Chapter -6

Pricing of the product

Contents:-
Deposit pricing-Cost plus margin deposit,
product, market penetration, Conditional,
Relationship, upscale target pricing. Loan
pricing, Base interest rate, Risk based pricing
 Deposits

• it is the vital input or raw material for bank.

• It is the sources of capital to fund bank loans and security
purchase and help generate profit to support long term growth.
• it consist of money placed into banking institutions for
safekeeping
• a saving account, current account or any other type of bank
account that allows money to be deposited and withdrawn by the
account holder.
• It is generate cash reserve and it is out of the excess cash reserve
a bank holds that new loans are created.
Interest rates offered on different types of
deposits
•A different type of deposits carries a different interest rate. In general,
the longer the maturity of a deposit, the greater the yield that must be
offered to depositors, because of the time value of money.
•Savings deposits are subject to immediate withdrawal by the customer,
the interest rate offered by the bank is the lowest of all deposits.
•Certificate of deposits of a year or longer to maturity often carry the
higher interest rates that bank offer.
•The size and risk exposure of the offering banks also pay an important
role in determining the interest rates. For example, Nepal Standard
Chartered Bank Nepal and Nabil Bank Ltd are able to offer deposits at
the lowest interest rates due to their greater size and strength. On the
other hand, the new banks offer higher interest rate due to the high risk
and small in size.
Composition of Bank Deposits
•The most readily saleable deposits banks that offered to the
public have been time and savings deposits. The best mix of
deposits would generally prefer a high proportion of demand
deposits and low yielding time and savings deposits. These
accounts are among the least expensive of all bank sources of
funds and often include a substantial percentage of core
deposits.
• The combination of inflation, de-regulation, strong
competition, and better educated customers has resulted in a
dramatic shift in the mix of deposits banks are able to sell.
• Due to high competition between banks, Nepalese banks
also offer various scheme to attract the customers.
 Pricing Deposit Related Services
• The most popular of these deposit pricing approaches is the setting
of price schedules where the fee the customer is assessed is
conditional on the degree to which he/she uses a particular deposit
service.
• This approach gives customers more options in choosing the
particular deposit plan they find the least expensive and signals to
banker information about the customer’s money using habits.
•In a financial marketplace, bank management must decide if it
wishes to attract more deposits and hold all those it currently has by
offering depositors at least the market determined price.
•The deposit pricing models are discussed in the following section.
i. Cost-Plus Profit Deposit Pricing
ii. Pooled Funds Approach
iii. Marginal Cost Pricing
iv. Market Penetration Deposit Pricing
v. Price Schedules to Segment Deposit
vi. Upscale Target Pricing
vii. Relationship Pricing
viii. Bank Goal Deposit Pricing
 i. Cost-Plus Profit Deposit Pricing

•In cost plus profit deposit pricing, a estimates all the operating and
overhead costs incurred in providing each deposit service unit and adds
in a margin for profit to compensate the bank’s shareholders for placing
their funds at the bank’s disposal.
•The price of deposit services can be calculated from the following cost
plus profit deposit pricing formula:
Unit price charged the customer for each deposit service = Operating
expense per unit of deposit service + Estimated overhead expense
allocated to the bank’s deposit function + Planned profit from each
deposit service unit sold
• Deposits are usually priced separately from loans and other bank
services and each deposit service is often priced high enough to
recover all or most of the cost of
 ii. Pooled Funds Approach
•The cost plus deposit pricing demands an accurate calculation of the cost
of each deposit service.
•This approach considers the cost of each type of deposits i.e. the
weighted average cost of all bank funding sources. This requires the
banker (1) to calculate the cost rate of each source of bank funds
(adjusted for reserves required by the central bank, deposit insurance fees,
and float); (2) to multiply each cost rate by the relative proportion of bank
funds coming from that particular source; and (3) to sum all resulting
products to derive the weighted average cost of bank funds.
•This is called pooled funds approach because it is based on the weighted
average cost of all bank funding sources. This method determines the
minimum rate of return is the bank going to have to earn on any future
loans and securities to cover the cost of all new funds raised.
Step 1: Calculate the cost rate of each source of bank funds
Cost rate for related deposits = Interest and noninterest raising
costs/(1- reserve requirement in fraction)
Cost rate for owner’s capital = Interest and non interest fund raising
costs/1
Step2: Calculate the proportion of the bank funds
Proportion of related deposits = Related Deposits/ Total funds raised
Proportion of owner’s capital = Owner’s Capital/ Total funds raised
Step 3: Multiply result of step 1 and step 2 to get the weighed
average before tax cost
Weighted average cost = Proportion of deposit * cost rate of deposit +
Proportion of owner’s capital * cost rate of owner’s capital
 iii Marginal Cost Pricing
• Marginal cost is the added cost of bringing in new funds. Marginal
cost pricing set the price at a level just sufficient to attract new
deposits and still earn a profit on the last rupee of new funds raised
• It is more realistic than weighted average cost to price the deposits
and other bank funds sources. If the interest rates are declining, the
added cost of raising new money may fall well below the average
cost over all funds raised by the bank. Some loans and investments
that looked unprofitable when compare to average cost will now
look quite profitable when measured against the lower marginal
interest cost. If interest rates are on the rise, the marginal cost of
today’s new money may substantially exceed the bank’s average
cost of funds. If bank books new loans based on average cost, they
may be highly unprofitable when measured against the higher
marginal cost of raising new funds.
The new loan yield represents marginal revenue, the added operating revenue the
bank will generate by making new loans from the new deposits. The marginal
cost of money deposit rate from one level to another and the marginal cost rate is
the percentage cost of the volume of additional funds coming into the bank. The
marginal cost rate must be compare with the expected additional revenue
(marginal revenue) the bank expects to earn from investing its new deposits.
Marginal cost and marginal cost rate is calculated as follows:
Marginal cost* = New interest rate × total funds raised at new rate – Old interest
rate × total funds raised at old rate
Marginal cost rate = Change in total cost Additional funds raised
The marginal cost approach provides valuable information to bank managers
about the setting deposit interest rates and decide in expanding the its deposit
base. When the profits to fall, management needs either to find new sources of
funding with lower marginal costs or to identify new loans and investments
promoting greater marginal revenues or both.
Current marginal cost – previous marginal cost.
 iv. Market Penetration Deposit Pricing
•This method does not focus profits and cost recovery, at least in
the short run.
•This method offer high interest rates and low fees well below
the market standards in order to bring in as many new customers
as possible. Initially customers are encourage to opening an
account and then raise prices and fees later on.
•Management hopes that the resulting larger deposit volume
and the associated loan business brought in will offset a lower
profit margin.
•Market penetration pricing is a strategy aimed primarily at
rapidly growing markets in which a bank is determined to
capture the largest possible market share. For examples NIC
bank use this model.
 V. Price Schedules to Segment Deposit
•Under this method, interest rate the customer may earn
and the fees are conditional on the intensity of use of
deposit services and the balance in the account. So, it is
called conditional pricing.
•The bank sets up a schedule of fees in which the customer
pays a low fee or even no fee if the deposit balance
remains above some minimum level; but higher fee is
assessed if the average balance falls below that minimum.
• The customer pays a price conditioned on how he/she
uses the deposit.
Vi Upscale Target Pricing
•Upscale target pricing setting of prices and fees on deposit
accounts in an effort to attract those customers who hold high
balances and purchase the bank services.
•They use carefully designated advertising programs to target
established professionals (e.g., doctors and lawyers), business
owners and managers, and other high income households
with services and service fees that build in high profit
margins. Other deposit accounts, especially the low balance,
high activity ones, may be priced to break even or they may
be discouraged altogether through higher prices.
 Vii. Relationship Pricing

• The price of the deposit depends on the number of services the

customer uses. The customers who buy two or more bank
services may be granted lower deposit fees or have some fees
waived compared to the fees charged customers having only a
limited relationship to the bank. The selling of multiple
services increases the customer’s dependence on the bank and
makes it harder for that customer to go elsewhere because of
strong relationship between customer and bank.
• Relationship pricing promotes grater customer loyalty and
makes the customer less sensitive to the interest rates offered
on deposits or the prices posted on the banking services by
competing financial service firms
 Viii. Bank Goal Deposit Pricing
•This deposit pricing is used to protect and
increase the bank profitability rather than to
simply add more customers, take make shares
away from competitors, or even drive less
desirable customers away.
Loan Pricing
Base Interest Rate

•The base rate is a rate set by a bank below which it cannot

lend. Banks currently use a number of methods to calculate
their base rates, such as using their average, blended or
marginal cost of funding.
Base rate = Cost of fund + Cost of CRR + Cost of SLR + Cost of
operating expense + Return on assets