The Price of Everything

A stable banking system is the bedrock of the US and global economies. While airlines have operated at a net loss over their entire history, banks have always been out for profits. And while there’s an occasional rough patch - like the current subprime mess - over time, we’re solidly in the black.

Yet despite our long-term financial acumen, sometimes we give the store away. What’s that about?

One reason is that deposit prices are simply counter-intuitive. When prices go up in the supermarket, the souk, or on the web site, profit margins normally follow. Our pricing brains are wired this way and bankers must constantly tune out the the siren song of higher rates. In other words, there’s very little “gut-check” in sound deposit pricing.

A second problem is that the other side of the banker’s profit calculus, wholesale rates, moves much quicker than retail prices. This is typical historically but especially so in modern times (check out The Economist (sub. reqd.) for a few helpful papers in this area).

Generally speaking, the greater the share of raw materials in a product, the more often its price moves: petrol prices change, on average, in five months out of six in both America and Europe; the prices of fresh food are altered far more frequently than those of processed goods.

This effect applies not only in physical raw inputs like crude oil, but also notional inputs such as wholesale borrowing costs. While depositor satisfaction, good branch networks, friction and other factors allow us a high profit margin, we can’t lose sight of one important fact: almost all the marginal costs in taking in the next dollar are related to the cost of wholesale borrowing.

Consumers (and bankers) recognize that with oil prices doubling over the last year, gas price rises at the pump quickly follow. But are bankers as aware that Fed Funds halved in the last six months? A rate that was profitable in September bleeds red ink today. A nimble approach is needed in order to avoid being caught flat-footed.

Unfortunately, bankers often are not constitutionally prepared to move quickly. Changing rates requires analysis, decision-making, and implementation, and by the time a new strategy reaches the customer, it may already need to be changed. Simply streamlining the time to bring rates to market can have the same outsized benefits in retail banking that process reengineering has brought to manufacturing industries.

The final issue is the massive complexity of setting the right rate. The best rates are determined by many factors, among them wholesale costs, competitive rates, and consumer behavior. To find all the rates at a large bank, this exercise must be repeated hundreds of times. It’s easy to get stuck in the weeds of managing rates while hacking through them, leaving unprofitable rates unchanged.

Bankers, it’s time for a pledge: Leave the unprofitable business on the table. If the rest of the industry is acting irrationally, let them. Gather in profitable deposits and finance your shortfalls in the wholesale market. When rates come up again, you’ll be better placed to build your deposit base. In the meantime, stop the bleeding while the patient is still relatively healthy.

Bookmark to:
          

Ever notice prices so strange, you couldn’t believe your eyes? When I was a kid, Crazy Eddie advertised how insane his prices were. Today, it’s the “fiscally conservative” banking industry instead.

While the subprime mess has captured all the recent headlines, the distortions in retail deposit pricing are just as striking. A recent WSJ article points out that today’s astronomical rates are beginning to come back to earth. It also gives an indication for how out of orbit prices have been.

According to the article, consumers can still buy a 4 year CD from a nationally-respected institution at 5%; this isn’t just a great retail rate - this is better than banks pay wholesale.

So let’s do the numbers. Wholesale rates for four-year money are currently 3.88% at the FHLB. This means the bank in the article is paying 1.12% above wholesale. Even at the $10,000 account minimum, the bank pays the consumer $510 above cost over 4 years. Put another way, for every $1MM of deposits the bank accepts, it loses at least $50,000.

Leaving aside complications like servicing cost, marketing fees, and cannibalization of existing customers, this practice still costs beaucoup bucks. Maybe there’s a little profit in cross-selling other accounts or in higher-profit renewals later, but nowhere near enough to claw back the losses on the front end.

Solid deposit pricing can be tricky. Often, a bank needs to predict customer behavior and run tricky mathematics to find the most profitable price. Sometimes, though, the answers are clear even without the statistical crystal orb. As one deposit pricer recently summed it up to me, “If you can’t profit on a single account, how are you going to make it up on volume?”

Next: How banks went crazy

Bookmark to: