In the current low-rate environment, deposits are often given a target ROE of zero. This is because it’s very difficult to make money on deposits, especially if they are interest-bearing and overhead expenses necessary to service the account are factored in. However, there are other reasons that deposits may be desirable, not all of them economic. Aside from providing a source of funding, deposits may create customer loyalty or serve as an introduction to other, more-profitable bank products and services. So why does adding deposits to an opportunity result in a lower overall ROE for the opportunity?
In the example below, a $500,000 loan with a ROE of 16.48% results in a lower opportunity ROE of 14.87% once interest-bearing deposits of $25,000 are added to the opportunity. This is because the deposits have a target profitability of zero, which means they add nothing to the numerator of the ROE calculation, but they still require capital reserves, which increases the denominator.
If management has chosen to incentivize deposits, a lender cannot worry about deposit profitability or its overall impact on an opportunity since:
- Lenders do not control the pricing of deposits
- Management may have non-economic reasons behind their goal of increasing deposits.
Best practice suggests any incentive program should use deposit volume as the determinant of whether management goals for deposit acquisition are being met rather than the profitability of opportunities that include deposits. Lenders, however, should also be cognizant that the existence of deposits alone is not sufficient to reward a customer with a reduction in loan rates.