Book 4. Liquidity and Treasury Risk

FRM Part 2

LTR 12. Managing and Pricing Deposit Services

Presented by: Sudhanshu

Module 1. Transaction and Non-Transaction Deposit Types

Module 2. Methods of Pricing Deposits

Module 3. Challenges to Offering Deposit Accounts

Module 1. Transaction and Non-Transaction Deposit Types

Topic 1. Transaction (Demand) Deposits

Topic 2. Non Transaction (Savings or Thrift) Deposits

Topic 1. Transaction (Demand) Deposits

• Transaction (demand) deposits are used for day-to-day transactions and payments and represent one of the oldest and most fundamental funding sources for banks. They provide depositors with a liquid and accessible way to manage their finances.

• Liquidity and Predictability: As withdrawals can be made without prior notice, these deposits are considered the least predictable funding source for a bank. This volatility means banks must carefully manage their liquidity to ensure they can meet a depositor's demands at any time.

• Bank's Perspective: From a bank's point of view, these accounts provide an important, though often volatile, source of funds. They also generate significant non-interest income from various fees

• Key Types of Transaction Accounts:

  • Noninterest-bearing demand deposits: These are accounts that do not pay explicit interest. They were historically favored by businesses that needed to make frequent payments and preferred to maintain a liquid balance for operational needs. The prohibition on paying interest on these accounts, a key part of financial regulation for decades, was finally lifted for all depository institutions by the Wall Street Reform and Consumer Protection Act of 2009.

  • Interest-bearing transaction deposits: These accounts offer both transaction services and a return on the funds held.

  • Negotiable Order of Withdrawal (NOW) accounts: Introduced in the early 1970s, they became available nationwide in 1981 following a period of financial deregulation. They function as a hybrid checking and savings account, paying interest while allowing unlimited check writing. However, by regulation, they can only be held by individuals and nonprofit organizations.

  • Money Market Deposit Accounts (MMDAs): Developed in 1982 to help banks compete with the rising popularity of money market mutual funds. These accounts offer market-level interest rates that are not subject to the interest rate caps of other deposit accounts. While offering limited check-writing privileges, they are technically classified as savings deposits by regulators and can be held by both individuals and businesses.

Practice Questions: Q1

Q1. Which of the following deposit accounts will most likely have the highest interest rate?
A. Demand deposit account.
B. Time account (certificate of deposit) with one-year maturity.
C. Money market deposit account (MMDA).
D. Negotiable order of withdrawal (NOW) account.

Practice Questions: Q1 Answer

Explanation: B is correct.

Generally, the longer the maturity of a deposit, the higher the interest rate. This
suggests that the time account should have the highest rate of interest. The phrase demand deposit account implies that it is a transaction account, which may be interest bearing or not. Now accounts are interest-bearing checking accounts, but as they are transaction accounts, they will have a lower interest rate than a time account (certificate of deposit). The MMDA will earn interest, but again, because it allows for some liquidity in terms of check writing, it will likely earn less than the one-year time account.

Topic 2. Nontransaction (Savings or Thrift) Deposits

• Definition and Purpose: These accounts are primarily designed for customers who want to save for future expenditures, financial emergencies, or retirement. They are not intended for daily transactional use.

• Stability and Cost: They generally pay higher explicit interest rates than transaction deposits but have lower management and administrative costs for the bank. This makes them a more stable and cost-effective funding source.

• Key Types of Nontransaction Accounts:

  • Passbook savings deposits: These are traditional savings accounts that can be opened with a small initial deposit. While banks technically have the legal right to require a 30-day notice before withdrawal, this is a rarely enforced provision.

  • Time deposits (Certificates of Deposit or CDs): These accounts have a fixed maturity date, ranging from as short as seven days to several years.

    • Retail CDs: Typically held by individuals in denominations of less than $100,000, these are illiquid and cannot be traded in a secondary market. A significant penalty is incurred for early withdrawal.

• ​Negotiable (Jumbo) CDs: Denominated in amounts of $100,000 or more, these are sold to wealthy individuals, companies, and government entities. They can be bought and sold in a secondary market, which allows the holder to sell them before maturity without a penalty.

• Retirement savings deposits: Accounts like Keogh plans and Individual Retirement Accounts (IRAs) provide a very stable source of long-term funding for banks. The deposits are locked in for long periods and there are often substantial tax-related penalties for early withdrawal, making them a reliable and predictable liability for a bank.

• Innovative CD Designs: To attract a wider range of customers, banks have developed various flexible CD designs, including:

  • Bump-up CDs: Allows the depositor a one-time option to switch to a higher interest rate if market rates increase during the CD's term.

  • Step-up CDs: The interest rate periodically adjusts upward on a pre-defined schedule.

  • Liquid CDs: Permits penalty-free partial withdrawals, offering a balance between a higher savings rate and some liquidity.

Practice Questions: Q2

Q2. Which of the following describes a certificate of deposit (CD) that carries an interest rate that periodically adjusts upward?
A. Liquidity CD.
B. Bump-up CD.
C. Step-up CD.
D. Index CD.

Practice Questions: Q2 Answer

Explanation: C is correct.

The step-up CD has an interest rate that periodically adjusts upward. The bump-up CD has a rate that may increase if interest rates increase.

Module 2. Methods of Pricing Deposits

Topic 1. Deposit Account Costs

Topic 2. Deposit Services Pricing

Topic 3. Cost-Plus Pricing of Deposit Services

Topic 4. Marginal Cost Method to Set Deposit Rates

Topic 5. Conditional Pricing

Topic 1. Deposit Account Costs

• Goal: Banks aim to find the lowest cost funding sources to maximize the difference between asset yield (loans) and cost of funds (deposits).

• Transaction Deposits (Checking/Demand Accounts):

  • Generally the lowest cost funding source overall for banks.

  • Interest expense is often low-to-zero.

  • However, they typically have higher management and administrative costs (e.g., payment processing).

• Time Deposits (Certificates of Deposit - CDs):

  • Carry the highest explicit interest expense per dollar, often about three times that of transaction deposits.

  • They have generally lower management and administrative costs than transaction accounts.

• Core Deposits: These include checking, savings, and time accounts. They are the least expensive and most stable source because they are not highly sensitive to interest rate changes.

• Cost Reductions: The shift to electronic banking, automatic bill-pay, and mobile check deposits has helped to reduce the administrative costs associated with all deposit accounts.

Topic 2. Deposit Services Pricing

• Historical Implicit Interest: Prior to deregulation (Regulation Q), banks could not pay explicit interest on transaction accounts.

  • They competed by offering implicit interest through services, gifts (toasters, airline tickets), or pricing services below cost.

• Shift to Unbundled Service Pricing: Following deregulation (early 1980s), the overall cost of deposits increased.

  • Banks moved to pricing deposit services separately (unbundled).

  • Fees on deposit accounts (overdrafts, returned checks, ATM usage) have increased to generate fee income and offset overhead costs.

• Pricing Methods: To ensure profitability in a competitive market, banks use several pricing approaches:

  1. Cost-Plus Pricing

  2. Marginal Cost Method

  3. Conditional Pricing

Topic 3. Cost-Plus Pricing of Deposit Services

• Principle: Each deposit service (like a transaction fee or a monthly account fee) is priced to fully cover all associated costs plus a desired profit margin.

• The Cost-Plus Pricing Formula: The unit price charged to the customer for each service is calculated as:

$$\begin{aligned}\text{Unit Price} &= \text{Operating Expense} + \text{Allocated Overhead Expense}\\ & + \text{Planned Profit Margin}\end{aligned}$$

• Example Application:

  • If the operating expense is $2.50 per month.

  • The allocated overhead expense is $1.25 per month.

  • The planned profit margin is $0.25 per month.

  • The calculated monthly fee should be:

    $$\$2.50 + \$1.25 + \$0.25 = \mathbf{\$4.00 \text{ per month}}$$

Practice Questions: Q1

Q1. A bank is located near a college campus and would like to attract students to the bank. Which of the following conditional pricing demand deposit accounts would most likely appeal to a college student?
A. A high minimum balance, no item charge/activity fees account.
B. A high minimum balance, high item charge/activity fees account.
C. A low or zero minimum balance account with low- to moderate-item charge/activity fees account.

Practice Questions: Q1 Answer

Explanation: C is correct.

College students generally have less deposits than, for example, the average depositor in an affluent neighborhood. The conditional pricing that would most appeal to students would be a low minimum balance demand deposit account with low- to moderate-item charge and activity fees. However, this fee structure may be unprofitable for the bank.

Topic 4. Marginal Cost Method to Set Deposit Rates

• Concept: Banks must evaluate the marginal cost to bring in one additional dollar of deposits, as current rates may be higher or lower than historical averages.

• Goal: To determine if the marginal revenue earned from investing the new funds exceeds the marginal cost of raising them.

• Marginal Cost Formulas:

  • Change in Total Interest Cost:

​$$\Delta \text{Total Cost} = \begin{pmatrix} \text{New Rate} \times \text{New Total Funds} \end{pmatrix} - \begin{pmatrix} \text{Old Rate} \times \text{Old Total Funds} \end{pmatrix}$$

• Marginal Cost Rate (as a Percent): $$\text{Marginal Cost Rate} = \frac{\text{Change in Total Cost}}{\text{Additional Funds Raised}}$$
• ​Scenario: A bank needs to raise an additional $10 million.

• Option 1: MMDA Rate Increase

  • Initial funds: $400M at 2.0%. To raise $10M, the rate must increase for all $410M to 2.5%.

  • Marginal Cost (in dollars): ($410M × 0.025) - ($400M × 0.02) = $2.25 million

  • Marginal Cost Rate: $2.25M / $10M = 22.5%

• Scenario: A bank needs to raise an additional $10 million.

• Option 1: MMDA Rate Increase

  • Initial funds: $400M at 2.0%. To raise $10M, the rate must increase for all $410M to 2.5%.

  • Marginal Cost (in dollars): ($410M × 0.025) - ($400M × 0.02) = $2.25 million

  • Marginal Cost Rate: $2.25M / $10M = 22.5%

• Option 2: Negotiable CD Funding

  • The bank pays the Negotiable CD rate (e.g., 4%) only on the new $10 million.

  • Marginal Cost (in dollars): $10M × 0.04 = $0.40 million

  • Marginal Cost Rate: $0.40M / $10M = 4.0%

• Conclusion: The bank should choose the Negotiable CD option, even though its nominal rate (4.0%) is higher than the new MMDA rate (2.5%), because the overall marginal cost to the bank is much lower (4.0% vs. 22.5%) when the new rate does not have to be paid on existing "old" deposits.

Topic 5. Conditional Pricing

• Definition: Pricing of deposit services where the fee charged (or rate earned) is conditional upon the customer maintaining a certain balance, or limiting the number of transactions.

• Key Examples:

  • A monthly fee is waived if the customer maintains a minimum daily balance of $1,000.

  • A premium interest rate is paid only if the account has a minimum balance of $5,000.

  • A per-item transaction charge applies if the account balance falls below the threshold.

• Conditional Pricing Categories (Dunham):

  1. Flat-Rate Pricing: A fixed charge per time period or per transaction.

  2. Free Pricing: No charge for the account or transactions, but the customer foregoes interest income (opportunity cost). Often attracts smaller, active, and potentially unprofitable accounts.

  3. Conditionally Free Pricing: Fees apply only if conditions (like a minimum balance) are not met. This favors large deposits and provides valuable market signaling about customer segments.

Practice Questions: Q2

Q2. A bank currently has $100 million of deposits earning an average rate of 2%. It would like to raise an additional $50 million, but to do so, will have to raise the deposit rate to 3% on both the old and new accounts. What is the marginal cost rate of the additional $50 million in funds?
A. 3%.
B. 5%.
C. 7%.
D. 9%.

Practice Questions: Q2 Answer

Explanation: B is correct.

The marginal cost of the new funds is equal to 5%. The formulas for calculating marginal cost are:

Module 3. Challenges to Offering Deposit Accounts

Topic 1. Deposit Insurance

Topic 2. FDIC Insurance Premiums

Topic 3. Bank Disclosures

Topic 4. Overdraft Protection

Topic 5. Basic (Lifeline) Banking

Topic 1. Deposit Insurance 

• Establishment: The Federal Deposit Insurance Corporation (FDIC) was established in 1934 following the Great Depression.

• Impact on Funding Cost: Deposit insurance significantly lowers the bank's cost of funds because it reduces the risk perceived by depositors.

• Current Coverage: The standard maximum deposit insurance coverage is $250,000 per account holder for funds held in a single institution.

  • This limit was temporarily raised in 2008 in response to the financial crisis and made permanent in 2010 by the Dodd-Frank Act.

  • Initial coverage in 1934 was only $2,500.

• Types of Insured Accounts

  Insurance covers a wide range of accounts, including:

  • Demand deposits (checking) and Savings deposits.

  • NOW accounts, Christmas club accounts, and Time deposits (CDs).

  • IRA and Keogh retirement deposits.

  • Cashiers' checks, money orders, and outstanding drafts.

• Rule of Thumb: Deposits are aggregated in a single institution. Depositors with funds in multiple, legally distinct institutions are covered up to the maximum in each bank.

• Merger Rule: If two insured institutions merge, and a customer held $250,000 in each prior to the merger, the new coverage will immediately cap at the single $250,000 limit (not $500,000).

• Increasing Coverage at One Institution: Depositors can legally increase their coverage at a single institution by placing funds in legally different ownership categories.

  • Example: A married couple could have $250,000 in a joint account, and each spouse could have an additional $250,000 in a separate individual account, totaling $750,000 in coverage.

Topic 2. FDIC Insurance Premiums

• The Bank's Cost of Insurance

  • The deposit insurance system provides a massive benefit to banks by stabilizing their funding base.

  • Mandatory Fee Payment: Although deposit insurance lowers the overall cost of funds, the bank must pay deposit insurance fees (premiums) to the FDIC.

  • Note: The specific calculation or structure of these premiums is not detailed in the provided reading material, only the requirement to pay fees is mentioned.

• Transparency and Consumer Issues

  • Challenge: Bank managers face the challenge of providing adequate and necessary disclosures related to their deposit products and services.

  • Scope: Disclosures generally relate to terms and conditions, fee schedules, and how interest is calculated on accounts.

  • Note: The provided reading material identifies disclosures as a challenge but does not specify the regulatory requirements or contents of those disclosures.

Topic 3. Bank Disclosures

• A Challenging Service

  • Social/Ethical Issue: Overdraft protection is highlighted as a complex challenge facing banks.

  • Function: It is a service that allows a customer to withdraw funds beyond the available account balance, typically incurring a significant fee.

  • Conflict: Banks earn substantial fee income from overdrafts, but the practice has been a point of contention regarding consumer protection and fairness.

  • Note: The provided reading material identifies overdraft protection as a challenge but does not provide details on its operation or regulatory status.

Topic 4. Overdraft Protection

• The Social/Ethical Mandate

  • Concept: Basic banking (or lifeline banking) refers to the idea that all adults have a fundamental right to simple, affordable financial services.

  • The Social Debate: This raises an important social and ethical issue: Who should pay for these basic services?

    • Should the costs be borne by the banks themselves (subsidizing through other products)?

    • Should the government subsidize these accounts?

    • Should the customer accept limited services (e.g., no free checks, no interest) to minimize the bank's cost?

  • Purpose: These accounts are designed to offer minimal, low-cost services to low-income or unbanked individuals to ensure financial inclusion.

Topic 5. Basic (Lifeline) Banking

Practice Questions: Q1

Q1. Which of the following is not a criticism of financial institutions providing credit lines to cover overdrafts?
A. It creates moral hazard. To prevent moral hazard, people who write bad checks should have to suffer the cost and embarrassment of dealing with the consequences so that they will not do it in the future.
B. It encourages people to write bad checks because they know they will be covered if there are insufficient funds in their accounts.
C. It leads to predatory lending. It preys on lower income individuals because they may be more likely to write bad checks and the interest rate on overdraft lines of credit tend to be high.
D. People who have overdraft protection may neglect to balance their monthly bank statements.

Practice Questions: Q1 Answer

Explanation: A is correct.

• Criticisms include:
  • The customer pays a fee to set up the account and rates are high, making it (to some) predatory lending.
  • Low-income individuals who are more financially vulnerable may rely more heavily on the service.
  • Customers may be more likely to write bad checks if they know they will be covered.
  • People may avoid balancing their bank statements because they know they are protected from overdrafts.

Moral hazard means that one does not suffer a consequence for “bad behavior.” In this case, the customer does pay for overdraft protection. There is no spoken criticism that the person with insufficient funds to cover the debit should be embarrassed into behaving in the future, although some people might believe this to be true.