One of the most important sources of funding for financial institutions is checking accounts and regular savings accounts. Depending on the institution, such accounts often represent between 10% and 50% of funding. While they are the most basic of deposit services, a great deal of controversy surrounds analyzing the sensitivity of these core deposits to changes in market rates.

This is the first of a series of articles that focus on how you might evaluate the rate sensitivity of your core deposits. It begins by discussing the two markets available to institutions for managing their interest rate risk, retail markets and wholesale markets. The retail market discussion focuses on importance of pricing in controlling demand for products and services and introduces techniques for making pricing decisions. Subsequent articles will build upon the pricing base established in this article by showing you how to use readily available financial information to evaluate the rate sensitivity of core deposits.

How Institutions Manage Interest Rate Risk

Strategies aimed at managing interest rate risk are generally implemented in two markets, wholesale markets and retail markets. The methods used by institutions to modify their interest rate risk are different in each market.

Wholesale Markets

The primary wholesale markets used by financial institutions are the securities markets where financial instruments are bought and sold. Financial instruments offered in the securities markets are underwritten to meet a set of standards that are commonly recognized throughout the market. For example, when a broker attempts to sell an institution a five-year US Treasury bond, the buyer knows by definition how it gives off its cash flows. Once a bond’s issue date and rate is known, comparative prices can readily be obtained from other brokers because their bonds will offer identical cash flow characteristics. Generally, an institution will buy the bond from the bond house offering the best price.

Very few financial institutions are big enough and influential to play a significant role in setting the price of instruments sold in the wholesale markets. Consequently, an institution will either accept the market rate/price offered by the market or not participate in the market. Institutions manage their interest rate risk in the wholesale markets by selling products with undesirable interest rate risk characteristics and purchasing products that have desirable characteristics.

Retail Markets

Retail markets are markets in which an institution negotiates the rate on its products and services with its customers. The customers can be consumers or businesses. The negotiation occurs either across the table from the customer, or through the actions taken by the institution’s pricing committee. An important difference between the retail markets and wholesale markets is that retail products are not standardized, at least not in the eyes of the customer. Retail products have features, rate-related and non-rate related, that differentiate one institution’s products from those offered by the institution down the street, across the state and across the country.

The rate-related features are components of a product’s price related to its rate that are important to the customer. An example would be interest payment frequencies, compounding methods and early withdrawal penalties on CDs. Because institutions often underwrite products that don’t meet national standards, these features vary from institution to institution.

Non-rate related features are components of a product’s price that are not related to its rate. Such factors as location convenience time convenience, other account relationships, safety and soundness and customer loyalty may be as important to a CD customer as rate.

Generally, the greater the value a customer places on a product’s rate-related and non-rate related features, the less sensitive the customer will be to the rate paid on the instrument. Because the values placed on rate-related and non-rate related features will vary from customer to customer, their responses to an institution’s pricing actions will also vary. Financial institutions control the demand for their products and services by varying their rates relative to rates offered by competitors.

Pricing is the primary technique used by institutions in managing interest rate risk in the retail markets. If a deposit account has desirable interest rate risk characteristics, an institution will raise its rates relative to its competitors, bringing in more rate sensitive customers. If a deposit account has undesirable interest rate characteristics, the institution will lower its rates relative to competitors, losing some of its rate sensitive customers in the process. Because pricing is a key tool in managing interest rate risk, it makes sense for institutions to develop a mechanism for evaluating pricing alternatives and making pricing decisions.