With the market anticipating higher interest rates, banks may find it increasingly difficult to get customers to accept longer-term deposit accounts. One way to overcome this reluctance is by offering them rate change features in their account.
However, as banks design these accounts, it is essential that all the variations are considered in order to avoid any unintended consequences and reputational risks that could result. The first aspect that must be addressed is the nature of the rate change. Is it a scheduled change or an option given to the customer?
Scheduled Rate Change. This is a commitment on the part of the financial institution to automatically increase the certificate yield at the designated time or time intervals if multiple rates are issued. The rates are disclosed according to a schedule and the Annual Percentage Yield (APY) is calculated over the holding periods that are possible. If the account does not provide an option for a penalty-free withdrawal prior to maturity, this promotion provides no real option value to the depositor other than the potential for a slight variation in the magnitude of the early withdrawal compared to a fixed rate certificate with the same APY. This occurs when the early withdrawal penalty is based on a number of months of interest and the initial interest rates are lower, thereby creating initially lower early withdrawal penalties.
Because the difference in value to the depositor of these accounts compared to a fixed rate certificate is minimal, a case can be made that they are merely marketing gimmicks. However, accounts that provide penalty-free withdrawals at rate change intervals can provide real value to depositors. Banks that provide penalty-free withdrawals at rate change intervals and determine their scheduled rate increases based upon the embedded forward implied yields of their fixed rate accounts can make a strong case that they are delivering real value to customers while not adding materially to their own interest rate risk.
For example, let’s consider a bank that is currently offering a one-year fixed rate APY of 0.75% and a two-year of 1.20%. The forward implied yield is calculated by determining the total earnings over two years for the longer one (2.40%) and subtracting the total earnings of the shorter one (.75%) = 1.65% and then dividing the result over the remaining term of one year = 1.65%. This makes a good benchmark for the yield in the second year of the automatic rate change. If the bank is not trying to extract value for the optionality, then 0.75% could be advertised as the interest rate for the first year and 1.65% for the second year with a blended APY of 1.20%. At the end of two years, the rate change certificate and the fixed rate certificate would have the same net account values.
To extract some value for the embedded optionality, the rate could be lowered in the initial term and added to the rate on the last term leaving the APY alone. Alternatively, the rate could be lowered on one or both rates and the APY could be adjusted downward on the basis of the advantages of the penalty-free options at the rate change dates compared to the fixed rate certificates.
Optional Rate Changes. When structured as an option granted to the depositor, the nature of the option needs to be clearly defined and stated explicitly in the account disclosure in regards to:
- The number of times the rate change option can be exercised;
- The index that determines the optional future interest rate;
- The impact of term maturities and renewals on the option.
Clearly, a one-time option is considerably less valuable to depositors than multiple chance options because depositors only get one opportunity to upgrade their interest rate. The process of timing the rate increase for maximum impact has a natural consequence of causing hesitation. Unless rates are rising aggressively, most one-time options can be reasonably expected to expire without customers exercising their option.
The future interest rates the depositor can select will typically be defined as the then-current rate offering on either the 1) same term as the original term to maturity of the account or 2) the term of a currently offered account that is the closest to the remaining maturity of the depositor’s account. Noting that the bank will consistently be positioned to manage current offering rates, there is very little risk to a certificate issuer, if it allows depositors to trade up to the currently offered yield on the closest remaining term. There is significantly more risk if the original term rate is used as the future rate index.
We recommend all accounts be automatically renewable. The availability of the option can extend through one of the following (listed from least valuable to most valuable to the depositor):
- Only the first term to maturity, regardless of utilization during the first term;
- The first use, which may include subsequent renewal periods;
- Each term as the option resets for usage by the customer for each subsequent term regardless of utilization in any prior term.
There is nothing about rate change certificates that necessitates the need for call features. However, the higher the interest rate accruals, the more likely the bank will desire to use any call features embedded in their certificates. Depositors get excited about the higher yields, but often claim they did not understand what they had agreed to when the issuer subsequently calls the certificate before maturity and leaves the depositor to reinvest at disadvantageous interest rates. We discourage the use of call options because of the negative impressions created when depositors are adversely surprised. For this reason we discourage the use of callable certificates by banks seeking to build a customer-based franchise.
It is easy to find financial institutions issuing rate change certificates. A little research will reveal a spectrum of approaches used in the marketplace in regards to the aspects highlighted here. Your customer service representatives may find the details of your research to be valuable when customers try to compare your offerings to others. Warnings about the complexity of some offers may be helpful.
We encourage you to duly consider the structures you assemble in light of your funding and customer experience goals and prepare your front line staff to talk about the advantages of your offers compared to those of your competition.
Neil Stanley is CEO/founder of The CorePoint, an Omaha, Neb.-based firm offering a web-based retail deposit pricing and sales platform and performance analytics. He can be reached at Neil@TheCorePoint.com.