An odd contradiction may be impacting your institution’s ability to raise deposits. Financial institutions routinely disclose substantial early withdrawal fees on deposit accounts — fees that, historically, they never really expect to collect. Yet in recent years many continue the fiction by increasing these highly theoretical fees.
Consumers hate even the threat of penalties. So for banks and credit unions the mention of penalties constrains new business development with both existing and prospective depositors. The words “substantial penalty for early withdrawal” are always present in the minds of current and prospective retail depositors, and rank in “popularity” with overdraft fees.
At least with overdraft fees, banks and credit unions have revenue to show. Has your institution’s early withdrawal penalty strategy helped it create and capture any value?
Recognizing this, some financial institutions are differentiating themselves from the crowd of insured depositories which threaten early withdrawal penalties fixed at X-months of interest or other static approaches to penalties. They have been replacing fear of discussing the fees with creation of an alternative version of time deposits that takes the punishment out of early withdrawal penalties.
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The Fallacy of Early Withdrawal Penalties
Your institution’s finance team likely lies behind encouragement of bigger penalties. It has looked at the consequences of early withdrawal in a rising-rate environment and concluded correctly that the institution faces exposure to rising rates.
As rates rise, ineffective early withdrawal penalties allow depositors both to escape the fixed rate they had agreed to and to gain the new higher-rate offerings. An ineffective penalty structure exposes an institution to interest rate risk in a rising rate environment.
Unfortunately new, larger penalties are still often ineffective in protecting the institution’s interest margin. Increasing your penalty from 90 days interest to 180 days interest may be directionally correct. However, the change is unlikely to achieve the desired impact of interest rate risk protection.
Revisiting the Underlying Principle: What’s the Point?
Let’s step back a moment. The ultimate purpose of the penalty is to protect the institution from the damage of early withdrawal. When the institution receives funds that are committed for a fixed term at a fixed interest rate it can invest to lock in a profit margin for that same term. This is only possible if the funds are truly committed. An effective and efficient penalty is necessary only when the early withdrawal damages the institution. The arbitrary conventional penalties of “X months of interest” or “Y% of the amount withdrawn” don’t align with value.
To align value the penalty should weigh the potential damage: size of the withdrawal; the amount of time left in the commitment; the difference between the interest rate on the funds and what it will cost the institution to replace the funds at the time the early withdrawal is made.
In this regard, institutions can reduce the penalty down to what really matters. The arbitrary penalty formulations in most time deposits have no correlation with the actual damage. The actual damage can be determined at the time of withdrawal with a simple calculation of the value of the cash flow from the time deposit discounted by the interest rate on the funds that will replace the deposit.
This technique is applied in finance every day in other financial contracts. Now it is being applied to insured term retail deposits as institutions create a new category of time deposit which “right-sizes” early withdrawal penalties.
Finding a “Goldilocks Solution”
If the actual damage from the withdrawal is not considered, then the penalty will be either too weak or too strong. Institutions seeking long-term retail deposits require a Goldilocks solution — not too hard and not too soft.
Institutions can establish an appropriate redemption price for fixed-rate term deposits to optimize the value to depositors while simultaneously assuring their institutions that they will be able to obtain the fixed-term funding value that they had arranged with the depositor when the deposit was made.
It turns out that the process of protecting a bank or credit union can in most cases create a better result for depositors at the same time. Having the ability to offer fair and effective “right-sized” early withdrawal penalties is smart business for institutions not intellectually bound by decades of traditions.
Borrowing an Idea From FHLB System
The paradigm for accomplishing this already exists. You can find a variation of it in “make whole penalties” for premature return of Federal Home Loan Bank advances. This method is also consistent with determining the fair value of any fixed-rate agency bond. The secondary market in bonds creates a fair market value determined by the parameters of the remaining term and the prevailing current interest rates for the remaining term.
This process has been used for a number of years by a few visionary financial institutions, marketed under a variety of names.
Here’s how N.D.’s The Bank of Tioga promotes its variation on this theme:
“Withdrawals only carry penalties if they damage the bank. The penalty is not based on some worst-case scenarios like other banks use, but is based on what it would cost us to replace the funding. In fact, if the withdrawal is beneficial to the bank because we could replace the deposit with less expensive funds, we pass the benefit to the depositor for early withdrawal. Bank clients could get all of their principal and interest plus extra interest for withdrawing early.”
The relatively quiet CD market seen since the concept’s introduction in 2011 has meant that few institutions have considered this relatively new alternative to legacy CD offerings. Now, with rates increasing and the demand for retail deposits creating a much more competitive environment, many institutions are taking notice of this new way to attract, win, and retain deposits without overpaying.
Your Approach Differentiates You From Rivals
Institutions using the process have observed that although initially shy about anything new, depositors will always select this smarter approach to CDs when all other parameters are the same and the early withdrawal fee is capped to never be more than the conventional CD early withdrawal penalty. This means that institutions using this approach are delivering more value without creating any additional cost or burden upon themselves. It is one of those rare “win-win” opportunities where there is no downside for anyone involved.
In those cases where depositors will not react to harsher conventional penalties, institutions can and should strengthen penalties and continue to offer traditional CDs with old-fashioned penalties structures. However, anytime it matters to the depositors at inception the more successful approach incorporates this alternative product offering.
To be sure retail depositors are not always aware of the variations and the granularity in differences between institutions. When made aware of the differences between early withdrawal penalties, many depositors are surprised to discover that early withdrawal penalties can vary materially among banking institutions.
When retail representatives make their depositors aware of these variations in penalties, consumers often alter their buying decisions. Front-line representatives ask the depositor if they understand the difference between the competitor’s hard and harsh penalties and their institution’s “right-sized” penalties. This creates a clear value proposition for depositors who are reluctant to lock up their money. It’s a great value story to share, and makes the CD choice more than just a hunt for the highest interest rate.