Deposit Pricing Best Practices Session 3 Thomas Farin President Farin & Associates, Inc tfarin@farin.com 1 Agenda Session 1 Inputs What We Need to Know Role of Benchmarks Four Models to Look at Profitability Spread to Benchmark Economic Value FTP ROE (RAROC) FTP ROA Session 2 Marginal Yield and Cost Conducting Deposit Audits Effective use of Survey Data Price/Demand Tracking Developing Pricing Rules Session 3 Deposit Strategies for Rising Rates Non-Maturity Deposits Loans Note: Along the way I will take you through an example of developing a pricing strategy for a 200 bp rising rate environment. 2 1
Last Week - But What if Marginal Cost is Considered? Assumes 20% growth We pay an additional 60 bp on $25,000 K (150K) to add $5,000K at 0.67% (+$34K), a net increase in expense of $184K; divided by the $5,000K increase in volume gives a marginal cost of 3.67%. Does this decision still make sense? But what if volume doubles? 3 Reducing Marginal Cost Ideally, we d attempt to attract new money without paying up for all the existing money Segmentation strategies can be used to reduce paying up on current customers while going after new customers. Existing Customers - less than 100% cannibalization New customers and new money 4 2
Elements of Segmentation Strategies We divide deposits into sectors because It allows us to develop different pricing strategies for each sector Checking Low rate, nominal pricing response in exchange for transaction capability. Savings/MMDA Slightly higher rate, more significant pricing response with limited transaction capability. Short-Term CDs Returns similar to those offered on comparable Treasuries and significant pricing response. Long-Term CDs Returns similar to those offered on comparable Treasuries and significant pricing response. In the most basic segmentation strategy we pay up on CDs, but not on non-maturity deposits. Customers wanting a better deal must move funds from one sector to another. 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% 0.00% Shift Dec-91 Dec-93 Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 12 Mo Treas 12 Mo CD 6 Mo CD Savings MMDA 5 Elements of Segmentation Strategies Segmentation Strategies that Separate Rate Sensitive from Non-Rate Sensitive Customers Have been used by most financial institutions forever Savings vs CD rates Pay up on CDs as rates rise Don t pay up on non-maturity deposits If customer wants a better deal, he must move into a CD Are entirely consistent with pricing actions by successful retailers sales, coupons, mail-in rebates, loyalty cards Are very unlikely to antagonize customers as long as you are willing to grease the squeaky wheel. Are necessary if you hope to compete for the most rate sensitive customers 6 3
Inter-Sector Segmentation We divide sectors into multiple product offerings because Different value propositions appeal to different customers. Pay rates to those that value rates. Deliver services to those that value services It allows accounts to be priced independently of each other. To encourage selection of one product over another. To separate rate sensitive from non-rate sensitive customers. Pay up on premium service lines (CD specials and premium NMDs) Don t pay up at all or no where near as significantly on regular service lines. Segmentation strategies run within sectors allow rate sensitive customers to get a better deal without leaving the sector. 7 Inter-Sector Segmentation Under Strategy 1 regular CDs are used to compete for rate sensitive funds. The institution cannot afford to pay rates near the top of market. Under strategy 2, rates are reduced on regular CDs. A 13 month special is priced more aggressively, holding on to funds eroding under Strategy 1. Marginal cost of $375 thousand of growth and retention is 1.122%, well below the 2.64% marginal cost incurred when regular CD rates are raised to by 20 bp, but above the 0.489% benchmark. 8 4
Creating Barriers to Entry We create barriers to entry to make it more difficult for existing customers to take advantage of premium accounts It reduces the amount of money paid up on existing customers in order to attract new customers. Examples Minimum balance requirements Tiering Geographic Segmentation New Money Specials A segmentation strategy can deliver multiple barriers to entry. Segmentation strategies employing one or more barriers to entry allow customers to get a better deal within the same sector as loan as they can hurdle the barrier to entry. 9 Barrier to Entry Segmentation Under Strategy 1 regular CDs are used to compete for rate sensitive funds. The institution cannot afford to pay rates near the top of market. Under Strategy 2, rates are reduced on regular CDs. A 13 month special is priced at $1K rates below $50K, and above the benchmark above $50K. Marginal cost of retaining/growing the $301 thousand is 1.029%, in spite of a special priced above the benchmark. 10 5
Barrier to Entry Strategies Segmentation strategies incorporating barriers to entry are generally practiced by big banks. Big banks have the majority of deposits in the US (and the world). If you want to grow market share, you must match the sophistication of big bank segmentation strategies. Barrier Strategy Existing Customers - less than 100% cannibalization New customers and new money 11 Executing Segmentation The bigger the differential, the more powerful the strategy. Can you push down current rates today to benefit from segmentation? Many banks have already pushed funding cost below 50 bp. On the other hand there is significant potential in rising rate environments. In dealing with rising rates, we need to talk about pricing betas. 12 6
Why Rising Rate Strategies Are Important Rate environments don t come at you 200 bp at a time. They are more like water torture. If you have not decided what to do in advance, you are likely to make the least cost effective decision. In your A/L model, rate environments are run immediately. If you have not thought through your rising rate strategy, you are likely to overestimate the increase in your cost of funds. 13 Savings/MMDA Sector Segmentation Rising rates (+200 bp) Defensive MMDA Special Offensive MMDA special Tools Marginal Cost Betas (rising rates) Core deposit intangible 14 7
New Product Defensive (+200) 0.38 0.31 0.25 0.35 0.50 0.35 0.50 0.75 0.09 0.14 0.19 0.17 0.25 0.37 0.75 15 Case Study Institution Evaluate alternative strategies for ST CD Sector. Recommend a strategy along with rising rate pricing rules. Evaluate alternative strategies for Savings/MMDA Sector Recommend a strategy along with rising rate pricing rules 16 8
Last Week - Derived Pricing Rule - CDs Current - ABC Institution s pricing rule for short-term (10-15) month CDs is to price the regular accounts near the competitive median. When offering specials we price near the top of the market based on survey data. Previous - ABC Institution s pricing rule for short-term (10-15) month CDs was to price the regular accounts in the 60-70 th percentile based on survey data. When offering specials we price near the top of the market based on survey data. Effect of removing special from Previous strategy and moving from Previous to Current Strategy was material. Current strategy running off 5% per quarter. 17 Rates Up 200 bp Pay Up Strategy 1 Maintain median strategy No runoff in rising rates Strategy 2 Move to top ¼ of market rather than CDs remaining static, we grow 10% Marginal cost is 417 bp above FHLB benchmark 18 9
Rates Up 200 bp 14 Month Special Strategy 1 Maintain median strategy no runoff as rate bribe to stay in CDs has increased. Strategy 2 Move special to top ¼ of market, cut beta on regular CDs from 1.0 to 0.8 rather than flat, we grow 10% Marginal cost is 160 bp below FHLB benchmark 19 Modified ST CD Strategy 200 bp Rising Rates When rates rise, introduce an off-maturity tiered CD special. Price in the top ¼ of market. Meanwhile hold ST CD rates until they drop to the 25 th percentile based on survey data then keep them there is rates continue to rise. Review actual cannibalization and back test the marginal cost. Tweak the strategy if appropriate based on need for funds and back testing. 20 10
Last Week - Derived Pricing Rule Money Market Price in the 25 th to 40 th percentile based on survey data with higher tiers near the top of the range Savings Price in the 25 th percentile based on survey data In spite of non-aggressive pricing, balances continue to grow, particularly in upper tiers. Growth is attributable to surge balances Coming out of CDs. But what will happen when rates go up and We begin moving CD rates by the full change in market rates while moving savings and money market rates more moderately. 21 Rates Up 200 bp Pay Up Strategy 1 Maintain current strategy 10% surge balance runoff in rising rates Strategy 2 Move to top 1/3 of market balances remain static. Marginal cost is 23 bp below FHLB benchmark 22 11
Rates Up 200 bp Prem MMDA Strategy 1 Maintain current strategy 10% surge balance runoff in rising rates Strategy 2 Move promo MMDA to top ¼ of market, $25K Barrier to entry, cut beta on regular MMDAs and savings with rates 25-35 bp lower than Strategy 1, hold onto existing balances, Marginal cost is 253 bp below FHLB benchmark 23 Modified MMDA/Sav Strategy 200 bp Rising Rates When rates rise, introduce a Premium MMDA account. Price in the top ¼ of market. Meanwhile hold betas on savings to 0.13 and regular money markets to 0.28 to 0.48. Review actual cannibalization and back test the marginal cost. Tweak the strategy if appropriate based on need for funds and back testing. 24 12
What We ve Accomplished Developed basic tools for assessing deposit profitability both CDs and NMDs Compared average cost to marginal cost marginal cost is the superior decision making tool Laid out best practices framework for deposit decision making Divide products into sectors Deposit audits by sectors Survey data at sector level 25 What We ve Accomplished Discussed the value of tracking systems for evaluating customer behaviors Tracking pricing strategies Tracking effect on demand Showed how to derive pricing strategies and rules from historical data. Discussed variety of segmentation strategies Used segmentation to manage marginal cost in 200 bp rising rate environment 26 13
Next Steps Develop pricing strategy for your shop for 200 bp rising rate environment Deposit audit Competitive survey Derived pricing rule Run marginal cost tests on two scenarios, each comparing two strategies Make recommendation including modified pricing rule and any product introductions needed to implement. 27 14