Earlier this week (HERE), we laid the foundation and highlighted the finer skills needed to be an expert in deposit pricing. We talked about how banks destroy value by indexing deposit rates, how banks need to look forward when setting rates and that how understanding depositor behavior is usually the missing piece of deposit pricing. Also, last week, we highlighted how many banks are unknowingly cheapening the deposit account for no good reason as the relationship between fees and deposit balances are negative for many products. In this article, we put it all into practice while highlighting a few more tactics that can help your bank not only lower their cost of funds, but also create a less sensitive deposit base. Using this analysis, your bank can achieve optimal deposit pricing.
Understanding Deposit Product Sensitivity
As we discussed, more important than understanding product elasticity is understanding “Relasticity,” a concept promoted by Dr. Dan Geller at Analyticom. Relasticity is similar to elasticity in that it is a numerical measure of price/volume sensitivity, but different from elasticity, Relasticity takes into account depositor behavior and allows for an inverse relationship. This is important as these days, many deposit products have inverse relationships to price and volume. In these cases, dropping rates may result in an increase in deposit balances, while increasing rates may only result in higher deposit costs.
For example, 5-year certificates of deposits (CDs) have a Relasticity of 0.55 for the month of April, while 3-year CDs come in at 0.40. This means that all things being equal, your 5-year CDs are more sensitive to rate movement which makes sense. The interesting thing is that they are not that much more sensitive.
In comparison, savings accounts have a -0.19 Relasticity, while checking comes in at -0.32. This means that banks that are trying to market on rate for these products are largely a wasting their time and money. The public isn’t sensitive to rate in this area and by increasing your rates you are likely to get the same volume as if you left rates alone. When an inverse relationship exists, it underscores the fact that to grow deposit balances you should be marketing on everything but rate. Promoting the brand, highlighting product attributes, your service/convenience or anything else will result in a greater response than rate.
Conversely, if you were going to market on rate (and we don’t advise it), then targeting your 5-year CDs will at least give you the greatest bang for your buck. Long-term savers like the 5-year area of CDs and they tend to be rate sensitive. By moving up your rate you will see a heighten response versus other area of the curve. This includes longer term CDs that you would think would be more responsive but the rate differential required to attract new money is even greater.
Putting It Into Practice In Florida
Now let’s put it into practice. We will take premium money market accounts as an example. The product currently has a Relasticity of -0.36 (April), or very strongly inversely correlated to rate. Thus, we can calculate optimal pricing where we can gain the most deposit balances without wasting our money. Below is a rate survey from MarketRates Insight. This shows CenterState Bank and most of our competitors for the premium money market account in Florida.
Florida, like many other states, has a large number of banks paying much more than they have to. The reaction to pay more than you need is usually born out of a feeling of deposit insecurity. Seeing strong loan volume usually allows a banker to conclude that they must raise their rates in order to attract more deposits to fuel the growth. These bankers likely reach this conclusion irrespective of rate sensitivities. If they either looked at the data or tested sensitivity themselves, they would likely find that about 0.22% is the maximum a bank would want to pay. Above that, and their franchise value erodes faster than the value of the higher priced deposits they are trying to attract.
Below the maximum, it is up to each bank to find their sweet spot given their customer base, geography and goals. For CenterState, we place most of our effort on DDA accounts and so deemphasize our money market accounts. Paying 0.10% makes us competitive without suffering any runoff.
Don’t Make This Mistake
Finally, it is worth mentioning that a bank could be doing everything right, but just have bad data. It is not uncommon to find that a banker set their rates according to their rate survey, but the rate survey contained a “fruit basket” of different accounts mixed in. As a result, a bank may be unknowingly using a survey that contains jumbo and premium account types and the bank ends up setting their rate too high.
Managing your deposits is the most important thing you can do as a banker. A strong deposit base can drive an enormous amount of franchise value and contribute multiple times more ROE than compared to loans. Having good analytics and good data is central to this mission. Finally, keep in mind that the analytics change. Strong economic data, media hype and an improving economy tend to serve to increase sensitivities and change elasticity / Relasticity calculations. As behaviors and outlooks change, so does the response of volume and rate.
Asset-liability committees that are on top of their deposit pricing game will be proactive in managing their deposit portfolio and work each product in order to optimize total return value.
Submitted by Chris Nichols on May 19, 2016