Managing and Pricing Deposit Services

Welcome to Managing and Pricing Deposit Services!

Hello there! Welcome to one of the most practical chapters in your FRM Part II journey. We are diving into Liquidity and Treasury Risk Measurement and Management. You might think of deposits as just "money in the bank," but for a Risk Manager, they are the bank's primary source of funding and a major source of liquidity risk. If the deposits vanish, the bank can't lend or pay its bills.

In this chapter, we will explore the different flavors of deposits, how banks decide what interest rates to pay you, and how they calculate the cost of these funds. Don't worry if the math or the terminology seems a bit dry at first—we'll use everyday analogies to keep things clear and relatable!

1. Understanding the Deposit Menu: Types of Accounts

Banks offer a variety of ways for customers to store their money. From a liquidity perspective, we care most about how "sticky" this money is—meaning, how likely is the customer to suddenly withdraw it?

Transaction Deposits

These are accounts where the customer expects to make frequent withdrawals or payments.
• Demand Deposits: Your standard checking account. You can take the money out at any time without warning.
• NOW Accounts: (Negotiable Order of Withdrawal) These pay interest but technically the bank could ask for prior notice before you withdraw (though they rarely do).
• Money Market Deposit Accounts (MMDAs): These pay higher interest but usually limit the number of transactions per month.

Nontransaction (Savings) Deposits

These are designed more for long-term storage and usually pay higher interest than transaction accounts.
• Passbook Savings: The classic "savings account."
• Time Deposits (CDs): Certificates of Deposit. Here, the customer agrees to leave the money for a specific period (e.g., 6 months, 2 years) in exchange for a higher rate. If they take it out early, they pay a penalty.

Key Distinction: Core vs. Volatile Deposits

Core Deposits: These are "sticky" funds. They are usually small-denomination accounts held by local customers who have deep relationships with the bank. They don't leave just because a competitor offers 0.10% more interest. These are a bank's best friend for liquidity.
Volatile (Hot) Money: These are large deposits (often from corporations or other banks) that chase the highest interest rates. If another bank offers a better deal, this money vanishes instantly. This is a major source of liquidity risk.

Quick Review: Core deposits = Stable and reliable. Volatile deposits = Risky and rate-sensitive.

2. How Banks Price Their Deposits

Pricing isn't just about picking a random number. Banks use several strategies to attract the right amount of money at the right cost.

Cost-Plus Pricing

This is the most straightforward method. The bank calculates how much it costs to provide the service and adds a small profit margin.
The logic: \( \text{Deposit Rate} = \text{Operating Expenses} + \text{Interest Expense} + \text{Planned Profit Margin} \)

Market-Penetration Pricing

Think of this as the "New Store Opening" sale. A bank offers very high interest rates (higher than the competition) to grab market share quickly. It’s expensive in the short term but helps build a customer base.

Conditional Pricing

This is where things get interesting for consumers. The bank sets fees or interest rates based on customer behavior.
Example: "If you keep a balance of at least \$1,000, your checking is free. If it drops below \$1,000, we charge you \$15 a month." \n
This encourages customers to keep more money in the bank, which helps the bank's liquidity position.

Relationship Pricing

The bank looks at the "whole person." If you have a mortgage, a credit card, and a business loan with them, they might give you a better rate on your savings account. It’s all about loyalty.

Did you know? Banks often use "unbundled" pricing for new customers (charging for every little thing) and "bundled" pricing for loyal customers to keep them from leaving.

3. Calculating the Cost of Funds

As an FRM candidate, you need to understand how the bank measures what it's paying for its money. There are two main ways to look at this.

The Historical Average Cost

This looks backward. It calculates the average interest rate paid on all existing deposits. While easy to calculate, it doesn't tell you what it will cost to raise new money today.

The Marginal Cost of Funds (MC)

This is the critical concept for decision-making. Marginal cost is the cost of the next dollar the bank raises. If a bank wants to grow, it usually has to raise interest rates to attract new customers. This means the cost of the new money is higher than the old money.

The formula for the Marginal Cost Rate is:\n
\( MC = \frac{\text{Change in Total Cost}}{\text{Additional Funds Raised}} \)

A common mistake: Students often forget that when a bank raises its interest rate to attract new customers, it often has to pay that same higher rate to its existing customers too! This makes the marginal cost much higher than it looks at first glance.

Example:\n
A bank has \$100 million in deposits at 2%.
To get another \$10 million, it raises the rate to 3% for everyone.\n
Old Cost: \( \$100M \times 0.02 = \$2M \)\n
New Cost: \( \$110M \times 0.03 = \$3.3M \)\n
Marginal Cost: \( \$3.3M - \$2M = \$1.3M \)
Marginal Cost Rate: \( \frac{\$1.3M}{\$10M} = 13\% \)
Wait, 13%? Yes! Even though the rate is only 3%, the "true" cost of those extra funds is 13% because you had to pay more on the original \$100M too.

4. Liquidity and Regulatory Constraints

Why can't a bank just pay whatever it wants? Because of Risk and Regulation.

Deposit Insurance (FDIC in the US)

Government insurance protects small depositors. This is great for stability because it prevents "bank runs." However, it can lead to Moral Hazard: banks might take huge risks because they know the government will bail out the depositors if things go wrong.

Liquidity Requirements

Regulators require banks to keep a certain amount of "high-quality liquid assets" (HQLA) to cover potential deposit outflows. If a bank relies too much on volatile, high-interest deposits, regulators will force them to hold more cash as a buffer, which reduces the bank's profitability.

Summary Key Takeaway: Effective deposit management is a balancing act between Cost (paying as little as possible) and Liquidity (ensuring the money doesn't leave when you need it most).

Quick Review Box

• Transaction Deposits: High liquidity for the customer, low stability for the bank.
• Core Deposits: The "gold standard" for bank funding stability.
• Marginal Cost: The true cost of raising the next dollar, accounting for rate increases on existing funds.
• Relationship Pricing: A strategy to lower liquidity risk by deepening customer ties.

Great job getting through these notes! Remember, in the world of FRM, deposits aren't just liabilities—they are the fuel that powers the bank. Keep practicing those marginal cost calculations, and you'll be well on your way to mastering Liquidity Risk!