Reverse Elasticity Driving Deposit Balances As Consumers Continue to Worry About the Future

by tom 5. August 2010 10:31

In the abnormal market we have today, banks are increasing their deposits by lowering their rates below the market average. It seems counter-intuitive, but as consumers continue to worry about the future of the economy, banks are seeing their balances increase when they lower their interest rates.

In a recent article by Dr. Dan Geller, executive vice president and head of research here at MRI, entitled “Reverse Elasticity Drives Up Deposit Balances,” Dan explains the phenomena:

It’s called “rate minimization,” where banks literally push their rates to the floor to continue raising funds rather than trying to match the top payers, as would be the case under “rate optimization.” And it’s all being enabled by an extremely unusual phenomenon known as “reverse elasticity of demand.”

Because of the abnormal market dynamics, bank pricing managers can lower their cost of funds without jeopardizing liquidity levels. Dan has identified two major factors and one indicator that is driving this trend:

1. Consumer uncertainty. With near-record unemployment, a soft housing market, and slow economic growth, consumers are opting to keep their assets liquid, using checking and savings accounts where they can tap their cash immediately. Therefore, a lower interest rate on transaction accounts is not deterring consumers from adding balances to checking and savings, so these accounts are growing despite declining rates.

2. Lack of substitution. There are no alternatives for consumers to stash their cash. The volatile stock market makes mutual funds unpredictable. And the recent stock market downturn is driving individual investors to the security of insured deposits, despite the low interest rates.

3. The indicator is the decline in the bottom rates of deposits.  The latest research report from MRI shows that between July 2009 and July 2010, the average of the lowest rates offered on CDs dropped from an annual percentage yield (APY) of 0.47% to 0.26% – a decline of 21 basis points. The deepest decline in the lowest rates occurred with 30-month CDs, which fell from 0.75% to 0.15% during the period – a drop of 60 basis points. Institutions that have lowered their bottom rates are benefitting from the lower cost of funds without a shift in balances.

With these new market conditions, institutions are changing their pricing strategies from rate optimization to rate minimization. Dan writes:

Under rate optimization, which follows the traditional elasticity model of demand, the practice is to measure the impact of rate fluctuation on balances, accounting for the highest competitive rates as intervening variables. Conversely, in the model of reverse elasticity, the intervening variables are the lowest rates offered by the competitive set rather than the highest. The reason for the shift, from the highest to the lowest, is our statistical finding that when the independent variables (rates) go down, the dependent variable (balances) go up.

You can read Dan’s complete article at, and you can access the latest MRI research on the decline in the bottom rates of deposit at

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