After 11 years of not raising interest rates, the European Central Bank (ECB) brought about the end of an era with a rate hike that will have a long-lasting impact on the German banking sector. Custody fees haven’t just presented the market with legal, technical, and economic problems, they’ve also been a challenge in terms of communication and enforcement toward end customers. So, what’s to be done?
From custody fee to zero
For better enforcement, many institutions have arranged to contractually link their custody fees to the key interest rate. For those that haven’t, their boards of directors have guaranteed, or made clear statements, that an end to the negative deposit facility at the ECB will also mean the end of custody fees.
Unfortunately, banks that are legally bound or have made commitments to their customers don’t have much leeway in working around custody fees. Even without guarantees or binding agreements, the public pressure after the ECB’s rate hike will make it virtually impossible to stick to the custody fee.
From zero to credit interest – but only for newly launched products
As soon as the short-term deposits exceed zero, banks’ scope for action and design increases considerably. Therefore, it’s important to keep some basic design principles in mind.
For banks unsure how to proceed, it’s particularly important they don’t attempt to please the entire customer base with an undifferentiated approach by offering credit interest rates that are just about acceptable for existing overnight deposit or account products. Not only would this be very expensive, but it would also likely be ineffective in preventing the outflow of investments.
Instead, attractive credit interest rates should be applied to newly launched products that don’t have a high portfolio volume. An example for the short term would be a new notice fee with a five-week notice period, which also has benefits for overall bank management (more on this later).
Newly launched products act as “internal exits” for price-sensitive customers. This way, price-sensitive and more attentive customers will find a new offer with a competitive, attractive interest rate at their current bank (“internal exit”), and actively transfer the funds within their bank. The attractive interest rates and the difficulty of transferring the funds to another bank (“external exit”) will keep these price-sensitive customers and their investments in-house.
Crucially, since depositors who are less price sensitive won’t opt to transfer funds either internally or externally, they vast majority will stick with existing interest-free products for the time being. Even if interest rates continue to rise, this will result in credit interest lagging behind market conditions, allowing for adequate passive condition contributions for the first time in years.
However, as mentioned, this only applies if banks offer attractive and clearly visible internal exits in the investment portfolio. This is so customers can transfer deposits internally if interest rates become a factor in their decision-making. This alternative solution for customers helps lower the risk of an outflow of deposits.
In the context of the interest rate reversal, the principle of differentiating prices depending on customers’ price sensitivity should always be considered. This can be achieved through self-selection by customers, who either act and transfer their investments to new products (demonstrating greater price sensitivity) or do nothing (demonstrating lower price sensitivity).
Create a new portfolio of investment products using a comprehensive investment strategy
When implementing the internal exit, another key design principle is to create a larger portfolio of investment products that gives customers multiple options to choose from.
In recent years, banks have continued to streamline their portfolios and have largely eliminated products such as fixed-term deposits, savings bonds, bearer bonds, and savings deposits with different notice periods. Low and negative interest rates made these products unsalable. With the interest rate reversal in effect, it’s now necessary to rebuild a differentiated portfolio of offers – one that’s based on a comprehensive investment strategy and the requirements of bank management.
It’s also important to learn from the period of negative interest rates and refrain from reactivating legacy assets such as savings deposits. The current political and macroeconomic situation is volatile, with high inflation, low growth, rising global national debt, supply chain disruptions, a pandemic, and over 350 wars and conflicts in the world.
Central banks are currently trying to bring the effects of inflation under control through a reversal in interest rates, even though the tools at their disposal have little effect on exogenous factors. In the medium and long term, banks will not be spared from another period of negative interest rates. This must be taken into account when developing a strategy for investment products. If negative interest rates return, savings deposits, growth savings, and bonus savings plans could become a problem again, since they can’t be adjusted quickly and can’t be charged custody fees without violating terms and conditions.
Banks should focus on creating a product portfolio that is attractive to and benefits both parties – customers and the bank. As the yield curve is currently steep, especially at the shorter end, banks can offer customers attractive conditions for relatively short terms (one to two years or with notice deposits of more than 365 days) and still generate passive condition contributions while taking action to relieve pressure on the net stable funding ratio (NSFR).
Regarding Basel III liquidity coverage ratios (LCR), according to the relevant deadlines for LCR, a notice deposit with more than 30 days’ notice (e.g., five to six weeks) could become an important new product in the portfolio of short-term investment products. This type of product could help relieve pressure on the LCR and simultaneously differentiate prices via the granularity factor in theoretical maturity scenarios to relieve pressure on market price risk management in the context of the different scenarios.
In terms of optimizing investments, maximum amounts will also play a role in the new short-term investment products – including from the bank’s internal management perspective. In addition to imposing caps on interest payments (e.g., a maximum of EUR 100,000), they will also affect condition contributions compared to opportunity costs, since different maturity scenarios are used for products with an indefinite capital commitment depending on the size of the volumes (granularity effect).
A portfolio with small-volume investments can therefore be viewed as significantly more stable and administered for longer than very large cash products. A reason for this is that small-volume investments can potentially occur on the sidelines and can, therefore, be disposed of quickly when the opportunity presents itself.
Differentiate interest rates within products
In addition to diversifying the range of investment products, banks should also apply price differentiation to interest rates within the newly created products – another important design principle. For example, in line with the notion of “whoever does a lot of business with us will receive better conditions,” loyal customers who use the bank across all its divisions could receive a premium interest rate. The closeness of the relationship is reflected in their “house bank” status, which can be linked to other benefits (see table below).
This allows banks to communicate attractive interest rates just to the relatively small group of their most loyal customers, improving customers’ overall product price perception. This in turn allows the banks to offer lower entry rates for lower house bank loyalty tiers, where most of the customers and volume are found. As a result, the average interest paid is well below the maximum interest rate that the bank indicates it could achieve.
Customers can earn a better interest rate by deepening their relationship with their house bank (principle of “favor for a favor”). The resulting revenue from cross-selling to these customers can be added to the contribution margin per customer. This approach also increases customer loyalty.
This differentiation logic can be implemented across all products, enabling banks to communicate attractive conditions across the entire investment portfolio without driving up the average purchase price.
Offer customers the right mix of interest rates and availability
What matters most to customers is having a good mix of interest rates and availability of investments. Banks looking to collect longer-term investments while offering customers regular access to funds without including implicit options should look at two things.
First, back to periods with steep yield curves and second, the successful rolling investment products they had in place then. Rolling investment products are an alternative to growth savings products but without the implicit options that cause significant problems in market price risk management. In short, they take each customer’s investment and deposit it in a number of tranches (three in this example):
The first tranche expires after one year and (if another order isn’t defined) it’s automatically extended by three years. The second tranche expires after two years and (if another order isn’t defined) will automatically be extended by three years. The same thing happens with the three-year tranche.
This allows customers to benefit from the high three-year interest rate while still giving them access to a third of their volume in liquid from the start and not disadvantaging the bank in any way.
We have also designed these products for four- and five-year terms. The steeper the yield curve in the one-to-five-year maturity range, the more attractive the products become in the respective maturities. The term premiums on capital markets of 15 to 20 basis points per year currently provide a good basis for price differentiation.
In addition, banks should always design and advise customers on their preferred interest-availability mix using a combination of short-term and longer-term investments. Customers can get advisory support through innovative online investment configurators, where they can split their investments into shorter-term and longer-term sections (0 to 100 percent and vice versa) and then select a suitable short-term or long-term investment product for each section.
Consider strengthening the capital base
With regulatory capital requirements continually increasing, banks should consider strengthening the capital cover as part of their management strategy for investments. For example, long-term subordinated investments can be added to the portfolio, appealing to both the bank and customers, increasing the risk-bearing capacity by raising supplementary capital.
Since the opportunity interest rates on the capital market for these kinds of investments are high, this gives customers a very attractive interest warrant. The risk associated with these investments is minimal, both in terms of customer perception and the institution's security mechanisms.
For cooperatives, the dividend on business assets included in the core capital is a logical upper limit for interest warrants on subordinated investments. Systematically strengthening core capital by building up business capital is another way to facilitate growth and better meet regulatory requirements.
However, this raises the question: Which members should be allowed to benefit from the revenue generated by the cooperative via the dividend policy and by how much? Once again, differentiating based on the depth of the customer relationship with the bank (i.e., house bank status) offers a good solution. Members who don’t do any business outside of their account contribute very little due to the limited subscription options provided by the business assets (in practice e.g., max. EUR 500) and therefore can expect just a symbolic dividend.
Members who use the cooperative for all their finances and have a very high house bank status can subscribe to four- or five-figure sums of business assets and receive benefits proportional to the bank's successes as a result. The entire approach can and must be established systematically – arbitrary individual decisions directly contradict the principle of equal treatment the cooperative is built upon.
With our approach to differentiating based on house bank status, we have supported banks in achieving membership volume growth of over 40 percent in just a few months. However, banks should proceed with caution when individual payments are too high because very high business assets suggest to the membership that the process of calculating the risk-bearing capacity may come under corrective regulatory measures should uncertainty arise.
Develop your portfolio and reap the rewards
The end of custody fees is imminent. As banks return to passive condition contributions, they will need to differentiate their range of offers.
Banks have a limited amount of time to prepare for this before investment rates start to move again. Due to advances in digitalization, changes in regulations, and increased customer mobility, they can no longer look to the past for a ready-made solution to the challenges ahead.
If banks are going to tap into the revenue opportunities presented by this change, their goal must be to develop an attractive new portfolio for investments that differentiates between customers to provide the maximum possible benefit to both the bank and its customers.