Interest rates and term deposits

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Here at Family King we tend to pay money to the banks. But our friends Tony and Sonia have reached that enviable position where they want the banks to pay them some money. So T&S went to check out term deposits at the banks.

This is where the oddity starts.

For example at the Commonwealth Bank, if you invest $10,000 to $49,999 in a term deposit for 7 months (4 weekly interest payments) you get 5.95%. If you invest for 8 to 11 months you get 3.20%. But 12 months gives you 5.90% before it falls back to 5.30% for 13 to 23 months.

Why?

You would expect that as you lock your money up for a longer period (with associated reduction in flexibility and increased risk) you normally get a higher return. But this is turned on its head at the Commonwealth Bank except for very specific maturities.

They are not alone. At the Bank of Queensland (interest paid annually) you get 6.30% for 6 months ($5,000 to $49,999), 3.40% for 7 months, 3.50% for 8 months 6.35% for 9 months then 3.60% for 10 months.

Hmmm. The dinner discussion between T&S and the Family King looked at transactions costs but we couldn’t see how this explained the high variability and lower rates for longer term investments. We wondered about the costs of coordinating term lengths – but this didn’t gell as people invest at different times so there is no ‘maturity coordination’ issue. We wondered why 6 months was a ‘good’ term for the BoQ but not 7 months while the reverse holds for the Commonwealth (6 months is 3.20% for them). After failing miserably to explain the rate structure we:

  1. decided to hand it over to the readers of CoRE Economics to try and explain it for us; and
  2. headed back for another beer.

If anyone knows the reason for these rate structures, please let us know.

 

14 Responses to "Interest rates and term deposits"
  1. My theory is that it is all about the long term funding the bank has managed to get on the wholesale markets. Very roughly half their money for lending comes from borrowing overseas in enormous chunks, at specific maturities. Which might occasionally leave them with a gap in their maturity profile that they need to fill. So they give retail depositors good rates at that maturity.

    But of course it could all just be a marketing game to pick a maturity that none of the other banks are targeting to get rid of was comparisons. Possibly a bit of both?

  2. Within the Retail bank (what you and I use), deposit committees typically think about term deposits in maturity buckets (e.g., a bank may consider all 4-7 month term deposits as “shorter”).  Banks often choose one maturity period within that band to promotionally price higher, which explains why CBA has a dip between their 7-month (“shorter” term promo) and 12-month CDs (“medium-term” promo).

    This is primarily driven by the fact that customers tend to not really care if their CD is 11 months or 12 months; customers worry more about the ~12 month period rather than optimizing the 11-month vs. 12-month vs. 13-month rate.

    Most banks follow this sort of system, with a relatively high rate offered for customers who care.  When the TD matures, banks often try to renew the money into a similarly-termed account earning a lower rate.

    This convention explains why the 6-month term may be “good” for QLD, but 7-month term is “good” for CBA – both banks just consider them to be in the ~6 month range and the nuance for the specific number of months is less important.

    Note, however, that there are all sorts of reasons which may impact which term a bank chooses as the promotion: they may be trying to create a maturity bulge (offer 7-mo promo this month, 6-mo next month, and 5-mo the month following to create a big slug of acquisition all maturing at the same time), they may be trying to flatten a bulge, they may have technology limitations, they may have just screwed up…

  3. ING Direct have a more conventional term deposit profile, although it drops from 6.30% at 7 months to 6.00% at 9 months, before rising to 6.50% at 12 months. Their standard at-call rate is 5.0%
    I’m not an economist, so can someone explain how government-guaranteed banks can afford to pay these rates when the RBA cash rate is 4.75%?
     

  4. My guess is that it is a combination of factors.improvements (narrowing) in wholesale credit spreads in recent weeks mean that the trend is likely to be lower in retail td rates, so I would expect to see an inverted term deposit curve over the near term. That said there will be exceptions if bank balance sheets want to plug a hole in a particular maturity bucket, so tell your friends to shop around.

  5. Oh and Matt, they can ‘afford’ to pay these rates because they can pass on the extra funding costs to borrowers, which we see as ‘out of synch’ rate rises or rises greater than the RBAs rate hikes.

    Another way of putting it is that competition for retail funds (which are sticky) is high as the banks have bid it up in the face of post gfc wholesale funding cost hikes.

    Now that the pressure is reducing in wholesale territory, the first thing banks will do is back away from high td rates in maturities where they already have sufficient funding. This will vary from bank to bank which is why I think you are seeing the phenomenon Stephen describes.

    Eventually it will settle down, but more than likely at a lower level. So it pays to shop around.

    Oh and in my earlier comment, I should have said that the curve comprising the margin between retail td rates and wholesale rates will invert. The wholesale term premium Stephen describes is likely to be there for all curves. So too will be an expectation of rate rises later in the calendar year.

  6. We tend to find that the banks promote higher interest rates for the 3, 6, 12 and 24 month terms as these are the most popular deposit terms and the ones they market the hardest. For some reason the big banks like Commonwealth also tend to market 7 month terms heavily.
    By contrast 8 – 11 month terms and 13 – 23 month terms are less popular, less marketed and don’t carry the headline rates as a result. The theory that you should get a higher rate for a longer investment does however hold true when you look at extremely long terms like 3 years and five years.
    Within the spread of popular terms, most banks usually market a particular term heavily at any one time with a really competitive rate. This may be because they have a particular funding requirement for that period or they are simply trying to create a marketing opportunity in a highly competitive market.

  7. It’s just a rip-off. This month, the 7 month rate is OK, most of the rest are terrible. Next month, it might be the 4 month rate that’s good, and all of the rest will be terrible. When your deposit matures, they’re hoping that you won’t check the currently prevailing rates, and will just roll-over the deposit for the same term, at the terrible rate instead of the good rate.

  8. Are they trying to establish a confusopoly?
     
    Or is it just the old supermarket price discrimination trick?  Offer good prices to those who are prepared to look for them, but rubbish prices for the lazy who pick the first thing they see (a generalisation of SJ’s idea).

  9. BTW, I’ve been observing this phenomenon since about 2004. When CBA first started doing it, I got so annoyed with them that I withdrew everything and shifted to Westpac. Then Westpac started doing it too, plus some other evil stuff, so I went back to CBA as the lesser of two evils.

  10. the short story, after studying this for the last 3 years, is there are two things to consider.
    The first what Jonathan suggested; maturity matching of liabilities against cashflows/investment return to the bank (i.e. alpha). The second thing you want to consider is the term structure of interest rates and what the ‘market’ (i.e. cba) is implying about its view of the money market rates over the period (not just the rba short term cash rate in aus, but returns from off-shore funding sources etc).
    They jam these two things into a black box and outcomes the rates you see. Everyone is in awe at the magic (or confused as hell as to how they came up with them)
    The term structure of interest rates iss where economics and finance converge.
     

  11. “They jam these two things into a black box and outcomes the rates you see. Everyone is in awe at the magic (or confused as hell as to how they came up with them)
    The term structure of interest rates iss where economics and finance converge.”
    This is stupid, almost beyond belief. In what way exactly have you been “studying this for the last 3 years”? Theory is fine up to a point, but when it doesn’t match observed reality, you have to at least consider that there’s something wrong with either your theory or your assupmtions.
    As someone qualified in both finance and economics I can tell you that this ain’t the place where economics and finance converge. Finance theory offers no insights into this at all. It’s pure price discrimination. Exploitation of those remaining people who can’t belivee that their bank will rip them off.

  12. Just to clarify my original question: the RBA rate – 4.75% – is considered the risk-free rate. Now, bank deposits in Australia are government guaranteed, and are thus, I would assume, risk-free as well.
    So how can banks offer a higher rate than the RBA? Do bank deposits carry some additional risk that I’m not aware of?

  13. Although some of you have touched on it, the answer is about renewals. When a term deposit expires, it is automatically renewed for the same period. Often there is little notification of maturation meaning it’s hard to know when it’s coming back up. The bank says that it will be matured again for the same period (at the prevailing “market” rates) so most consumers will just let it roll over obliviously.

    So… if a bank knows that customers (or a sizeable minority, at least) will blindly roll-over at whatever rates apply, it’s in their interest to ensure that roll-over rates are very low. However, in order to get new business they need to have competitive rates. As suggested above, people will want to invest for ~6 months, so if the 5 month rate is good, that’s what new customers will choose, while rolling-over muppets will get a dodgy rate for 6 months. In 5 months time, I guarantee you that the 5 month rate will be pathetic and the 6 month rate will be good. And so, the cycle continues, with banks trying to extract all consumer surplus from their unaware customers.

    Think “Monopolistic competition”

    My advice – invest in shares.

  14. Matt, the rate set by the RBA is an overnight rate, whereas banks need to fund 30 year mortgages with longer term liabilities than overnight loans. Further, APRA is pushing them to increase the term of their liabilities just as the cost has gone up. Competition for term deposits is what has pushed the rate up and when the counterfactual is to borrow in the very expensive wholesale market, rates will very readily decouple from the overnight rate set by the RBA. The anomaly described by the author is, I am convinced, a sign that the glory days of retail term deposits are nearly over.

    Since I posted my initial comment there have continued to be improvements in credit markets, including ME Bank returning to 3yr RMBS issuance this week, when it upsized a deal and priced it at BBSW+100 without government support. This represents a circa 30 basis point improvement since Dec.

    Term deposit rates will fall. It’s as simple as that.

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