Core Deposits, Minimize Marginal Cost of Funding
By Alan Smith,
Growing core deposits is
absolutely crucial to stabilizing and improving a bankís performance and
building long-term franchise value. Further, the recent FDIC Restoration Plan
identifies funding the bank with non core funds as riskier and potentially more
costly. If your bank does not
currently have a solid strategy in place for increasing core funds Ė itís
time to make that a priority. Following
are important considerations that can assist you in guiding your bank to grow
deposits while keeping
cost of those funds in check.
Bankís Funding Strategy
By definition, core funding is made up of demand deposit accounts (DDAs),
negotiable order withdrawal accounts (NOW), savings and money market accounts
and retail CDs less than $100,000. These types of core deposits are widely
recognized to be less volatile and cheaper than non-core funding, such as jumbo
CDs (those above $100,000) and borrowings from
Federal Home Loan Bank.
Do you know if your bank
already has a strategy and budget in place for generating core funding, and do
you understand how your bank goes about generating
se different types of deposits? If your bankís strategy is primarily based on
offering the highest rates on products (all or most of time),
n your bank is probably undervaluing its services and very likely driving up
marginal cost of funding.
Recognize Price Elasticity and the Marginal Cost of Funding
To meet the objective of driving the highest volume in core deposit accounts, at
the lowest possible cost, your bank must set pricing to recognize that all
depositors are not equal in terms of price sensitivity. As a general rule, as
your bank moves through
spectrum of deposit types, from demand depositors, who are least sensitive to
most sensitive jumbo CD holders, it should be paying out higher rates. Further,
to increase balances in interest bearing accounts, the bank should not
automatically increase rates across the board, and it must continually evaluate
the marginal cost of growing these deposits.
The marginal cost of funding
is the total cost incurred for the marginal increase in deposit balances. For
example, assume the bank has $50,000,000 in money market accounts yielding 2%
and increases the rate to 3% and attracts $5,000,000. Since the increased rate
applies to the entire account balance, the cost of raising $5,000,000 is
$650,000 or 13%. ($55,000,000 times 3% equals $1,650,000, minus $50,000,000,
times 2% equals $1,000,000 for a difference of $650,000 or 13%).
Develop Pricing Strategies
to Minimize Cost of Funds
The key is to delineate customers based upon
ir sensitivity so that you donít overpay customers who are less motivated by
rates. Every depositor has different priorities; for some, itís a convenient
branch location, for o
rs itís personalized service Ė donít presume that each of your bankís
products must always be
most price competitive. For example, customers opening savings accounts may be
most concerned with
ease of accessibility to
ir funds, while customers opening a six-month CD may be focused on getting
marketís best rate. Why offer
highest rate if you donít have to?
One excellent way to attract
new deposits while minimizing
marginal cost of funding is to introduce new products. Instead of increasing
rates on current account types, your bank could introduce special offerings such
as a Super Saver account that may provide a higher rate than an existing money
market product if customers meet certain criteria (i.e.
y must hold
ir primary checking account with bank,
y must execute 10 debit transactions each month, etc.).
Understand How You Stack
Unlikely a routine conversation, you should begin engaging in regular dialogue
with management regarding how
bank is, and intends to continue, generating and pricing core deposit accounts.
A vital part of this dialogue is discussing how your bank compares with its
peers (banks that have similar operating strategies and funds composition). Know
what makes up
ir funding mix (i.e. ratio of core versus non-core funding) and
ir cost of acquiring funds.
Bank to Build Core Deposits
As a director, you can play an integral role in helping to fine-tune and execute
a strategy for growing core deposits, that will in turn, improve
bankís performance and streng
n its valuation. First, know whe
bank has a plan in place. Second, ensure that you, fellow Board members and
management fully understand
bankís marginal costs of funding. Third, ensure that
bankís pricing strategy is aligned with
ďsensitivitiesĒ that motivate its respective markets. And lastly, know how
bank stacks up against its peers in
se key areas.
to November 2008 Directors Digest>