12.

Managing and Pricing Deposit Services

2.1 Types pf Deposits:

1.Transaction (Payments or Demand) – requires financial services providers to honor

immediately any withdrawals made either in person by the customer or a designated third
party. Transaction deposits include:
*Regular noninterest bearing do not earn an explicit interest payment butt provide the
customer with payment services, safekeeping of funds, and recordkeeping of any
transaction carried out by check, card, or via an electronic network
*Interest bearing provide all of the foregoing services and pay interest to the depositor as
well.
Negotiable order of withdrawal (NOW accounts) interest-bearing savings deposits that give
the offering depositary institution the right to insist on prior notice before the customer
withdraws. ( this right however is not very often exercised)
After 1982, banks and thrift institutions could offer deposits competitive with the share
accounts offered by money market funds that carried higher, unregulated interest rates and
are normally backed by a pool of high quality securities. As a result, was the appearance of
MMDAs and SNOWs that offer flexible money market interest rates but accessible via
check or preauthorized draft.
MMDAs short term maturity deposits held by both individuals and businesses. Up to 6
preauthorized drafts per months are allowed, but only 3 with drawls made by writing
checks, no limit to personal withdrawls that the customer may make.
SNOWs held only by individuals and nonprofit institutions, no limits on the number of
checks the depositor may write. However, offering institutions post lower yields on them
because SNOWs can be drafted more often by customers.
Bankers would prefer a high proportion of transaction deposits and low-yielding time and
savings deposits.

2. NonTransaction (Savings or Thrift Deposits)

-designed to attract funds from customers who wish to set aside money in anticipation of
future expenditures or for financial emergencies, and pay higher interest rates, less costly
to process and manage on the part of offering institution.
 2.2 The Cost of Different Deposit Accounts:

1. Checkable deposits( less costly): regular checking accounts, special checkbook

deposits (which often pay no interest) and interest bearing checking accounts –
lowest cost. Even if check processing and account maintenance are major expense
items, the absence of interest payments reduces their cost.
2. Thrift deposits -particularly money market accounts, time deposits, and savings
accounts -generally rank second as the least costly. Savings deposits are cheap bcs
they carry low interest rates and absence of monthly statements for investors. More
expensive than demand deposits because of fees and regulations.

2.3 Pricing Deposit - Related services

Financial institutions are price takers and must decide if it wishes to attract more
deposits and hold all those it currently has by offering depositors at least the market
determined price, or if it willing to lose funds.

2.4 Pricing Deposits at Cost Plus Profit Margin

In the beginning customer charges were set below operating costs to capture market share
and this lead to the development of the Implicit interest rate- the difference between the
true cost of supplying fund raising services and the service fees.
Deregulation brought more frequent use of unbundled service pricing (deposits are usually
priced separately from other services)
*Each Deposit service may be priced high enough to recover the costs of providing that
service: Cost -Plus Pricing formula
Unit price charged the customer for each deposit service=Operatingexpense per unit of deposit service+ Estimated ov

Box 12 .6 New Deposit Insurance Rules Insights and Issues:

Government supplied deposit insurance allows depository institutions to sell deposits at
relatively low rates.
In 1943 the Federal Deposit Insurance Corporation (1934) was set up in the US and deposits
are recoverable up to at least 250.000. Goals: promotes public confidence and deals with
inflation. U.S govt securities, shares in mutual funds, safe deposit boxed and funds stolen
from an insured depositary institution are not covered by FDIC insurance. Depositary
institutions generally carry private insurance for these items.
Fees: if the federal insurance fund falls below 1.25$ in reserves pe $ 100 in covered despots
the FDIC will raise its insurance fees.

2.5 Using Marginal Cost to set Interest Rates on Deposits

Marginal cost- the added cost of bringing in new funds and not historical average cost,
should be used to price funds, frequent changes in interest rates is an argument against
using the historical average cost.
The Marginal Cost approach provides valuable information to the managers of depository
institution before the added cost of deposit growth caught up with additional revenues and
total profits begin to decline.
Marginal Cost=Change∈Total Cost =New Interest Rate∗Total funds raised at new rate−Old Interest rate∗Total fund

Change∈total cost
Marginal Cost=
Additional fundsraised

Conditional Pricing
Definition: 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.
It depends on:
1. Number of transactions passing through the account
2. Average balance held
3. Maturity
Classification by Constance Dunham of checking account conditional pricing schedules:
1. Flat-rate pricing (fixed charge per check, time or both)

2. Free Pricing (absence of monthly account maintenance charge or per transaction

charge)

3. Conditionally free pricing (services are free if the account stays above some minimum
value)

Depositary Pricing Policy is sensitive to at least 2 factors:

1. The types of customers that it plans to serve
2. The cost that serving different types of depositors will present to the offering
institution

2.6 Relationship Pricing If the customers purchases more than services might be
granted lower deposit fees. ( pricing deposits according to the number of services the
customer uses)
Factors that customers look at: convenience, service availability and safety above price.

Chapter 13: Managing Non deposit Liabilities

Introduction: The traditional source of funds for most depositary institutions is the deposit
account. This chapter gives the solution to what management does to find new money
when deposit volume is inadequate to support all loans and investments.

3.1 Customer Relationship Doctrine the priority of a lending institution is to make loans
to all those customers from whom the lender expects to receive positive net
earnings. Lending decisions therefore precede funding decisions. However, it should
have some limitations because it might result in poor quality loans (ex. 2008 crisis).

In 1960s the rise of the liability management strategy – buying funds from other
financial institutions in order to cover good quality credit requests and satisfy any
legal reserve requirements. It may acquire funds by borrowing short term through
Federal Funds market or borrowing abroad through the Eurocurrency market.

3.2 Alternative Nondeposit Sources of Funds

1. Fed Funds – originally consisted of deposits held at the Federal Reserve banks.
Why are they hold? To satisfy legal reserve requirements, clear checks, pay for
purchases of government securities.
In technical terms Fed funds are short term borrowing of immediately available
borrowing. Financial firms in need of immediate funds can negotiate a loan with a
holder of surplus interbank deposits or reserves at the Fed, promising to return
the borrow funds next day.

Functions:

1. Satisfy immediately loan demand

2. If short of reserves, it allows the institution to meet the legal requirements.
3. Supplement deposit growth and give lenders a relatively safe outlet for
temporary cash surpluses on which interest can be earned.
4. Helps Fed to control the growth of money and credit, stabilize the economy.
Def: Accommodating banks (fund brokers) buying and selling Fed funds, even
though it might not have the needs for extra funds.

What is the mechanism of Fed Funds?

1. Borrowing and lending institutions communicate one with each other directly
or through a correspondent bank/ funds broker
2. The lending institution agrees to transfer reserves from a deposit it holds
either at the FED or with an accommodating bank into a deposit controlled by
the borrowing institution
3. When the loan comes due, the funds are transferred back into the lending
institution’s reserves account
 FED funds market usually uses one of the 3 types of loan agreements:

1. Overnight loans -unwritten agreements negotiation via phone or wire , the

borrowed funds are returned the next day. Usually do not require collateral,
however the borrower may be required to place government securities in a
custody account in the name of the lender.
2. Term loans- long term contracts lasting several days, weeks, months and often
accompanied by a written contract
3. Continuing contracts- automatically renewed every day unless borrower or lender
decides not to do so.

2. Repurchase Agreements as a source of Fed Funds

- Collateralized fed funds transactions and the lender must be satisfied with the quality
of securities provided as collateral.
- The borrower is temporarily exchanging securities for cash. They involve the
temporary sale of high-quality, easily liquidated assets (“staring leg”) ex: T-bills,
accompanied by an agreement to buy back those assets on a specific future date at a
predetermined price (“closing leg”).
 - The Interest cost for Fed funds and Repos is below:

{Interest Cost of RP = Amount borrowed × Current RP rate ×

Number of days∈ Rp borrowing
360 days
}

3. Borrowing from Federal Reserve Banks

- Fed usually makes its loan through the discount window by crediting the borrowing
institution’s reserve accounts. As collateral depositary institutions usually post: US
government securities, certain federal agency securities, high- grade commercial
paper and other assets judged satisfactory.

Types of loans available:

1. Primary credit – available for short term (usually overnight but might extend to
90 days). It usually carries a credit above the Federal Reserve’s target Fed funds
rate. Users of funds do not have to show that they have exhausted other sources
of funds before asking Fed for a loan. It can even borrow and loan that money in
the Fed funds market.

2. Secondary Credit – loans available at higher interest rate to institutions that

didn’t qualify for primary credit, monitored by the Federal Reserve banks to make
sure the borrower is not taking excessive risk. Usages: help resolve financial
problems, to reduces its debt on the Fed, and strengthen the borrowing
institution’s ability to find additional funds from private-market sources.

3. Seasonal Credit- loans covering longer periods than primary credit for small and
medium-sized depositary institutions experiencing seasonal (intrayear) swings in
their deposits and loans (ex: farm banks). The interest rate on these deposits is set
at the average level of the effective Fed funds rate and the secondary market rate
on 90-dat certificates of deposit.

4.Development and Sale of Large Negotiable CDs

Def: Negotiable CD – interest – bearing receipt evidencing the deposit of funds in the
accepting depositary institution for a specified time period at a specified interest rate or
special formula for calculating the interest rate.
Types:
1. Domestic CDs issued by US banks in the US

2. EuroCDs- Dollar-denominated CDs issued by banks outside the US

3. Yankee CDs issued by largest foreign banks active in the US

4. Thrift CDs- non bank savings institutions

Negotiable CD’s were confined to short-term maturities, concentrated mainly in the one
to 6 month maturity range, negotiable meaning that it would be able to be sold in the
secondary market any number of times before reaching maturity (main advantage:
provides corporate customers with liquidity).
Management can control the quantity of CDs outstanding simply by varying the yield
offered to CD customers.
Formula for the interest rate on fixed- rate CDs:
{Amount due CD Customer= Principal + Principal ×
Days ¿ maturity ¿ × Annual Rate of Interest }
360 days

Variable rate CD-s have their rates reset after a designated period of time. New rate
basendon ex: Libor attached to borrowing of Eurodollar Deposits or the average interest
rate prevailing on prime-quality CD’s traded in the secondary market.
Negotiable CD is a popular borrowing instrument because of low cost, large volume of
funds available and flexibility.The net result of CD sales to customers if often a simple
transfer of funds from one deposit to another within the same depositary institution
( usually from checkable deposits to CDs)
*Advantages of CDs:
- legal reserve requirements for CDs are at 0 (at least in the US, while for checkable
deposits is at 10%).
– Deposit stability- will not be withdrawn until maturity
*Cons: sensitive interest rates attached to CDs, therefore depositary institutions must
combat volatile earnings and make aggressive use of rate hedging techniques.
Nondeposit sources of funds:
Risk factors 2 main types:
1. Interest Rate Risk – volatility of credit cost. The shorter the term of the loan, the
more volatile the prevailing market interest rate tends to be, as Fed funds loans are
overnight as a result the most volatile of all.
2. Credit availability -lack of guarantee that lenders will be willing and able to
accommodate every borrower Most affected are: Negotiable CD, Eurodollar and
commercial paper markets. Fund managers must be prepared to switch to alternative
sources of credit and if necessary pay more for any funds they receive.
The Length of Time funds are needed
Some funds sources may be difficult to access immediately (ex: commercial paper and
long-term debt capital). If the need for capital is urgent, the manager would be inclined
to borrow in the Fed funds market. If they are not needed for a few days, selling longer-
term debt is a better option.
The Size of the Borrowing Institution
The standard trading unit for most money market loans is 1 million – this denomination
might exceed the borrowing requirements of the smallest financial institutions. The
central bank’s discount window and the Fed funds market can make a relatively small
denomination loans that are suitable for smaller depositary institutions.
Regulations:
Federal and state regulations may limit the amount, frequency, and use of borrowed
fund.
Ex: CDs in the US must be issued with maturities of at least 7 days. Federal Reserve
banks may limit borrowing from the discount window for depositary institutions that
appear to display risk of failure.