Limited Time Offer: Save 10% on all 2022 Premium Study Packages with promo code: BLOG10

# Managing And Pricing Deposit Services

After completing this reading, you should be able to:

• Differentiate between the various transaction and non-transaction deposit types.
• Compare different methods used to determine the pricing of deposits and calculate the price of a deposit account using cost plus profit margin, marginal cost, and conditional pricing formulas.
• Explain challenges faced by banks that offer deposit accounts, including deposit insurance, disclosures, overdraft protection, and basic (lifeline) banking.

## Transaction and Non-Transaction Deposit Types

There are three broad categories of deposits offered by banks and other deposit institutions. These include:

1. Transaction (Payments or Demand) Deposits
2. Non-transaction (Savings or Thrift) Deposits
3. Retirement Savings Deposits

We discuss them in the following sections:

### I. Transaction (Payments or Demand) Deposits

A transaction deposit is an account used primarily to make payments for purchases of goods and services. The financial-service providers must instantly honor whatever withdrawals a customer makes in person, or by a third party chosen by the customer to be the recipient of funds withdrawn.

Transaction deposits are further divided into noninterest-bearing transaction deposits and interest-bearing transaction deposits.

• Noninterest-bearing demand deposits: offer customers payment services, safekeeping of funds, and recordkeeping for any transactions committed by card, check, or an electronic network. They are the most volatile and unpredictable source of funds.
• Interest-bearing demand deposits: offer all the services provided by noninterest-bearing demand deposits and pay interest to the depositor. Additionally, they give the depository institution the right to ensure a prior notice before any withdrawal of funds by customers. They are subdivided into:
• Negotiable orders of withdrawal (NOW) accounts;
• Money market deposit (MMDA) account; and
• Super NOW (SNOW) account.

### II. Non-transaction (Savings or Thrift) Deposits)

Savings or thrift deposits have features that attract funds from customers who wish to reserve money in expectation of future expenditures or for financial emergencies. In other words, a thrift account is an account whose primary purpose is to encourage the bank customer to save rather than make payments. Compared to transaction deposits, non-transaction deposits usually pay substantially higher interest rates and are less costly to process and manage for the offering institutions.

Non-transaction deposits are split into:

• Passbook savings deposits: pay the depositor a competitive interest rate. A physical notebook, called a passbook, accompanies the depositor to monitor (track) the flow of funds into and out of the account.
• Statement savings deposits: include transactions involving deposits, withdrawals, and interest earned, which are recorded as computer entries. The depositor receives a regular statement of account, showing all transactions up to the posting date. However, unlike passbook savings deposits, the depositor does not receive a passbook evidencing ownership of the account.
• A time deposit: also known as a certificate of deposits in the United States, is a bank deposit that has a specified period to maturity and bears interest. This deposit cannot be withdrawn for a specific term unless a penalty is paid.

### III. Retirement Savings Deposits

Retirement savings deposits can be categorized into three:

• Individual retirement account (IRA): Salaried and wage-earning individuals make tax free and limited contributions each year to this account type, offered by depository institutions, brokerage firms, insurance companies, and mutual funds, or by employers with a qualified pension or profit-sharing plans.
• Keogh Plan: Self-employed individuals or businesses have access to a tax-deferred pension plan called a Keogh Plan for retirement purposes. It can either be a defined benefit or a defined contribution plan.
• Roth IRA: This is a retirement savings account that is tax-advantaged. In other words, it permits an individual to withdraw their retirement savings tax-free.

The main difference between Roth IRAs and traditional IRAs is that Roth IRAs are financed with after-tax dollars. This means that the contributions are not liable to tax-deductions, but once one starts withdrawing funds, the money is tax-free. Conversely, traditional IRA deposits are made with pre-tax dollars. This implies that an individual is liable to a tax deduction on their contribution and consequently pays income tax when they take out money from the account when they retire.

Interest rates on deposits majorly depend on:

• The maturity of the deposit;
• The size of the depository financial institution;
• The risk of the depository institution; and/or
• The marketing philosophy and goals of the depository institution.

Core deposits are a stable base of funds that are not highly sensitive to market interest rate fluctuations and which tend to remain with the bank. The following figure illustrates the core deposits.

## Methods Used to Determine the Pricing of Deposits and Calculation of the Price of a Deposit Account

The main goal of depository institutions is to price their deposit services in a way that attracts new funds and makes a profit. The management faces a difficult decision-making scenario as it has to balance between the institution’s needs to pay a high enough interest return to attract and hold customer funds, at the same time, avoid paying an interest rate so costly it erodes any potential profit margin.

However, financial institutions are price takers, not price makers in a perfectly competitive market. The management must, therefore, decide if it wishes to attract more deposits and hold all those it currently has by offering depositors at least the market-determined price, or whether it is willing to lose funds.

Methods of calculating the price of a deposit account are discussed below:

### Pricing Deposits at Cost Plus Profit Margin

Cost-plus deposit pricing encourages banks to determine the costs they incur in labor and management time, materials, among others, in offering each deposit service. Cost-plus pricing typically calls for a bank to charge deposit service fees enough to cover all the costs of providing the service in addition to a small margin for profit.

Every deposit service may be priced high enough to recover all or most of the cost of offering that service, using the following cost-plus pricing formula:

\begin{align*} & \text{Unit price charged the customer for each deposit service} \\ & =\text{(Operating expense per unit of deposit service} \\ & + \text{Estimated overhead expense allocated to the deposit service function} \\ & + \text{Planned profit margin from each service unit sold)} \\ \end{align*}

The above equation ties deposit pricing to the cost of deposit-service production, which has encouraged deposit providers to keenly match prices and expenses and eradicate many formerly free services.

Nowadays, most depository institutions charge for excessive withdrawals, customer balance inquiries, bounced checks, and ATM usages, as well as raising required minimum deposit balances, among others. These trends have been favorable to depository institutions.

#### Example 1: Cost Plus Profit Pricing

ABC savings bank determines that its basic checking account costs the bank $3.00 per month in servicing costs (assume the servicing costs are labor and computer time) and$2.00 per month in overhead expenses. This account requires a $600 minimum balance. Additionally, the bank also tries to build a$0.60 per month profit margin on these accounts.

Determine the monthly fee that the bank should charge each customer.

#### Solution

Breaking down the information given in the question.

Operating expense per unit of deposit service = $3.00 Estimated overhead expense allocated to the deposit service function =$2.00

If the bank saves about 5% in operating expenses for each $150 held in balances above the minimum of$600, then a customer who maintains an average monthly balance of 1,200 saves the bank 20% in operating expenses. $$\text{New operating expenses} = 3.00 – (20\%×3.00)=2.40$$ The appropriate amount that the bank should charge to protect its profit margin is therefore $$\text{Monthly fee} = 2.40 + 2.00 + 0.60 = 5.00 \text{ per month}$$ ## Using Marginal Cost to Set Interest Rates On Deposits Many financial analysts would argue that the marginal cost, and not the historical average cost, should be used to price deposits and funding sources. This is because frequent fluctuations in interest rates make historical average cost an unreliable standard for pricing. The marginal cost formula is as follows: \begin{align*} \text{Marginal cost} & = \text{Change in total cost} \\ & =\text{New interest rates}×\text{Total funds raised at new rate} \\ & – \text{Old interest rate× Total funds raised at old rate} \\ \end{align*} Where, $$\text{Marginal cost rate} =\cfrac {\text{Change in total cost}}{\text{Additional funds raised}}$$ #### Example: Using Marginal Cost to Set Interest Rates on Deposits A bank that has a base amount of savings deposits of50 million and currently pays 8% rate on these funds. The bank seeks to raise additional funds but will have to increase the interest rate as the amount of cash raised increases. Management anticipates an investment yield of 10% after investing deposits.

$$\small{\begin{array}{l|c|c|c|c|c|c|c} \bf{\text{Funds} \\ \text{Raised}} & \bf{\text{Average} \\ \text{Rate} \\ \text{Paid} } & \bf{\text{Total} \\ \text{Interest} } & \bf{\text{Marginal} \\ \text{Cost} } & \bf{\text{Change in} \\ \text{Total} \\ \text{Cost} } & \bf{\text{Expected} \\ \text{Revenue} } & \bf{\text{Difference} \\ \text{Expected} \\ \text{less} \\ \text{Marginal} } & \bf{\text{Total} \\ \text{Additional} \\ \text{Profit} } \\ \hline {50m} & {8.0\%} & {4m} & {4m} & {8.0\%} & {10.0\%} & {2.0\%} & {\1m} \\ \hline {100m} & {8.5\%} & {8.5m} & {4.5m} & {9.0\%} & {10.0\%} & {1.0\%} & {\1.5m} \\ \hline {200m} & {9.0\%} & {18m} & {9.5m} & {9.5\%} & {10.0\%} & {0.5\%} & {\2m} \\ \hline {300m} & {9.5\%} & {28.5m} & {10.5} & {10.5\%} & {10.0\%} & {-0.5\%} & {\1.5m} \\ \hline \end{array}}$$

The calculations are as follows:

\begin{align*} \text{Total interest} &= \text{Funds raised}×\text{Average Rate Paid} \\ &=50,000,000×8.0\%= 4,000,000 \\ \end{align*}

\begin{align*} \text{Marginal cost} & = \text{Change in total cost} \\ & =\text{New interest rates}×\text{Total funds raised at new rate} \\ & – \text{Old interest rate× Total funds raised at old rate} \\ & =(8.5\%×100,000,000)-(8.0\%×50,000000)=4,500,000 \\ \end{align*}

For the second case,

$$\text{Change in Total Cost} =\cfrac {4,500,000}{100,000000-50,000000}=9.0\%$$

### Basic (Lifeline) Banking

Basic (lifeline) banking is the low-cost deposits and other services designed to meet the banking needs of customers who cannot afford standard bank service offerings. These services carry low service fees and usually do not provide all the components of banking services which carry full-service charges.

The compulsion on managers to offer essential banking services has triggered an extensive controversy. From a profit-making perspective, banks should only provide valuable (profitable) services. On the other hand, the government partially subsidizes financial institutions in the form of low-interest loans and deposit insurance. This obliges them to some public-service responsibilities, which may include providing certain essential services to all liable customers, regardless of their income or social status.

### Deposit Insurance

As mentioned in the previous subsection, it is the responsibility of financial institutions that take deposits to provide lifeline financial services. This has been incorporated in the new legal requirements to serve the local community entirely. Furthermore, essential aids may be extended to depository institutions from the government, granting them a competitive advantage over other financial institutions. If depository institutions benefit from protection backed ultimately by the public’s taxes, they have a public responsibility to provide some services that are accessible to all.

### Overdraft Protection

Overdraft fees and revenue have skyrocketed over the past decade. However, there is no evidence that banks have been earning profits or “rents” from the growing overdraft protection usage. On the contrary, there is an emerging competitive market for overdraft protection among banks offering overdraft services and with comparable products, such as payday lending. There is no evidence of reasonable returns to the banking industry, generally from the growth of overdraft protection.

### Disclosures

The Truth in Savings Act of 1991 requires depository institutions to make greater disclosure of the terms attached to the deposits they sell the public. Specifically, it requires consumers to be informed of the deposit terms before they open a new account.

Under this act, depository institutions must disclose:

1. The minimum balance required to open the account;
2. The minimum needed to be kept on deposit to avoid paying fees;
3. How the balance in each account is figured;
4. When interest begins to accrue;
5. Any penalties for early withdrawal;
6. The options at maturity; and
7. The annual percentage yield (APY).

### Annual Percentage Yield

The annual percentage yield is calculated using:

$$\text{APY earned} =100 \left[ 1 +\cfrac {\text{Interest earned}}{\text{Average account balance}^{\frac {365}{\text{Days in period}}} } -1 \right]$$

where the account balance is the average daily balance held in the deposit for the period covered by each account statement. Customers must be informed of the effect of early withdrawals on their expected APY.

#### Example: Annual Percentage Yield

James Leo is a customer at ABC Savings Bank Limited. Leo holds a savings deposit in the bank for a year. The balance in the account stood at $3,000 for 200 days and$150 for the remaining days of the year.

Assuming that ABC Bank paid Leo 10.05 in interest earnings for the year, what APY did Leo receive? #### Solution The correct formula is: \begin{align*} \text{APY earned} &=100 \left[ 1 + {\left(\cfrac {\text{Interest earned}}{\text{Average account balance}}\right)}^{\frac {365}{\text{Days in period}} } -1 \right] \\ \text{Average account balance} & =\cfrac {(3,000×200 \text{ days})+(150×165 \text{ days})}{365 \text{ days}}=1,712 \\ \text{APY} & =100\left[ { \left( 1+\frac { 10.05 }{ 1,712 } \right) }^{ \frac { 365 }{ 365 } }-1 \right] =0.59\% \\ \end{align*} ## Practice Question Abacca Bank determines that its basic checking account costs the bank3.00 per month in servicing costs (assume the servicing costs are labor and computer time) and $2.00 per month in overhead expenses. This account requires a$500 minimum balance. Additionally, the bank also tries to build a $0.50 per month profit margin on these accounts. Further analysis of Abacca Bank customer accounts reveals that for each$100 above the $500 minimum balance maintained in its checking accounts, the bank saves about 6% in operating expenses with each customer account. For a customer who is consistent in maintaining an average monthly balance of$700, how much should the bank charge to protect its profit margin?

A. $3.14 B.$4.64

C. $2.64 D.$5.14

If the bank saves about 6% in operating expenses for each $100 held in balances above the minimum of$500, then a customer who maintains an average monthly balance of \$700 saves the bank 12% in operating expenses.

$$\text{New operating expenses} = 3.00 – (12\%×3.00)=2.64$$

The appropriate amount that the bank should charge to protect its profit margin is therefore:

$$2.64 + 2.00 + 0.50 = 5.14 \text{ per month}$$

Featured Study with Us
CFA® Exam and FRM® Exam Prep Platform offered by AnalystPrep

Study Platform

Learn with Us

Subscribe to our newsletter and keep up with the latest and greatest tips for success
Online Tutoring
Our videos feature professional educators presenting in-depth explanations of all topics introduced in the curriculum.

Video Lessons

Daniel Glyn
2021-03-24
I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
michael walshe
2021-03-18
Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
Nyka Smith
2021-02-18
Every concept is very well explained by Nilay Arun. kudos to you man!