Recent changes in rates have given bankers a fantastic window into their deposit base. If you are serious about building a more valuable bank, use this time to look at your data in order to see what deposit customers are rate sensitive and which are not. By knowing this, bankers can better market, plan and manage their deposit base in order to achieve better performing liabilities. In this article, we take a look at how banks can analyze their data and what it means.
The Valuable Deposit Base
In banking, we do ourselves a disservice by having everyone face the same pricing, as it assumes that everyone’s preferences, sensitivities, and objectives are the same. The reality is that people, because of sociodemographic class, geography, profession, age or what they had for breakfast, all care about price differently. For example, when it comes to pricing deposits, we highlight the elasticity of two money market accounts at two different banks on a static pool basis (no new accounts are included). We hold constant a dollar amount of $100 million. One bank used to pay 5bp for their money market accounts, while one paid 60bp. Because each bank has selected and trained their respective groups, each has various levels of price sensitivity. This price sensitivity can be seen by the elasticity curve below where price is varied by 10bp and volume adjusted based on historic sensitivities.
If you assume the market price for these money market accounts started off at 10bp, then the money market account that pays 5bp was profitable. The bank that paid 60bp was not profitable and was at a funds transfer cost of about $500k per year.
Not Just Cost, But Performance
Bankers that know how to build a deposit base are keen to not just monitor their cost of funds but their performance. Of the two, performance is more important as a banker would rather pay a higher cost of funds but have superior performance over time instead of the other way around. In our example above, as can be seen, when rates started to rise, even just a little, large, interest rate-sensitive customers that parked money there because of rate, left. To keep these accounts, the bank would have had to keep raising rates in the same proportion of the increase in market rates. In other words, these customers display a beta, or sensitivity, of one.
This is vastly different than the account that started off paying a below market rate. The elasticities on these accounts are much lower. Thus, when rates rise, earnings are immediately improved and run off is limited. Even the most interest rate sensitive customers within this money market account have a beta of around 20%. Thus, for every 10bp of upward market movement, rates on the account would have to rise 2bp, to keep these accounts static.
The money market account that paid 60bp a couple years ago had a set of customers that are more sensitive to rates, exhibited a much shorter duration and a much lower convexity. Thus, they are now seeing a huge run off with just a slight increase in rates. The account that started at 5bp had customers that were largely focused on service and use the money market account as a parking space for their cash. As such, when rates rise, customers maintained their balances, thereby creating more value for the bank.
Segmentation Based on Elasticities
Most likely, your bank contains both sensitive and not so sensitive customers within each account type and each tier. The trick is to understand how these balances perform with rate movement and then segment according to sensitivity. Now is the time to go back and look at your deposit accounts and see how balances are changing with the recent upward movement in rates. From here, accounts are only going to get more interest rate sensitive so it pays to know which accounts are more likely to run off in the future. Further, now would be the good time to recognize the characteristics of your more rate-sensitive accounts. Maybe it is geography, maybe balance size or maybe demographics.
We see a day in the future where each account is offered customized pricing optimized for their individual sensitivities and needs. While this is now largely the domain of large banks, community banks will soon start down this path.
Until then, if you have not done so already, it pays to employ some of the many strategies to start to reduce the rate and replace balances with lower priced and less sensitive customers. In this manner, both funding cost and sensitivities can be reduced making your bank more profitable when rates further rise.
Submitted by Chris Nichols on June 14, 2018