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Avoiding the Pitfalls in Innovative CDs
By Tom Farin, President, Farin & Associates
You can tell loan demand is accelerating and funding is getting tighter. CDs are growing so many warts (i.e., imbedded options) that they are beginning to look like toads. Let’s discuss some of the options being used to sweeten CD offerings that potentially place a significant number of land mines in your institution’s CD portfolio.
Before we get started, let’s spend a minute on the difference between retail and wholesale options. When you sell an option to a player in the wholesale markets (like the Seattle Bank), there is a professional money manager on the other side of the transaction. If you borrow 10-year money from the Seattle Bank that grants the bank the option to put your debt back to you after one year, you can be almost certain the option will be exercised if it is to the bank’s advantage. It isn’t personal, it’s just business.
On the other hand, consumers are not professional money managers. And because they are distracted by life, may procrastinate, and are often not up to doing sophisticated financial analysis, they won’t always exercise an option when it is to their advantage to do so. To a great extent, when we offer these options to consumers, we count on only a portion of customers exercising in-the-money options.
Early Withdrawal Options
Virtually all CDs issued by financial institutions include at least one option: an early withdrawal option. This option generally calls for a penalty if the consumer exercises the option. Your customers may wish to cash in a CD early and reinvest the funds at higher rate in a rising rate environment. The benefit of reinvesting at a higher rate is a factor of the remaining term of the CD, the coupon rate on the CD, the difference between the coupon rate and reinvestment rates, and the size of the penalty. Those of you attending the Seattle Bank’s upcoming Deposit Pricing seminar series will receive a model that allows you to evaluate the adequacy of your CD early withdrawal penalties.
Fully or Partially Penalty-Free Withdrawal Options
These options allow a customer to withdraw all or a percentage of balances in a CD without penalty. The greater the percentage that can be withdrawn and the longer the term of the CD, the more dangerous this option is to the issuing institution. The concern here is that you may be forced to seek alternative sources of funding in a rising rate environment. Inadequate early withdrawal penalties on long-term CDs used to fund fixed-rate mortgages were a major contributing factor to the thrift crisis in the late 70s and early 80s. If you are considering an unlimited no-penalty, early withdrawal option, limit this option to your shortest-term CDs. If you offer a penalty-free withdrawal on longer-term CDs, we recommend you limit the percentage that can be withdrawn to no more than 20% of the original deposit.
Add-On CD Options
Add-on CD options allow a customer to add balances to a CD after its opening date. New balances receive the same rate as the original coupon rate on the CD. This option works to the institution’s disadvantage for two reasons. First, new money is priced off the full-term point of the yield curve, rather than the point on the curve for the remaining term at the time funds are added. Second, if rates drop, a customer could slam significant balances into the CD, receiving yields well above market rates. The longer the term of the CD, the greater the potential damage. If you offer this option, be sure to limit the amount that can be added on to no more than the original amount of the CD. And avoid adding this option to CDs with maturities of 24 months or more. Yes, rates have been going up, but...
Bump Rate CD Options
Bump rate CD options allow the customer to bump the rate on their CD to the prevailing market rate one or more times during the term of the CD. The disadvantage of this option to the institution is that costs may be variable in a rising rate environment and fixed in a falling rate environment. The customer captures the benefit over the remaining term, rather than over the original term of the CD. In designing such a CD, it is to the institution’s advantage to:
- Limit the CD to a single bump rather than allowing multiple bumps
- Lengthen the amount of time that must elapse between the time the CD is issued and the date the customer is first able to exercise the option
- Limit the option to short-term rather than long-term CDs
- Apply the CD’s bumped rate to only the remaining term of the CD, rather than upon the entire original term
Step-Up CD Options
A step-up CD is much like a step-up bond in that it has a rate that automatically increases during the CD’s term. For example, a three-year CD might offer a rate of 3.0% the first year, 3.5% the second year, and 4.0% the third year. This pricing approach works to the institution’s advantage for two reasons. First, money has a time value. While the CD in the previous example has an average rate of 3.5%, payment of 0.5% of the first-year rate is deferred until the third year. Second, the step-up feature effectively assesses a penalty for early withdrawals without actually charging a penalty. If you are considering a reduced penalty or no-penalty CD, think about offering it as a step-up product.
Sports Team CDs
This is really a fixed-rate CD with an annual percentage yield that is unknown at the time of issue. For example, your Seattle Seahawks 11-month CD might be offered at a rate of 3.0% plus 10 basis points for every regular season win the Seahawks post in the 2005 – 2006 season. Your institution is betting the Seahawks tank. Your customer is betting the Seahawks make the playoffs. I like products like these because they include a feature—other than the rate—that is engaging to the customer. They are particularly attractive to sports team fans and to those who enjoy an occasional wager. If the sports team is the local high school football team, it is a great community institution product as it is unlikely that the large institution with a branch in your town is likely to match this offering.
Aside from these options, there are a number of other warts being added to CDs. For example, a customer may receive a higher rate if he or she meets relationship requirements, like having a checking account or putting balances in other maturities in a CD ladder. Or a customer may receive a higher rate only if a minimum amount of new money is brought into the CD. Or high-balance customers may receive a higher rate than low-balance customers (tiering).
It is very difficult to price options like those we’ve discussed because the consumer is not a professional money manager and because the value of the option varies with the size of rate movements. So track what actually happens if you introduce products like these. Did the option really attract any new funds? What kind of pricing action was required on the option product to generate demand? And to what extent did customers exercise the option when it went into the money?
We’ll talk about product design and pitfalls, as well as pricing and segmentation strategies, in the upcoming Seattle Bank Deposit Pricing seminar series. Here’s hoping your financial institution’s ”prince” of a deal isn’t turned into a toad by your CD options! 
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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