Why care about CD early withdrawal penalties? Since their introduction bank CDs have been marketed as relatively simple financial investments. CDs provide secure, fixed income to the depositors at interest rates that are more attractive than checking or savings. The depositor investing in CDs has traded off liquidity for income. They have acknowledged that there is a “substantial penalty for early withdrawal” and have accepted that for the opportunity to get a FDIC insured, fixed rate investment.
CDs have historically provided banks with a stable source of funds at a known interest cost. This has allowed banks to lock-in interest margins on longer-term investments in loans and securities. Banks have modeled their future earnings based on these contracts they have with depositors to pay a fixed rate of interest for a fixed period of time.
Over the last 25 years early withdrawal of CDs has not been a significant problem for the banking industry. The depositors are well aware that there is a “substantial penalty for early withdrawal”. The banks have generally maintained the same penalty language in their contracts with depositors ever since they began offering CDs. Current CD customers are not interested in early withdrawal today since virtually all CDs on the books now have higher interest rates than those presently being offered. Why should financial institutions be concerned?
Are your CD early withdrawal penalties “substantial”? Do you know how to measure the value of the embedded options in your CD early withdrawal penalties?
As long as rates remain at the lowest level of our careers there is little reason for banks to be concerned about early withdrawal penalties. If however, interest rates go up in the future, will economics allow depositors who hold CDs to improve their financial position without any risk to them, but at the expense of their current financial institution, and for the benefit of their new bank that attracts these funds at fair market rates?
In most banks CDs constitute 20-45% of the balance sheet. What defensive and offensive strategies have you developed regarding this important component of your bank?
Neil Stanley, Bank Performance Strategies will be a featured speaker at the IBA Management Conference, February 8-9, 2011 in Des Moines.