You can always tell a good banker by the way they handle their deposits. When it comes to loans, it’s hard to discern expert level skills unless you know the market and know the credit. Deposits, however, are pure. When we analyze a bank, it is normally the first thing we look for as deposit pricing and structure is the one metric that tells you the most about the quality of a bank. A low cost of funds is just part of it. Almost equally important, and lost with most analysts, is the behavior or performance of a bank’s liability base with movement in interest rates. This article is about developing more of those expert level deposit pricing skills.
How To Destroy Bank Franchise Value
The best way to quickly destroy value is to peg a deposit product to an index such as libor, Prime, Fed Funds or Treasuries. You also automatically get a failing grade if you are one of those banks that say, “Our deposit rates will always be in the top 25% of our market” or “We will always be ranked 3rd.” In all these cases, banks completely give up their ability to control their cost of funds and take on the sensitivity of the market (or worse, sometimes more than the market). Each bank faces a different cost structure, market, goals and risk profile so pricing to the market or to other banks never makes sense.
The goal is the complete opposite – have the lowest cost of funds you can with the least interest rate sensitivity and the most positive convexity for your market and target customer base. When it comes to convexity, not only do you want a low cost deposit base whose volume does not change with changing rates but when volume does change, you want more deposits when rates go up and less when rates go down.
You should also be looking forward. This means not only looking ahead for interest rates and sensitivities, but you should design your deposit products and pricing not for the customers you have, but for the customers you want to attract.
Understanding Elasticity or Relasticity
Elasticity is a concept that equates the change in rate to a change in volume. If you move rates up 1%, how much will you increase your volume in that product?
Dr. Dan Geller, the CEO of Analyticom and a man who basically has a PhD. in deposit pricing, points out that you should really be looking at “Relaticity.” Dr. Geller points out that elasticity is best used for commodity like products such as bonds, wheat or oil futures. Elasticity does not capture behavior changes or the concept that customers may substitute product or take a different behavior path. Most important, elasticity is incapable of capturing negative or inverse relationships. This last part is particularly germane because as we pointed out last week on our piece titled The Mistaken Cheapening Of The American Bank Account (HERE), deposit balance changes to rates and fees now have an unprecedented inverse relationship for many products.
Forward Not Back
As Dr. Geller says, you “need to see ahead to stay ahead.” Too many banks just use rate surveys to set their deposit pricing. The better methodology to use is to start with rate surveys and then take the time to understand the forward curve and understand how competitors and customers will react. This behavior forecast is what is missing in many bank’s analysis when it comes to rate setting.
As can be seen by the chart above, deposit rates ticked up when the Fed was expected to move and did so after the Fed did move. Since the first of the year, several large banks have begun to move rates up and we are seeing more and more banks either increase rates or drop fees. The chart above also predicts that deposit rates will continue to increase for the rest of the 2Q. As such, banks should take this into account and be proactive.
From the forecast above, we can now look forward and see where deposit rates could be going. We know by looking at the behavior of our competitors in the past what they are likely to do in the future. This gets us the “Mid-range line” that we see below. Here, we see how this particular market is more sensitive than the market and our competitors will likely increase rates above the forecast. We can also draw the upper and lower bounds of what our competitors are likely to do in order to understand all the potential paths that could be taken. Given the past and the number of banks surveyed, you can have a 98% confidence in this statistical forecast – a forecast that is very accurate.
Putting It Into Action
Later this week, we will show exactly how banks can put the above concepts into action in order to help improve their forecasting methodology. We will also take a look at the Relacticity of several deposit products and help banks understand how to get the most leverage out of their cost of funds.
Until then, bankers should get a sense that setting deposit rates is not a static exercise and should be reviewed every asset-liability meeting as the market, competitor pricing, supply and demand all change in a dynamic fashion. By understanding the past, looking ahead and taking into account behavior, banks can lower their cost of funds while making their deposit base less sensitive – a result that will give you expert-level deposit skills.
Submitted by Chris Nichols on May 17, 2016