Transaction Deposits

• One of the oldest services offered by depository institutions has centered on making payments on behalf of customers. This transaction, or demand deposit service, requires financial service providers to honor immediately any withdrawals made either in person by the customer, or by a third party designated by the customer to be the recipient of funds withdrawn.

• Transaction deposits include regular non-interest-bearing demand deposits (that do not earn an explicit interest payment but provide the customer with payment services), safekeeping of funds, and recordkeeping for any transactions carried out by check, card, or via an electronic network, and interest-bearing demand deposits that provide all of the foregoing services and pay interest to the depositor as well.

• There are three types of transaction deposits –
  • Non-interest-Bearing Transaction (Demand) Deposits
  • Interest-Bearing Transaction Deposits

Transaction Deposits – Non-Interest Bearing

• Interest payments have been prohibited on regular checking accounts in the United States since passage of the Glass Steagall Act of 1933.

• Congress feared at the time that paying interest on immediately withdrawable deposits endangered bank safety – a proposition that researchers have subsequently found to have little support.

• However, demand (transaction) deposits are among the most volatile and least predictable of a depository institution’s sources of funds, with the shortest potential maturity, because they can be withdrawn without prior notice.

• Most noninterest-bearing demand deposits are held by business firms.

• In 2009 the U.S. Congress passed the Wall Street Reform and Consumer Protection Act, allowing banks offering demand deposits to corporations to pay interest on these accounts.

Transaction Deposits – Interest Bearing

• Many consumers today have moved their funds into other types of transaction deposits that pay at least some interest return. There are 3 main types of interest-bearing transaction deposits –
  • 1. Negotiable Order of Withdrawal (𝑁𝑂𝑊)
  • 2. Money Market Deposit Accounts (𝑀𝑀𝐷𝐴)
  • 3. Super Negotiable Order of Withdrawal (S𝑁𝑂𝑊)

1. Negotiable Order of Withdrawal (𝑁𝑂𝑊)

• Beginning in New England during the 1970s, hybrid checking-savings deposits began to appear in the form of negotiable order of withdrawal (𝑁𝑂𝑊) accounts. 𝑁𝑂𝑊s are interest-bearing savings deposits that give the offering depository institution the right to insist on prior notice before the customer withdraws funds. Because this notice requirement is rarely exercised, the 𝑁𝑂𝑊 can be used just like a checking (transaction) account to pay for purchases of goods and services.
• 𝑁𝑂𝑊s were permitted nationwide beginning in 1981 as a result of passage of the Depository Institutions Deregulation Act of 1980. However, they could be held only by individuals and nonprofit institutions.
• When 𝑁𝑂𝑊s became legal nationwide, the U.S. Congress also sanctioned the offering of automatic transfers (𝐴𝑇𝑆), which permit the customer to pre-authorize a depository institution to move funds from a savings account to a transaction account in order to cover overdrafts.
• The net effect was to pay interest on transaction balances roughly equal to the interest earned on a savings account

2. Money Market Deposit Accounts (𝑀𝑀𝐷𝐴)

• 𝑀𝑀𝐷𝐴s are short-maturity deposits that may have a term of only a few days, weeks, or months, and the offering institution can pay any interest rate competitive enough to attract and hold the customer’s deposit.
• Up to six pre-authorized drafts per month are allowed, but only three withdrawals may be made by writing checks. There is no limit to the personal withdrawals the customer may make (though service providers reserve the right to set maximum amounts and frequencies for personal withdrawals).
• Unlike 𝑁𝑂𝑊s, 𝑀𝑀𝐷𝐴s can be held by businesses as well as individuals.

3. Super 𝑁𝑂𝑊s

• Super 𝑁𝑂𝑊s were authorized at about the same time as 𝑀𝑀𝐷𝐴s, but could be held only by individuals and nonprofit institutions.
• The number of checks the depositor may write is not limited by regulation. However, offering institutions post lower yields on 𝑆𝑁𝑂𝑊s than on 𝑀𝑀𝐷𝐴s because the former can be drafted more frequently by customers.
• Incidentally, federal regulatory authorities classify 𝑀𝑀𝐷𝐴 s today not as transaction (payments) deposits, but as savings deposits. They are included in this section on transaction accounts because they carry limited check-writing privileges.
• Savings or thrift deposits are designed to attract funds from customers who wish to set aside money in anticipation of future expenditures or for financial emergencies. These deposits normally pay significantly higher interest rates than transaction deposits do. While their interest cost is higher, thrift deposits are generally less costly to process and manage on the part of offering institutions. These non transaction deposits include –

1. Passbook savings deposits

• Passbook savings deposits were sold to household customers in small denominations (frequently a passbook deposit could be opened for as little as $5), and withdrawal privileges were unlimited.
• Individuals, nonprofit organizations, and governments can hold savings deposits, as can business firms, but in the United States businesses could not place more than $150,000 in such a deposit.
• Some institutions offer statement savings deposits, evidenced only by computer entry. The customer can get monthly printouts or electronic statements, showing deposits, withdrawals, interest earned, and the balance in the account. Many depository institutions, however, still offer the more traditional passbook savings deposit, where the customer is given a booklet or electronic message, showing the account’s balance, interest earnings, deposits, and withdrawals, as well as the many rules that bind depository institution and depositor.

2. Time Deposits

• For many years, wealthier individuals and businesses have been offered time deposits, which carry fixed maturity dates (often covering 30, 60, 90, 180 or 360 days and 1 through 5 years or more) with fixed and sometimes fluctuating interest rates.
• More recently, time deposits have been issued with interest rates adjusted periodically (such as every 90 days, known as a leg or roll period).
• Time deposits must carry a minimum maturity of seven days and normally cannot be withdrawn before that.
• Time deposits come in a wide variety of types and terms. However, the most popular of all time deposits are 𝐶𝐷s – certificates of deposit. 𝐶𝐷s may be issued in negotiable form – the $100,000-plus instruments purchased principally by corporations and wealthy individuals that may be bought and sold any number of times prior to reaching their maturity – or in nonnegotiable form – smaller denomination accounts that cannot be traded prior to maturity and are usually acquired by individuals.
• Innovation has entered the 𝐶𝐷 marketplace recently with the development of –

i. Bump-up 𝐶𝐷s (allowing a depositor to switch to a higher interest rate if market interest rates rise)

ii. Step-up 𝐶𝐷s (permitting periodic upward adjustments in promised interest rates)

iii. Liquid 𝐶𝐷s (allowing the depositor to withdraw some of his or her funds without a withdrawal penalty)

iv. Index 𝐶𝐷s (linking returns on these certificates to stock market performance, such as returns on the Standard and Poor’s 500 stock index).

3. Retirement Savings Account

• Retirement Savings account allowed wage earners and salaried individuals to make limited contributions each year, tax free, to an individual retirement account (𝐼𝑅𝐴), offered by –

i. Depository institutions

ii. Brokerage firms

iii. Insurance companies

iv. Mutual funds

v. Employers with qualified pension or profit-sharing plans.

• In some cases, workplace retirement plans periodically reallocate a worker’s payroll savings into different retirement assets as circumstances change, even if the worker herself doesn’t do so (known as a “default option”).
• These employer-engineered decisions regarding employees’ retirement accounts are subject to the provision that the manager running the retirement plan act not recklessly but as a “prudent person” would.
• Today depository institutions in the United States hold about a quarter of all IRA and Keogh retirement accounts outstanding, ranking second only to mutual funds.
• The great appeal for the managers of depository institutions is the high degree of stability of IRA and Keogh deposits – financial managers can generally rely on having these funds around for several years.
• Moreover, many IRAs and Keoghs carry fixed interest rates – an advantage if market interest rates are rising – allowing depository institutions to earn higher returns on their loans and investments that more than cover the interest costs associated with IRAs and Keoghs.

Methods Used To Determine The Pricing of Deposits

• The main methods used to price deposits are –

1. Cost plus profit margin
2. Margin cost
3. Conditional pricing formulas

1. Cost plus profit margin
   • The idea of charging the customer for the full cost of deposit-related services is relatively new. This approach was mainly adopted because they were flooded with numerous low-balance, high-activity accounts that ballooned their operating costs.
   • Deregulation has brought more frequent use of unbundled service pricing as greater competition has raised the average real cost of a deposit for deposit-service providers. This means that deposits are usually priced separately from other services. And each deposit service may be priced high enough to recover all or most of the cost of providing that service, using the following cost-plus pricing formula:

𝑈𝑛𝑖𝑡 𝑃𝑟𝑖𝑐𝑒 𝐶ℎ𝑎𝑟𝑔𝑒𝑑 𝑡𝑜 𝑡ℎ𝑒 𝑐𝑢𝑠𝑡𝑜𝑚𝑒𝑟 𝑓𝑜𝑟 𝑒𝑎𝑐ℎ 𝑑𝑒𝑝𝑜𝑠𝑖𝑡 𝑠𝑒𝑟𝑣𝑖𝑐𝑒 =

𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑒𝑥𝑝𝑒𝑛𝑠𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝑜𝑓 𝑑𝑒𝑝𝑜𝑠𝑖𝑡 𝑠𝑒𝑟𝑣𝑖𝑐𝑒 + 𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑂𝑣𝑒𝑟ℎ𝑒𝑎𝑑 𝑒𝑥𝑝𝑒𝑛𝑠𝑒

+ 𝑃𝑙𝑎𝑛𝑛𝑒𝑑 𝑝𝑟𝑜𝑓𝑖𝑡 𝑚𝑎𝑟𝑔𝑖𝑛 𝑓𝑟𝑜𝑚 𝑒𝑎𝑐ℎ 𝑢𝑛𝑖𝑡 𝑠𝑜𝑙𝑑

2. Margin cost

• Many financial analysts argue that, whenever possible, marginal cost (the added cost of bringing in new funds) and not historical average cost (which looks at the past) should be used to help price funds sources for a financial-service institution.
• The reason is that frequent changes in interest rates will make historical average cost a treacherous standard for pricing. For example, if interest rates are declining, the added (marginal) cost of raising new money may fall well below the historical average cost over all funds raised.
• Some loans and investments that looked unprofitable when compared to historical cost might look profitable when measured against the lower marginal interest cost that must be paid today.
• Conversely, if interest rates are on the rise, the marginal cost of today’s new money may substantially exceed the historical cost of funds. If management books new assets based on historical cost, they may turn out to be unprofitable when measured against the higher marginal cost of raising new funds in today’s market.
• In order to estimate the deposit interest rate that a bank should offer its customers, it is important to know the two crucial elements –

i. The marginal cost of moving the deposit rate from one level to another

ii. The marginal cost rate, expressed as a percentage of the volume of additional funds coming into the bank.

Once the marginal cost rate is known, it can be compared to the expected additional revenue (marginal revenue) the bank expects to earn from investing its new deposits. The items needed are:

𝑀𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝐶𝑜𝑠𝑡 = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡

= 𝑁𝑒𝑤 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 × 𝑇𝑜𝑡𝑎𝑙 𝑓𝑢𝑛𝑑𝑠 𝑟𝑎𝑖𝑠𝑒𝑑 𝑎𝑡 𝑛𝑒𝑤 𝑟𝑎𝑡𝑒 — (𝑂𝑙𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 × 𝑇𝑜𝑡𝑎𝑙 𝑓𝑢𝑛𝑑𝑠 𝑟𝑎𝑖𝑠𝑒𝑑 𝑎𝑡 𝑜𝑙𝑑 𝑟𝑎𝑡𝑒)

3. Conditional pricing formulas

• Conditional pricing allows a depository to set up a schedule of fees, in which the customer pays a low fee or no fee if the deposit balance remains above some minimum level but faces a higher fee if the average balance falls below that minimum. Thus, the customer pays a price conditional on how he or she uses a deposit account.
• Conditional pricing techniques vary deposit prices based on one or more of these factors:

1. The number of transactions passing through the account (e.g., number of checks written, deposits made, wire transfers, stop payment orders, or notices of insufficient funds issued)
2. The average balance held in the account over a designated period (usually per month)
3. The maturity of the deposit in days, weeks, months, or years.

• The customer selects the deposit plan that results in the lowest fees possible and/or the maximum yields, given the number of checks he or she plans to write, or charges planned to be made, the number of deposits and withdrawals expected, and the planned average balance.
• Of course, the depository institution must also be acceptable to the customer from the standpoint of safety, convenience, and service availability.
• Economist Constance Dunham has classified checking account conditional price schedules into three broad categories –

i. Flat-rate pricing

ii. Free pricing

iii. Conditionally free pricing

• In flat-rate pricing, the depositor’s cost is a fixed charge per check, per time period, or both. Thus, there may be a monthly account maintenance fee of $2, and each check written, or charge drawn against that account may cost the customer 10 cents, regardless of the level of account activity.
• Free pricing, on the other hand, refers to the absence of a monthly account maintenance fee or per-transaction charge. Of course, the word free can be misleading. Even if a deposit-service provider does not charge an explicit fee for deposit services, the customer may incur an implicit fee in the form of lost income (opportunity cost) because the effective interest rate paid may be less than the going rate on investments of comparable risk. Many depository institutions have found free pricing decidedly unprofitable because it tends to attract many small, active deposits that earn positive returns for the offering institution only when market interest rates are high.
• Conditionally free deposits have come to replace both flat rate and free deposit pricing systems in many financial-service markets. Conditionally free pricing favors large- denomination deposits because services are free if the account balance stays above some minimum figure. One of the advantages of this pricing method is that the customer, not the offering institution, chooses which deposit plan is preferable. This self-selection process is a form of market signaling that can give the depository institution valuable data on the behavior and cost of its deposits. Conditionally free pricing also allows the offering institution to divide its deposit market into high- balance, low-activity accounts and low-balance, high-activity accounts. These price differences reflect differences in the philosophy of management and owners of these two banks and the types of customers each bank is seeking to attract.

Challenges Faced By Banks – Deposit Insurance

• A major reason depository institutions are able to sell deposits at relatively low rates of interest compared to interest rates offered on other financial instruments is because of government supplied deposit insurance.

• The Federal Deposit Insurance Corporation (𝐹𝐷𝐼𝐶) was established in 1934 to insure deposits and protect the U.S. money supply in those cases where depository institutions having FDIC membership failed.

• Insured depository institutions must display an official sign at each teller station, indicating they hold an 𝐹𝐷𝐼𝐶 membership certificate. 𝐹𝐷𝐼𝐶 insurance covers only those deposits made in the United States, though the depositor does not have to be a U.S. resident to receive FDIC protection.

• 𝐹𝐷𝐼𝐶 insurance coverage has increased substantially in recent years in an effort to promote public confidence in the banking system and deal with inflation, among other factors.

• The insurance coverage includes – Savings deposits
• Checking accounts
• 𝑁𝑂𝑊 accounts
• Christmas Club accounts
• Time deposits
• Cashiers’ checks
• Money orders
• Officers’ checks
• Any outstanding drafts

• Certified checks, letters of credit, and traveler’s checks for which an insured depository institution is primarily liable are also insured if these are issued in exchange for money or in return for a charge against a deposit.

• On the other hand, U.S. government securities, shares in mutual funds, safe deposit boxes, and funds stolen from an insured depository institution are not covered by 𝐹𝐷𝐼𝐶 insurance. Depository institutions generally carry private insurance for these items.
• Deposits placed in separate financial institutions are insured separately, each eligible for full coverage. However, deposits held in more than one branch office of the same depository institution are added together to determine the total amount of insurance protection available.

• If two formerly independent institutions merge, for example, and a depositor holds $250,000 in each of these two merging institutions, the total protection afforded this depositor would then be a maximum of $250,000, not $500,000, as it would have been before the merger.

• However, the 𝐹𝐷𝐼𝐶 normally allows a grace period so that, for a short time, a depositor with large deposits in two institutions that merge can receive expanded coverage up to at least $500,000 until arrangements can be made to transfer some of the depositor’s funds to other institutions.
• Insurance coverage may also be increased at a single institution by placing funds under different categories of legal ownership. For example, a depositor with $250,000 in a savings deposit and another $250,000 in a time deposit might achieve greater insurance coverage by making one of these two accounts a joint ownership account with his or her spouse.
• Only natural persons, not corporations or partnerships, can set up insurance-eligible joint accounts. Each co-owner of a joint account is assumed to have equal right of withdrawal and is also assumed to own an equal share of a joint account unless otherwise stated in the account record. No one person’s total insured interest in all joint accounts at the same insured depository institution can exceed $250,000.

• The amount of insurance premiums each 𝐹𝐷𝐼𝐶-insured depository institution must pay is determined by the volume of deposits it receives from the public and by the insurance rate category in which each institution falls.

• Under the current risk-based deposit insurance system more risky depository institutions must pay higher insurance premiums. The degree of risk exposure is determined by the interplay of two factors:

i. The adequacy of capital maintained by each depository institution

ii. The risk class in which the institution is judged to be according to its regulatory supervisors.

• Well-capitalized, A-rated depositories pay the lowest deposit insurance fee per each $100 of deposit they hold, while undercapitalized, C-rated institutions pay the greatest insurance fees. Twice each year the board of directors of the 𝐹𝐷𝐼𝐶 must decide what insurance rates to assess insured institutions.

• If the federal insurance fund falls below $1.25 in reserves per $100 in covered deposits (known as the Designated Reserve Ratio (𝐷𝑅𝑅)), the 𝐹𝐷𝐼𝐶 will raise its insurance fees. When the amount of reserves exceeds the $1.25 per $100 standard, insurance fees may be lowered or eliminated.

Challenges Faced by Banks – Disclosures

• In November 1991, the U.S. Congress passed the Truth in Savings Act, which requires depository institutions to make greater disclosure of the terms attached to the deposits they sell the public.

• On September 14, 1992, the Federal Reserve Board issued Regulation DD to spell out the rules that depositories must follow to conform with this law. The Fed’s regulation stipulates that consumers must be fully informed of the terms on deposit plans before they open a new account.

• A depository institution must disclose –

i. The minimum balance required to open the account

ii. How much must be kept on deposit to avoid paying fees or obtain the promised yield

iii. How the balance in each account is figured

iv. When interest actually begins to accrue

v. Any penalties for early withdrawal

vi. Options available at maturity

vii. Re-investment and disbursement options

viii. Advance notice of the approaching end of the deposit’s term (if it has a fixed maturity)

iX. Any bonuses available

• When a consumer asks for the current interest rate the offering institution must provide that customer with the rate offered within the most recent seven calendar days and also provide a telephone number so consumers can get the latest offered rate if interest rates have changed.

• On fixed-rate accounts offering institutions must disclose to customers what period of time the fixed rate will be in effect. On variable-rate deposits institutions must warn consumers that-

i. Interest rates can change

ii. How frequently they can change

iii. How a variable interest rate is determined

iv. Specify if there are limits on how far deposit rates can move over time.

• For all interest-bearing accounts the depository must disclose the frequency with which interest is compounded and credited. If a customer decides to renew a deposit that would not be automatically renewed on its own, the renewed deposit is considered a new account, requiring full disclosure of terms.
• Customers must also be told if their account is automatically renewed and, if not, what will happen to their funds (e.g., will they be placed in a noninterest-bearing account?) if the customer does not remember to renew his or her deposit (Generally, customers must receive at least 10 days’ advance notice of the approaching maturity date for deposits over one year to maturity that are not automatically renewed).

• If a change is made in terms that could reduce a depositor’s yield, a 30-day advance notice must be sent to the depositor. Depository institutions must send to their customers the amount of interest earnings received, along with the annual percentage yield earned. The annual percentage yield (or 𝐴𝑃𝑌 ) must be calculated using:

\( APY\ earned = 100 \left[ \left( 1 + \frac{\text{Interest\ earned}}{\text{Average\ account\ balance}} \right)^{\frac{365}{\text{Days\ in\ period}}} – 1 \right]\ )

Where the account balance is the average daily balance kept in the deposit for the period covered by each account statement. Customers must be informed of the impact of early withdrawals on their expected 𝐴𝑃𝑌.

• Deposit plans covered by the Truth in Savings Act are confined to those accounts held by individuals for a personal, family, or household purpose.

Challenges Faced By Banks – Overdraft Protection

• Financial managers, customers, and government regulators have weighed in recently on one of the most controversial services financial institutions offer today. That service is overdraft protection (sometimes called “bounce protection”).

• If you accidentally overdraw your deposit account, this service is designed to make sure your incoming checks and drafts are paid and that you avoid excessive 𝑁𝑆𝐹 (not sufficient funds) fees.

• There are a variety of these deposit protection plans, but most commonly your bank will set you up with a line of credit (say, $1,000) in return for an annual fee (perhaps $25 to $50 per year).

• Another type of overdraft plan calls for you to maintain a second account from which the financial-service provider will transfer enough money to pay any overdrafts. Priced correctly, deposit overdraft protection can bring in substantial revenues for the financial firm. You pay a fee just to get signed up even before you use the service. Then, if the lender has to cover your bad checks, you will have to pay off the loan the lender extended to you (normally within 30 days) plus pay a substantial contract interest rate (say, 18 percent).
• The combined charges plus short-term nature of the overdraft loan may force you to pay an actual interest rate (measured by the 𝐴𝑃𝑅) of 200 percent or more. To some observers these loans resemble predatory lending, especially for low-income individuals who may need short- term credit just to get by each month.

• Moreover, customers, knowing they will be covered if they spend too much, may tend to run repeated overdrafts, winding up paying large amounts of interest instead of preparing for the possibility of overdrafts by building up their savings.

• Further, feeling they are safe, people may tend to avoid balancing their account statement each month, making more frequent overdrafts likely. Faced with adverse public and regulators’ comments some financial firms have reduced or eliminated their overdraft fees.

• Despite the controversy and the reservations of the regulators and some experts, this is a service that has remained popular, especially in recent years when most 𝑁𝑆𝐹 fees have been sharply on the rise at a pace faster than the rate of inflation. Customers seem to like the convenience, particularly in making sure their most important bills (e.g., home mortgage payment and utility bills) get paid on time. For the financial-service provider it is an important source of fee income that flows through to the bottom line and increases profits.

Challenges Faced By Banks – Basic (Life-Line) Banking

• One of the greatest social issue in finance today is revolving around the concept of basic (or lifeline) banking. The idea has raised some important questions including –

i. Should every adult citizen be guaranteed access to certain basic financial services, such as a checking account or personal loan?

ii. Is there a minimum level of financial service to which everyone is entitled?

iii. Can an individual today really function – secure adequate shelter, food, education, a job, and health care – without access to certain financial services?

• Some authorities refer to this issue as lifeline banking because it originated in the controversy surrounding electric, gas, and telephone services. Many people believe these services are so essential for health and comfort they should be provided at reduced prices to those who could not otherwise afford them.

• The basic, or lifeline, banking issue catapulted to nationwide attention during the 1980s and 1990s when several consumer groups, such as the Consumers Union and 𝐴𝐴𝑅𝑃, first studied the problem and campaigned actively for resolution of the issue. Some depositories have been picketed and formal complaints have been lodged with federal and state regulatory agencies.
• During the 1990s, inquiries by the Federal Reserve indicated that about 12 percent of Americans had neither checking nor savings accounts and about 15 percent had no transaction deposits.

• A more up-to-date 𝐹𝐷𝐼𝐶 population survey, carried out in 2010 in conjunction with the U.S. Census, found that a substantial segment of the U.S. population (about 8 percent or 9 million households) is “unbanked” (i.e., with no deposits or loans of any kind) and another major portion (amounting to about 18 percent or 21 million households) is “underbanked” (i.e., having access to some critical services but not others),.

• Most financial-service providers are privately owned corporations responsible to their stockholders to earn competitive returns. Providing financial services at extremely low prices, that probably would not cover production costs interferes with that important goal.