By Mark H. Smith, Founder, Mark H. Smith, Inc.
Segmentation strategies continue to evolve as a tool to manage the cost of funds and optimize the flow of deposits. We began urging clients to consider segmentation strategies in 2001 and continue to advocate their use.
The objectives of a segmentation strategy are:
- Separate rate-sensitive from non-rate-sensitive deposits
- Minimize the cost of non-rate-sensitive funds at a very low level
- For rate-sensitive deposits, minimize the cost at or below market rates and control the flow of funds. That is, attract needed deposits when necessary and discourage undesirable deposits
- Validate the rate sensitivity assumptions used in your income simulation modeling scenarios
Remember that in terms of economic substance, shares and deposits are the same and I use the terms interchangeably. Also the terms interest expense, dividend expense and cost of funds are used interchangeably.
The basic principle of segmentation works best within a class of deposits. We suggest beginning with a single class: the one almost universally called regular shares.
The most effective starting point is the point when rates are low—as they are now. The segmentation occurs by offering savings relationships with different rates and characteristics and allowing savers to choose. For example, in the non-maturity shares class we would offer regular shares and money market shares. For the moment, the rates on both relationships would be very low—for example say 10 bp for regular shares and 25 bp for money market shares.
Traditionally, regular share savers have more utilitarian motives for saving, such as convenience, safety, access, and tradition. They are often not motivated by rate. Money market account savers are more rate-sensitive but may not be as rate-sensitive as we often assume.
When rates increase, our objective is to retain the non-rate-sensitive shares in the regular shares relationships and continue to pay a low rate. Savers who are rate-sensitive can capture a competitive rate by migrating into a money market relationship. As rates increase, our strategy will be to hold the line and not increase dividends on regular shares. We will increase the dividend on money market shares so as to be competitive at the low end of the money market range. At some point in time, our rate-sensitive savers with money in regular shares may notice the disparity in rates. It is a simple solution for them to obtain a competitive rate by transferring the relationship to money market shares.
In previous editions of our CU ALM Report we talked about surge shares and the unknowns they create in our non-maturity shares classes. We may have an unknown component of rate-sensitivity in our regular shares that has resulted from surge shares. A segmentation strategy is an ideal approach to retaining these relationships if it is to the credit union’s advantage to do so. If the surge shares are not rate sensitive they will, as rates rise, remain with the regular shares. If they are found to be rate sensitive, they will migrate to the money market shares or to a certificate relationship. If the credit union does not need funding, these shares can be sent on their way when rates increase.
Here is an example of a segmentation strategy in its simplest form. First, the Beginning Scenario: the credit union has $100 million in regular shares currently paying 10 bp with no segmentation. The credit union does not offer a money market shares relationship at this time. Our cost of funds in this scenario is 10 bp x $100 million which equals $100,000/year.
Now let’s consider a Rates Up Scenario where rates rise by 90 basis points: The credit union now has several options as to how to proceed:
Choice A is to continue the status quo without segmentation and increase the dividends on regular shares to 100 bp. This choice would allow the credit union to retain the rate-sensitive regular shares and make every saver happy. Under this choice the cost of funds is 1% x $100 million which equals $1,000,000/year, an increase of $900,000 over the beginning scenario above.
Choice B is to deploy a segmentation strategy as follows: Continue to offer regular shares at 10 bp. Offer a money market shares relationship which pays at 100 bp. The members now have a choice. They can accept 10 bp in their regular shares or transfer to money market shares. One would think that every member would make the transfer. Based on our experience, that will not happen. In fact, if experience is any indicator, only a small number of the regular shares will transfer to money market shares. But just to be conservative and to take into account the unknown impact of surge shares, let’s say that 50% make the transfer. This is often referred to as the cannibalization rate. As in Choice A, above, all of the members are happy. Those that transferred to the money market share are receiving the higher rate that they want. Those that didn't transfer apparently don’t care.
Here are the numbers:
$50 million remains in regular shares – Annual cost @ 10 bp = $50,000
$50 million moves to money market shares- Annual cost @ 100 bp = $500,000
Total cost of funds = $550,000
Conclusion: The new cost of funds without segmentation in Choice A above is $1,000,000. The cost of funds in choice B is $550,000, a savings of $450,000 over Choice A, the no segmentation approach. With rates now at historic lows it’s hard to imagine a downside to a segmentation strategy.
Obviously, I can make whatever assumptions I want in this example. I can tell you from experience over the last 14 years from clients who have deployed this strategy, the level of cannibalization from regular shares to money market shares in a scenario like this would have been much lower than used in the above example. I used the very conservative assumptions above recognizing there may be a component in your regular shares that is more rate-sensitive than in the past due to surge shares.
The real point here is that, in a rising rate environment, it is almost always foolhardy to raise rates unilaterally.
Segmentation strategies are very effective in managing the cost of funds when interest rates are increasing. In the rising rate environment that we face in the future, a segmentation strategy may be the difference between negative or positive net income.
Lastly, a caveat, when making changes to a large component of your balance sheet remember the impact can be very significant. The impact may be positive or negative. In the case of segmentation strategies the likelihood of negative impact appears low. However, it is important that you have a feedback mechanism in place to evaluate the impact of your decision on a very timely basis. While it may not be likely, you must be ready to alter your strategy promptly or reverse it if necessary when the outcome is not as you anticipated.
We wish you success in your efforts and, as always, welcome your questions and feedback.