Pub. 10 2022 Issue 2

Rising Rates: It’s Time to Implement a Marginal Cost Culture in Your Bank Rates are on the rise. Banks are watching what their competitors are doing with their deposit rates. Richard H. Thaler, Behavioral Economist and recipient of the 2017 Nobel Prize for Economic Sciences, once summed up the human gut-level emotion of peer pressure and competition: “An especially good way to gain weight is to have dinner with other people. On average, those who eat with one person eat about 3% more than they do when they are alone; members of a group of four eat about 75% more; those in groups of seven or more eat about 96% more.” Being Mindful of Decision-Making Biases The current rate environment stirs up the competitive juices of many a bank, causing deposit pricing decisions to come from error-prone biases as: availability (this just happened), outcome (that’s never happened), confirmation (that’s what I thought would happen) and salience (fear factor) and even the ostrich effect (that can’t possibly happen). To temper decision-making biases, now is a good time to pull out your college microeconomics textbooks and instill a marginal cost of funds culture within your bank. The Role of Marginal Cost in Deposit Pricing You remember the marginal cost equation, right? In any profit-seeking enterprise, it’s the relationship between the change in a firm’s total cost relative to the change in the quantity of goods produced. If your marginal cost exceeds your marginal revenue, you’re out-of-the-money. In the case of banking, the same concept would apply, especially in the areas of deposit pricing and promotion. Economic theory would dictate that if you are able to attract deposits at an incremental rate that is less than your marginal cost, you will attract funds below your marginal cost. The worst thing you can do is attempt to attract deposits at a rate that is higher than your marginal cost. When it comes to deposit pricing, especially when you’re launching defensive strategies, it’s critical to get your bank to understand the concept and adopt a marginal cost culture. You’ll see that shifting to a marginal cost of funds mindset will help you minimize the cost of obtaining funding and force you to think about how your rate-sensitive members might impact any incremental deposit growth, as well as how varying degrees of rate sensitivity might alter your cost of obtaining funds in a rising rate environment. Building an Effective Defensive Marginal Cost of Funds Strategy in a Rising Rate Environment You’ve likely seen an inordinate degree of deposit growth in recent years. It’s been a tough environment in which to invest your low-cost source of funds. What will break the snap? The end of the zero-interest-rate It’s Time to Dust Off Your Economics Textbooks and Develop a Marginal Cost of Funds Culture GUEST ARTICLE By John Biestman, FHLB 18 The Community Banker mibonline.org

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