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.

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

The figures coming from deposit pricing are more accurate and useful than any static valuation study.

1. The rate-balance models are more robust and can be easily backtested
2. Rate sensitivities capture deeper real world complexities than simple decay rates and runoff assumptions
3. Data oddities have been automatically weeded out in import process
4. Users can drill down in subtype, region, etc.
5. Users can evaluate unrealized gain with only existing balances (useful for regulators) or all balances (needed for running a bank)
6. Numbers tie seamlessly to profits and pricing
7. Figures are automatically displayed graphically and in tables
8. Cash flows can be integrated into ALCO packages

Ultimately, deposit valuation provides answers to important questions:

• How much are my deposits worth?
• How much could they be worth with better rates?
• What is the relationship between balance, rate, and profit?
• What happens to value when external rates change?

Economic value can be calculated for any set of rates, including those projected by today’s forward curve. Essentially, this is a method of boiling down profits over time - and valuing the short-term profits higher.

Bankers need to model economic values in a special way when building numbers for the regulators (existing deposits only). In this case, the bank owes $2.3BN to its depositors (book value, red bar on right). Because the bank is able to repay deposits over a long period of time and at a low rate, the value of these deposits is pretty large - $200MM (green bar on right).

Regulators also need to know how the value of the bank is affected by changes in the external environment. This information is combined with changes in loan and investment value (so regulators know the bank is not assuming outsized interest rate risk). Here, deposits are worth an additional $60MM (green bars on right) when there’s a +100 basis point rate shock. Even though deposits run off quicker, there’s more profit each month.

Bankers value deposits in a different way when they are focused on running the bank than when preparing regulatory reports. Deposit valuation don’t depend solely on existing deposits. Bankers must also price (and value) new deposits coming in to replace deposit runoff. The total unrealized gain (CDI) is $350MM (green bar on right).

Of course, this all ties back to deposit price optimization. Better rates deliver higher CDI. Here, we see an improvement from $350MM to $480MM - because of optimized rates.

Previous: Profitability

• What happens to profits as balances change?
• What happens to profits when wholesale rates change?

We can look at any set of rates - whether we change what we give customers or if the external economy changes. Let’s look at what happens if rates stay flat, but treasury rates follow the forward rates embedded in today’s yield curve.

These rates will affect balance flows and therefore, profits. The profit graph on the right shows how profits change over time.

Finally, let’s bring this all together by viewing wholesale cost, servicing cost, and interest all in one screen. The difference (profit) is shown in green.

The deposit pricing approach is helpful in a few ways beyond the added accuracy:

1. Provided in a pivot chart - the user can drill down to different regions or account types.
2. Integrated with the other numbers used by the bank - no wasted effort nailing down discrepancies.

Next: Economic Value

Hidden complexity is an important part of good software design. We often push some functionality towards the background in order to focus on the primary benefits. This makes software easier to use, but runs the risk of appearing incomplete. In the worst case, users will look outside to complete tasks already handled by the software.

Think about a good kitchen faucet. It will be easy to clean, move to where you need it, and remember the last cold/hot mix you used. But most important, it should be easy to turn on. So this feature is made very obvious.

Deposit pricing software is no different. The major reason for using it is optimize rates for higher profits (different from measuring profitability). So this is what is properly emphasized and this is what users think of first.

But it also makes sense to consider some of the secondary features that are integrated into any complete deposit pricing package. Three of the most important are:

1. Profitability - How much is the bank earning from various deposit types and regions?
2. Economic Value - How much are our deposits worth (core deposit intangibles)? What are they worth in different economic scenarios?
3. Rate Exception Monitoring - How much are actual rates deviating from posted rates? Where do these exceptions occur?

The same calculations that are needed for deposit price optimization also let you answer other important questions. And the answers are superior to any external calculations because they are:

1. More accurate - the underlying models are more precise
2. More complete - all relevant factors are included in the numbers
3. More detailed - you can drill down to specific regions, account types, etc.
4. More accessible - output is provided in both Excel charts and tables

The moral of the story: even if necessity drives you to throw in everything including the kitchen sink, put the most important features front-and-center. But make sure the complete feature list is available for everyone, including prospects.

It was a tough demo. But after the stress of the demo is gone, there’s time to debrief and polish up any aspects that went awry.  Demo in haste, repent in leisure.  And this is how software gets good.

I worked with Ivan and Sergey and realized that our numbers were right. The bank had been locking in 12 month CDs at 4%, but treasury rates have recently plummeted close to 3%. This brings loans from the wholesale market down to about 3.5% - and all of the 4% CDs were earning negative interest.

It takes 12 months for all of these CDs to be replaced at a lower rate. Also, the shape of the yield curve indicates it will be a while before rates come up again.

But even with the calculations working out, I still got pretty sweaty during the demo. It might not be all that different for a user looking at the same information.

We made a few subtle changes that should block surprises from this particular gremlin:

1. Added a note to the user when the wholesale market changes drastically. Drastic changes only happen every few years - and the user may not easily remember the effect on profits and optimal rates.
2. Displayed negative profits (instead of just cutting off the graph at zero). This leaves a constant reminder of deposit profits during the last low rate environment in 2004.

Note that both changes are so subtle you can barely notice them. But the problem disappears and the fix doesn’t create more issues. The last thing we want is software bearing the weight of a thousand error messages and menu choices.

While these changes are pretty minor, it starts adding up after a while. We’ve completed nearly 5,000 cases like this. And the gremlins are getting spread pretty far apart.

In real life, you never get a do-over.   But software inhabits a cartoon world  where stressing the system and watching for mistakes makes the product better and better.  Do it enough times and you get something really smooth.

I often demo with a version that has not gone through the testing checks applied to software for customers.  This lets me exercise the latest features and also works quality control a little harder.

I demoed SmartRate to a prospect the other day over the net.  We ran into a few glitches with GoToMeeting.  And then the software (seemed to) hit a major bug. CD profits in the demo displayed as negative.

In case you’ve never demoed software as part of a sales call, the experience can be intense. I’d liken it to asking a girl out while drag racing. Adrenalin is coursing through your body and it’s only compounded by your reluctance to visibly break a sweat.

I knew I couldn’t think clearly, but negative profits seemed obviously wrong. Unless Crazy Eddie is running the bank, they probably aren’t losing money by paying out too much on interest.

I latched on to demo rule number one (move past the bugs). Unfortunately, this was right in the heart of the demo, so there was a large portion of the software which I never showed.

Turns out there’s a good reason for negative profits. Wholesale rates have been diving with the subprime mess. This means that CDs which were locked in months ago at pretty high rates are no longer making money (because the bank could get money at lower rates from the wholesale market). Today’s negative profits are a different kettle of fish (to be explained in a different post).

Even though SmartRate worked properly, there was still a problem. If I was flustered during the demo by negative profits, imagine the user hitting this issue during a presentation to the CFO. Good software should not make you sweat. Even if it’s complex.

When gremlins attack, part II

My buddy Mark measures physical properties like outer diameter, durometer, and Young’s modulus when he builds custom rubber parts for F500 companies. He’s constantly improving quality along whatever dimensions his customers need. That’s life in the ISO-9001 world.

Business took a page from the manufacturing book with an adage from Edward Deming, “you can’t manage what you don’t measure”. Unfortunately, the quality guru never said it - because many important parts of your business can’t be gaged well. This applies most to employees.

Humans are much trickier to measure than rubber boots for submarine telecommunication cables. People game the metrics to look good.

Look at software. Programming managers like to measure software bug counts and lines of code. Coders naturally respond to bug counts by arguing with the testers about bugs instead of fixing them - or even avoid the bug tracking system. If you measure lines of code written, developers will tend to write bloated, unmaintainable code. Either criteria will cause worse performance.

Expect similar fun in banking:

• Measure number of incoming customer calls handled? The call center will cut the customer short.
• Pay branch managers according to deposit growth? They’ll push harder for unprofitable rate exceptions.
• Pay tellers on customer satisfaction? They’ll waive fees too easily.

Employees are a little like subatomic particles - the very act of measurement will change them. Even if the yardstick is not explicitly linked to pay, people know that you are measuring because it’s important.

So what’s left?

• Make the measurements ungameable: combine multiple measures together to make sure there’s no way to adversely affect the numbers. For example, profits measured with funds transfer pricing are much less vulnerable to bad rate exceptions than deposit growth. Or just stop using rate exceptions completely. Note: Fair Isaac’s James Taylor rightly points out that decision automation has side benefits of reducing gamesmanship while focusing employees on the customer.
• Allow your employees to skew their outlook: it may not be a bad thing if tellers are solely focused on the customer - even if this drops fee income a little.
• Manage subjectively: Throw out the worst metrics and replace them with good judgement.
• Inspire your employees: Most people want to do the right thing. Make sure everyone understands how important banking is to the rest of society - a world without mortgages or savings accounts puts people in worse homes and keeps money hidden under the mattress. Explain how better customer service lets someone’s grandmother relax a little when worrying about money; higher profits allow the bank to help more people. Listen to their own ideas for how to improve.

Bankers: We rely heavily on yardsticks - and even more since SarbOx came along. Take the time to ensure these measures clearly transmit the right information and help the business.

The car only had 5,000 miles and looked pretty sharp, but when I got to the checkout booth, I heard horrible valve tap (a good sign the engine is in trouble). The guard not only heard it too, he noticed it on a different new Charger last week.

The rental agency quickly hooked me up with a different car and I was on my way. I had the car up to a whiny 25 mph before I realized I was stuck in first gear. Turns out the car has Tiptronic-type shifting (automatic, but you have to wiggle the gear shift to change gears). Unfortunately, the designer didn’t make this obvious to the user (build one position for normal and one position for Tiptronic).

All it takes is a nudge on the gear shift and you’re locked in first. Pretty natural for a manual driver or just about anyone with a right arm.

Mystery solved. The previous driver was distracted by kids in the backseat or finding his way in a new town. He didn’t notice the plague-of-angry-wasps sound, so he redlined on the highway for five minutes before catching on.

Note to Detroit: don’t make it easy for drivers to accidentally wreck expensive machinery.

Which brings us to software.

Everyone has used software designed to enrage humans. We bankers have suffered worse than anyone - I shudder when I remember working with one particular core processing system.

User interface is often an afterthought. But good user interface is more than having a pleasant day at work. Good user interface makes it harder to get bad results.

Interface becomes more important in complex business domains, like deposit pricing. There are just a heck of a lot of intricacies when the job is done properly. Bootstrapped forward curves, activity-based costing, maximized economic values, data cleansing, nonlinear predictive analytics, and so on.

A crisp interface is all that stands between the user and information overload. Some of the basics:

1. Stick to familiar ground. Make the application work like it came from Microsoft. In fact, if you need to present complex data, use Excel for building reports and editing data.
2. Stay consistent. If you refer to a “rate scheme” in one place and a “rate outlook” in another, users will spend more time thinking about trivia and less about their business issues.
3. Organize, organize. Make sure the software is lined up with the user’s internal model for how the underlying problem works. Precise organization allows people to look deeply into complexity when needed, but not worry about most concepts most of the time.
4. Take the time to refine. Even a great designer will not create a perfect interface from the outset. Great ui comes from removing a thousand tiny snags.
5. Watch for user “mistakes”. User errors are maps to better ui. What cues misled the user? How can the software subtly nudge the user in the right direction next time?

UI is much more than pretty graphics (also good, but the equivalent of the Charger’s beautifully aggressive styling). UI is the combination of a thousand subtle design choices that keep the user in control. UI refinement may be difficult to notice during a sales demo, but is critical in real usage.

Business software is never going to reach the heights of iPod-level design. Bad software design is unlikely to leave a family stranded on the shoulder of I-70 with a seized engine. But the goal of our software is also important: make the bank millions in extra profits through price optimization.

It’s worth making sure ui doesn’t stand in the way of results.

From today’s Wall Street Journal ($): Banks’ Cry: Give Us Your Cash

Total deposits as a percentage of assets on hand at the end of September at the country’s more than 8,700 insured banks and thrifts reached the lowest level since the Federal Deposit Insurance Corp. was established in 1933. At the same time, the banking industry’s net interest margin — the difference between the average rate banks earned on their interest-bearing investments and the rate they paid to fund those investments — dropped to a 17-year low in the third quarter of 2006.

So, in the scramble to sign up new customers for savings, checking and other accounts, the industry has decided it needs a new specialist: the chief deposit officer.

Banks are smart to shift focus to deposits - they are the engine of bank profits. The graph below shows that Wall Street rewards higher deposit banks with a larger price to book.

The takeaway from this graph is to focus more on deposits. But this doesn’t mean banks should avoid wholesale funding. In fact, wholesale funding can protect solid deposit strategies. It allows banks to avoid cannibalizing their current deposit base.

Is the Chief Deposit Officer a smart idea or a fad (like Chief Reengineering Officer or Chief Customer Experience Officer)?

I think this is idea is a keeper. Banks need an executive to focus on the various approaches to deposit pricing. Optimized deposit pricing is coming. Large changes in profitability are coming. Will your bank be ready?

Hat tip: Steve Janaszak