Raise Rates or Stand Pat: What's Your Deposit Pricing Game Plan?

It's playoff season, and as we consider the deposit pricing problem posed in our last issue, we're reminded of some words of advice from the inimitable Yogi Berra: "When you come to a fork in the road, take it." What do Yogi's words have to do with your deposit pricing strategy?

In our last issue, we posed a scenario that many financial institutions face in a rising rate environment: you’re currently pricing your six-month CDs at 1.0%. A sudden upward shift in rates has increased wholesale advance rates by 50 basis points (from 1.25% to 1.75%) and prompted your competitors to raise their six-month CD rate to 1.25%. Let’s further assume that six-month CDs comprise $10 million of your funding base. Should you match the competition in an effort to stem the exit of your valued depositors?

What’s the Cost of Standing Pat?
If you elect to stand pat, what level of deposit attrition should you expect? By not raising rates and pricing below the current market, you might experience a certain amount of attrition—say 5% if your depositors are not rate sensitive, or 35% if they are. In the case of a 5% rate of deposit attrition, your deposit balances would drop by $500,000. Your cost of standing pat is represented by the need to replace any lost funds through alternative sources, ideally at the lowest marginal cost.

What’s the Cost of Raising Rates?
There are two costs associated with raising your CD rates by 25 basis points to match the competition. First, you’ll have to pay 25 basis points above previous levels to preserve the remaining balance of $9.5 million ($23,750). You’ll also be facing an opportunity cost of retaining the $500,000 at 1.25% ($6,250), that would have been lost had you elected to stand pat. So, your total cost of proceeding with a strategy to match the competition is $30,000.

Any pricing changes you make represent the combined incremental or marginal changes from existing, departing or new funds. If you decide to match a competitor’s rate, you have to identify the increase in total deposit costs relative to the retained funds that otherwise would have been lost. The formula looks like this:

Marginal Cost of Matching Competition in Rising Rate Environment =
((Incremental Cost of Preserving Remaining Balance) + (Opportunity Cost of Retaining Balances)) / (Forecast Reduction in Balances if No Increase in Deposit Rates)

In our example, the marginal cost of matching the competition would be: ($23,750) + ($6,250) / ($500,000) = .06. Suffice it to say, a marginal cost of 6% is significantly higher than your incremental source of funding (e.g., the current six-month Seattle Bank advance rate of 1.75%).

It All Depends
So, here's the $64,000 question. At what attrition point does it make sense to invoke a price increase of 25 basis points? Your answer is directly dependent upon one observation: when electing to raise rates, the greater the proportion of non-rate-sensitive money to rate-sensitive money, the higher the marginal cost of the new funds.

Let’s now assume that a much higher percentage of your depositors are rate-sensitive and that by standing pat and pricing below the current market, you expect to see a 35% rate of attrition. In this case, you’d calculate the marginal cost of matching the competition in a rising rate environment as follows:

Incremental Cost of Preserving Remaining Balance = ($6,500,000 * .0025) = $16,250
Opportunity Cost of Retaining Balance = ($3,500,000 * .0125) = $43,750
Forecast Runoff in Balances if No Increase in Deposit Rates = (.35 * $10,000,000) = $3,500,000
Marginal Cost of Matching the Competition = ($16,250 + $43,750) / ($3,500,00) = .0171

If you were faced with losing 35% of deposits as a result of failing to match the competition, the marginal cost of matching the competition would reduce to 1.71%. At this attrition rate, the marginal cost is slightly less than the cost of incremental funding (e.g., the current six-month Seattle Bank advance rate of 1.75%). At the 35% level of runoff, it would make sense to consider raising rates on the CD.

The Seattle Bank has an Excel-based program that readily makes these calculations. Contact Dave Kidd (206.340.2471), or John P. Biestman (206.340.2473) for more information.

The Wild Card: Estimating Your Run-off Rate
As we’ve discussed, deciding whether or not to raise rates depends on your comparison of the marginal cost of matching the competition with the cost of alternative incremental funding (i.e., the wholesale advance rate). The wild card in this process is estimating your runoff rate. This is a complex and somewhat inexact process, but there are several variables you can use to help you estimate your proportion of rate-sensitive to non-rate-sensitive accounts:

Types of deposits. CD holders are often more rate sensitive than holders of MMDAs, DDAs and other products without defined maturity dates that have direct deposit or check-writing features, which help to retain customers.
Competing return levels from both bank and “non-bank” institutions. It’s not just the bank across the way that raised the six-month CD by 25 basis points. The competition is frequently just a “click away”—and may not be a bank.
Length of relationship with depositor. Generally speaking, length of customer relationship is inversely correlated with rate sensitivity.
Number of other products used by the depositor. Generally, the more products used by a customer (e.g., automatic payroll deposit), the less their degree of rate sensitivity.
Historical frequency of roll-overs at previous or lower-than-previous rates. Past propensity to rollover at previous rates during historical rate rises indicates less rate sensitivity.

The latter can be monitored by tracking specific deposit balances by product type, along with their corresponding rate histories during times of rate instability. Various service providers (e.g., Farin & Associates-iPrice and McGuire Performance Solutions) can analyze historical deposit behavior and estimate deposit runoff levels via econometric modeling.

Know the Other Players: Segment and Target Your Markets According to Rate Sensitivity of Depositors
You’d be making a mistake if you targeted both your rate-sensitive customers and your non-rate-sensitive customers with a “stay-the-course” pricing policy. At the end of the day, your job is to hold on to market share and not pay more for funding than you need to.

Let’s consider the example of the airline industry. While this industry is often maligned for many aspects of their service, it is increasingly doing one thing right: segmenting the price-sensitive versus the non-price-sensitive markets, and developing product strategies accordingly. Many airlines now offer constant “Web specials” that are aimed at their most price sensitive customers. These specials typically offer destinations that vary from week to week and target customers that regularly shop for the best rate online. Here’s an industry that's providing the best price for rate sensitive customers, without having to provide the best price to non-rate-sensitive customers.

The same concept can apply to effective deposit pricing. Practically speaking, how could your institution best segment rate-sensitive and non-rate-sensitive depositors? By paying the best rate, not the best rates across the board. Here are some steps you can take:

1.
 Consider reducing rates for your “on-the-run" maturity CDs. Access market data to price below the median for your market. One such source of competitive information is Informa Research Services (www.informars.com), which conducts daily surveys of your competitors’ deposit and loan products.
2.
 Initiate a program of “off-the-run" maturity CDs. Price these CDs well into the upper quartile of your market. When renewal notices are remitted to depositors, your non-rate-sensitive customers will likely roll over their deposits.
3.
 When rate-sensitive customers tell your institution not to roll-over a deposit and specify pricing reasons, present them with an unadvertised special—an “off-the-run” maturity CD—a CD with an odd renewal period.
4.
 CD specials, if offered at all, should be offered when expected roll-over balances are low to minimize cannibalizing existing CD accounts. CD balances coming off specials should be rolled into a regularly priced CD. You'll not only have a tidier balance sheet, but you'll also place the onus of rate sensitivity back on the depositor at the time of the next renewal.

The Name of the Game: Minimizing Your Cost of Funds at the Margin
When rates are rising, it’s all to common to use average cost of funds and match the competition's thinking when setting deposit rates. This thinking, however, results in higher deposit costs and lower profits. Remember: the name of the game is to minimize your cost of funding at the margin. You can do this by implementing a proven strategy used in other industries and segment your market between price-sensitive and non-price-sensitive customers. You may find you've underestimated the rate sensitivity levels of your depost base and be pleasantly surprised that a decision to stand pat really pays off.

So, do you raise rates to match your competition or stand pat? According to Yogi, “If you can’t imitate him, don’t copy him.”

John Biestman is an IMS consultative sales advisor at the Federal Home Loan Bank of Seattle.