12-2 12-3

Key topics Key issues depository institutions are faced with

• 1. Types of deposit accounts offered

1. Where can funds be raised at lowest possible
• 2. The changing mix of deposits and deposit
costs cost?
• 3. Pricing deposit services and deposit interest 2. How can management ensure that there are
rates
enough deposits to support lending and other
• 4. Conditional deposit pricing
services the public demands?
• 5. Rules for deposit insurance coverage
• 6. Disclosure of deposit terms
• 7. Lifeline banking

12-4

Types of deposit accounts Transaction accounts

◼ Transaction (payment or demand) deposits ◼ Although the interest cost of transaction

◼ Making payment on behalf of customers
accounts is very low, the non-interest costs can
◼ One of the oldest services
◼ Provider is required to honor any withdrawals be quite high
immediately
◼ Generally, low balance checking accounts are
◼ Non-transaction (savings or thrift) deposits
◼ Longer-term not profitable for banks due to the high cost of
◼ Higher interest rates than transaction deposits processing checks
◼ Generally less costly to process and manage
 12-7

Transaction accounts Types of transaction deposits

◼ Most banks offer three different transaction • Noninterest-bearing demand deposits

accounts
◼ Demand deposits ▪ Interest was prohibited by Glass-Steagall Act
◼ DDAs (Demand Deposit Accounts) ▪ One of the most volatile and unpredictable
◼ Negotiable Order of Withdrawal sources of funds
◼ NOWs
▪ Most deposits are held by business firms since
◼ Automatic Transfers from Savings
◼ ATS
Regulation Q prohibits banks from paying explicit
interest on for-profit corporate checking accounts
Regulation Q: http://www.bankersonline.com/regs/217/217-3.html

Transaction accounts Transaction accounts

Interest-bearing demand deposits with limited or no ◼ Money market deposit accounts
check-writing privileges
◼ Short-maturity deposit (a few days, weeks, months)
▪ Negotiable Orders of Withdrawal (NOW)- hybrid
savings instrument – pay interest ◼ Pay interest but holders are limited to 6 transactions
▪ ATS (Automatic Transfers) Accounts per month, of which only three can be checks
➢ Customer has both a DDA and savings account
◼ Attractive to banks because they are not required to
➢ The bank transfers enough from savings to DDA
each day to force a zero balance in the DDA hold reserves against MMDAs
account
◼ Held by both individuals and businesses
◼ For-profit corporations are prohibited from owning
NOW and ATS accounts
 12-10

Non-transaction (savings or thrift) deposit Non-transaction accounts

◼ Savings accounts: Have no fixed maturity

▪ Denomination from $5
An account whose primary purpose is to ▪ Withdrawal privileges are unlimited, without prior notice
▪ Stable fund to banks with little interest rate sensitivity
encourage the bank customer to save rather ▪ Low interest rate
than make payments. ▪ For individuals, non-profit organization, businesses,
governments (firms cannot put > $150,000 in saving
deposits)
▪ In form of
◼ Passbook savings account

◼ Statement savings account

12-13

Non-transaction accounts Popular types of CDs

◼ Time deposits (CD is most popular type): Have a
specified maturity ranging from 7 days on up • Bump-up CD – allows a depositor to switch to a
◼ Large time deposits (Jumbo CDs): higher interest rate if market rates rise
◼ for corporation & wealthy individuals
◼ in negotiable form CDs of $100,000-plus • Step-up CD – permits periodic upward
◼ Typically can be traded in the secondary market adjustments in the promised interest rate
many times before reaching maturity
◼ Small time deposits: • Liquid CD – permits the depositor to withdraw
◼ Usually acquired by individuals some or all of their funds without a withdrawal
◼ nonnegotiable form CDs with smaller denomination
penalty
◼ Cannot be traded before reaching maturity
 12-14

Non-transaction accounts Non-transaction accounts

▪ Retirement savings deposits ◼ Individual Retirement Accounts
▪ Individual Retirement Account (IRA) - the ▪ Each year, a wage earner can make a tax-
Economic Recovery Tax Act of1981 deferred investment up to $3,000 of earned
▪ Keogh Deposit – have tax benefits income
▪ Roth IRA – The Tax Relief Act of 1997 allows ▪ Funds withdrawn before age 59 ½ are subject to
non-tax-deductible contributions a 10% IRS penalty
▪ Default Option Retirement Plans – The Pension ▪ This makes IRAs an attractive source of long-
Protection Act of 2006 term funding for banks

12-16 12-17

Interest rates on deposits depend on: The changing composition of deposits in the US

◼ The maturity of the deposit

◼ The size of the offering institution

◼ The risk of the offering institution

◼ Marketing philosophy and goals of the offering

institution

* Saving deposits include MMDAs

 12-18 12-19

Core deposits Core deposits

◼ A large proportion includes transaction deposits and
low-yielding time & savings deposits.
◼ Small time and savings deposits can be withdrawn
A stable base of funds that is not highly
immediately, their effective maturity spans over years
◼ Increase bank’s liability duration and reduce interest
sensitive to movements in market interest rates
rate vulnerability
(low interest-rate elasticity) and which tend to ◼ Share in total deposits in small banks (80%) higher
than in large banks (63%) (FDIC: 2007)
remain with the bank. ◼ Declining trend due to inflation, deregulation, stiff
competition and better educated-customers.

Holders of deposits Cost of deposits

◼ Checkable deposits (checking accounts, special
◼ Private sector: individuals, partnership and
checkbook deposits and interest-bearing checking
corporation (75%) accounts)
◼ State and local government (4%) ◼ Thrift deposits (money market accounts, time
deposits and savings accounts)
◼ Foreign governments, businesses, individuals,
◼ Business transaction accounts are more
mostly in off-shore offices
profitable than personal checking accounts
◼ Other financial institutions (correspondent deposits) ◼ Deposits are determined by public preferences
and competition
 12-23
Cost and revenue accounting data for Check 21 and substitute checks
deposit accounts at FirstBank
Unit Cost
Demand Savings Time ◼ Effective October 28,2004 – permits depository
Income
Interest income (estimated earnings credit) 2.6% 2.5% 3.0% institutions to electronically transfer check images
Noninterest income (monthly estimates per account)
Service charges $ 2.80 $ 0.44 $ 0.11 ◼ The images are called substitute checks and is a
Penalty fees $ 4.32 $ 0.28 $ 0.27
Other $ 0.63 $ 0.16 $ 0.05 legal copy of the check
Total noninterestiIncome $ 7.75 $ 0.88 $ 0.42
Expenses ◼ Protects depositors against loss
Activity charges (unit costs per transaction)
Deposit—electronic $ 0.0089 $ 0.0502 $ 0.1650 ◼ Benefits institutions by reducing the cost of check
Deposit—nonelectronic
Withdrawal—electronic
$
$
0.2219
0.1073
$
$
0.7777
0.4284
$
$
3.1425
0.5400 clearing
Withdrawal—nonelectronic $ 0.2188 $ 0.7777 $ 1.4933
Transit check deposited $ 0.1600 $ 0.5686 ◼ Substitute checks can be sent electronically instead
Transit check cashed
On-us check cashed
$
$
0.2562
0.2412
of sending bundles of checks
Official check issued
Monthly overhead expense costs
$ 1.02
◼ More information: http://www.federalreserve.gov/
Monthly account maintenance (truncated) $ 2.42 $ 4.10 $ 1.99
Monthly account maintenance (nontruncated) $ 8.60
Net indirect expense $ 4.35 $ 1.81 $ 18.38
Miscellaneous expenses
Account opened $ 9.46 $ 33.63 $ 5.78
Account closed $ 5.67 $ 20.18 $ 3.38

12-25

Substitute check authorized by Check 21 FDIC insurance coverage

◼ Banks insured through Bank Insurance Fund (BIF)

◼ Savings and loans insured through Savings
Association Insurance Fund (SAIF)
◼ Covers only those deposits payable in the U.S.
◼ Many types of accounts are covered up to $100,000
(increased to $250,000 until year-end 2009 by the
Emergency Economic Stabilization Act of 2008) for
each account holder within the same bank (even if
different branches)
◼ Deposits placed in separate institutions are insured
separately
 12-26 12-27

Truth in Savings Act Pricing deposit-related services

◼ Consumers must be informed of the deposit terms ◼ Banks need to pay high enough to attract
before they open a new account
◼ Depository institutions must disclose:
depositors
▪ Minimum balance to open ◼ Banks should avoid costly interest rate to protect
▪ Minimum to avoid fees potential profit margin
▪ How the balance is figured
▪ When interest begins to accrue ◼ Banks are price takers, not price maker
▪ Penalties for early withdrawal ◼ Banks must decide to pay market-determined
▪ Options at maturity
price to attract and hold depositors or lose funds
▪ And the APY (average yields)

12-28 12-29

Pricing deposit-related services Cost plus profit deposit pricing

• - The Glass-Steagall Act of 1933 – Federal limits on
interest rates paid on deposits – why?
▪ Cost-plus pricing • → protect banks from “excessive” interest rate
competition for deposits
▪ Marginal cost of deposits • → non-price competition as free-of-charge deposit-
related services or below-cost pricing
▪ Conditional pricing • → implicit interest rate
• → fund allocation distortion
▪ Relationship pricing
• - The Depository Institutions Deregulation Act of
1980 gradually phases out federal limits on deposit
interest rate (http://www.allbusiness.com/glossaries/depository-institutions-deregulation-
monetary-control-act/4953012-1.html)

• → unbundle service pricing: deposits are priced

separately
 12-30 12-31

Cost plus profit deposit pricing Historical average cost approach

Deposit services are priced high enough to cover all

costs:
Determines the bank’s cost of funds by looking
Estimating
Unit Price Operating Planned at the past. It looks at what funds the bank has
Overhead
Charged the Expense Profit from
Expense
Customer = Per Unit of + + Each
for Each Deposit
Allocated to
Service Unit
raised to date and what those funds have cost.
the Deposit
Service Service Sold
Function

Calculating the average net cost of deposit Calculating the average net cost of deposit
accounts accounts
◼ Average historical cost of funds ◼ Example:
◼Measure of average unit borrowing costs for ◼ Every month, a demand deposit account that
existing funds does not pay interest has $20.69 in
◼ Average interest cost transaction costs charges, $7.75 in fees, an
◼ Calculated by dividing total interest expense
average balance of $5,515, and 5% float plus
by the average dollar amount of liabilities 10% required reserve would have a yearly
outstanding net cost of 3.31%
Average Net Cost of Demand Deposit =
Average Net Cost of Bank Liabilities =
$0 + $20.69 - $7.75
Interest Expense + Noninteres t Expense - Noninteres t Income 12 = 3.31%
$5,515  (1 - .15)
Average Balance x [1 - (Required Reserve Ratio + Float ratio)]
 12-35

Measuring the cost of funds The marginal cost approach

◼ Average historical cost of funds

◼ Many banks incorrectly use the average Determine the bank’s cost of funds by looking at the
historical costs in their pricing decisions
future. What minimum rate of return is the bank going
◼ The primary problem with historical costs is that
they provide no information as to whether future to have to earn on any future loans and securities to

interest costs will rise or fall. cover the cost of all new funds raised?
◼ Pricing decisions should be based on marginal
costs compared with marginal revenues

12-36

Using marginal cost to set interest rates

Marginal cost rate
on deposits
Marginal cost = Change in total cost
Many financial analysts would argue that the added
= (New interest rate x total funds raised at new rate) –
cost (not weighted average cost) of bringing new (Old interest rate x total funds raised at old rate)

funds into the bank should be used to price

deposits. Change in total cost

Marginal cost rate =
Additional fund raised
 12-39

Measuring the marginal cost rate Market penetration deposit pricing

◼ Costs of independent sources of funds
◼ Example:
▪ Market interest rate is 2.5%
▪ Servicing costs are 4.1% of balances The method of selling deposits that usually sets
▪ Acquisition costs are 1.0% of balances
▪ Deposit insurance costs are 0.25% of balances low prices and fees initially to encourage
▪ Net investable balance is 85% of the balance
(10% required reserves and 5% float) customers to open an account and then raises

prices and fees later on.

0.025 + 0.041 + 0.01 + 0.0025
Marginal Cost = = 0.0924 = 9.24%
0.85

12-40 12-41

Conditional pricing Upscale target pricing

◼ Schedule of fees were low if customer stayed

above some minimum balance - fees Bank aggressively goes after high-balance,
conditional on how the account was used
◼ Conditional pricing based on one or more of the low-activity accounts. Bank uses carefully
following factors
◼ The number of transactions passing through the designed advertising to target established
account
◼ The average balance held in the account during the business owners and managers and other high
period
◼ The maturity of the deposit income households.
 12-42 12-43

Relationship pricing Basic or lifeline banking

The bank prices deposits according to the number

of services purchased or used. The customer Some people feel that all individuals are entitled

may be granted lower fees or have some fees to a minimum level of financial services no

waived if two or more services are used. matter their income level

Medium Balance,
Low Balance, Low High Activity,
Activity, Truncated Nontruncated High Balance
Monthly Monthly Monthly
Calculating the Average Net Cost of

Income / Income / Income /

Activity Expenses Activity Expenses Activity Expenses
Income
Interest income $ 500 $ 0.93 $ 4,589 $ 8.50 $11,500 $ 21.30
on average monthly balance (after float)
Noninterest income (average montly estimates)
Service charges $ 2.80 $ 2.80 $ 2.80

MANAGING AND PRICING

Penalty fees (estimated for account) $ 8.56 $ 6.32 $ 2.01
Other $ 0.63 $ 0.63 $ 0.63
Total noninterest income $ 11.99 $ 9.75 $ 5.44
Total revenue $ 12.92 $ 18.25 $ 26.74

DEPOSIT SERVICES
Expenses
Activity charges
Deposit—electronic 1 $ 0.01 2 $ 0.02 2 $ 0.02
Deposit—nonelectronic 1 $ 0.22 3 $ 0.67 3 $ 0.67
Withdrawal—electronic 15 $ 1.61 12 $ 1.29 10 $ 1.07
Withdrawal—nonelectronic 3 $ 0.66 14 $ 3.06 8 $ 1.75
Transit check deposited 1 $ 0.16 2 $ 0.32 2 $ 0.32
Transit check cashed 1 $ 0.26 2 $ 0.51 2 $ 0.51
On-us checks cashed 2 $ 0.48 3 $ 0.72 3 $ 0.72
Official check issued $ - $ - $ -
Deposit Accounts

Total activity expense $ 3.40 $ 6.59 $ 5.06

Monthly expenses
Monthly account maintenance (truncated) 1 $ 2.42 $ - $ -

Chapter 3
Monthly account maintenance (nontruncated) - $ - 1 $ 6.60 1 $ 6.60
Net indirect expense $ 4.35 $ 4.35 $ 4.35
Total reoccurring monthly expenses $ 6.77 $ 10.95 $ 10.95
Interest expense $ - $ - $ -
Total expense $ 10.17 $ 17.54 $ 16.01

Net revenue per month $ 2.75 $ 0.71 $ 10.73

Average percentage cost (net of service charges and fees) -5.12% 2.38% 1.29%
Average interest cost 0.00% 0.00% 0.00%
Average noninterest cost 28.53% 5.36% 1.95%
Average noninterest income 33.66% 2.98% 0.66%
Average account balance $ 500 $ 4,589 $ 11,500
Required reserves 10% 10% 10%
Float 5% 5% 5% William Chittenden edited and updated the PowerPoint slides for this edition.