Many banks have their certificates of deposits modeled on their asset-liability systems without optionality. That is, they treat the final maturity as gospel with little weight given towards repayment. This could be a mistake, as just assuming the forward curve is accurate, CD’s are set to exhibit about a 20% shorter duration than modeled. In a rising rate environment, banks are short the option value of a CD and thus are exposed to a market loss in the form of opportunity cost should the investor redeem early. Of course, the early withdrawal penalty offsets some of this risk, but many banks have little or no protection in this department.
If rates go along the forward curve, many CD depositors will weigh the small penalty against the higher interest rates and decide to redeem early. Banks are worried about losses on loans and investments, but few pay attention to their liability structure, as if not having sufficient penalties is akin to not having any prepayment protection on a loan.
Part of the problem comes from our historic low rates. Given the environment, customers have become less sensitive. If you doubt this, try an experiment – change your rates by 30% and see what happens – not much. Given low interest rate apathy and the fact that a 30% change does not motivate customers to switch banks – small changes in this environment mean little. However, once the media starts focusing on rising rates, coupled with the fact that a 30% change in rates means more at 1.0% than it does at 0.1% and you have the makings of negative convexity in a liability.
A quick informal survey done this week revealed that more than 50% of the banks have penalties of 90 days interest or less with almost 30% of the banks having penalties of 30 days. By 2015, rates may be making some big swings and paying a 1 month penalty won’t matter if customers can gain another 1% on their funds with a new CD investment.
On the other side of the equation, having little or no CD penalties is a huge plus for investors and is a good reason to invest in CDs instead of Treasuries. Here, while many banks price along the Libor or swaps curve to set their CD rates, they should really be pricing below the rate on Treasuries for FDIC insured CDs. Given the insurance, investors have the full faith and credit of the US Government PLUS the ability to pay only a 1 month penalty at many banks. If the CD investor were holding Treasuries instead, they would be subject to market conditions and take a much bigger loss than 1 month worth of interest in a rising rate environment. Our point here is that if you are not willing to charge penalties, then banks should consider marketing that attribute and pricing CDs accordingly.
Studies show that CD investors are more sensitive to rate than to early withdrawal penalties. As such, the solution is larger penalties. Depending on the sensitivity of the customer base, penalties should be at least equal to 6 months’ worth of interest if not 12 months. This covers small rate movements of 25bp and 50bp depending on remaining maturity (mostly for CDs with under 2 years left).
However, to cover longer term CDs (i.e. 4-years and greater) or larger movements of more than 1%, then a greater penalty on CDs that are more than a year is probably in the bank’s best interest. An example might be a fixed charge of $100 plus 3% penalty on the withdrawal amount. This structure decreases the option’s value and extends the CD’s duration to near its final maturity to take into consideration the current forward curve. This covers the bank in all but the largest interest rate increases. Of course, having the penalty equal to the replacement value or having the full remaining interest deducted from the principal balances solves most of this problem in all maturities and with any rate move.
While we are not for heaping penalties on customers, a CD is a contract that should be strengthened, otherwise the bank is exposed to rising rates. This is only fair, since the CD investor is expected at origination to keep their money with the bank for a period of time. Without the proper penalty structure, the average bank exposes its balance sheet to an average of 10% capital impact on CDs with maturities of 2-years to 10-years. In a rising rate environment, banks are already going to take a hit on their fixed rate loan portfolio. By using more stringent penalties, banks can present a similar impact on the liability side of their balance sheet.
Submitted by Chris Nichols on February 05, 2014