Chapter Ten

Managing and Pricing Deposit Services

Key Topics

•Types of Deposit Accounts Offered •The Changing Mix of Deposits and Deposit Costs •Pricing Deposit Services •Cost plus Pricing•Conditional Deposit Pricing •Truth in Savings Act•Relationship Pricing •Lifeline Banking

Introduction p. 293

•Deposits are a key element in defining what a bank does and what critical roles it plays in the economy

•Deposits provide most of the money for making loans and represent the primary source of profits and growth for a bank.

Introduction (continued) p. 294

•Two key issues every bank must deal with in managing the public’s deposits

1. Where can funds be raised at the lowest cost?

2. How can management be sure that the bank always has enough deposits to provide loans and other services people demand?

•So challenging has it become today to get large, new deposits that many banks have created a new leadership position – chief deposit officer

Types of Deposits Offered by Banks p. 294

1. Demand Deposits, or Transaction Deposits

A. Non-interest bearing demand deposits

B. Interest-bearing transaction deposits

i. NOW accounts

ii. Money Market Deposit Account

2. Nontransaction Deposits

A. Savings accounts

i. Passbook

ii Statement savings

B. Time Deposits

C. Retirement Savings

Types of Deposits Offered by Banks p. 294

A. Non-interest bearing Demand Deposits, or Transaction Deposits▫Used mostly for making payment on

behalf of customers for goods & services▫One of the oldest services▫Bank is required to honor any withdrawals

immediately▫Hottest item in the transaction deposit field

today appears to be the mobile check deposit▫Designed principally for customers on the

move, carrying camera-equipped smart phones

Types of Deposits Offered by Banks (continued) p. 294-295

▫Interest was prohibited by Glass-Steagall Act, 1933. Too costly to banks.▫One of the most volatile and

unpredictable sources of funds▫Most deposits are held by

business firms

Types of Deposits Offered by Banks (continued) p. 294-295

B. Interest-Bearing Demand Deposits▫Negotiable Orders of Withdrawal

(NOW) – like a checking and savings in one account. It pays some interest but customers must give notice before withdrawing funds.

▫Money Market Deposit Account (MMDA) created as an innovation by the bank to Regulation Q. Pay higher interest rates backed by low risk securities, bonds.

Types of Deposits Offered by Banks p. 294

2. Nontransaction (Savings) Deposits▫Longer-Term ▫Higher Interest Rates Than Transaction

Deposits▫Generally Less Costly to Process and

Manage▫An account whose primary purpose is

to encourage the bank customer to save rather than make payments

Types of Deposits Offered by Banks (continued) p. 296-297

2. Types of Nontransaction DepositsA. Savings Accounts

i. Passbook Savings Account – small deposits, less limits on withdrawels. Used savings book.

ii. Statement Savings Deposit – electronic e-statements

B. Time Deposit (CD) – purchased for as few as 7 days and up to 5 years. Also known as Certificates of Deposit

Types of Deposits Offered by Banks (continued) p. 296-297

C. Retirement Savings Deposits

▫Individual Retirement Account (IRA) – Save for retirement, tax deduction

▫Keogh Plan retirement accounts – available to self-employed persons

▫Roth IRA – The Tax Relief Act of 1997 allows non-tax-deductible contributions that can grow tax free and pay no tax on investment earnings when withdrawn

Interest Rates Offered on Different Types of Deposits p. 297-298

• The Composition 组成 (zǔchéng) of Deposits – CORE DEPOSITS▫Bankers would generally prefer a high

proportion of transaction deposits (including regular checking or demand accounts) and low-yielding time and savings deposits

• These accounts are among the least expensive of all sources of funds and often include a substantial percentage of CORE DEPOSITS. Core deposits are stable sources of funds for the bank with low interest rate risk.

CONCEPT CHECK

1. What are the major types of deposit accounts that banks offer today?

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

Interest Rates Offered on Different Types of Deposits p. 297-298

•The Ownership of Deposits

▫The dominant holder of bank deposits inside the US is the private sector

•The Cost of Different Deposit Accounts

▫Managers of banks would prefer to sell only the cheapest deposits to the public but it is public preference that determines which types of deposits will be created

TABLE 10–1 The Changing Composition of Deposits in the United States p. 298

Pricing Deposit-Related Services p. 302

•An individual depository institution has little control over its prices in a financial marketplace that approaches perfect competition

• It is the marketplace, consumers like you and me (the public), not the individual financial firm, that ultimately sets prices

• Financial institutions, like most other businesses, are price takers, not price makers

Pricing Deposit-Related Services p. 302

• In pricing deposit services, management has a dilemma (problem)• It needs to pay a high enough interest return to attract and hold customer funds, but must avoid paying an interest rate so costly it takes away from profit margin

Pricing Deposits at Cost Plus Profit Margin p. 302-304

•The Glass-Steagall Act of 1933 – Federal limits on interest rates paid on deposits

•Deregulation has brought more frequent use of single service pricing as greater competition has raised the average real cost of a deposit for deposit-service providers.

Pricing Deposits at Cost Plus Profit Margin p. 302-304

•This means that deposits are usually priced separately from other services

▫COST PLUS PRICING FORMULA

Using Marginal Cost to Set Interest Rates on Deposits p. 305-306

•What deposit interest rate should the bank offer its customers?▫We need to know▫The marginal cost of moving the

deposit rate from one level to another▫The marginal cost rate, expressed as a

percentage of the volume of additional funds coming into the bank

Using Marginal Cost to Set Interest Rates on Deposits p. 305-306

TABLE 12–2 Using Marginal Cost to Choose the Interest Rate to Offer Customers on Deposits p. 305

Using Marginal Cost to Set Interest Rates on Deposits p. 306-309

•Conditional 有条件的 (yǒu tiáojiàn de) Pricing ▫Where a bank sets up a schedule of fees in which the customer pays a low fee or no fee if the deposit balance remains above some minimum level, but faces a higher fee if the average balance falls below that minimum

Using Marginal Cost to Set Interest Rates on Deposits p. 306-309

•Conditional Pricing ▫The customer pays a price depending on how

they use the account, based on these factors:1. The number of transactions passing

through the account (e.g., number of checks written, deposits made, wire transfers, stop-payment orders, or notices of insufficient funds issued)

2. The average balance held in the account over a designated period (usually per month)

3. The maturity of the deposit in days, weeks, months, or years

Using Marginal Cost to Set Interest Rates on Deposits

•Conditional Pricing ▫Deposit pricing policy is sensitive to at least two factors:1. The types of customers each

bank plans to serve2. The cost that serving

different types of depositors will present to the bank

EXHIBIT 10–1 Example of the Use of Conditional Deposit Pricing by Two Banks Serving the Same Market Area p. 309

Truth in Savings Act 1991 p. 307

•Consumers must be informed of the deposit terms before they open a new account, including fees, penalties & interest rate.

•Depository institutions must disclose such things:▫Minimum balance to open▫Minimum to avoid fees▫How the balance is figured▫When interest begins to accrue▫Penalties for early withdrawal▫Options at maturity ▫The APY (Annual percentage yield)

Truth in Savings Act 1991 p. 307

▫The APYAnnual Percentage Yield

Relationship Pricing Based on the Total Customer Relationship with the Bank p. 310

•Related to the idea of targeting the best customers for special treatment is the idea 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 compared to the fees charged customers having only a limited relationship to the offering institution

Relationship Pricing Based on the Total Customer Relationship with the Bank p. 310

•The main idea of relationship pricing is that it promotes greater customer loyalty and makes the customer less sensitive to the prices posted on services offered by competing financial firms

TABLE 10–3 Factors in Household and Business Customers’ Choice of a Financial Firm for Their Deposit Accounts (ranked from most important to least important) p. 310

CONCEPT CHECK

3. Describe the differences between the following deposit pricing methods in use today: cost-plus pricing, conditional pricing, and relationship pricing.4. What does the 1991 Truth in Savings Act require financial firms selling deposits inside the United States to tell their customers?

Basic (Lifeline) Banking: Key Services for Low-Income Customers p. 312-313

• Should every adult citizen be guaranteed access to certain basic financial services, such as a checking account or personal loan? •A recent survey found that a substantial

segment of the U.S. population is either• “Unbanked” ▫No deposits or loans of any kind

• “Underbanked”▫Having access to some important

services but not others

Basic (Lifeline) Banking: Key Services for Low-Income Customers p. 312-313

•Among the “underbanked” are those families relying on expensive payday loans, check cashing firms, pawnshops, and money order services to pay their bills•Racial and ethnic minorities are more likely than the general population to be “underbanked”

Basic (Lifeline) Banking: Key Services for Low-Income Customers p. 312-313

• Banks receive aid from the government to provide low interest loans to lower income communities and provide deposit insurance.• The Community Reinvestment Act of

1977 requires banks to have a certain number of banks in lower income communities.•Who should bear the cost of the extra

services to the poor are issues that banks face today and add pressure to managers.

Concept Check Q and A1. What are the major types of deposit plans that depository institutions offer today? A: Deposit plans can be divided into transaction deposits or nontransaction deposits, and retirement savings deposits. The primary function of transaction deposits is to make immediate payments to the customers. The principal function of nontransaction deposits is to serve as savings accounts and pay higher interest rates than transaction deposits do. Other deposit accounts include passbook and statement savings accounts, certificates of deposits (CDs), and other time deposit accounts. Retirement savings deposits are an instrument especially for saving for the future.

Quick Quiz – Concept Check Q and A

2. What are CORE DEPOSITS, and why are they so important today? Core deposits are the most stable parts of a banks funding base and usually include smaller savings accounts. They have relatively low interest-rates. Holding a large amount of core deposits has an advantage in having access to a stable and cheaper source of funding with a relatively low interest-rate risk.

Quick Quiz – Concept Check Q and A

3. Describe the differences between the following deposit pricing methods in use today: cost-plus pricing, conditional pricing, and relationship pricing. Cost-plus deposit pricing 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.

Quick Quiz – Concept Check Q and AConditional pricing is used today as a tool by banks to attract the kinds of depositors they want to have as customers. With this kind of pricing a bank will post a schedule of offered interest rates or fees assessed based on account activity. This type of pricing encourages customers to hold a high average deposit balance which gives the bank more funds to invest in earning assets.Relationship pricing involves basing fees charged to a customer on the number of services the customer purchases from a bank. Many services means a lower fee or no fees.

Quick Quiz – Concept Check Q and A

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

The 1991 Truth in Savings Act requires banks to fully inform their deposit customers on the terms offered to each depositor. The customer must be informed about any penalties or service fees which could reduce his or her expected yield. Other disclosures include minimum balance to open, annual percentage yield (APY) and options at maturity.

Quick Quiz – Concept Check Q and A

5. What is LIFELINE BANKING? What pressures does it put on the managers of banks and other financial institutions?

Quick Quiz – Concept Check Q and A

5. What is LIFELINE BANKING? What pressures does it put on the managers of banks and other financial institutions? Lifeline banking refers to basic service packages offered by banks to poorer customers not able to afford normal bank service offerings. Banks are helped 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