Commercial Banking Management

BAF 421

HO# (4)
Chapter Twelve

Managing and Pricing Deposit Services

THIS HANDOUT COVERS:
CLO#5: Recognize the major types of deposit plans banks offer to their
customers and comment on the change in bank deposits composition in
recent years

https://lms.ectmoodle.ae
McGraw-Hill/Irwin Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
 Learning Outcomes
• 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
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-2
 Introduction
• Deposits are a key element in defining what
a banking firm really does and what critical
roles it really plays in the economy.

• Deposits provide much of the raw material

for making loans and, thus, may represent
the ultimate source of profits and growth for
a depository institution.
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-3
 Introduction…Cont.
• Two key issues every depository institution must deal
with in managing the public’s deposits:
1. Where can funds be raised at lowest possible cost?
2. How can management ensure that the institution
always has enough deposits to support lending and
other services the public demands?
• So challenging has it become today to attract
significant new deposits that many financial firms
have created a new executive position – Chief
deposit officer.
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-4
 Types of Deposits Offered by Depository
Institutions
• Transaction (Payment or Demand)
Deposits:
▫ Making payment on behalf of customers
▫ One of the oldest services
▫ Provider 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
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-5
 Types of Deposits Offered by Depository Institutions
(continued)
• Transaction Deposit
▫ An account used primarily to make payments for purchases of
goods and services.
• Types of Transaction Deposits:
1.Noninterest-Bearing Demand Deposits
1. Interest was prohibited by Glass-Steagall Act
2. One of the most volatile and unpredictable sources of funds
3. Most deposits are held by business firms

2.Interest-Bearing Demand Deposits

a) Negotiable Orders of Withdrawal (NOW)
b) Money Market Deposit Account (MMDA) and Super NOW
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-6
 Types of Deposits Offered by Depository
Institutions… Cont.
• Non-transaction (Savings or Thrift)
Deposits
▫ Longer-Term.
▫ Higher Interest Rates than Transaction
Deposits.
▫ Generally less Costly to Process and
Manage.
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-7
 Types of Deposits Offered by Depository Institutions
(continued)
• Nontransaction Deposit
▫ An account whose primary purpose is to encourage the bank
customer to save rather than make payments

• Types of Non-transaction Deposits:

1.Passbook Savings Account
2.Statement Savings Deposit
3.Time Deposit (CD)
4.Retirement Savings Deposits

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-8
 Interest Rates Offered on Different
Types of Deposits
• The Composition of 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.
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-9
 Interest Rates Offered on Different Types of
Deposits…Cont.
• The Ownership of Deposits
▫ The dominant holder of bank deposits is the private
sector.

• The Cost of Different Deposit Accounts

▫ Managers of depository institutions would prefer to
sell only the cheapest deposits to the public but it is
predominantly public preference that determines
which types of deposits will be created.
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-10
 TABLE 12–1 The Changing Composition of Deposits in the
United States

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-11
 Pricing Deposit-Related Services
• In pricing deposit services, management is
caught in a dilemma:
▫ 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 erodes any potential
profit margin.
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-12
 Pricing Deposit-Related Services…Cont.
• An individual depository institution has little
control over its prices in a financial
marketplace that approaches perfect
competition
▫ It is the marketplace not the individual
financial firm that ultimately sets prices
▫ Financial institutions like most other
businesses, are price takers not price makers.
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-13
 Pricing Deposits at Cost Plus Profit
Margin

• Deregulation has brought more

frequent use of unbundled service
pricing as greater competition has
raised the average real cost of a
deposit for deposit-service providers.

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-14
 Pricing Deposits at Cost Plus Profit Margin…
Cont.

• This means that deposits are usually priced

separately from other services.

▫ 1) Cost-plus pricing formula:

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-15
 Example:
• 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 it charge a
customer who opens one of these checking accounts?
The relevant formula is:
Unit price charged the customer for each deposit service =
Operating expense per unit of deposit service +
Estimated overhead expense allocated to the deposit-service function +
Planned profit margin from each service unit sold

• In this case, the unit price charged per month should be $6.69
= ($4.87 + $1.21 + [0.10 × ($4.87 + $1.21)]) = $6.69
for each $500 minimum- balance checking account it sells.
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-16
 Using Marginal Cost to Set Interest Rates on
Deposits
• 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

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-17
 TABLE 12–2 Using Marginal Cost to Choose the Interest
Rate to Offer Customers on Deposits

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-18
 2) Conditional Pricing
Where a depository 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.
(Encourage more stable, larger denomination
accounts. Give the bank more money to use,
more stable funding base).

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-19
 ▫ Conditional pricing techniques vary deposit
prices based on one or more of 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
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-20
 EXHIBIT 12–1 Example of the Use of Conditional Deposit
Pricing by Two Banks Serving the Same Market Area

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-21
 • Conditional Pricing
▫ Deposit pricing policy is sensitive to at least
two factors:
1. The types of customers each depository
institution plans to serve
2. The cost that serving different types of
depositors will present to the offering institution

▫ Problems with this pricing policy is:

May drive away many small depositors to other
banks.

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-22
 Pricing Based on the Total Customer
Relationship and Choosing a Depository
• Related to the idea of targeting the best customers for
special treatment is the notion 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.
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-23
 Pricing Based on the Total Customer Relationship and
Choosing a Depository…Cont.

• In theory, relationship pricing promotes

greater customer loyalty and makes the
customer less sensitive to the prices
posted on services offered by competing
financial firms

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-24
 Essential differences between 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.

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-25
 Essential differences between deposit pricing methods in use
today: cost-plus pricing, conditional pricing, and relationship
pricing (continued)
• 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.
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-26
 Essential differences between deposit pricing methods in use
today: cost-plus pricing, conditional pricing, and relationship
pricing (continued)

• Relationship pricing involves basing fees

charged to a customer on the number of
services and the intensity of use of services the
customer purchases from a bank.

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-27
 TABLE 12–3 Factors in Household and Business Customers’
Choice of a Financial Firm for Their Deposit Accounts.
(ranked from most important to least important)

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-28
 Basic (Lifeline) Banking: Key Services for
Low-Income Customers
• 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 critical services but not others
• Among the “underbanked” are those families relying on
expensive payday loans, check cashing firms, pawnshops, and
money order services to pay their bills.
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-29
 Truth in Savings Act
• Passed in November 1991
• Consumers must be informed of the deposit terms before they open
a new account
• Depository institutions must disclose:
▫ 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 Annual Percentage Yield (APY)

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-30
 Example: APY Calculation
• Suppose that a customer holds a savings deposit in a savings bank for a
year. The average account balance is $2,037 .If the Savings bank paid
this depositor $8.50 in interest earnings for the year, what is the Annual
Percentage Yield (APY) did this customer receive?

• APY = 100[ ( 1 + $8.5 )^365/365 - 1]

$2,037

= 0.908 percent.

McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-31
 Quick Quiz
• What are the major types of deposit plans that depository institutions offer
today?
• What are core deposits, and why are they so important today?
• How has the composition of deposits changed in recent years?
• Describe the essential differences between the following deposit pricing
methods in use today: cost-plus pricing, conditional pricing, and
relationship pricing.
• What factors do household depositors rank most highly in choosing a
financial firm for their checking account? Their savings account? What
about business firms?
• What does the 1991 Truth in Savings Act require financial firms selling
deposits inside the United States to tell their customers?
• What is lifeline banking? What pressures does it impose on the managers
of banks and other financial institutions?
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
Bank Management and Financial Services, 7/e 12-32