After a decade of organic growth in consumer deposits, domestic balances are decreasing.  The 2nd quarter report from the FDIC show a decrease of $32 billion in domestic balances, and the September projection is for a zero growth.  This means that your gain is someone else’s loss and vice versa.

Now more than ever, pricing your deposits optimally means the difference between keeping your existing deposits or losing them to the competition – there is no third way.  Moreover, if you want to increase your balances, you need to pricing over the opti9mal pricing position.
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This is the new reality in deposits caused by a stronger economy (3% GDP in Q2), where people are saving less and spending more. The most cost efficient way to retain your existing balances and to acquire new deposits (from someone else) is to price optimally and scientifically with Deposits Dynamics.

The ability of interest rates to attract deposit balances is dynamic even if the rate itself stays the same.  This means that a 1.00 percent interest rate on a CD can be attractive or not very attractive based on how people respond to changes in the economic environment.

This is the finding from the latest scientific study on this subject – “Dynamics of Yield Gravity”, which is the basis for the Deposits Dynamics pricing model.  The study shows that behavioral economics factors greatly impact people’s response to deposit rates.
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Therefore, pricing your deposits only based on your competitive-rate survey will result in mispricing because you are not taking into account the impact that behavioral economics has on the way people respond to interest rates.  Hence, use Deposits Dynamics to price optimally and scientifically

A new scientific study shows that the ability of yield to attract money is dynamic rather than static.  This means that the same yield, for the same product and in the same competitive environment, can attract balances at one time and not so much on another time.  This is the finding of a breakthrough scientific study titled: “Dynamics of Yield Gravity.”

The study, co-authored  by Dr. Dan Geller and Professor Nahum Biger, was validated by a double-blind peer review of two international organizations of economics and finance research:  1) The International Conference on Business and Economic Development, , and 2) The International Conference on Economics, Finance and Management Outlooks.

The far reaching implications of this study (full details at the end of the article) are that rates and balances of deposits do not operate in a vacuum, and they are greatly impacted by behavioral economics factors.  Thus, any model for forecasting and pricing of deposits must include behavioral economics as a mediating variable.  Otherwise, the outcome of the model is likely to be false.

The “Dynamics of Yield Gravity” study shows that the main factor impacting the ability of yield to attract balances (gravitational pull) is the level of money anxiety of consumers.  As illustrated in Figure 1, when money anxiety is lower, the gravitational pull of yield is greater, which is why the “orbiting” deposits balances are closer to the magnetic field of yield.  Conversely, when money anxiety is higher, the gravitational pull of yield is weaker and the “orbiting” deposit balances are farther away from the magnetic field of yield.

We can clearly see the changes in the gravitational pull of yield by comparing the behavior of yield and balances of deposits during two time periods – five years prior the beginning of the Great Recession vs. five years during and in the aftermath of the Great Recession. 

Figure 2 shows how during the pre-recession period (2003-2007), balances of liquid accounts (checking, savings and money market) increased by 39.3% while average APY of liquid accounts increased by 44.7%.  Similarly, balances of term accounts increased by 50.04% and average APY of term accounts increased by 117.0%.  Most importantly, as we will see later, the ratio between the average APY of term accounts (0.48%) and the average APY of liquid accounts (2.78%) was 5.79.  

Now let’s compare the behavior of APY and balances of liquid and term accounts to the five-year period that includes the recession and its aftermath (2008-2012).  Figure 3 shows how balances of liquid accounts increased by 78.9% , hence twice as much as the increase in the pre-recession period (2X), and balances of term accounts decreased by 22.0%, hence three times different than the pre-recession period (3X).  And here is a critical fact – the ratio between the average APY of term (0.23%) and the average APY of liquid account (1.26%) remained nearly identical to the pre-recession time period at 5.48.   

This means that despite the fact that the ratio between APY of liquid accounts and the APY of term account remained nearly the same, balances of liquid and term accounts were five times different in the post-recession period compare to the pre-recession period.  So, what caused this phenomenon?  What made the gravitational pull of term APY so much weaker compare to liquid APY even though the ratio between the two remained the same?  The answer may surprise you – its money anxiety.

Money anxiety is a common and normative response to economic and financial uncertainty.  This is according to the latest survey by the American Psychological Association (Figure 4), which shows that money anxiety tops the categories causing stress and anxiety in the U.S.  Moreover, about 7 of 10 people reported having money anxiety on a regular basis, and we can clearly see how the level of money anxiety increased during and in the aftermath of the Great Recession.

In order to be able to objectively measure money anxiety, which is a latent variable and can’t be directly observed or measured, we used a special statistical model called Structural Equation Modeling (SEM) that is capable of measuring the impact money anxiety has on the financial behavior of people.  We tested the money anxiety model using five different goodness of fit tests shown in Figure 5.

Finally, we tested the correlation between the average APY of liquid and term accounts, and balances of liquid and term accounts with the Money Anxiety Index and we found that they all have very strong and highly significant relations to the Money Anxiety Index (Figure 6).  Moreover, we conducted a mediation test and found that money anxiety significantly mediates between APY and balances of both – liquid and term accounts.

So how is the dynamics of yield gravity impacting your bank?  Here are two areas you need to be concerned with and what you should do about it:

Implications on interest expense
Problem: Financial institutions tend to misprice deposits because they do not incorporate behavioral economics factor when forecasting and pricing their deposits.
Solution: Deposit pricing models should include behavioral economics factors to ensure that interest rates are optimal for the economic environment.  Otherwise, unnecessary interest expense can put the financial institutions at risk of low net interest margins.

Implications on term liquidity
Problem: Diminishing yield gravity during economic slowdown will prevent financial institutions from complying with Basal III Net Stable Funding Ratio (NSFR) requirement of one-year liquidity.
Solution: Financial institutions can’t rely on yield alone to attract term liquidity during economic slowdown (high money anxiety).  Product features and other non-yield incentives should be used instead.

 
About Dr. Dan Geller
Dr. Dan Geller is a behavioral economist who pioneered the research and application of behavioral economics to the banking services.  Through his research firm, Analyticom, He provides banking executives with scientific forecasting and pricing tools enabling them to improve financial performance. 

Dr. Geller is the author of the behavioral economics book Money Anxiety which was named a “must read book” by Business Insider. He a frequent speaker and media guest, appeared on national TV and radio, such as CNBC and Fox, and delivered the keynote address at the American Banker's Symposium.

About Professor Nahum Biger
Professor Nahum Biger is an Emeritus Professor of management and financial economics.  He received his Ph. D. from York University in Toronto and published more than 70 articles in academic journals. He published five books and conducted numerous consulting reports.  Professor Biger was the founding Dean of the Graduate School of Business at the University of Haifa, Israel and served at that capacity for 8 years.

Professor Biger was sent on several missions of the World Bank to Botswana and to Chile. He is a regular economic advisor to governments and to courts of law as an expert on economic and financial issues. Professor Biger was and continues to act as a visiting professor at top universities. He was a visiting professor at Northwestern University, University of California at Davis, University of Cape Town, University of Rotterdam and the Peter Drucker Graduate School of management in Claremont, California.

A new study, “Dynamics of Yield Gravity,” shows that banks are at risk of not having enough term liquidity (Certificates of Deposits) during the next financial crisis that would be needed to comply with the latest liquidity requirements of the FDIC. That’s because interest rates of deposits lack the ability to attract term deposits during times of high money anxiety, according to a new peer reviewed scientific study by Dr. Dan Geller and Professor Nahum Biger.

The authors of the study, Dr. Dan Geller and Professor Nahum Biger, were invited to present and publish the “Dynamics of Yield Gravity” after the paper passed a double-blind peer review by two international conferences on economics and finance.   The first conference is the International Conference on Business and Economic Development, which will be held on April 10-11, 2017 in New York, USA, and the second conference is the 13th International Conference on Economics, Finance and Management Outlooks April 27-28, 2017 in Dubrovnik, Croatia.

Stringent liquidity requirements were put in place after the financial crisis of 2008-2009, when banking regulators worldwide established new guidelines at their conference in Basel, Switzerland.  The latest Basel III Revised Liquidity Framework requires banks to maintain some level of their bank deposits for a period of one year and over in order to cover losses from loan defaults and avoid a repeat of the need for a government bailout of banks. However, the new study shows that higher interest rates failed to attract term deposits during the Great Recession due to diminishing gravitational pull, thus placing banks at a greater risk of default during the next major financial crisis.

The study shows that during the Great Recession and its aftermath,  2008-2012, the average rate of Certificate of Deposits (CDs) was nearly 5 times that of liquid accounts (checking, savings and money market). Yet the amount of bank deposits in CDs decreased by 22 percent, while balances of liquid accounts increased by 78.9 percent.  Moreover, the study shows that  during the same time period of 2008-2012, the Money Anxiety Index, used to measure the level of financial stress and anxiety, increased from 58.8 (May 2008) to 100.82 (June 2012).

“The implications of this study,” said Dr. Dan Geller, “suggest that financial institutions should incorporate behavioral economics into their forecasting and pricing models to ensure that deposit rates are optimally positioned to control interest expense and manage required liquidity levels.”

“Moreover,” notes Professor Biger, “recognition of the dynamics of yield gravity phenomenon by the banking, economics and finance sectors is the starting point in developing measures to offset the adverse impact diminishing gravity of yield has on interest expense and long-term liquidity.”

About Dr. Dan Geller

Dr. Dan Geller is a behavioral economist who pioneered the research and application of behavioral economics to the banking services.  Through his research firm, Analyticom, Dr. Geller provides banking executives with scientific forecasting and pricing tools enabling them to improve financial performance.  Dr. Geller is a frequent speaker and media guest.  He appeared on national TV and radio, such as CNBC and Fox, and delivered the keynote address at the American Banker's Symposium.

Dr. Geller is the author of the behavioral economics book Money Anxiety which was named a “must read book” by Business Insider. He is also the developer of the Money Anxiety Index, which pointed to a looming recession 14 months in advance because it is the only financial confidence index that measures what people do rather than what people say in response to confidence surveys and opinion polls. 

About Professor Nahum Biger

Professor Nahum Biger is an Emeritus Professor of management and financial economics.  He received his Ph. D. from York University in Toronto and published more than 70 articles in academic journals. He published five books and conducted numerous consulting reports.  Professor Biger was the founding Dean of the Graduate School of Business at the University of Haifa, Israel and served at that capacity for 8 years.

Professor Biger was sent on several missions of the World Bank to Botswana and to Chile. He is a regular economic advisor to governments and to courts of law as an expert on economic and financial issues.

Professor Biger was and continues to act as a visiting professor at top universities. He was a visiting professor at Northwestern University, University of California at Davis, University of Cape Town, University of Rotterdam and the Peter Drucker Graduate School of management in Claremont, California.

The economy is like an ocean with varying sizes of waves.  Behavioral economics are economic “waves” caused by financial uncertainty and anxiety. Bankers who understand this principle know how to ride these behavioral economics waves to improve their financial performance.

Scientific studies show that there is an inverse relation between the level of financial stress and anxiety and the sensitivity of people to interest rates of liquid deposit accounts.  Specifically, the analysis shows that during such times, people are five times less sensitive to interest rates of savings and money market accounts than they are to interest rates of CDs. 

This phenomenon provides bankers an opportunity to “ride” the current behavioral economics wave to reduce interest expense on liquid accounts.  Most liquid balances today are made up of hoarded money in response to behavioral economics factors.  Bankers should distinguish between rates on hoarded money vs. rates on hot money by establishing an optimal pricing position for the base product (retention of hoarded money) separate from a high-yield rate geared towards acquisition of new money (hot money).  

The only way to establish an optimal pricing position for your base and your high-yield rates is to use Deposits Dynamics, which incorporates behavioral economics as a mediating factor in its model.  Deposits Dynamics was designed to identify and capture the direction and severity of the behavioral economics waves so that you can ride them nice and high.  

Yield management of deposits means distinguishing between two main deposit categories- retention and acquisition.   Retention is the function of maintaining your current balances from existing customers by offering an optimal rate for retention and rollover of existing balances.   Acquisition is an attempt to attract new balances from customers by competing with higher yield.

Many financial institutions have only one rate for retention and acquisition of each deposit product.  For example; a rate of 0.50% for a one-year CD of $10,000. The problem with this type of “generic” pricing is that it was dome based on a competitive survey that includes both – base and high-yield rates of the competitors.

As a result,  the 0.50% rate that was established for the one-year CD is overpriced for retention and underpriced for acquisition, which means that this institution is paying too much to maintain existing balances and too little to attract new customers.  Here is how you can avoid this situation by practicing yield management of deposits.

1) Separate base from high-yield rates: Make sure that your competitive survey distinguishes between base rates and high-yield rates.  This means that each of your deposit products, tier and term is listed twice – once with the base rates of each competitor and once with the high-yield rates of your competitors.  High-yield is anything that is not “pure vanilla” i.e., specials, relationships, new money etc.

2) Position base rates and high-yield rates separately: Using Deposits Dynamics establish the optimal pricing position for base rate and for highest yield of each product.  The optimal pricing position for your base product is calculated to maintain the status quo of your current balances at the lowest level of interest expense.  The optimal pricing position for your highest-yield rate is calculated for efficient acquisition of new balances based on the highest-yield rates your competitors offer.

3)Marketing expense vs. interest expense: The best high-yield product you can offer, regular or special, is a relationship product to checking account.  This means that if a new customer wants to take advantage of the higher yield of your deposit products, this customer is required to open a checking account at your institution.  The reason a relationship account is best suited for high yield is because the premium you are paying to make this product high yield is not really additional interest expense, but rather part of marketing expense since you are acquiring a new customer.

In summary, practicing yield management for deposits is the only way you can achieve your liquidity needs at the most efficient level of interest expense.  Moreover, by distinguishing between retention and acquisition rates, you are avoiding overpaying for existing balances and underpaying for desired balances.  With Deposits Dynamics, you can establish the optimal pricing position of your base rate as well as your high-yield rate. 

When marketing your deposit products, establish your price based on behavioral economics rules, and not based on marketing principles.  The latest scientific studies in behavioral economics show that pricing is governed by behavioral economics principles and not by the conventional marketing mix of price, product, promotion, and place.

Consumers respond to interest rates on deposits, or price, differently then they respond to other components of marketing such as promotion and product type.  When it comes to deposit rates, consumers’ response is mediated by behavioral economics factors such as financial fear and anxiety.  This means that during times of economic uncertainty, consumers are willing to forgo higher interest rates in return for quick and easy access to their money.

The link between emotions, such as fear and anxiety, and financial decisions has been firmly established in the behavioral economics and finance literature (Ackert et al 2003). Their findings are that “A newer branch of financial economics called behavioral finance applies lessons from psychology to financial decision making, but most of these studies have focused on cognitive biases rather than emotion.”  Moreover, when emotions and cognitive evaluations diverge, the emotional aspect is likely to have greater influence on behavior (Ness and Klass 1994; Rolls 1999).

The behavioral aspect of financial decision is relatively new and is generally dated back to the 1980s (Schinckus 2008). The “battle” between the expected utility theory and prospect theory continues until today and it represents two schools of thoughts on financial decisions.  Whereas the expected utility theory suggests that people make financial decisions based on expectations of reward, Kahneman and Tversky (1979) used experimental psychology to show that the expected utility theory is too abstract and general to describe reality. In prospect theory, Kahneman and Tversky show that emotions do play a role in financial decisions, and that people hate to lose more than they love to wine.

Robert J. Shiller, Sterling Professor of Economics Yale University (Shiller 2015), explores the link between people’s feelings of uncertainty about the future and the unusual dynamics at work in today’s economic world. According to Shiller, “I suspect that there is a real, if still unsubstantiated, link between widespread anxieties and the strange dynamics of the economic world we live in today—a link that helps to explain why it’s not just short-term interest rates that are very low, but long-term rates, too.”

Shiller explains that despite low interest rates on savings, depositors continue to pill up their money in bank accounts “When rates are this low, there may seem to be very little incentive for people to save. Yet according to the Bureau of Economic Analysis, personal saving as a fraction of disposable personal income stood at 4.9% for the United States in December.”

In summary, position your deposit pricing based on behavioral economics factors while using product, promotion and place to market your deposits.  This way, you are assured that your marketing initiatives are in synch with the optimal pricing position for each of your deposit products.

References
Ackert, F. Lucy, Church, K Bryan and Deaves. Richard (2003), Economic Review - Federal Reserve Bank of  Atlanta. Atlanta: Second Quarter 2003. Vol. 88, Iss. 2.

Kahneman, Daniel and Tversky, Amos (1979), "Prospect Theory: An Analysis of Decision Under Risk", Econometrica, Vol. 47, No. 2, pp. 263-292.

Ness, R.M., and R. Klass. (1994). Risk perception by patients with anxiety disorders. Journal of Nervous and Mental Disease 182:466-70.

Schinckus, C. (2008), "The Financial Simulacrum", Journal of Socio-Economics, Vol. 37, No. 3, pp. 1076-1089.

Shiller, J. Rober (2015), Anxiety and Interest Rates, Yale Insights, New York Times op-ed,    February 8, 2015.

Scientific validation of any model used for forecasting and pricing of deposits is done only with statistical coefficients.  Charts, graphs and nice pictures make for fine art, but it is not scientific validation.

Forecasting and pricing deposits consist of three types of variables.  Rates are the independent variable, balances are the dependent variable and most importantly, behavioral economics is the mediating variable.  The mediating variable is the most critical factor in the model because it represents the way consumers respond to rates and types of deposits based on economic conditions.

For example, let’s examine the Deposits Dynamics model (above), which shows the Pearson coefficients of the relations between these three variables for the time period of 2008-2012.  Each arrow represents relations between the variables with two figures; Beta is in bold and Alpha below it. In a nut shell, the bolded figure (Beta) represents the strength of the relations.  The closer the coefficient to 1.0, the stronger the relations.  The figure below it (Alpha) represents the significance of the relations; the closer the figure to 0.0, the higher the significance of the relations between the variables.

As you can see from the model coefficients, the relation between rates and balances of liquid accounts is inverse mostly due to the mediation effect of behavioral economics factors.  This means that rates, in and of themselves, are not a major factor in the increase of balances of liquid accounts – behavioral economics mediates that.  Conversely, rates and balances of term accounts have tandem relations, meaning they are both decreasing in tandem, and behavioral economics factors mediate this decline.

There are two main take away from this illustration.  The first is that any forecasting and pricing model of deposits that does not incorporate behavioral economics as a mediating variable is likely to produce erroneous results.  More importantly, the mediating variable MUST be independent of rates and therefore, the Fed funds rate, LIBOR, or T-bills rates are NOT independent of deposit rates and should not be used for mediation.

The second takeaway is that any claim of “scientific” approach to forecasting and pricing of deposits must past the litmus test of statistical coefficients.  Only statistical coefficients can validate the strength and significance of the relations between the variables, and additional test can be done to validate that the outcome is not due to random occurrence, and the impact of mediation.

I hope that this information is helpful to you in distinguishing real science from artistic representation of “science.”  As always, if you would like to discuss this issue further, feel free to contact me directly.   

Many institutions overprice deposits because they hate to lose more than we love to win.

On average, deposit rates are overpriced even in today’s low-rate environment.  Of course there are many institutions that are priced below the optimal pricing position, but on the other hand, there are just as many institutions that are priced above the optimal pricing position even if they no intention to increase liquidity.

Scientific studies in behavioral economics show that on average, we hate to lose twice as much as we like to win.  This means that our fear of losing balances is twice as much as our desire to reduce interest expense.  Moreover, when the fear level is higher than normal due to economic uncertainty, we hate to lose four times as much as we love to win.

This phenomenon is evident is today’s pricing of deposits.  In many instances, rates of liquid accounts are overpriced relative to the optimal pricing position despite scientific evidence that rates of liquid accounts, in and off themselves, are not a major factor in the decision of consumers to deposit money into liquid accounts.  But since most institutions price their deposits instinctively rather than analytically, they are subjected to the lose/win fallacy.

A sure way to overcome the tendency to overprice deposits due to fear of lose is to use a scientific and empirical mechanism to establish the optimal pricing position.  An optimal pricing position is the price point where you will maintain your current level of balances at the lowest level of interest expense.  The optimal pricing position should always serve as your benchmarking point to either increase rates if you want to increase liquidity, and vice versa.

The bottom line is that when you price instinctively, as most do now, you are subjected to the tendency to overprice because the emotional impact of losing balances is greater than the emotional impact of improving profitability.  You can easily overcome this phenomenon by using scientific analytics to guide you. 

Deposit pricing today is based mostly on instinctive decisions dressed up as analytical decisions.  For example, pricing deposits between competitor “A” and competitor “C”, or positioning the rate at 10 basis points above the market average are all types of instinctive-pricing decisions.  Moreover, pricing based on the Fed funds rate or LIBOR is also a form of instinctive pricing decision because their relations to balances can’t be measured independently of deposit rates.

The litmus test for distinguishing between instinctive and analytical pricing decision is the answer to the question: “How do you know?”  If the answer is “We have always priced this way” or “It is part of our pricing strategy”, you know you are pricing instinctively because the pricing decision is not evidence based and is not supported by empirical analysis. The only valid answer is a figure representing the relations of a rate, in and of itself, to balances.

A true analytical pricing decision is one that is based on the relations between rates and balances excluding the impact of the economic environment on demand for balances.  Why?  Because you have no control over the economy.  Your focus should be on the impact your rate has on balances at the current economic environment. 

The only way to statistically isolate the impact of rates from the impact of the economic environment is to include behavioral economics as an intervening variable in the model and then exclude its impact on demand from the final outcome. That is the model used in Deposits Dynamics to establish the optimal pricing position for each deposit product in your market.

The main reason most pricing decisions are instinctive is because our default decision-making process is instinctive.  People are “programmed” to make two types of financial decisions – instinctive or analytical.  This applies to banking executives making decisions on deposit pricing.  Instinctive decisions are fast and are not evidence based.  Analytical decisions are much slower and require calculations because they are evidence based.

In the professional jargon, instinctive decisions are called “system 1” and analytical decisions as “system 2.”   Scientific research shows that our default decision-making mode is system 1 (instinctive) because it is fast and requires less effort.  Therefore, it’s not surprising that most pricing decisions are instinctive – after all, our default decision-making is system 1.

In summary, if you are not using a model that measures the relations of rates as independent variable, balances as the dependent variable and behavioral economics as an intervening variable, you are making instinctive pricing decisions.  Unfortunately, scientific studies also show that most instinctive financial decisions are erroneous.  How do you think Las Vegas was built?