Taking a Deposit Neutral Approach in Relationship Pricing
The flattened yield curve has created a perplexing scenario for credit being applied to deposits. Operating expenses for deposits on average differ significantly due to the activity and processes put into place to manage the transactions. Demand Deposit Accounts (DDA) have the highest volume of activity therefore additional operating expenses are applied to this type of product. As an offset, there is significantly more non-interest income generated in this product category than other deposit products. Interest-Bearing Demand Deposits have a higher cost structure but not as significant as DDA’s since this product acts as a haven for immediate accessible funds daily. The non-interest income for this category is much less. Money Market Deposit Accounts (MMDA) are restricted by several transactions in a period thus the transaction costs are lower as a result with little non-interest income generated. Finally, Savings accounts have a higher non-interest expense than MMDA or Interest-bearing DDA’s because depositors tend to go in and out of that account more frequently thus more transactional costs. Finally, Certificates of Deposit are pretty much one and done from a cost perspective since the money sits there for stated term.
So, why the concern about deposit values? Deposits are gold! When utilizing a Funds Transfer Pricing (FTP) system, there are certain assumptions made by deposit category of their expected life or duration. The value assigned generally is the term equivalent of some index such as the FHLB Advance rates. The dilemma arises when the funding curb is relatively flat, and the term value equivalent does not offset the expense being applied to the deposit categories as outlined above. The deposit operating expenses can only be squeezed so much. Technology can only do so much in reducing the costs in managing the deposits. Extending the expected life for each category could be a way to represent value but how far out on the curve do you go; 10 years, 15 years? Deposits have worth but the math applied using a flat curve for some balance tiers/sizes result in negative values.
Until the funding curve normalizes, a tiered deposit neutral approach could be employed to avoid calculated negative deposit values. When building a cost distribution system product balance breakpoints are established for expense allocation. Each tier has a percentage of non-interest expense being applied in pricing. By applying the costs on a percentage basis for each deposit category and the related balances, a neutral effect, giving a zero value to the differing size of deposit balances can be achieved. Of course, for larger deposit balances, the operating expenses and FTP value applied would result in a positive value. The objective would be not to eliminate larger depositor contribution but to lessen the negative values for smaller deposits.
The result of this approach is to address the unusual economic circumstances that currently exist. As the funding curve begins to normalize, adjustments in cost allocations can be made to reflect a truer market condition and eliminate deposits not being perceived as “Gold”.
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Posted on Tuesday, September 28, 2021 at 9:45 AM
by John Robertson