PROFITABILITY AND DEPOSIT PRICING

The goal of bank management should be to maximize deposit revenues and minimize deposit
costs in an effort to maximize bank profitability. Cost/revenue analysis is one way in which
managers can better understand how deposit pricing decisions are affecting bank profitability.
Figure shows how bank costs and revenues change as the deposit base is expanded. The S-
shaped cost curve assumes economies of scale as deposits initially are expanded,


Which gradually reduce costs per unit deposits; however, diseconomies at some deposit level
increase costs per unit deposits and cause the cost curve to increase at an increasing rate. Total
bank costs equal fixed costs of land, buildings, and equipment, plus variable costs of deposits
and other activities. Total bank revenues include deposit revenues, loan and security portfolio
revenues, and other revenues. Profit maximization requires the following: (1) minimization of
total costs at each output level; (2) maximization of total revenues at each output level; and (3)
marginal total costs equal marginal total revenues (i.e., the cost of an additional dollar of deposits
equals the revenue it would provide when invested by the bank). The latter marginal
cost/revenue condition is represented in Figure at the deposit level where the slopes of the total
cost and total revenue curves are equal. Upper and lower breakeven points occur where costs and
revenues equal one another in absolute (rather than marginal) terms. These points describe the
output range within which the bank can profitably operate.

Once an optimal deposit level is estimated, the task of the pricing committee is to minimize net
deposit costs for the target deposit base. Some of the ways in which banks have been reducing
deposit costs in recent years are (1) truncating checks (i.e., not returning cleared checks to
customers) (2) levying stricter penalties for early withdrawal on time deposits (3) reducing the
number of deposit products to avoid spreading resources too thin; (4) using weekly or monthly
interest compounding instead of daily compounding; and (5) waiting for customers to ask for
higher-interest products rather than automatically moving their funds to these products.
Obviously, these cost-cutting techniques are not always successful because customers may
become dissatisfied with the bank's service and withdraw their deposits.

LENDING AND DEPOSIT COSTS

Deposit costs can be affected by bank loan policies. For example, most loans require that
compensating (deposit) balances be maintained by the borrower. Such balances are inexpensive
to maintain because they usually pay no interest) require no promotional expenditures, and
have minimum transactions costs (e.g., customer information is already on file). Another
advantage of compensating balances is that they are a relatively stable source of deposits that is
less likely to be withdrawn than other deposits, thus lowering the cost per unit risk of deposits.

Another way in which loan policy can lower deposit costs is through tie-in arrangements
between deposit and loan services. Those customers that have deposit accounts could be
provided greater access to credit For instance; many farm operators hold deposit accounts at rural
banks not so much to earn interest but to establish a banking relationship that would enable them
to obtain loans when needed. Thus, the credit function can be used by banks not only to raise
deposit funds (i.e., compensating balances) but to reduce deposit costs.

CUSTOMER RELATIONSHIP PRICING

Relationship banking is an expression that includes the total financial needs of the public rather
than just specific needs. It also includes fulfilling long-term needs, as opposed to immediate
needs, such as cashing a check. This can be done by cross-selling a variety of services that tends
to lower user costs and increase convenience compared with selling each service separately.
Also, patrons are viewed as clients, as opposed to customers, according to this viewpoint. This
pricing strategy greatly increased in importance subsequent to the Financial Services
Modernization Act of 1999, which expands the array of products and services that bank holding
companies can provide to full-blown securities and insurance activities. Many banks set goals of
selling (on average) three to five financial services to each customer. Managers are appropriately
rewarded in their compensation for achieving multiple product sales.

PROMOTIONAL PRICING

Promotional pricing is used to introduce new products. In brief, the product is priced below cost
to attract market attention. More frequently, promotional pricing is used to support or rejuvenate
demand for existing products. Some of the potential reasons for such promotions include
increasing or protecting market share, modifying existing products, developing brand recognition
or overall bank image, targeting particular market segments of the population in certain
geographic areas,' and increasing sales to a cost efficient level at which economies of scale can
be obtained.





OTHER MARKETING ELEMENTS RELATED TO PRICING

Product Differentiation

Designing products and services to meet the needs of specific market segments is known as
product differentiation. As mentioned earlier, banks typically must price their liabilities in
different ways to compete effectively for funds. If banks did not differentiate their products, and
instead competed side-by-side for the same customers, many customers might be forced to
purchase products that are not priced to fit their needs.

Distribution

Another part of the pricing decision that bank managers should consider is the physical delivery
of deposit services to the public. The problem here is one of logistics-namely, how to optimize
the time and place preferences of customers, while minimizing bank operating costs net of
associated revenues. Banks have two basic distribution channels from which to choose: (1) retail
channels that distribute services to the general public (e.g., driven teller windows, ATMs, and
internet access), and (2) wholesale channels that distribute large volume services to corporate
enterprises and government units (e.g., lock boxes, electronic transfers of funds, and oversight of
cash management functions).

ESTIMATING THE COSTS OF BANK FUNDS

Cost Definitions

The acquisition of bank funds entails incurring both financial and operating costs. Financial costs
pertain to explicit payments to lenders minus revenues obtained from service charges and fees,
whereas operating costs relate to land, labor, and equipment expenditures. When discussing the
costs of bank funding, it is also necessary to distinguish between average costs and marginal
costs. Average costs are simply calculated by dividing the total dollar costs of funds by the dollar
amount of funds. Marginal costs are the incremental costs of acquiring an additional dollar of
funds. Marginal costs are superior to average costs because they more accurately reflect current
costs as opposed to past costs.

WEIGHTED-AVERAGE COST OF FUNDS

On an aggregate basis, costs of bank funds are measured in weighted average terms. The
weighted-average cost of funds can be calculated by summing the average cost of each source of
funds times the proportion of total funds raised from each respective source of funds,
We may write this average cost of funds as follows:

where CT is the weighted average cost of funds, Cn is the average cost of the nth source of
funds, Fn is the funds acquired from the nth source of funds, and TF is the total funds acquired
by the bank. The ratio F,/TF is the proportion of total funds obtained from a particular source of
funds, or the weight used for this source's average cost of funds. Theoretically, the average costs
of the individual sources of funds, or Cn' are equal to one another as well as to CT, after
adjusting for differences in risk. This must be so because the bank would naturally acquire funds
from the cheapest risk-adjusted source until its cost per unit risk rose to the cost per unit risk of
other funds' sources.

PURPOSES OF COST ANALYSES

Performance Reports

Table 13-5 provides example historical cost data for different sources of funds (excluding ,;
equity) that could be included in a performance report, Funds available for investment are less
than the amount of funds acquired by the amount of reserves required (because of either legal
requirements or management preferences). Financial costs equal total interest costs net of service
revenues, and operating costs are based on allocated expenses for labor, premises, occupancy
expenses, and other operations associated with physically producing accounts. The total cost of
funds is divided by funds available for investment to obtain the average cost of each type of
fund. Notice that reserve requirements raise the effective cost of funds, which is associated with
funds usable for investment purposes. The final step is to calculate the weighted average cost of
funds by applying equation (13.1). As shown in Table 13-5, this historical cost equaled 7.12
percent.

The information displayed in Table 13-5 can be used by the pricing committee to identify both
problems and opportunities. For example, public deposits were costing an average of 10 percent,
which exceeds the average cost of any other type of funds, even though the risk associated with
these funds is relatively low (because government accounts are a fairly stable source of deposits).
Thus, management could work on reducing the cost of public deposits. On the other hand, the
average cost of demand deposits was only about 1 percent, well below the cost of other kinds of
funds. Bank management could increase promotional expenses, lower service charges and fees,
or increase implicit service returns (by increasing operating expenses) to expand this relatively
inexpensive source of funds. This kind of historical overview of costs can help guide bank
management in minimizing the costs of funds in the future. In turn, cost minimizing behavior of
bank managers causes the marginal costs of all sources of funds to remain about the same,
including the cost of equity funds, on a risk-adjusted basis.