest-rate risk.

12-3. How has the composition of deposits changed in recent years?

There has been a shift in the public’s holdings of deposits toward greater relative proportions
of the highest-yielding time deposits and toward hybrid accounts that maximize depositor
returns, while still giving them access to deposited funds to make payments.

12-4. What are the consequences for the management and performance resulting from
recent changes in deposit composition?

While depository institutions would prefer to sell only the cheapest deposits to the public, it is
predominately public preference that determines which types of deposits will be created.
Institutions that do not wish to conform to customer preferences will simply be outbid for
deposits by those who do. Managers who fail to stay abreast of changes in their competitors’
deposit pricing and marketing programs stand to lose both customers and profits.

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12-5. Which deposits are the least costly for depository institutions? The most costly?

Commercial checkable deposits, particularly regular noninterest bearing demand deposits, are
usually the least costly. The most costly deposits are passbook savings accounts having
substantial deposit and withdrawal activity and higher interest-rate time deposits.

12-6. First State Bank of Pine is considering a change of marketing strategy in an effort to
lower its cost of funding and maximize profitability. The new strategy calls for aggressive
advertising of new commercial checking accounts and interest-bearing household
checkable deposits and de-emphasizes regular and special checking accounts. What are the
possible advantages and possible weaknesses of this new marketing strategy?

The cost data presented in the text suggest that certain kinds of checkable deposits are often
among the least-cost deposits a bank can sell (especially because of low or nonexistent interest
rates paid) so First State Bank may be able to achieve some of its profit and cost goals with the
proposed new strategy. Moreover, adjusted for revenues generated through the use of deposited
funds, interest-bearing checking accounts appear to be more profitable than regular (noninterest-
bearing) accounts and commercial checking services more profitable than retail (personal)
checking services. However, the deposit services that First State Bank wants to pursue more
aggressively tend to be more interest-sensitive and less loyal to a bank and, thus First State Bank
may be adding to its liquidity problem with the new strategy.

12-7. Describe the essential differences between the following deposit pricing methods in use
today: cost-plus pricing, conditional pricing, and relationship pricing?

Cost-plus deposit pricing encourages banks to determine what costs they are incurring in labor
and management time, materials, etc., in offering each deposit service. Cost-plus pricing
generally calls for a bank to charge deposit service fees adequate to cover all the costs of
offering the service plus a small margin for profit. Conditional pricing is used today as a tool by
banks to attract the kinds of depositors they want to have as customers. With this pricing
technique a bank will post a schedule of offered interest rates or fees assessed for deposits of
varying sizes and based on account activity. Generally larger volume deposits carry higher
interest returns to the depositor or are assessed lower service charges, encouraging customers to
hold a high average deposit balance which gives the bank more funds to invest in earning assets.
Finally, relationship pricing involves basing fees charged a customer on the number of services
and the intensity of use of services the customer purchases from a bank.

12-8. 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 run 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 the bank charge a customer who opens one of these
checking accounts?

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The relevant formula is:

Unit Price Operating Overhead Planned

Charged = Expense + Expense + Profit Margin
per Month Per Unit Per Unit Per Unit

In this case:

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

12-9. To price deposits successfully, service providers must know their costs. How are these
costs determined using the historical average cost approach? The marginal cost of funds
approach? What are the advantages and disadvantages of each approach?

The historical average cost approach looks at the past. It asks the following question:
what funds has the bank raised to date and what did they cost? The marginal cost deposit-pricing
method focuses upon the weighted average cost of new funds raised from all of the different
sources of funds the bank draws upon or plans to draw upon in the current period.

12-10. How can the historical average cost and marginal cost of funds approaches be used to
help select assets (such as loans) that a depository institution might wish to acquire?

The historical average cost rate is called break-even because the institution must earn at least this
rate on its earning assets (primarily loans and securities) just to meet the total operating costs of
raising borrowed funds and the stockholders' required rate of return. Therefore, the institution
will know the lowest rate of return that it can afford to earn on assets it might wish to acquire.
The marginal cost of funds approach can be used as a guide to select loans and other assets
because the institution interested in profit maximizing would want to be sure to cover its fund-
raising costs.

12-11. What factors do household depositors rank most highly in choosing a financial firm for
their checking account? Their savings account? What about business firms?

Studies cited in this chapter indicate that households (individuals and families) appear to
consider, in rank order, the following factors in choosing an institution to hold their checking
account: convenient location, availability of other services, safety, low fees and low minimum
balances, and high deposit interest rates. In selecting an institution to hold their savings account
households appear to consider, in rank order: familiarity, interest rate paid, transactional
convenience, location, availability of payroll deduction, and any fees charged. Business firms,
on the other hand, seem to consider such factors as the financial health of the lending institution,
whether the institution will be a reliable source of credit in the future, the quality of managers,
whether loans are competitively priced, the quality of financial advice given, and whether cash
management and operations services are provided.

12-12. What does the 1991 Truth in Savings Act require financial firms selling deposits inside
the United States to tell their customers?

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The Truth in Savings Act requires financial firms to fully inform their deposit customers on the
terms offered each depositor. The customer must be told when a new account is opened or if a
deposit is renewed, what annual percentage yield (APY) is being offered and what minimum
balance is required to receive that yield. Moreover, the depositor must be informed about any
penalties or service fees which could reduce his or her expected yield. If the terms of a deposit
are changed in a way that would reduce the depositor's return advance notice must be given to
the account holder.

12-13. Using the APY formula required by the Truth in Savings Act for the following
calculation. Suppose that a customer holds a savings deposit for a year. The balance in the
account stood at $2,000 for 180 days and $100 for the remaining days of the year. If the Savings
bank paid this depositor $88.50 in interest earnings for the year, what APY did this customer
receive?

The correct formula is:


APY  Interest Earned
100 (1 
365 Days in Period

- 1
 Average Account 
)
Balance

In this instance,

APY  $88.50 365
365 
100  (1  ) - 1
or  $1036.99

APY = 8.53 percent,

where the average account balance is:

$2000 x 180 days  $100 x 185 days

365 days  $1036.99

12-14. What is lifeline banking? What pressures does it impose on the managers of banks and
other financial institutions?

Lifeline banking consists of basic service packages offered by banks to customers not generally
able to afford conventional bank service offerings. The essence of these services is that they
carry low service fees and usually do not offer all of the features of banking services carrying
full service fees. The pressure on managers to offer basic or lifeline services has aroused a big
controversy. From a profit motive point of view banks should not offer unprofitable services.
On the other hand, financial institutions are partially subsidized by government in the form of
low- interest loans and deposit insurance and, therefore, have some public-service
responsibilities which may include providing certain basic services to all potential customers,
regardless of their income or social status.
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12-15. What does the Expedited Funds Availability Act require U.S. depository institutions to
do?

The Expedited Funds Availability Act mandates a time schedule that sets maximum delays for
the receipt of deposit credit that depository institutions can use, and it requires them to inform
their customers about their policies for making funds available for customer use.

Problems

12-1. Exeter National Bank has a funding mix to support its assets as follows:

Cash and Interbank Dep 50 Core Deposits 50

S.T. Securities 15 Large Negotiable CDs 150
Total Loans, Gross 375 Brokered Deposits 65
L.T. Securities 150 Other Deposits 140
Other Assets 10 Money Mkt. Liabilities 95
Total Assets 600 Other Liabilities 70
Equity Capital 30
Total Liab. & Eq. 600

a. Evaluate the funding mix of deposits and nondeposit sources of funds employed by
Exeter. 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 = 8.33%

Large Negotiable CDs/Assets = 25.00%
Brokered Deposits/Assets = 10.83%
Other Deposits/Assets = 23.33%
Money Market Liabilities/Assets = 15.83%
Other Liabilities/Assets = 11.67%
Equity Capital/Assets = 5.00%

The proportion of core deposits at Exeter is exceptionally low, while large CDs and other
money-market borrowings make up more than 40 percent of the bank’s total funding sources.
This funding mix tends to subject the bank to excessive vulnerability to quick withdrawal of
funds and high interest-rate risk exposure. Exeter 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 Exeter’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.

b. Suppose market interest rates are projected to rise significantly. Does Exeter appear to
face significant losses due to liquidity risk? Due to interest rate risk? Please be as specific as
possible.

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If interest rates rise, Exeter 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
$600 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 deposit
(see the 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?

One Two Three

This Year Years Years
Types of Deposits Year Ago Ago Ago
Regular & Special Checking Accounts 235 294 337 378
Interest Bearing Checking Accounts 392 358 329 287
Regular (Passbook) Savings Dep. 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
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 and passbook savings deposits) toward longer-term deposit instruments with fixed
maturities, giving the bank a somewhat longer term and, perhaps, somewhat more predictable
funding base.

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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 or other draft.
 For average monthly account balances of $1000 to $1500 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 $1000, 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 schedule?

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.

12-4. Diamond Pit 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 Rate of Interest

Volume of New Offered Depositors
Deposits
$ 10 million 5.00%
15 million 5.25
20 million 5.50
26 million 5.75
28 million 6.00

Management anticipates being able to invest any new deposits raised in loans yielding 7 percent.
How far should this thrift institution go in raising its deposit rate in order to maximize total
profit (excluding interest costs)?

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 Cost
$10 5.0% 0.5000 0.5000 5.000% 7.0% +2.0% $0.2000
15 5.25 0.7875 0.2875 5.750 7.0 +1.25 $0.2625
20 5.50 1.100 0.3125 6.250 7.0 +0.75 $0.3000
26 5.75 1.495 0.395 6.583 7.0 +.417 $0.325
28 6.00 1.680 0.185 9.250 7.0 -2.250 $0.280

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Emerald Isle National Bank should raise its deposit rate to 5.75%, attracting $26 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 6.0%, the marginal cost rate is greater than the marginal
revenue rate and total profits have fallen from a high of $0.325 million back down to $0.28
million.

12-5. Goldbrick 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 7.75
percent yield. Management believes that an offer rate on new deposits of 5.75% would attract
$100 million in new deposits and rollover funds. To attract $200 million, the bank would
probably be forced to offer 6.25 percent. Goldbrick’s forecast suggests that $300 million might
be available at 6.8%, $400 million at 7.25 percent, $500 million at 7.5 percent and $600 million
at 7.65 percent. What volume of deposits should the bank 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 5.75% 5.75 5.75 5.75% 7.75% +2.00% $2.00
$200 6.25% 12.50 6.75 6.75% 7.75% +1.00% $3.00
$300 6.80% 20.40 7.90 7.90% 7.75% -0.15% $2.85
$400 7.25% 29.00 8.60 8.60% 7.75% -0.85% $2.00
$500 7.50% 37.50 8.50 8.50% 7.75% -0.75% $1.25
$600 7.65% 45.90 8.40 8.40% 7.75% -0.65% $0.60

The marginal revenue rate is greater than the marginal cost rate up to $200 million in new
deposits. At $300 million, the marginal cost rate of 7.90% is greater than the marginal revenue
rate of 7.75%. Therefore, Goldbrick Bank should try and attract $200 million in new deposits.

12-6. Bender Savings Bank finds that its basic checking account which requires a $400
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.

Further analysis of customer accounts reveals that for each $100 above the$400 minimum in
average balance maintained in its checking accounts, Bender Savings saves about 5 percent in
operating expenses with each account. For a customer who consistently maintains an average
balance of $1000 per month, how much should the bank charge in order to protect its profits
margin?

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If the bank saves about 5 percent in operating expenses for each $100 held in balances above the
$400 minimum, then a customer maintaining an average monthly balance of $1,000 should save
the bank 30 percent in operating costs.

The appropriate fee for this customer would be:

[$2.65 -0.30 ($2.65)] + $1.18 + $0.50 = $1.855 + $1.18 + $0.50 = $3.535 per month.

12-7. Chris Orange maintains a savings deposit with Santa Paribe Credit Union. This past year
Chris received $13.64 in annual interest income from his savings account. His savings deposit
had the following average balance each month:

January $400 July $350

February 250 August 425
March 300 September 550
April 150 October 600
May 225 November 625
June 300 December 300

What was the annual percentage yield (APY) earned on Chris Orange's savings account?

Chris's account had an average balance this year of:

[$400 x 31 days + $250 x 28 days + $300 x 31 days + $150 x 30 days

+ $225 x 31 days + $300 x 30 days + $350 x 31 days + $425 x 31 days +
$550 x 30 days + $600 x 31 days + $625 x 30 days + $300 x 31 days]
365 days

= $373.56

Then the APY must be:


APY = 100 (1 $13.64 
)365/365  1  3.65 percent
 
 $373.56 
12-8. The National Bank of Taraville quotes an APY of 5 percent on a one-year money
market CD sold to one of the small businesses in town. The firm posted a balance of $2500 the
first 90 days of the year, $3000 over the next 180 days, and $5000 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:

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  Interest Earnings 365/365 
APY = 100 (1 )  1
 Average Balance 

 Interest Earnings 365/365 

5% = 100 (1 ) 1
 
 $3397.26 
Where the account's average balance is found from:
$2500 x 90 days  $3000 x 180 days  $5000 x 95 days
Average Balance =
365 days

= $3397.26

Then:
Earnings 
  0.029435 x Interest Earnings
Interest
5% = 100
 
 $3397.26 

or Interest Earnings = $169.86

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