Mod 2.pptx
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Banks use several methods to determine pricing for deposits and loans: 1. Pricing deposits at cost plus a profit margin to cover costs of providing deposit services and earn a small profit. 2. Using marginal cost rather than average historical cost to set interest rates on deposits due to fluctuating rates. 3. Conditional pricing where fees depend on maintaining a minimum balance or number of transactions. 4. Relationship pricing where customers receive lower fees for using multiple bank services. 5. Loan pricing is based on the bank's base rate plus a risk premium, where the base rate covers interest expenses, administrative costs, and cost of capital.
Mod 2.pptx
- 1. Developing Banking Products and Services
- 2. OBJECTIVES OF PRICING Price is a function of demand and supply. It means market forces determine the price and hence there is a little role for the producers in pricing the product, For instance, a firm that manufactures computers fixes a price based on its own estimation of demand at various price levels such that it achieves a maximum profit. Similarly, in banking services, banks fix the price for issuing demand drafts based on its own estimation of cost associated with the preparation and accounting of demand draft and expected return from such services. Survival: Business units typically pursue several objectives simultaneously for different time horizon. For many firms, particularly those operating in a competitive market, survival is the short-term objective. This objective may be for the entire business units or for a particular new product. Profit: Business units exist to maximise the profit. Profit equation shows that the quantity sold, cost and the price are three important elements of profit. If other things remain constant, profit can be maximised by fixing higher price. Often, price affects other elements of profit equation. Return on Investments (ROI): It is possible for a firm to make profit but may fail to achieve the required rate of return on investments. The profit objective fails to recognize the amount invested in generating profit. The pricing objective based on ROI is to fix a price, which ensures required or targeted ROI. In banking context, when a bank introduces a new product like loan scheme or service and commits funds or resources, the bank has to carefully assess the impact of price on volume and cost and return on investments.
- 3. Methods Used to Determine the Pricing of Deposits and Calculation of the Price of a Deposit Account • The main goal of depository institutions is to price their deposit services in a way that attracts new funds and makes a profit. The management faces a difficult decision-making scenario as it has to balance between the institution’s needs to pay a high enough interest return to attract and hold customer funds, at the same time, avoid paying an interest rate so costly it erodes any potential profit margin. • However, financial institutions are price takers, not price makers in a perfectly competitive market. The management must, therefore, decide if it wishes to attract more deposits and hold all those it currently has by offering depositors at least the market-determined price, or whether it is willing to lose funds. Methods of calculating the price of a deposit account are discussed below: Pricing Deposits at Cost Plus Profit Margin Cost-plus deposit pricing encourages banks to determine the costs they incur in labor and management time, materials, among others, in offering each deposit service. Cost-plus pricing typically calls for a bank to charge deposit service fees enough to cover all the costs of providing the service in addition to a small margin for profit. Every deposit service may be priced high enough to recover all or most of the cost of offering that service. Using Marginal Cost to Set Interest Rates On Deposits Many financial analysts would argue that the marginal cost, and not the historical average cost, should be used to price deposits and funding sources. This is because frequent fluctuations in interest rates make historical average cost an unreliable standard for pricing.
- 4. • Conditional Pricing • Depository institutions, particularly banks, use conditional pricing as a tool to attract the kind of depositors they want to have as customers. In this case, a depository institution sets up a schedule of fees in which the customer pays a low fee or no fee given that the deposit balance is above some minimum level. However, the customer is liable to higher charges if the average balance drops below that minimum level. In other words, the customer pays the price conditional on how they use a deposit account. • Conditional pricing is based on one or more of the following factors: • The average balance in the account during the period; • The maturity of the deposit; and/or • The number of transactions going through the account. For example, the number of deposits made, or notices of insufficient funds issued. • Relationship Pricing • Depository institution prices deposits according to the number of services purchased or utilized. The depositor may be given lower fees or have a part of the cost waived if they have used two or more services – for example, having a checking account, a savings account, and his/her mortgage at the same financial institution.
- 5. • Methods of Loan Pricing followed by Commercial Banks • The price/interest rate is determined by the true cost of the loan to the bank(base rate)plus profit/risk premium for the bank’s services and acceptance of risk. The components of the true cost of a loan are: • Interest expense, • Administrative cost, and • Cost of capital • These three components add up to the bank’s base rate. The risk is the measurable possibility of losing or not gaining the value. The primary risk of making a loan is repayment risk, which is the measurable possibility that a borrower will not repay the obligation as agreed. • A good lending decision minimizes repayment risk. The prices a borrower must pay to the bank for assessing and accepting this risk is called the risk premium. • Since the past performance of a sector, industry, or company is a strong indicator of future performance, risk premiums are generally based on the historical quantifiable amount of losses in that category. • Price of the loan(Interest Rate Charge) = Base Rate + Risk Premium. • Loan pricing is not an exact science- it gets adjusted by various qualitative and qualitative variables affecting demand for and supply of funds. These are several methods of calculating loan prices.
- 6. • Internal factors • The objectives of the company • The components of the marketing mix • Risks • Costs