Dealing with High CD Rates in Your Market
By Tom Farin
If you are like many of our customers, you are competing with financial institutions currently offering CD rates well above wholesale market rates. One of the most common questions we receive from our iPrice customers is how to compete in this environment.
First of all, what we are currently experiencing is a real world demonstration of the lag relationship between the movement in wholesale rates and the reaction of retail deposit rates in falling (and rising) rate environments. The following chart that tracks and compares the 1 year Treasury to national average rates for a variety of deposit accounts demonstrates this lag relationship.
In both rising and falling rate environments, rates on 6 month and 12 month CDs lag 90 days or more behind movement in rates on 12 month Treasuries. And of course because the FHLBs raise funds in the wholesale markets, FHLB rates tend to move with Treasury rates. On the other hand, rates on brokered CDs tend to track more closely to retail rates. At the right side of the chart you can see the dramatic drop in the 12 month Treasury that occurred in late 2007. You can also see that retail deposit rates have responded by only a small percentage of the change in wholesale rates.
So the bad news is that CD rates are currently irrationally high. The good news is that it is likely to be a relatively short-range problem. Once the Fed is finished taking corrective actions and wholesale rates stabilize, based on history, it is likely that CD rates will drop to more rational levels (relative to wholesale rates) within 90-120 days.
“Yea Farin, but I need to meet the goals in my 2008 plan. Based on the health of the economy, it may take the Fed a while to turn things around. What should I do NOW?”
In dealing with the short-term irrational CD pricing problem, you might:
- Shorten terms of any aggressively priced CD specials you offer. Across our iPrice customer base, there has been a significant movement in short-term CD specials in the last six months from the 10-15 month subsector to the 5-9 and even the 1-4 month subsector. The thought process seems to be, “If I’m going to pay an irrationally high rate, I’ll keep the term over which I implement this insanity short.” If you decide to compete with irrationally high CD rates, you could take the same approach – keep your most aggressively priced CD specials short.
- If you decide not to compete, it makes sense to train your CSRs to monetize rate differentials on short-term CDs for their customers. For example, a 50 bp difference between your rates and competitor rates on a $10,000 six month CD is $25 in interest. “Is it worth your time and hassle (and gas) to move your CD somewhere else for $25? After gas and taxes, how much will you really come out ahead?”
- Fortunately competitive pricing on long-term CD specials is currently more rational in most markets. In many markets, there are no long-term CD specials at all. So it may make sense to offer a longer-term CD special priced no where near as aggressively as the short-term CD specials in your market. “Rather than the 5.0% our competitors are offering on their six month CD, we can offer you 4.5% on a 25 month CD. They are offering the high rate anticipating further rate reductions by the Fed. They expect to roll your rate down in six months when your CD matures. Wouldn’t you rather lock in a 4.5% rate for 25 months? You might recall that in the last falling rate environment, CD rates fell into the low 2% range. Are you sure you want to take that kind of risk?”
If you elect not to compete with rate for customer CD money, you might elect to compete with additional features that imbed options in your CDs. In selling an option to a consumer we are selling the option to someone that is not a professional money manager. Often, they don’t exercise the option even when it is to their advantage to do so. The three most common add-on options to CDs are:
- No penalty early withdrawal.
- Bump rate
- Add on
The first two are most attractive in rising rate environments as they allow the customer (through an early withdrawal or exercising a bump option) to raise the rate before the end of the CD term. Of the two, I prefer the bump rate as it doesn’t raise the liquidity issues the no penalty early withdrawal raises. The early withdrawal could “walk down the street.” In addition, with the bump’s terms and conditions you can limit the potential impact of the bump.
Of course, the bump and no penalty options are not as appealing in the current rate environment as rates are currently falling rather than rising.
With an add-on CD, the customer can add balances to the CD and earn the original contract rate for the remaining term. Customers find the add-on option attractive in falling rate environments as they earn a higher rate on the add-on than they would by opening a new CD. This option can be dangerous to the institution’s cost of funds if offered without restrictions. Scenario – customer opens a $1,000 CD at the top of the rate cycle. When rates subsequently drop, he slams an additional $1,000,000 into the account. So we recommend the institution limit the term of CDs with add-on options. The longer the term, the longer the period of time over which the customer is able to take advantage of the option. Second, the size of the add-on should be limited. I frequently recommend a ‘double-down’ limit. “We’ll allow you to add additional funds up to the original CD amount.”
Finally, it may make a great deal of sense to focus marketing efforts on growing non-maturity deposits like checking, savings and money market accounts. While in some areas of the country teaser rates on money markets may also be high in relation to wholesale funding rates, institutions are in a position to reduce funding costs more rapidly as rates adjust downward because of the immediately repricable nature of these accounts.
Of course which of these ideas make the most sense is highly dependent on your business objectives, your interest rate risk position, and the characteristics of your customer base. If you’d like to discuss your situation, give me a call at 608-273-1004 x4219 or send me an email at tfarin@farin.com. Or you might think about enrolling in either our Deposit Boot Camp or Advanced Deposit Boot Camp Webinars.
Tom Farin