Usually, in the face of rising rates, banks increase their early withdrawal penalties in an attempt to stem customers from requesting their money back early so that customers can reinvest at higher rates. Increasing withdrawal penalties serve to increase liability duration and help bring convexity closer to zero. In a rising rate environment, this is exactly what you want as a bank. Oddly, banks are doing the opposite.
Early Withdrawal Penalties Are Shortening
Banks facing stronger loan growth and competition for deposits have been decreasing penalties over the last several months. We analyzed the spectrum of certificates of deposit data from MarketRates Insight’s Fee Builder tool to help figure out what is going on. Back in September of 2015, banks charged an average of 177 days of interest. As of the end of last month, those same banks now charge 163 days’ worth of interest, a reduction of 8%.
How It Impacts Duration
From a duration standpoint, reducing penalties decreases liability duration and decreases convexity which banks the bank more interest rate sensitive. Most banks are already 92% correlated to interest rate movement and this correlation would increase the more a bank relies on CDs for funding.
This is a material advantage that brokered CDs have over in-market CDs that have short early withdrawal penalties. Consider that a 2-year brokered CD or a bank CD with the full 2 years of protection provides a duration of 1.97. However, the most common 2-year CD structure in the market is one that provides only 180 days of interest rate protection. If your bank offers this 2-year CD at a 0.75% rate, then should rates go up more than 0.25%, the depositor now has an economic incentive to break the CD and withdrawal the funds from your bank. In similar fashion, as media headlines keep reminding customers about higher rates, your customer might break the CD right now and move their money to one of the many banks that pay over 1%. Whatever the case, only having a 6-month early withdrawal penalty quantitatively reduces the interest rate protection to a duration of 1.36, a 31% drop in value.
However, Some Banks Have Changed
The only maturity that has increased withdrawal penalties are the banks issuing 5-year CDs. Here some banks have increased the penalty from 6 months to 12 months. In addition, some banks have moved to charging a percentage of the withdrawal amount instead of just a day’s calculation of foregone interest. Salem Five, out of Boston, for instance, offers a 0.25% CD with a 4% penalty for early withdrawal. Finally, some banks have quietly moved from charging the penalty rate on just the withdrawn amount to charging the penalty on the total CD amount.
Summing It Up
A CD is a contract for a certain maturity and the penalty helps ensure that contract is fulfilled. Given rising rates, now is the time to make sure your CD structure is where you want it and your penalties are in-line with your goals and your market. This is an area that can get you in trouble if you blindly copy your competition. As the data above shows, the competition isn’t likely executing in optimal fashion.
Submitted by Chris Nichols on December 17, 2015