The Big Mistake When Pricing Deposits
Many banks work hard to have a low-cost deposit base only to undermine their efforts. One of the biggest mistakes bank make when pricing deposits is advertising an above-market rate, thereby shortening deposit duration and increasing negative convexity for that one account and the whole product offering. This subtle distinction might be lost on many inexperienced bankers, and it is worth a review – while the rate impacts an account, the mere advertising also affects the account.
Pricing Deposits High – Maybe The Customer Is Worth It?
Consider a money market account at a bank. In order to keep a customer with a $75,000 balance, the account representatives extends a rate of 1.75%. In today’s market, that rate is not that competitive to a top-paying bank as that range is 3.20% to 4.11%, but it is far above a national bank (around 0.25%) and above the nation’s 0.15% average bank rate for January of 2023. That 1.75% money market account likely has a duration of 0.18. This means that when rates go up, the account is going to gain little in value because that money can travel to another bank at any time. While this could be better, it is not the worst thing as maybe the customer is worth keeping, and that is the rate required.
But, Maybe The Whole Deposit Base Isn’t
However, our point today is that as soon as you post a rate, that makes all other accounts more interest rate-sensitive and results in cannibalization. Money from not only other money market accounts come in, but money from checking, savings, or 3-month CDs flow into this account. The higher the rate and the better you are at advertising, the more value your bank will lose in deposits. The big point here is that when you set and advertise a rate on one account, it could negatively impact the entire deposit base, multiplying your cost, sometimes geometrically.
Does It Work In Reverse When Pricing Deposits?
Of course, posting a lower-than-average market rate should have the opposite effect. Yes, posting a lower-than-average rate compared to the rest of your deposit base allows other deposit holders to feel special about their rate and aids in retention. The problem is, again, the mere act of advertising rate shortens duration over time, no matter what rate you post. While duration will increase on some deposit accounts if you post a lower rate than they currently enjoy, many of those accounts will then start to focus on rate and become more rate sensitive. The net result is that while posting a low rate may help for a short period, over a longer period, banks posting any rate trains their accounts to be more rate sensitive.
The Worst Part About Rate Advertising
While advertising on rate has a detrimental impact on deposit performance, where the real unseen tragedy lies when pricing deposits is in what advertising a rate does to employees. Post an aggressive rate, and the whole staff starts to believe that rate, not service, is the most important. Talk to almost any Ally Bank or Capital One employee, and they will crow about their deposit rates. Ally and Capital One can get away with this because of their business model, but most banks can’t.
Once a bank’s staff learns that rate is essential, it is hard to change internal behavior as it can take years. In the meantime, employees teach other employees and customers about the importance of rates. As they do, deposits become more sensitive, and a bank loses value.
Putting This Into Action
The biggest mistake when pricing deposits is advertising rate. Controling deposit costs is the third most important thing you can do in 2023 (our top 5 HERE).
Now is the time to be extremely careful, as having low rates for so long has made the average bank depositor less sensitive to rates in general. Pricing deposits effectively includes being aware of how you present rate to customers. By posting any rate, we train our employees and customers to be rate sensitive and introduce a price element to your deposit base. It is far better to stay away from advertising rate entirely.
If you want to advertise, market any other aspect – product attributes, service, flexibility, community, branches, or other aspects of your bank’s value proposition. Doing so will only dissuade the more rate-sensitive customers while attracting those customers that are non-rate-sensitive. The result will be a better-performing bank for years to come.