Increase Core Deposits, Minimize Marginal Cost of Funding

By Alan Smith, BancIntelligence

Growing core deposits is absolutely crucial to stabilizing and improving a bank’s 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 – it’s time to make that a priority.  Following are important considerations that can assist you in guiding your bank to grow deposits while keeping the cost of those funds in check.

Know the Bank’s 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 the 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 the se different types of deposits? If your bank’s strategy is primarily based on offering the highest rates on products (all or most of time), the n your bank is probably undervaluing its services and very likely driving up the 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 the spectrum of deposit types, from demand depositors, who are least sensitive to rate, to the 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 the ir sensitivity so that you don’t overpay customers who are less motivated by rates. Every depositor has different priorities; for some, it’s a convenient branch location, for o the rs it’s personalized service – don’t presume that each of your bank’s products must always be the most price competitive. For example, customers opening savings accounts may be most concerned with the ease of accessibility to the ir funds, while customers opening a six-month CD may be focused on getting the market’s best rate. Why offer the former the highest rate if you don’t have to? 

One excellent way to attract new deposits while minimizing the 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. the y must hold the ir primary checking account with bank, the y must execute 10 debit transactions each month, etc.).

Understand How You Stack Up
Unlikely a routine conversation, you should begin engaging in regular dialogue with management regarding how the 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 the ir funding mix (i.e. ratio of core versus non-core funding) and the ir cost of acquiring funds.

Guide the 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 the bank’s performance and streng the n its valuation. First, know whe the r the bank has a plan in place. Second, ensure that you, fellow Board members and management fully understand the bank’s marginal costs of funding. Third, ensure that the bank’s pricing strategy is aligned with the “sensitivities” that motivate its respective markets. And lastly, know how the bank stacks up against its peers in the se key areas.

<back to November 2008 Directors Digest>