Pricing is the single most powerful weapon in your asset/liability arsenal. The pricing decisions you make affect a far greater percentage of both assets and funding than anything you do in the wholesale markets—investments or borrowings. Yet, in many financial institutions, the pricing process works something like this:

It’s Monday morning or whatever day you set your rates. You stick your head out the window, look up and down the street at rates charged or paid by competitors. Having gathered the survey data, your pricing committee collectively grabs the seat of its pants and prices off the competition.

All it takes is one institution that doesn’t know how to price, and everyone in the market is making pricing mistakes. Those mistakes cost most institutions we encounter hundreds of thousands of dollars per year.

The deposit pricing process in most shops is broken and needs to be fixed. Here are some concrete recommendations on how to get started.

Think of Deposits in Sectors
A sector is a grouping of accounts, in which all the accounts included have roughly the same utility to your customers. For example, while you may offer four different kinds of checking products to a consumer, all meet a fundamental need—the need to conduct transactions.

I’d start with four sectors: checking, savings and MMDA, short-term CDs, and long-term CDs.

“But,” you say, “I have different kinds of customers in my MMDAs than in my savings accounts. Why put them in the same sector?” Because both savings and MMDAs meet a similar customer need—the need to segregate balances from checking in a highly liquid account, at a higher rate, with limited transaction capability. You create different accounts within a sector to provide your customers with different value proposition combinations within the sector. These accounts segment the customers within the sector.

Develop a Pricing Strategy for Each Sector
A pricing strategy is made up of two components:

For example, the pricing rule in your short-term CD sector might be, “We price our short-term CDs in the top quartile of the market based on survey data, but no higher than the rates on comparable maturity Seattle Bank bullet advances.” Am I advocating this rule? No, just offering it as an example.

Implement Both Tactical and Strategic Pricing Processes
The strategic pricing process is a quarterly review of the success or failure of the pricing strategies we’re employing in each sector. Based on the review, we may change the product mix within the sector and/or modify the pricing rule. It is in the quarterly strategic review that our pricing process is tied into our ALCO process.

The tactical process is your weekly pricing committee meeting. The weekly decisions involve applying the pricing strategies developed as part of the strategic (quarterly review) process. You don’t have a lot of time to turn the weekly decision—in most shops, a day or less from the time you have survey data in your hands. But you don’t need a great deal of time because you are merely applying the pricing rules you established as part of the strategic process.

When Choosing Between Strategies, Avoid the Most Common Mistakes
As part of the quarterly strategic review, you are considering modifications to pricing strategies. Common mistakes in modifying strategies include the following:

	The committee lacks the appropriate inputs. The most common missing piece is historical data on the relationship between past and current pricing strategies and the effect they have had on demand.
	The decisions are made emotionally. Comments like “The competitors just raised their rates. We must respond!” and “They are some of our most loyal customers. They deserve a rate increase.” are common emotional arguments.
	The decisions are made based on average cost rather than marginal cost. When you raise rates to go after market share, you pay up on existing funds to attract new funds. Thus the real cost of the additional funds is higher than the average rate paid.
	The committee lacks a good set of benchmark rates to use in determining when deposits are well or poorly priced.

Recommendations on Benchmark Rates
Benchmark rates are wholesale market rates you can compare to your deposit rates and those paid by competitors to determine whether deposits are well or poorly priced. We look for answers to three questions in selecting a good set of benchmark rates:

	Does the potential benchmark provide a complete funding curve?
	Is it a true alternative source of funding for your institution?
	Is the data easy to obtain before walking into pricing committee?

The Seattle Bank's bullet advance curve gets an affirmative response to all three questions, and it is what we typically recommend that institutions use in selecting benchmark rates. If you raise funds below rates for comparable duration advances, it will be accretive to your net interest margin. And Seattle Bank bullet advance rates commonly serve as discount rates in marking deposits to market.

Applying Marginal Cost
Say you are paying 0.75% on regular savings. Let’s assume a regular savings duration of four years and a servicing cost of 1%. As I write this article, the four-year Seattle Bank bullet advance rate was 4.45%. At an all-in cost of 1.75% (rate plus servicing), the savings account is priced 2.7% below its wholesale funding alternative.

If you are under pressure to fund growing loan demand, some might argue that you should raise rates on regular savings by 50 basis points to go after additional market share. Average cost advocates would argue that after the rate increase, all-in cost is only 2.25%, still 2.2% below the wholesale benchmark.

But let’s take a look at this recommendation from the perspective of marginal cost analysis. My first question upon hearing the recommendation would be, “How much new money will the pricing action raise?” Be honest. Most of you would respond, “Not much.” Let’s say “not much” translates into a 5% growth in demand from $20 million to $21 million.

Marginal cost is calculated by comparing the pricing alternatives. No calculus or trigonometry is needed here. It’s just grade school math.

I don’t think I need to explain how to multiply balance times rate to calculate annual expense. The difference between the two strategies (subtraction) is that, in the Pay Up strategy, we raise an additional $1 million in balances. Expenses are up by $122,500 per year. Divide the change in balances into the change in expense and you have your marginal cost: $122,500 / $1,000,000 = 12.25%

“How can that be, Farin? You’re saying that there’s a marginal cost of 12.25% when my all-in average cost is 2.25%?” Yes, that’s what I’m saying. You are incurring an all-in cost of 2.25% on the $1 million of new money, costing you $22,500 in additional interest expense per year. You are also paying an additional 0.50% on the $20 million of old money you could have retained at the lower rate, costing you an additional $100,000 per year—for a total additional cost of $122,500.

You just can’t afford to do that. You would save 780 basis points on the $1 million of new funding ($78,000 per year) by borrowing the money from the Seattle Bank instead of raising savings rates in spite of what the average cost comparison implies.

Segment, Segment, Segment
Yes, there’s that dirty word again. I used it earlier. Actually if your institution has more than one deposit account, you already segment. I’ll bet you’ve raised your CD rates significantly in this rising rate environment. I’ll bet you’ve raised regular savings rates nominally, if at all. What message did this send to your regular savings customers? “If you want a better rate, you have to actively manage your money.” The rate sensitive money moves into CDs. The non-rate sensitive money stays in your regular savings service line. Caught you in the act of segmenting, didn’t I?

If you hope to manage your cost of funds effectively in this rising rate environment, while meeting your funding needs, you have to segment. Raising CD rates more than savings rates is segmentation toilet training. And there isn’t room in this article to go through advanced segmentation strategies. But I’ll tell you what. There is a series of deposit pricing articles at the Farin & Associates Web site (www.farin.com). The series goes through everything we’ve discussed in this article, only in far greater detail. You will find six articles with a seventh scheduled to be published in mid-April. Actually, I should refer to the articles collectively as a book, as they amount to nearly 100 pages of material. When you arrive at the Farin site, press the Read More button by the cartoon. At the bottom of the next page will be the most recent article. The Archive link in the top left corner of the page will take you to the other articles.

Be Proactive Rather Than Reactive
As for the savings decision, the solution to high marginal cost dilemma is to introduce a new service line priced at the higher rate. Set a high minimum balance requirement on the new account. The articles explain why. Keep the rate on the existing savings account where it is. Your marginal cost will be driven by how many high balance customers are willing to actively manage their money by moving balances to the new high rate service line. That and how much new money you raise. I’ll leave it to you to run the numbers for that scenario.

But this idea will do you no good unless you have a new service line ready to go when rates rise. In this rising rate environment, I’m a big believer in having some non-maturity accounts in your quiver. By that I mean they are set up on your data processing system, brochures are ready to go to print, and print ads already to go. The arrows are ready. When non-maturity rates lift off, the arrows come out of the quiver and are shot at the rising rate environment.

The time to get ready is now!

Thomas A. Farin is president of Farin and Associates, Inc., financial-services consulting firm that provides asset/liability management solutions, retail product-pricing solutions, and Web-based products and services to banks, thrifts, and credit unions nationwide. He is a widely known banking industry lecturer and consultant. Mr. Farin is the author of three books on financial institution asset/liability management, as well as an asset/liability newsletter. He advises banks, thrift institutions, credit unions, and Federal Home Loan Banks across the country.

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