Deposit pricing’s safety and soundness implications

In the context of bank pricing, the bride and groom here symbolize the "monogamous" customer, for whom segmented pricing strategies carry certain consequences, as sketched out in one section of Mitch Lucas' latest installment.

This is the second part of a series on the safety and soundness elements of pricing decisions. You can read the introductory article here.

Given today's low interest rate environment and excess reserve deposits, bankers require complex pricing strategies in order to satisfy the needs of a variety of bank customers. However, aggressive pricing strategies must be tempered with safety and soundness considerations, particularly in terms of protecting long-term customer relationships.

In this article, we will consider various pricing models commonly employed in the setting of rates and fees on deposit products. A smart deposit pricing strategy will not only increase safety and soundness, it will establish with concrete steps and analysis how you have met your duty to operate in a safe and sound manner.

It can also:

• Help control asset and liability management issues.

• Create more stable and adequate core deposits.

• Help demonstrate appropriate awareness of the risks and opportunities faced by the bank in light of its particular customer base.

Moving away from simplistic pricing models

Although quite common, a comparative pricing model--one that seeks to set rates and fees in simple comparison to those of the competition--is outdated and largely ineffectual.

Comparative pricing does not take into consideration important factors related to an institution's unique customer base, risk profile, capital position, etc. Each bank possesses operational inefficiencies, fluctuations in depository balances, and market sensitivities that cannot be accounted for under a pure comparative pricing model.

Similarly, margin pricing fails to take into consideration the needs of an institution's customer base, and actually may discourage customer loyalty and long-term deposit relationships.

While the long-term depositor is not the only type of customer an institution may desire, certain of these customers can be the foundation of secure core deposits. Pricing in order to obtain a wide margin can be short-sighted. It serves to encourage depositors to shop around for the best rate and does not open the door to cross-selling opportunities for new customers who might, with effective targeting, move additional accounts to the bank, thus establishing a more permanent relationship.

On the other hand, aggressive rate promotions may backfire once the special offer expires, resulting in a flow of funds out of the bank. This places safe and sound operations at risk.

Recognizing account segmentation

Pricing that focuses on account segmentation requires a bank to identify and understand the characteristics and needs of its customer base.

Generally, depositors can be broken down into categories based on their perceived loyalty to the bank:

• "Monogamists"—Depositors who have a loyal, long-term relationship with the bank. Are not expected to shop around for better rates and offers for new funds that may become available for deposit.

• "In a relationship"—depositors who are generally loyal to the bank, but have a wandering eye.  Will look for better rates when placing new funds on deposit.

• "Playing the field"—Depositors who are not tied to a single institution. Always seek the best deal.

Identifying depositor types from within the bank's customer base can enhance the institution's ability to attract and maintain deposits, and more importantly, help identify how and to whom product offerings should be tailored.

Each of these customer categories demonstrates a varying degree of rate and fee sensitivity. The bank can use analytics to zero in on the appropriate pricing strategy necessary to grow and/or stabilize the institution's core deposit base. The ability to accurately target optimal rates for each segment based on a prediction of customer behavior will maximize margin revenue for the institution overall.

Note that factors beyond rates and fees can contribute to bringing customers who tend to play the field into a committed relationship with the institution.

Account access is a factor: Larger institutions may be able to offer more in terms of convenience to appeal to these customers--ATMs, mobile apps, remote deposit capture, etc. 

By contrast, smaller, less robust institutions still may have to rely heavily on pricing to attract these customers initially, and then must balance the benefit of maintaining these customers long term against the potential costs.

Keeping the special offers going may not always be worth it in the long run.

Behavioral economics and bank pricing

Employing behavioral economics to identify and categorize customers by segments can require complex analytics. However, once these categories are identified, products can be more effectively designed to capture the needs of each customer segment and then can be more specifically marketed to them. 

Behavioral economics explores why people make the decisions they do given the economics of a particular situation and how it affects the individual's psychology. Put more simply, how do various factors--for example, a cost or fee--impact our decision-making behavior?

Behavioral economics can help a bank understand:

• Why a small business may look for a low-fee, non-interest bearing account.

• Why a complex corporation with full cash management needs will expect to pay fees and want reasonable rates paid on excess balances on deposit.

• And why a consumer who has strong loyalty to the institution will be less concerned with competitive rates and services than will an interest- or fee-sensitive consumer.

Behavioral economics can also help a bank understand and predict more irrational behavior. One example: When consumers object to the introduction of a $1 per month fee on a formerly free checking account, while expressing no objection when an existing $1 fee is doubled to $2  per month.

Furthermore, new marketing techniques can also influence customer behavior.

For example, look at "switch kits"--account transfer packages that enable a customer to gather the necessary information to more easily change institutions. Use of these tools may inspire some long-time monogamists to play the field. Switch kits make it easier for customers to collect data on recurring electronic transfers and provide form letters to simplify the process of changing banks--something to which customers in the monogamist category have traditionally been averse.

This tool works to change established customer behavior, which provides even more reason to move to a more analytical pricing and customer retention model.

Using behavioral economics changes the way a bank thinks, too. It shifts the focus from the deposit product itself to a more customer-centric focus. Institutions can use existing data to develop behavioral profiles and use those profiles to identify market opportunities, especially those opportunities created by market inefficiencies.

This model can be particularly important because it helps to explain irrational behavior that may not be accounted for in traditional pricing models. For example, a large segment of customers demonstrate a preference for "free" accounts, whether or not a particular "free" account actually provides the most appropriate benefit to that customer in light of other factors.

Finding the path means finding your location

In practice, a complex pricing strategy will require commitment and investment. Data must first be mined from the core processing system to reflect historical depositor behavior. Only then can predictive models, relying on algorithmic approaches, analyze the data and optimal pricing can be determined. 

Products can then be designed and marketed appropriately. While a tall order for a smaller bank, it is ultimately one that may influence the long-term profitability and growth of the institution if done well.

If an institution is already collecting some demographic data about customer preferences and is relatively well-acquainted with the general makeup of its customer base, moving toward a more in-depth pricing analysis utilizing behavioral economics is a reasonable next step.   

Tying up safety and soundness with pricing

Smart deposit pricing strategy can allow for individual account pricing within each customer segment, giving your account managers flexibility and increasing customer loyalty.

This is particularly important when it comes to account combinations, those involving important commercial loans and deposits. Now that an environment of rising interest rates appears to be around the corner, serious consideration must be given to pricing strategies across all product lines.

In the next article in this series, we'll take a look at commercial loan pricing strategies.

By Mitchell V. Lucas, vice-president, Product Management and Legal Compliance, Harland Financial Solutions