Banking – Challenges with Deposit rates and ALM

It is customary for financial organizations / banks to indulge in a little window shopping on a weekly basis by calling or surfing the websites of their close competitors to get at the current rates being paid by them on different classes of deposits and loans. This gives them a good idea of the current trends in the money market and an opportunity to adjust theirs with the objectives of earning a higher return while still remaining in the competition.

 Let us now take a hypothetical example to illustrate a scenario where a bank tries to establish its deposits rates a little above the current average for the market. Lets assume the Money Market (M/M) Checking rate for other banks is currently 1.70%, and our hypothetical bank is 2nd only to Thrift Bank, say Tbank that offers @ 1.95%.

Since lending / deposits rates do not remain the same over time, let’s now try to visualize what happens when rates fall.  Most lending institutions will respond by lowering their rates to match the current market, but not our sample bank; whose policy is to always price a little above the market rates. Before they take a final decision on the course of action to be taken, they need to find answers to some burning questions:  Do they stick with the same old price structure?, or do they come down very much, or slightly, or else, do they change their philosophy to be at the top and try to be at the lower end or somewhere in the middle of the market rates? Another tempting option is to offer a super CD product priced way above the market rate. “what-ifs” should  be performed for assessing the possible impacts on the bank in each of the above cases.

It is obvious that each of the  options available will yield  different results. Which of the  options the bank will finally decide to implement, and how that decision will affect its financial strengths is an example of what ALM is for, and how ALM can be coordinated to achieve strategic results.

The hypothetical bank will carry out scenario analysis to implement each of the  decisions arising from its “what ifs” exercise.  First option is to do nothing, but to move on with the same old rate structure. This decision may result in an eventual inflow of more deposits to the bank, since it is near the top of the market for rates paid for all classes of deposits. However, this new additional inflow could ultimately prove to be “hot money” making the bank unable to lend fast enough to its customers. Such a situation will ultimately lead to a shrinking of the bank’s margin.

Next option is to reduce rates on all products to be on par with the current market rates. It can be seen that the our hypothetical sample bank has “now reduced” its rates on all its products resulting in a drop in its simple average from previous average. If the bank makes this choice, then it will be operating from the lower end of the market, and run the risk of losing some its existing depositors.

The third option is to reduce the rates only marginally without going all the way with the new (current) market rates; that is, to keep to about the middle of the market. If the bank makes this choice, it may not lose customers, although prospects of attracting new customers are not too good.

The final choice the bank is left with is to put out its new proposed super 17-month CD priced well above the going market rate. On the face of it, this option looks as if it could prove to be a sellout! However, if managing ALM was that simple, then all other financial institutions would do it, and even our Hypothetical  Bank union could have done it a long time ago. With the Super CD, attracting new depositors is definitely a realistic possibility; but the Banks existing depositors who have already invested on its existing 12-month and 36-month CDs could simply start moving their funds from within the Bank itself to the more advantageous new higher interest bearing super CDs, thus defeating the Bank’s very purposes of launching the super CD project. This is called product cannibalism. The existing members would find it very advantageous to simply move their existing deposits from their  currently held low interest bearing 12-month and 36-month CDs to the new type without the need to find any additional funds for the new investment. The same scenario viewed from the Bank’s angle amounts to just an additional commitment to pay a higher interest charge on the same deposits they had from earlier.

 Thus, it may be obvious from the above example how the most ambitious brainchild projects any organization may launch with much expectations and fanfare could ultimately boomerang on them and prove to be a white elephant. It also shows the folly of concentrating only on a single component of the ALM structure without due consideration being given as to how the other variables will behave when one  moves from one extreme to other.  A change effected to one variable sets in motion a series or a circle of reactions and counter reactions causing other variables too to change to different extents – sooner or later. Similarly, when managing your ALM, there are no shortcuts. You should try to assess the effects of all the possibilities that one change could eventually lead to – in the short term as well as the long term so that you could always take more informed and correct decisions. This should make it clearer to us as to what ALM and its management and coordination are all about.

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