Now is the time for community banks to reconsider offering a three and six month certificate of deposit (“CD”) account. With interest rates going up, time is limited to phase these maturities out in order to make your liability structure more efficient.
Why A 3 and 6-Month CD Hurts You
By offering a three and six month CD, banks usually end up cannibalizing funds in their money market demand accounts (“MMDA”). The maturity of a 3-month CD, for example, serves as a reminder to the customer of a finite maturity and tends to shorten duration and hurt convexity. In other words, for some customers, banks take a non-maturity deposit with positive convexity and duration of 0.2 to 5 and turn it into an instrument that has negative convexity and a shorter duration.
As the economy picks up, households and corporations tend to add to their MMDA giving the product potentially positive convexity. By lagging the rate paid on these accounts with market rate or holding MMDA rates stable, banks can further increase convexity and hence deposit performance. In times of falling rates, banks can drop rates ahead of the forward curve, further helping margin performance.
Don’t Teach Your Customers to Be Rate Sensitive
By offering a 3-month CD, banks teach their customers how to be rate sensitive at the shorter part of the curve. With a 3-month maturity, most customers are content with leaving funds in a MMDA account. This is to say; the characteristics of the MMDA account holder and the three-month CD holder are very similar. Banks should teach them how to be different.
For different geographies in different markets, price and volume sensitivity of MMDA accounts may be the same for a number of CD maturities. However, as a rule of thumb, it is usually the case with the three and six month offering especially. Once maturities get to nine months, differences start to appear in both price and volume sensitivities.
As a general rule of thumb, the more competitive the rate on a bank’s CD structure, the more it hurts the overall performance of the rest of the deposit offerings. A competitive 3-month CD rate usually can have the largest impact on MMDA volume than a similarly competitive 36-month CD rate.
Consider Your Cost Structure
Another aspect is maintenance cost. The 3-month CD, because of the shorter maturity, tends to have higher costs compared to MMDA and longer CD maintenance.
The more banks can move customers out of CDs and back into the money market accounts the better. As short-term rates go up as they have since December, banks can maintain their margins more competitively by having more customers in a MMDA account. As loan volume increases, other banks will be offering more competitive CD rates and in case you have to start matching them, having a longer CD structure will at least afford you some protection against sharply rising rates, and you will be able to trade rate for duration.
What Not To Do
We don’t want to cast dispersion on any bank, but the bank below is a textbook case of what not to do. Not only do they heavily promote their money market and short-term CDs, but they do so with high rates. As a result, they have both one of the highest cost of funds in banking (at 1.26%) and the most rate sensitive customer base (98% correlation to interest rates). While this bank has a business model that can afford to do this, very few community banks can.
Putting It into Action
Every bank is different, so we urge you to at least experiment. Try discontinuing your shorter term CD products and see if you can improve MMDA performance. Given that most banks are still paying the same MMDA and three-month CD rate, now is the time to sunset the three and six month CD product (and maybe your 9-month) and just start your CD ladder twelve months.
Submitted by Chris Nichols on June 01, 2016