Banks are starting to turn to prepaid debit cards as a response to the new Dodd-Frank legislation, and as a means to find new profits from their least profitable checking customers. This from a Reuters report released this Tuesday:

NEW YORK (Reuters) - JPMorgan Chase & Co (JPM.N) plans to move its least profitable checking customers into new accounts that rely more heavily on debit cards, in an effort to boost earnings in a business that has been clobbered by new regulations.

The accounts are known as "prepaid debt cards," and are like a checking account, except that customers cannot write checks and instead spend via a debit card.

A loophole in 2010's Dodd-Frank financial reform law allows banks to charge merchants relatively high fees for processing payments made with this type of debit card.

Chase will market the cards mainly to people who frequently overdraw their accounts, keep low balances, or do not qualify for a checking account at all.

The new service is being marketed as Chase Liquid at $4.95 per month, making it even less expensive than Chase’s student checking. And the fees cannot be waived, but the card must be linked to a JPMorgan Chase checking account. It’s one way banks are getting out of the “overdraft business” and finding new ways to generate fees and cut the cost of maintaining the account by eliminating paper processing. The debit cards also are deliberately linked to other Chase products to increase profits and reduce overall costs.

At this stage,this is an experiment, but other banks are following Chase’s example. Chase is still working to refine its new debit card strategy. Chase estimates that 10 percent of its current accounts don’t pay for incremental costs such as check processing. The strategy seems designed to find a way to minimize losses from less profitable customers so the banks can spend more time and resources attracting high net worth individuals.

Chase is trying the card out in 23 states through 5.500 branches, and the bank is not adding fees for deposits or withdrawals at its ATMs or branches. Although JPMorgan Chief Executive Jamie Dimon said this "could be a breakthrough product for consumers in terms of pricing transparency, convenience and simplicity," it’s clear that Chase is not betting the farm on prepaid debit cards. Dimon noted ”The management team doesn't want me to get too excited in case it doesn't work."

The industry is watching to see if this is the next trend in bank products.

Our own Dr. Dan Geller recently contributed this article to BAI Banking Strategies. Much of the content was gleaned from Market Rates Insight’s new “Integrated Study on Service Fees” now being offered in our new Research Store.

When deciding whether to impose service fees, banks need to consider consumer preferences as well as the competitive landscape.

The amount of money banks generate from fees on deposit accounts decreased from $36.2 billion in January of 2011 to $34.1 billion by year end, a drop of $2.1 billion or 5.8%. This is not an isolated incident; rather it is a trend that started five years ago. Income from service fees on deposit accounts fell from $39.2 billion in December of 2007 to $34.1 billion in December of 2011, a fall of $5.1 billion or 13%.

On the surface, it might appear that the decline in service fees on deposit accounts is the result of various regulatory changes governing service fees. However, an examination of the data shows otherwise. The revision of Regulation E, which provides consumers a choice regarding their payment of overdraft fees for ATM and one-time debit card transactions, became mandatory for compliance on July 1, 2010 and the caps on debit card swipe fees took effect in late 2011. While these two major regulatory initiatives might explain a reduction in service fees in the last two years, they can’t explain the decline in service fees that started in 2007.

Interestingly, the fee decline occurred despite an increase in the total amount deposited in banks. Since the beginning of the recession in December 2007, total deposits at FDIC-insured institutions have risen by $1.8 trillion, from $8.4 trillion to $10.2 trillion, a 21% gain. Normally, an increase in total deposits leads to an increase in the service fees associated with deposit accounts due to an increased level of depository activity. However, in the last five years the relationship has inverted: an increase of 21% in total deposits vs. a decrease of 13% in service fees.

If the decrease in service fees started three years prior to any relevant regulatory mandate, and if the decrease in service fees occurred despite a record increase in deposit balances in the past five years, we should look elsewhere for the main cause of the change. The culprit seems to be changing consumer preference.

Traditionally, consumers had little say in what type of products and services banks offered. However, with the advent of social media, mobile connectivity and instant transactions in the past few years, consumer expectations have risen, as demonstrated by last year’s fee protests during the so-called Bank Transfer Day. This means that banks, when considering their strategy around fees, need to research, analyze and implement services that consumers want and are willing to pay for.

It may have sufficed in the past to consider mostly competitor actions before implementing your own fees but no longer. Only a three-dimensional view, which also includes consumers' preference and price sensitivity along with competitor actions, provides relevant information for safer and profitable decisions on service fees. Otherwise, financial institutions expose themselves to the danger of consumer backlash.

A simple comparison of yesterday’s uncertainty associated with service fees to today’s additional uncertainty shows how much riskier and more complex service fee decisions can be:

Yesterday’s uncertainty:

· Will consumers use the service?

· Will consumers pay for the service?

· What are competitors doing?

Today’s uncertainty includes those items but also:

· Will consumers protest?

· Will consumers move their business?

· How will the new Consumer Financial Protection Bureau react?

Using the three dimensional approach, institutions would design their fee strategy by addressing three issues: How likely are consumers to use the proposed service? How much are consumers willing to pay for the proposed service? And what is the competition doing in regards to the proposed service? Using only one or two or these dimensions to make a decision increases the risk of unintended consequences. For example, if your competitive survey shows that none of your competitors is charging a fee on a particular service, does this mean that consumers will accept such a fee? Not necessarily.

Moreover, even if you find out those consumers are very likely to use a particular service, would this information, by itself, be sufficient to introduce such a service? Not really. While consumers may embrace a new service on a theoretical basis, they might not be willing to pay extra for it. Hence the need for an integrated study that brings together information on consumers’ preference, price sensitivity and the competitive landscape.

Mr. Geller is the executive vice president of San Anselmo, Calif.-based Market Rates Insight , where he oversees the research and analytics services of the company. He can be reached at dan.geller@marketratesinsight.com.

American Banker and Market Rates Insight feature a weekly APY Spread and Premium indices to provide pricing executives with greater insight into national pricing trends and practices.

APY Spread Index
The APY spread is a simplified form of a standard deviation. It measures the variance between the high and low ends of the price range to the average, which indicates whether the APY of a particular CD is closer to the low or the high end of the pricing spectrum.

Premium Index
Premiums are used as the main vehicle to drive balances towards the most desired deposit products, and are an indication of the capital strategy of each individual institution. This week’s highest and lowest national premiums:

American Banker and Market Rates Insight feature a weekly APY Spread and Premium indices to provide pricing executives with greater insight into national pricing trends and practices.

APY Spread Index
The APY spread is a simplified form of a standard deviation. It measures the variance between the high and low ends of the price range to the average, which indicates whether the APY of a particular CD is closer to the low or the high end of the pricing spectrum.

Premium Index
Premiums are used as the main vehicle to drive balances towards the most desired deposit products, and are an indication of the capital strategy of each individual institution. This week’s highest and lowest national premiums:

American Banker and Market Rates Insight feature a weekly APY Spread and Premium indices to provide pricing executives with greater insight into national pricing trends and practices.

APY Spread Index
The APY spread is a simplified form of a standard deviation. It measures the variance between the high and low ends of the price range to the average, which indicates whether the APY of a particular CD is closer to the low or the high end of the pricing spectrum.

Premium Index
Premiums are used as the main vehicle to drive balances towards the most desired deposit products, and are an indication of the capital strategy of each individual institution. This week’s highest and lowest national premiums:

American Banker and Market Rates Insight feature a weekly APY Spread and Premium indices to provide pricing executives with greater insight into national pricing trends and practices.

APY Spread Index
The APY spread is a simplified form of a standard deviation. It measures the variance between the high and low ends of the price range to the average, which indicates whether the APY of a particular CD is closer to the low or the high end of the pricing spectrum.

Premium Index
Premiums are used as the main vehicle to drive balances towards the most desired deposit products, and are an indication of the capital strategy of each individual institution. This week’s highest and lowest national premiums:

American Banker and Market Rates Insight feature a weekly APY Spread and Premium indices to provide pricing executives with greater insight into national pricing trends and practices.

APY Spread Index

The APY spread is a simplified form of a standard deviation. It measures the variance between the high and low ends of the price range to the average, which indicates whether the APY of a particular CD is closer to the low or the high end of the pricing spectrum.

Premium Index

Premiums are used as the main vehicle to drive balances towards the most desired deposit products, and are an indication of the capital strategy of each individual institution. This week’s highest and lowest national premiums:

American Banker and Market Rates Insight feature a weekly APY Spread and Premium indices to provide pricing executives with greater insight into national pricing trends and practices.

APY Spread Index

The APY spread is a simplified form of a standard deviation. It measures the variance between the high and low ends of the price range to the average, which indicates whether the APY of a particular CD is closer to the low or the high end of the pricing spectrum.

Premium Index

Premiums are used as the main vehicle to drive balances towards the most desired deposit products, and are an indication of the capital strategy of each individual institution. This week’s highest and lowest national premiums:

By Dr. Dan Geller, Executive Vice President

Every year, Dr. Dan Geller, Market Rates Insight’s chief analyst, provides a prediction of deposit trends for the coming year. We recently posted the second part of this year’s report. What follows is the third and final in a series of articles with this year’s forecast.

HOW LONG WILL “FREE INSURANCE” LAST ?

The announcement by the U.S. Federal Open Market Committee to keep the federal funds rate at a near zero level through mid-2013 supports the possibility that the mounting amount of cash accumulating in US bank deposits is eventually going to cause a cost reversal in interest on deposits because interest income from lending and interest expense from deposits are on a collision course. This means that loan rates
are going to decrease even further to stimulate lending, and deposit balances are going to increase due to economic and market uncertainty.

The first case of cost reversal in U.S. banking industry was amounted in August by the BNY Mellon, which is charging an interest rate of 0.13% on deposits of $50 million and over. However, the underlying reasons for the need to charge a premium for deposits is evident also on the retail side of banking and it won’t be long
before the threshold for “cost reversal” will go down to lower level of account balances.

This transformation is not by design and was not concocted in the boardroom of any bank; rather it was created by market forces responding to economic circumstances. The phenomenon of cost reversal
became evident during the last recession and has intensified ever since, as we warned last October.
Here are some of the factors that are creating the need for cost reversal on the consumer side and the banking side. First, the last U.S. recession and its lingering “recovery” created economic uncertainty among consumers and businesses. Naturally, in times of economic uncertainty, the normal reaction is to seek safety and security of the capital at hand rather than focus on potential returns.

This is exactly what happened with insured bank deposits during and since the last recession. Domestic deposits increased by over a trillion dollars since the official start of the recession in December of 2007 despite the fact that the average interest rate paid on these deposits decreased from 3.82% to 0.82% – a decrease of 300 basis points.

Second, the purpose of capital, mainly in the form of consumer deposits, is to lend. Yet with the soft lending market, the excess deposit capital is becoming very costly because it keeps on generating interest expenses and FDIC insurance expense regardless of the demand for loans. As long as the Net Interest Margin (NIM) can be profitably maintained, banks can sustain the excess expense.

However, at some point, when deposits continue to grow and the lending market remains soft, the burden of the excess expense will pull the NIM to an unprofitable level. Based on the latest FDIC data, the trend is headed in that direction. In the first quarter of 2011, interest income stood at 3.88% of assists compared to
4.20% a year earlier.

At the same time, interest expense in the first quarter of 2011 stood at 0.70% compared to 0.88% as a result of decreasing interest rates on deposits. If interest income will continue to decrease due to soft lending market, interest expense will have to be reduced even further; and with interest rates already exceptionally low, the only way to achieve that is with negative interest rates, which de facto is a cost reversal from the banks to the consumer.

Are U.S. consumers going to “accept” the new reality of paying for the safety and security of their deposits? Chances are they will – not because they want to but due to a lack of alternatives. Most other investment options, such as mutual funds, stocks, bonds and commodities, involve risk to the principle. So the question facing the public becomes: how much is it worth knowing that your principal is safe no matter what? So far the answer is 13 basis points, which is the interest rate the Bank of New York Mellon is charging.

SHRINKING RATE VARIANCE BETWEEN INTERNET & BRANCHES

Deposit-rate variance between Internet banks and brick and mortar banks (aka Branch banks) is shrinking. However, the shrinkage is not uniform across all deposit products, which indicates that there is a difference between the liquidity strategy and risk of Internet vs. Branch banks.

As of December 1st 2011, the national average APY for term accounts of Internet banks is only 4 bps higher than that of Branch banks. The highest variance is in 12-month CD, 16 bps, and the lowest variance is in 5-year CD, where the variance is negative 24 bps (Figure 5).

The national average APY variance of liquid accounts is currently 41 bps, with MM commanding the highest variance at 71 bps, and checking the lowest with 10 bps (Figure 5).

In the last five years, the national average APY variance on term accounts dropped by 20 bps - from 0.24% to 0.04%. For liquid accounts, the national average APY variance dropped from 0.91% to 0.41% (Figures 5 & 6).

Implications:

• Internet banks are more price aggressive in liquid accounts, while branch banks are closing the APY gap of term accounts.
• Internet banks are more price aggressive in short-term CDs, while branch banks are more price aggressive in longer-term CDs.
• Internet banks are becoming more rate aggressive with checking accounts, which was not the case five years ago.

HOW TO PREPARE FOR UNCERTIANTY IN 2012

The only way to combat uncertainty is to be prepared and to increase focus in two main areas:

• Greater control over your interest expense
• Better management of your deposit balances

Control your interest expense:

Higher interest expense is caused primarily by product mispricing due to inability to identify various types of CDs (beyond term and tier) when establishing a rate. Mispricing occurs when a rate is established based on competitive information without the corresponding type of CD next to the APY. The APY variance between regular CD and other CD types, such as callable CD, can be as much as 39 bps. Thus, if a rate is set not knowing the type of the competing CD, an over pricing of up to 39 bps can occur.

Figure 7 is an analysis of APY differences between various types and regular CD.

Manage your deposit balances

Your deposit balances are impacted more by the APY variance between you and your market average than your APY alone. This means that your APY variance controls most of your balance changes. Nationally, 55% of the changes in balances derive from changes in the APY variance (varies by market). Thus, your balances
may change even if you do not change your rates. For example, the APY variance of MM up to $10K impacts 84% of the changes in the balance of this product. You will be able to conduct variance analysis for each of your product and markets and anticipate impact on balance.

Figure 8 is an analysis of the impact of APY variance on balances of different products.

By Dr. Dan Geller, Executive Vice President

Every year, Dr. Dan Geller, Market Rates Insight’s chief analyst, provides a prediction of deposit trends for the coming year. We recently posted the first part of this year’s report. What follows is the second in a series of articles with this year’s forecast.

In 2012, it will take more than just financial skills to understand and manage deposit rates and balances, it will require the use of macro economics, behavioral economics and understanding of risk based decision science.

The underlying reason for this transformation in the approach to deposits is the new economic reality since the beginning of the last recession in December of 2007. The last recession had a drastic impact on consumer behavior as a whole, but even more so on how they perceive and use deposits. In this publication, I will outline some of the major trends that have contributed to the new approach to insured deposits, and how these trends are likely to impact deposit rates and balances in 2012.

TRANSFORMATION OF DEPOSITS

Traditionally, deposits were a vehicle for gaining a steady and risk-free return. Therefore, the main criteria for choosing a deposit type was first and foremost the interest rate paid. However, all this changed since the beginning of the last recession in December of 2007, when the purpose of insured deposits changed from return on the money to return of the money. In other words, the assurance that the money deposited
is safe, and that it will not BE adversely impacted by the volatility of the equity market and the economic uncertainty, became the most attractive proposition for many consumers.

This transformation is evident from the elasticity analysis showing that bank deposits are among the most inelastic commodity, even more than gasoline, which is highly inelastic due to its absolute necessity. The latest figures on deposit balances and APY indicate that long-term elasticity of deposits is 0.22 compared to 0.58 for gasoline. The closer the elasticity figure to 0.00, the less sensitive demand is to changes in price, or
APY in the case of deposits. Short term (1 year or less) elasticity for deposits is at par with gasoline, 0.28 and 0.26 respectively (Figure 3).

The reason deposits are more inelastic in the long term than gasoline is because there is no substitution to insured deposits.

Typically, demand is more sensitive to price changes in the log run because over time consumers change their behavior by either reducing consumption or finding a substitution. When gasoline prices go up and stay high for a long time, consumers tend to buy more fuel efficient cars (hybrid or electric), drive less and/or use more public transportation.

However, in the case of deposits, there is no substitution because there is no other way to ensure that the principle amount is 100% safe. All other options, such as equities, mutual funds, bonds and alike, carry some level of risk to the principle.

CONSUMER DECISION PROCESS

Rather, they will intuitively (intuitive decisions are basically recollection of past experiences from memory) make a decision if an APY is within the range of what they remember to be the “average”. In intuitive decision making, the average is considered the default baseline for evaluation. For example, if all you know is that the average height of people living in New York is 5.7”, and Mary lives in New York, how tall is Mary likely to be? Most people will default to the average – 5.7”.

On the other hand, larger amounts of deposits, such as $100K and over, triggers the help of system two for a more analytical approach because the risk factor is much larger. In such cases, many consumers will take the time to do research and compare APY and other features that are offered. However, the comparison of your APY is not so much to the market average, but more to the highest competitor that they can find in their research. This is the reason the APY variance to the market average on jumbo accounts is less important to the decision making process (Figure 4).

Of course, there are always regional variations due to demographic and psychographic differences in the makeup of the population in each market, which makes it even more critical to monitor your APY variance for each of your product and markets on a regular basis.

Under the umbrella of inelasticity of deposits, there are variations in how consumers choose deposits based on two consumer behavior theories:

1) The Theory of Risk-Based Decision Making.
2) The Theory of Cognitive Decision Making.

Consumer decisions on deposits fall under the risk-based decision theory not because there is a risk of losing the deposit (they know it’s insured), but because there is a risk of not gaining enough. For example, if the same CD is available in two different places at 1% APY and 2% APY, the decision carries a risk of not gaining 1%, which is the difference between the two options.

The theory of cognitive decision making states that people have two cognitive processes for decision making. The first is intuitive (aka system one), which is done fast and most often, and the second is analytical (aka system two), which is much slower and requires mental work. Generally speaking, people use system one for most of their daily and ordinary decisions such as what to have for dinner, and they use system two for decisions that require analytical effort such as which mortgage option to choose.

Overall, the lower the risk of the outcome, the more likely are people to use system one (intuitive process) to make a decision. These two behavioral theories play a major role in deposit decision making in the matter described below. Currently, interest rates on deposits are at record low. The national variance between the average APY and the highest APY of a 12 months CD (non jumbo) is about 81 bps. This means that the “risk” factor here amounts to $81 for $10,000. For many people, such low risk (of not gaining) is considered insignificant, and they are not very likely to conduct an extensive analysis because the time and effort required is greater than the risk.

Rather, they will intuitively (intuitive decisions are basically recollection of past experiences from memory) make a decision if an APY is within the range of what they remember to be the “average”. In intuitive decision making, the average is considered the default baseline for evaluation. For example, if all you know is that the average height of people living in New York is 5.7”, and Mary lives in New York, how tall is Mary likely to be? Most people will default to the average – 5.7”.

On the other hand, larger amounts of deposits, such as $100K and over, triggers the help of system two for a more analytical approach because the risk factor is much larger. In such cases, many consumers will take the time to do research and compare APY and other features that are offered. However, the comparison of your APY is not so much to the market average, but more to the highest competitor that they can find in their research. This is the reason the APY variance to the market average on jumbo accounts is less important to the decision making process (Figure 4).

Of course, there are always regional variations due to demographic and psychographic differences
in the makeup of the population in each market, which makes it even more critical to monitor your
APY variance for each of your product and markets on a regular basis.

To be continued…