In Part I (HERE), we got all Warren Buffet against the backdrop of Jimmy Buffet and explored how rising rates were starting to impact deposit balances. We questioned whether “surge balances” are in fact a thing and if they are, is this the time that we will see an exodus of balances move into other asset classes like fixed income, equities, real estate and capital spending. In Part I, we also projected our cost of funds forward and showed why banks, contrary to common thinking, should prepare for lower net interest margins in the next period of rising rates. In Part II, we now look at how one bank came out with a first-of-its-kind product that might mitigate the impact of higher rates and sensitive balances.
Oklahoma State Bank (OSB) announced this week the launch of “CD1,” an innovative savings vehicle unlike any other in the marketplace: a certificate of deposit that pays interest to the investor on Day 1 of the deposit. The minimum deposit is $50,000 with an annual percentage yield and interest rate of 2 percent and maturity period of five years.
Depositors can walk in, deposit $50,000 and walk out of the bank the same day with a check for just over $5,000. The concept of your interest upfront is grabbing people’s attention and not only is attracting new balances but attracting new customers.
As long time readers know, we are never fans of marketing on rate. When you do, you train both your customers and your employees that rate matters. However, OSB had some good reasons for doing so and was willing to take a chance. They analyzed the pros and cons of this promotion and ran many scenarios on how this product would impact their performance.
After careful consideration, they decided to move forward with this product and rested on the following logic:
Velocity of Creativity: OSB is experiencing strong loan growth and healthy margins and felt they wanted to keep the momentum going. They could have slowed loan growth to match the pace of growing less rate sensitive deposits, but at the end of the day they felt that it was a larger risk. The power of the creativity of CD1 is allowing OSB to quickly raise liquidity to keep the bank growing and to gain operating leverage with their marketing dollars. In addition to word of mouth, the new concept would capture media attention thereby reducing their marketing costs and lowering their net effective cost of balances.
CD1 vs. Wholesale: The bank could have raised wholesale money. 5-year brokered CDs currently cost 2.15%, and FHLB advances cost 2.24%. Thus, CD1 is not only cheaper but has better performance characteristics (below) and has the advantage of bringing new customers to the bank with a positive lifetime value, something that wholesale funding does not do.
First Mover Advantage: The yield curve has steepened and on the verge of getting steeper. Thus, while this product likely does attract a more rate sensitive customer, it is capturing those customers early at the bottom of the market instead of capturing those two years from now when rates are higher. Higher rates are currently in the news allowing OSB to garner more attention from customers and cheaper relative marketing.
The graphic below highlights the number of searches that take place every day. As can be seen by the search engine inquiries, the trend of looking for saving opportunities is up. The green line is the current level of internet searches for “Savings Rates” (it is a similar trend for “CD Rates” and “Deposit Rates”) and 2016 is higher than the previous three years. Further, note the large spike last January. While every January has a spike (which is one reason why we say it is the best time to market bank products), it was December of last year that the Federal Reserve had their first rate hike in this cycle. The move garnered media attention and caused both businesses and households to look for higher rates. This year, we expect that media sensitivity to be even greater, and we predict the interest to hit the purple circle below or greater.
OSB has set themselves up well to not only capture interest before the Fed makes a move but to ride the attention come January. The business or household that moves early, while rate sensitive comes at a lower cost of raising five-year CD money two years from now.
Duration and Convexity: Another significant attribute of the CD1 product is that deposit duration is extended and convexity increased compared to a CD where interest is paid monthly. A traditional CD at a community bank usually has a limited breakage or repayment penalty. As such, in a fast-rising rate environment, investors pay the penalty and reinvest at the higher CD yield. Thus a traditional five-year CD if held to maturity has a duration of approximately 4.7, the effective duration of five-year CDs when issued today with a three-month prepayment penalty has a duration of 2.6. The CD1 instrument, by paying out all the interest upfront, locks the customer in for the complete five years, thus getting an effective duration of closer to 4.7.
Money Upfront Reduces Demand Elasticities: The most important characteristic of this CD is that it defies existing deposit modeling because the depositor gets their money upfront. The nature of the lump sum upfront payment causes the customer to compare their return in terms of dollars instead of rate. Depositors are more sensitive to the differences between two rates such as 2.00% and 2.20% than they are between interest payments such as the difference between $5.204 and $5,747. That is to say that more balances would be attracted by offering a 2.20% rate on a five-year CD than if you offered to pay $5,747 on a $50,000 deposit. The market, by way of convention, compares rate instead of dollars of interest returned.
The CD1 idea is not for every bank or customer segment, but we respect that OSB is experimenting and seeing how the vehicle will perform from both a financial performance standpoint and from a marketing angle. By getting out early in the rate cycle, OSB is smartly locking in funding early, and by paying dollars upfront, the Bank is getting a longer than normal duration while limiting interest rate sensitivities.
In the next part of the series, we will look at another product offering that has been successful in limiting interest rate risk as well as some new pricing strategies to make your deposit base less interest rate sensitive.
Submitted by Chris Nichols on December 08, 2016