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Escaping the self-inflicted pain of out-of-date penalties

May 6, 2021 / Consumer Banking

Federal Reserve Reg D clearly and simply states the early-withdrawal requirements for time deposits:

“If funds are withdrawn from a time deposit within six days of the date of deposit, an early withdrawal penalty of at least seven days’ simple interest on the amount withdrawn must be charged. An early withdrawal penalty must also be charged if part of the time deposit is withdrawn within six days of the most recent partial withdrawal.”

With this modest regulatory burden, why do so many banks continue with an arbitrary and static 90 or 180 days’ of interest as an early-withdrawal penalty?  These are dangerous relics and artifacts of the past that many bankers have inherited without assessment of their current merits. The benefits derived from recent early-withdrawal campaigns have opened the eyes of many bankers that early withdrawal isn’t by definition good or bad.  It depends on remaining term and the contractual rate compared to current market rates.

An equitable early-withdrawal penalty needs to be significant enough to protect the financial institution, yet modest enough to maximize the money back for the depositor given the resulting scenarios. Anything less should be considered an unforced error unacceptable to all stakeholders, including directors, employees and depositors. This is a clear and immediate call to action for every ALCO and ALM solutions provider.

Static penalties have one advantage: They are familiar and have been accepted by depositors for decades. However, adjustment is warranted, given that typical levels observed today simultaneously produce little if any revenue and fail to provide an effective barrier against early withdrawal when coming out of a low-rate environment.

Those who have the responsibility, authority and accountability to set these penalties at financial institutions should now be assessing the impact of their penalties in regard to (1) protection from the financial consequences of early withdrawal when rates are rising and (2) disincentives for depositors who hesitate to lock up their funds because of the fear of substantial penalties for early withdrawal.

Step 1: Fortify the standard penalties

Opportunistic bankers are now fortifying their early-withdrawal penalties for standard term deposits so that their penalties will provide material protection from early withdrawal that might eventually be motivated by rising interest rates.  Because the static format is familiar and historically accepted, financial institutions should continue to offer static penalties as a standard offering.

The magnitude of the penalty should be set to make these penalties much more effective than, for example, a six-month early withdrawal penalty on a five-year term deposit paying 0.8 percent. If, after 12 months, the interest rates available on a four-year term deposit are over 0.9 percent, a depositor would have a financial gain from cashing the original term deposit,  paying the penalty and reinvesting at the higher rate. Your management team needs to know and report how much interest rate risk is protected by your penalties in the current rate environment.

Step 2: Offer an enhanced option

While fortification of standard penalties should be done using a static penalty based on the original term of the deposit account, the strategic banker does not stop there.

The solution is to create an alternative to the standard early withdrawal penalty that can be offered when it becomes apparent that the depositor is determined to negotiate for better interest rates. This optional penalty offering compensates the bank and depositor for the actual damage done to the financial institution when a depositor breaks the term deposit contract before maturity. This allows depositors who are sensitive to penalties to get a fair and equitable mark-to-market adjustment that characterizes other fixed income instruments.

Expanding the sequential sales process to include the offering of this enhanced alternative option to early withdrawal that will never exceed the standard early withdrawal penalty creates a very desirable result for the financial institution – more deposit volumes without paying higher interest rates.

This approach of giving depositors more of what they want and simultaneously giving financial institutions more of what they want is available now. While the fintech industry advances in so many niche areas, the structuring of long-term savings programs remains an area in which financial institutions can create value differentials that are material and achievable.

Maximizing the money back for depositors regardless of whether they hold to maturity or redeem early is an obvious evolution in term deposit strategy. The opportunity to gain first-mover competitive advantage is still available in many markets across the U.S.

Neil Stanley is founder and CEO at The CorePoint.