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…
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