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RETAIL BANKINGACADEMYCourse Code 103 - Products

103.Products

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61© Retail Banking Academy, 2014

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RETAIL BANKINGACADEMY

Course Code 103Products

Introduction

Retail banking is a service industry and as a result, retail banking products are financial services which are quite different from physical goods. Examples of service industries are professional (legal, education), hospitality (hotels, restaurants), personal (hairstyling and grooming) and of course, financial (banking, insurance, investment management and planning). But even in the category of service industries, financial services stand out and have unique features of their own. Indeed, financial services share the common attributes of all service industries, but have additional features. For example, there is a fiduciary responsibility owed by the financial institution, as service provider, and customers have contractual responsibilities over the lifetime of the financial service (e.g., McKechnie*,1992).

Chapter 1 deals with the attributes of financial services that have important implications for customer service experience.

Retail banking products may be placed in different categories to serve different types of customer needs. While there are different categories of retail banking products ranging from payment products to those serving investment objectives, it is always important to approach them within a framework that is understandable from a customer perspective.

Chapter 2 presents a categorisation of retail banking products intended to match customer needs throughout the life cycle. This increases the likelihood of a correct match between customer needs and bank products.

Next, in Chapter 3, we consider the pricing of savings and loan products with a view to demonstrating that pricing in retail banking – financial intermediaries as shown in Retail Banking Overview – is always relative to some benchmark. This is the essence of pricing that is common in retail banking.

* Sally McKechnie, ‘Consumer Buying Behaviour in Financial Services: An Overview’, International Journal of Bank Marketing, Vol 10 Issue 5, pp 5 - 39 (1992).

Course Code 103 - Products

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The remainder of this module is organised as follows:

Chapter 1: Attributes of Financial Services in Retail Banking

Chapter 2: Retail Bank Products/Services – Categories and Functions

Chapter 3: Pricing of Retail Banking Products

Chapter 4: Products in Islamic Banking

This module concludes with a summary and review questions.

Open Question #1

Why is pricing of savings products or loan products conducted with respect to some benchmark such as the cost of funding?


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Chapter 1: Attributes of Financial Services in Retail Banking

Financial services share four attributes with other service industries. There are other features that are unique to financial services that we will discuss in due course. These four common attributes of service industries are:

1. Intangibility, which means that services lack a physical form. Hence, unlike physical goods that are tangible, services cannot be sensed or touched or even displayed in the pre-purchase stage of a customer-bank transaction. It is difficult to have an emotional connection to an actual savings account, as would be the case with a luxury watch, or car, or a designer handbag.

2. Inseparability, which means that a service is produced by the service provider and consumed (i.e., experienced) by the consumer at the same time. Think of a service such as a haircut delivered by a barber. There is no separation in time between the production of the service by the barber and the consumption of the service by the consumer.

3. Perishability, which means that service providers cannot store their service (i.e., it cannot be inventoried). In the context of financial services, perishability also means that once the term of the contract (e.g., a two-year loan) is reached, the service has perished, or is terminated.

4. Heterogeneity, which means that the quality of service delivered by bank staff is not exactly the same each time, but varies over time – not, it is hoped, with high variability.* This is normal customer experience in service industries. One does not expect that a concert performance is identical each day.

This has important implications for the retail bank. First, customer satisfaction is determined by the actions of the people delivering the service. Second, while training and development of bank staff can help to maintain consistency, there are always unexpected and uncontrollable factors that could create higher variation in service.

* Variability of service delivery is considered in Operations I where Lean Six Sigma is considered.


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The common four attributes of services are summarised below:

Intangibility

Inseparability

Perishability

Heterogeneity

Lacks Physical Form

Co-creation

No Storage & Finite Life

People Dependent

Serv

ices

103.1: Four attributes of services

There are implications for the bank staff that are derived from the four attributes, as stated above. These include:

a) There is a fiduciary responsibility of the retail bank as service provider over customer funds entrusted to them. Customers who own savings accounts understand that the bank will lend their savings in the form of loans to other customers and make a profit. But borrowers can default and the bank may not be able to get its money back in full. This may affect the return promised to savers. Hence savings accounts customers expect that the bank will exercise due diligence and not take excessive risks on its banking book.

The bank has discretionary power to affect the saver’s assurance of a guaranteed rate of return and principal. This is the essence of a fiduciary relationship – dependency by one party, which is the savings account customer.

b) Unlike other services, financial services can create inertia in the customer-bank relationship. This means that trust and confidence in the bank staff take time to develop. This means that customer experience with the bank staff must be confirmed and validated in order for a long-term relationship to develop. This investment by the customer in the relationship is a form of switching cost.

Customer inertia is created by, among other factors, high switching cost.

c) The third unique feature of financial services is based on the observation that while some customer transactions are short-lived (e.g., checking account balance), they are part of a longer-term customer-bank relationship that creates these short-term transactions. For example, a long-term loan contract creates short-term transactions such as interest payments. Hence a two-way flow of information is required to develop the long-term relationship that then creates short-term transactions. The bank requires this two-way flow to develop a correct view of the customer.

Three additional attributes of financial services

McKechnie (1992), as cited in Omarini (2011), identified three other characteristics present in financial services but not always for other services. These are:

“(1) transparency of performance, which refers to the availability of information presented by the bank, and consumer ability to make evaluations based on that information; (2) uncertainty of outcome, marked by consumer control over the uncertain external environment and by the process of co-creation during the production of services; and (3) poor comparability caused by the scarce number of identifiable attributes and the long-term maturity of the service offerings.”*

* Anna Omarini: ‘Retail banking: the Challenge of Getting Customer Intimate’, Banks and Bank Systems, Vol 6, Issue 3, p81 (2011).


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Note that transparency of performance is affected by the fact that customers may have limited information compared to bank staff. This is especially true when customers invest in bank mutual funds where customers may find that they have limited information to assess the reported investment performance. In addition, customers may not have sufficient knowledge about investment jargon and so may suffer doubt about the investment performance. So there are two sources of information risk that customers may incur when assessing performance – limited information and information ambiguity.

The fact that financial services are delivered in an environment that is unpredictable means that performance is not assured. Uncertainty arises from an economic environment that creates risk, as well as the more local issue of co-creation where performance depends on the ability of bank staff. There are two dimensions to uncertainty of performance – economic environment and the co-creation service delivery process.

The third unique attribute of financial services is the lack of sufficient information for the comparability of performance. This is due to the uniqueness of bank offers with different maturities. Of course, all personal loans incur credit risk. But each bank may underwrite personal loans based on customer-specific demographics and other variables. Hence the performance of a loan book may not be comparable with that of another bank.

We may summarise the attributes of financial services as follows:

Summary of Attributes

Services have four fundamental attributes: intangibility, inseparability, perishability and heterogeneity. Financial services have three additional attributes – transparency of performance, uncertainty of performance and poor comparability of performance.

We now categorise bank products according to the main benefits they deliver to the customer in a particular stage of his/her life cycle.

These attributes have important implications as pointed out in later modules in this programme such as Marketing, Effective Sales Management, Customer Service Quality and Relationship Management.


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Chapter 2: Retail Bank Products/Services – Categories and Functions

We begin this chapter with an open question that is based on an interesting perspective on bank products.*

Open Question #2

DiVanna (2004, page 20)* states that the principal product of a retail bank is “a solution that fulfills an individual’s need or, more precisely, a set of integrated solutions that support the individual’s lifestyle and financial responsibilities.”

What is your opinion about the philosophical point of view expressed by DiVanna?

As we stated in the previous module (course code 102), the core services of a retail bank are a direct response to demands of individual consumers and small and medium-sized businesses (SMEs).

In other words, banks create supply in response to customer demand.

Individual consumers and SMEs use retail banks to:

a) Make payments

As stated in Module 102 and repeated here for emphasis, customers can make payments through a ‘transactional account’. These accounts are called ‘checking accounts’ in the US and ‘current accounts’ in the UK. As opposed to, for example, time deposits, funds in current accounts are available on demand, and hence are also known as ‘demand deposits’. These accounts usually do not earn any interest income since they are intended to facilitate payment services. Banks provide several ways for the customer to conduct payments or money transfers. These include direct deposit (GIRO), standing orders (regular automatic transfer of funds), debit cards (direct cashless payment of merchandise purchases), credit cards, and international transfer of funds (SWIFT).

* Joseph DiVanna: The Future of Retail Banking: Delivering Value to Global Customer, Palgrave Macmillan, (2004).


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We present more details on these payment options.

Payments/Transfers – Allows for moving money either between accounts of the same bank (internally) or to accounts in other banks. This service also allows customers to make payments to service providers (utility companies, phone companies) by transferring money from their current/savings account to the entity. This provides the convenience of payment without using cash. In most countries, banks provide these services through online banking for maximum convenience.

By providing these services, the bank reinforces the banking relationship for customers who open accounts. These services induce customers to adopt the bank accounts and ensure use of the same. This in turn leads to customer satisfaction, customer loyalty and retention.

There may be fees for these services that cover the costs of the operation. Banks also may offer no-fee (waived) payment options to reinforce the relationship. Since the cost of providing these services in the physical world (branches) requires costly branch premises and manpower, most banks are adopting strategies to offer online services to customers, hence ensuring that customers do not need to come to branches. Customers are increasingly encouraged to arrange these payments online, which saves the bank money and often costs less for customers compared with doing it in the bank branch.

For the customer, payments and transfers offer convenience and security (especially in the case of large payments). For some operations, and with the advent of online-banking technology, the cost of transferring money may be less than that of writing a cheque or using other payment means, especially as fees are often waived for these transfers. Online service also provides the flexibility for the customer to make these payments and transfers anytime and anywhere in the world.

Currency Exchange – Currency exchange allows customers to exchange currency as an added service to the core account relationship or a convenient and secure means for non-bank customers (tourists and others) to exchange currency on the spot. This may include the ability to open foreign-currency accounts and exchange funds internally (or between accounts). With the global economy becoming more connected, customers of retail banks are increasingly travelling between countries. This has led to increased demand from customers to have access to multiple currencies from their bank.

Since banks exchange currencies, they maintain a ‘spread’ between their buying price and selling price. This spread is income for the bank that may be complemented by a fee charged to the customer for this transaction. In order to maximise the revenue opportunity, banks tend to charge higher fees from non-customers. This not only results in better earnings but is sometimes a reason for non-customers to initiate a relationship with the bank. Currency-exchange services provide an additional convenience for existing bank customers and can reinforce the core relationship when offered effectively to the ‘right’ customers.

Cards – Banks may provide ATM cards or debit cards to their customer as instruments for accessing accounts and making payments. Cards are typically tied to a current account, savings account or loan overdraft facility. This is the most used service for retail banks, and trends show that the number of cards and their use is growing at an astronomical pace. Increasingly cards are serving as a substitute for cash in making payments in retail and other outlets, a phenomenon called plastic money.

ATM cards provide access to customer current or savings account via the bank’s ATM machines or those of other banks in the network. They allow customers to withdraw money and also to perform some other transactions, such as balance enquiries and transfers across accounts. Therefore the ATM access to the account is restricted by the number of ATMs installed by the bank. ATM cards do not allow the customer to make payments at retail or other outlets.

Increasingly, retail banks are offering debit cards to their customers. This service enables customers to make payments at retail outlets across the globe. A vast majority of debit cards are


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issued by the banks using the Visa or MasterCard networks. These networks provide connectivity via debit cards to ATMs and retailers on the network. Thus debit cards are much like credit cards, but are backed by the customer’s current or savings account balance instead of an unsecured loan in the case of a credit card.

Cards play an important role in reinforcing the customer relationship as an access and payment means, and they ensure usage of the account. There have been extensive studies that show the positive correlation between card use and loyalty of customers. This service also provides insights into customer-purchase behaviour and thereby information to customise relevant offers and promotions. For example, customer patterns showing purchases at fashion clothing shops can prompt the bank to provide offers to these customers for more clothes, thereby increasing customer loyalty.

Some banks may charge fees for cards such as annual fees or withdrawal fees but this trend is reducing due to the importance of cards in building customer loyalty and retention. Banks also receive ‘interchange-fee’ revenue when customers use their debit/credit cards for making payments through payment systems, while they incur costs when the customer uses ATMs.

Customers enjoy the security of a substitute for carrying cash when making payments and travelling. This eliminates the need for costly traveller’s cheques as international banking becomes more advanced. They also allow the customer to track expenses and manage cash in one statement. However, there may be fees for withdrawals from other bank ATMs, depending on the country and bank.

Prepaid cards are yet another kind of card service being offered by banks. These are cards that are preloaded with a certain financial value and can be used at ATMs or retail outlets. These cards provide the customer with added security because if mislaid or stolen, the maximum loss is the extent of the value on the card. Customers use prepaid cards for travelling or to provide children with money in lieu of cash.

New Developments In Payments

Here are some recent initiatives by consumer banks to provide innovative payment opportunities for customers.

(i) Bank of Montreal (BMO) and Monitise announced they have entered into an alliance to develop new mobile money services, using Monitise’s market-leading technology platform that encompasses mobile banking, payment and commerce services. The collaboration builds on an agreement formed in 2010 with Clairmail, the US-based mobile banking and payments provider acquired by Monitise in 2012.

As BMO’s technology provider for the mobile channel, Monitise will work with the bank across its smartphone applications, mobile web offerings and SMS services, using its platform capabilities to provide added convenience for new and existing customers.

“With the size of the mobile money opportunity growing by the day, and the enhanced experience and convenience this channel provides to our customers, we plan to continue to build on our success in this area to date,” said Andrew Irvine, senior vice president, Bank of Montreal. (Source: Lafferty Retail Cards and Payments Insights, January 2013)

(ii) M-Shwari, the Kenyan market’s new micro-loan product, recruited 645,000 savers in a span of three weeks from its launch.

(iii) Orange and China Mobile have come together with a memorandum of understanding, aiming to accelerate the use of NFC-based payments in the future. NFC is an acronym for near field communications and contactless communication.

(iv) Safaricom is to offer mobile bank account services in an effort to improve its M-Pesa (pesa means money in Swahili) payment services that were first introduced in Kenya and are now


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offered in several developing countries such as South Africa and Tanzania and in India (in some markets it is known as M-Paisa).

Interesting Evidence on EasyPaisa in Pakistan

There is evidence of a close correlation between income level and demand for mobile payments in developing countries.

“Most of the EasyPaisa users (69 percent) are living on less than $3.75 per day.”

Source: State Bank of Pakistan on EasyPaisa, Branchless Banking News, Issue 1, July-September, 2011

b) Save for the future

Savings are defined as consumption postponed. This means that consumers will typically allocate the largest proportion of their disposable income to current consumption and the remaining amount is saved for future consumption. Savings usually take place in earnest at the middle of the individual’s life cycle – but we consider these issues in the context of the customer life cycle later in this chapter.

As a consequence, retail banks provide for deposit taking by customers by creating various types of savings products. Indeed, as stated in Retail Banking Overview, “The customer can make deposits through savings accounts that comprise money lent to the retail bank where the lender (i.e., depositor) earns a relatively low rate of return but obtains certain privileges, such as withdrawal when the depositor desires. In several countries, savings balances are insured up to a certain level by government agencies against a bank’s inability to meet its obligations to depositors.* Savings accounts also include time deposits,† which have a specified time period (e.g., 60 days) and which typically pay a fixed interest rate. The funds cannot be withdrawn without penalty before the term of the deposit ends. Certificates of deposit (CDs) are examples of time deposits. CDs may be sold, prior to maturity, to other investors in an open market.”

c) Take out personal loan and mortgages

Consumers typically require personal loans to cover, for example, education expenses, travel costs, and purchases of household durables such as refrigerators. Accordingly, retail banks facilitate this demand by providing personal loans to suitably qualified loan applicants. This requires that banks underwrite loans by conducting credit-risk evaluation of the potential customer/borrower.

The customer may also require a mortgage that is backed by the real estate asset that the borrowed funds will purchase or a credit card to facilitate payments for frequent routine expenditures. In each of these cases, a detailed review of the applicant’s financial health is conducted and a determination made of the amount, term and conditions of the loan.

Secured Loans are loans backed by some form of security (i.e., collateral). For individual customers, such collateral can be a home, car or other asset. They may be used to finance the actual collateral, as in the case of a mortgage financing a home, or a car loan financing a car, or they may be secured by an existing asset (such as bonds investments).

Secured loans are attractive for the bank because they are backed by collateral to cover the loan in the event of customer default. Interest is charged by the bank for the funds borrowed by the customer, which is payable over the term of the loan. Hence the repayment amounts of these loans are most often based on the principal, i.e., the initial amount borrowed and the interest charged by the bank.

* Deposit insurance is available for savings limit that varies across countries. For example, this limit is €100,000 across the EU.

† Time deposits are also known as ‘term deposits’ in some countries (e.g., Canada), a ‘fixed deposit’ in India and a bond in the UK.


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In order to follow prudent lending practices, the size of loan offered is dependent on the value of the asset taken as collateral and the customer’s creditworthiness. Creditworthiness is determined by the customer’s income, profile and track record in repaying loans. Most developed financial economies have credit bureaus that track the repayment history of individuals and may assign a credit rating. Banks participate in the information flow between these credit bureaus, making it easier to make a decision before providing funds to the customer. In several emerging markets, such national credit bureaus do not exist and an assessment of the creditworthiness of the loan applicant is done on a case-by-case basis.

The bank earns interest income in addition to various fees to cover the costs of evaluating the underlying collateral and documenting it in the name of the bank. Additional fee income may be included for things such as drawing the funds down, repayments, early repayment, etc.

While the bank benefits from having collateral, we have seen in recent years the risks to the bank of valuing and holding certain concentrations of collateral for the life of the loan. With the collapse of the property market in many countries, banks were left holding large portfolios of real estate that could not be sold to cover the full value of the original loans, leading to many bank failures. Managing or selling these devalued assets can be costly for the bank. This is one reason why it is critical that a retail bank has a diverse asset portfolio that does not have a concentration of a single kind of collateral. This mitigates what is called concentration risk.

Customers benefit from secured loans because they grant access to money to purchase assets, which the customer would not be able to buy if they were to use their own funds. Also, since these loans are backed by collateral, the interest rate for the customer is lower than if there were no collateral. Even though the secured loans allow for customers to pay over a period of time, customers may prefer to repay the loan as early as possible to reduce the interest cost. This would be the case of mortgages where individuals have the right to prepay a portion of the principal at certain intervals.

Unsecured Loans are loans without collateral that are supported only by the borrower’s creditworthiness. Generally, a borrower must have a high credit rating to receive an unsecured loan. Banks use credit bureau information (mentioned above) to assess customers, besides using other factors like the borrower’s income, assets and other personal factors and profile.

Since the interest rate charged to customers is always a reflection of the risk taken by the bank, unsecured loans bear a higher interest rate for the customer. This is because of the lack of collateral in the case of default. Due to the higher interest charged, these loans provide significantly higher interest income to the bank, assuming the borrower does not default. They also may include various sources of fee income, such as for late payments, penalty interest, processing fees, repayment fees, draw-down fees, etc. But robust underwriting of credit risk is required, and charging a high interest rate for an unsecured loan does not adequately deal with credit risk. The selection of customers is more important as demonstrated in Course Code 109, Credit Loss Management.

As part of prudent lending practice, banks may make provisions for loan losses in the form of reserves, which are put aside to cover future potential losses. They also invest heavily in credit-risk-evaluation processes and technology in providing these loans to the market. This is relevant for both secured and unsecured loans but takes a higher priority for unsecured loans, since they are more risky for the bank.

Term Loan – As the name suggests, this type of loan structure is for a fixed term. The customer borrows a sum of money (the principal) from the bank and contracts to pay it back over an agreed period. The repayment is normally in equal monthly instalments (EMIs) where each EMI is part principal and part interest. As the term of the loan continues, the outstanding principal diminishes to zero at the end of the loan period.

Banks generally offer term loans to retail customers for the purchase of assets. These are often secured loans, e.g., home loans or car loans. The bank earns interest on the loan and may charge a processing fee or an early repayment fee. Since these are fixed-term loans, banks can forecast


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the term of all loans to match the term of balance sheet deposits. Customers take term loans to purchase assets that they would not be able to buy due to the high upfront value of the asset.

Revolving Credit Line – A revolving credit line is a line of credit at an agreed limit, which typically can be drawn at any time. These loans are more flexible than fixed-term loans, in that they can be repaid based on minimum monthly repayments, and the outstanding balance can be carried forward from month to month, as opposed to having to pay off the loan in a fixed period. These lines may be secured or unsecured. For example, a credit card is an unsecured, revolving line of credit that uses the card itself as the main means for transacting. A home-equity line of credit is a common form of a secured revolving line of credit. It is usually accessed using cheques or by transferring money to a current account, and is backed by a property as collateral.

From the bank’s perspective, the pricing of these loans is based on the collateral availability, which is why unsecured revolving lines of credit have higher interest than secured. For example, credit cards have a high interest rate since these are unsecured revolving lines of credit. The bank receives both interest and fee income. However, the revenues and costs to the bank are harder to predict based on the flexibility of the drawing and repayment of the loans.

From the customer’s perspective, the revolving credit line is attractive in terms of flexibility. If the customer has low funds in a given month, they can pay the minimum amount due and still be in good standing. Interest is based on the extent of use of the credit facility and the number of days it is used. The costs of interest on large amounts over a long time can be excessive, especially in the case of (unsecured) credit card debt.

Overdraft – An overdraft is essentially a loan or credit line linked to a current account for use when the account is overdrawn. It reduces anxiety, allowing customers to automatically borrow from a bank account when there are insufficient funds in the account.

Generally, owing to the nature of this service, customers use it for covering gaps in funding, and not as a regular source of funds. Overdrafts can also be secured or unsecured in nature, which determines the interest charged.

From a bank standpoint, the overdraft is an attractive product since it results in relatively high interest income for short periods charged by the day. Since use of overdrafts is often contingency-driven, a customer is willing to commit to a higher interest rate to cover emergencies. Banks often charge fees for using the overdraft.

From a customer standpoint, the overdraft allows them to continue spending and not worry about penalty fees for insufficient funds on cheques, or having a payment rejected while shopping. On the other hand, the combined costs of daily interest charges as well as overdraft fees may outweigh the benefit. If repaid promptly, the overdraft may still be less costly than a credit card.

In some countries, such as Germany, overdrafts on bank accounts have traditionally been more popular than credit cards as a means of short-term financing.

d) Make investments

Individual consumers may require wealth-management advice, and retail banks provide investment products such as stocks, bonds, mutual funds and ETFs (exchange traded funds) to meet customers’ needs. The main reason is that the bank’s advisory role may create a demand for such investment products in order to achieve the aspirational goals of the customer’s retirement plan.

Retail banks also provide wealth-management services for private banking clients. Some of the wealth-management services include savings, discretionary portfolio management, establishment of trusts, inheritance as well as tax planning.


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e) Support cash management activities

Cash management is a service offered by retail banks for its small and medium-sized enterprise (SME) customers that includes liquidity management, where banks optimally balance cash requirements with investment of excess cash reserves. One popular method for conducting liquidity management is via a sweep account. A sweep account links a commercial current account to an investment account, which comprises money-market investments. In simple terms, excess cash (i.e., above a pre-determined target level) is automatically invested. The investment account is partially cashed-in when the company’s cash position falls below the target level.

f ) Provide third-party accounts

In order to provide additional financial services to their customers, banks also offer products in conjunction with third parties, such as insurance companies, investment managers, advisory services, appraisers and others. Banks take on the role of distributors or advisors, and carry these products in their suite of offerings.

Offering these products to their customers allows banks to provide more investment options to customers without having to ‘manufacture’ these products. Banks may offer life insurance from ABC Insurance Company, for example, without having an insurance company of its own. Banks earn commission/fee income from the third party for offering these products to the bank customers. They may also charge a fee for advising the customer on investment choices and recommendations.

Banks have to be extremely selective in offering third-party products because they may face reputational risk if the product is unsuitable or an inferior investment option. Careful selection of providers and their products is vital.

Customers have the benefit of other products without needing to associate with multiple service providers. The customer also benefits from third-party products in terms of pricing because banks are often able to seek deeper discounts from providers.

Third-party products are often offered to customers by customer sales representatives (CSRs) who view the customer relationship holistically. After understanding all the needs of the customers, CSRs may offer these products.

The Link to the Customer’s Family Life Cycle*

It is clear that as consumers move along their respective life cycles, their demand for bank products to meet their changing needs will also change. Indeed, demographic trends shape customer needs and attitudes and so banking products offered must adapt in order to match customers’ needs.

The traditional life cycle theory of savings states that the typical consumer borrows in the early stages of his/her life, saves in the middle age and then dis-saves (i.e., winds down savings) in the last stage of life. See, for example, Hogarth† (1991). This theory was first proposed by Franco Modigliani (Nobel Prize winner for economics) and basically states that people accumulate wealth in their early years for consumption in their later years. There is no consideration of wealth transfer to the next generation.

The life cycle theory was seen to be restrictive and lacking real life validity.

* This is different from the ‘customer life cycle’ that we consider in the module titled Relationship Management. This is the case where the customer evolves over five distinct steps: reach, acquisition, conversion, retention, and loyalty. It is similar to the customer continuum model from prospect, customer, client and, finally, promoter.

† J. M. Hogarth, “Asset management and retired households: savers, dis-savers and alternators”, Financial Counseling and Planning, 2, 93-122 (1991).


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Open Question #3

Why do you think that the life cycle theory of savings lacks real-life relevance?

Out of the weakness of this model, the family life cycle model, which looks at a wide range of family financial characteristics and expenditure patterns, found favour.

The family life cycle creates a demographic segmentation that tracks a typical family over time. This is summarised below:

Wealth

Accumulate Consolidate Retire/Transfer

Single Married Married with children

Approaching retirement

Retirement

103.2: Family life cycle demographic segmentation

First Stage – Wealth Accumulation

From the early stages of life – as a single person to being married with children – the family starts to accumulate wealth through savings and investments. Some degree of risk-taking is incurred based on the family’s tolerance for risk. Accordingly, there will be a demand for products such as savings accounts and mutual funds. The next phase of marriage will continue with wealth accumulation but may also bring in a demand for a mortgage loan when the family has children. There may also be a requirement for specialised savings and tax-deferred products to facilitate education planning. Throughout this period, there will be a demand for payment products such as current accounts and credit cards.

Second Stage – Wealth Consolidation

In this stage, the family is approaching retirement and with increasing age, the family’s tolerance for risk taking declines. Portfolio and retirement planning advice is the main focus. Some experts contend that a degree of retirement planning began in the first stage since real assets such as the family’s house are part of retirement planning consideration. Of course, the demand for payment services and credit cards continues.

Third Stage – Retirement/Transfer

The third stage is retirement and the family needs change to estate planning, such as the creation of wills and trusts for wealth transfer to heirs and others. The family’s investment portfolio will likely change to a higher proportion of cash and so there will be increased demand for savings


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products, annuities and money market mutual funds.

Open Question #4

Consider an SME and create a graph of a life cycle for this firm. Provide explanations.

In the early stages of the life of this firm, what type of banking products would be most in demand?

As the company becomes financially successful, what type of banking services would be most in demand?


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Chapter 3: Pricing of Retail Banking Products

In this chapter, we consider simple cases of how pricing of selected retail banking products is conducted. It is intended to emphasise that in retail banking, products are priced on a relative basis. Recall from Retail Banking Overview (Course Code 102), we introduced the concept of net interest spread (NIS). There we showed that:

NIS = Interest Income Interest Expense

Interest Earning Assets Interest Bearing Liabilities-

In other words, NIS is the difference between the bank’s asset yields and its funding costs. Retail banks rely mostly on deposits to fund interest-earning assets and so would incur lower funding costs. This is an example of relative pricing. For a single loan, NIS is simply the interest rate charged on the loan less the cost of funding the loan.

We now consider two typical examples – pricing of loans and of savings accounts.

a) Pricing of Loans

A common approach is to base the price of the loan (i.e., interest rate charged) on a target underlying profit (UP). This target UP will comprise the NIS on the loan as well as projected operating expenses and provisions for loan losses.

Recall from the previous module (102), we showed that underlying profit is given as follows:

Underlying Profit = (r – c ) X – OPEX – PROV where X = loan amount, r = rate charged on the loan, c = cost of funds backing the loan, OPEX = operating expenses and PROV = provision for loan loss.

To see how the loan rate is calculated, we make the following simplifying assumptions:

a) Assume that the target underlying profit = y as a fraction of the loan

b) The cost of funds ‘c’ is an internally set treasury rate that is fixed for the salesperson (e.g., branch manager)


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c) OPEX is a set annual amount – OPEX = a

d) PROV is a set annual loss percentage of the loan amount – PROV = b X where b is a fraction and X= loan amount.

We now have y = r – c– a/X – b which is simplified to:

r =c +a/x + b + y

Example:

Note that the bank will typically use several sources of funding – term deposits, corporate deposits, interbank funding or subordinated debt to fund loans. Hence, from a branch manager’s perspective, the cost of funding (transfer) price is a set treasury rate. We take this view in our example.

Suppose that:

The treasury rate (cost of funding) is 2 percent; this is the symbol ‘c’ in the formula;

OPEX as a/X percent of the loan amount is 1 percent; this means that the ‘a/X’ in the formula is 1 percent;

PROV as a percentage of loan amount is 3 percent, i.e., the symbol ‘b’ in the formula is 3 percent;

The target profit as a percentage of the loan amount is 1 percent; i.e., ‘y’ in the formula is 1 percent.

Then the minimum rate on the loan is 2 percent + 1 percent + 3 percent + 1 percent = 7 percent.

Note that the loan rate is derived from relative pricing since the benchmark is the bank’s internal treasury rate that reflects the cost of funding.

It is important to note that a retail bank with excessive operating costs or high provisioning levels will end up charging an interest rate on the loan that is too high compared to the market. This is why the competitor rate is also a benchmark.

Note that if the bank’s rate on this loan is deemed to be too high relative to the competition, it will take actions to be more efficient (lowering OPEX) and/or underwrite clients more selectively (lowering PROV).

Summary of Loan Pricing Formula

Loan interest rate = marginal cost of funds

+ Operating Cost / loan amount

+ Risk Cost (loan loss)

+ Bank’s desired profit margin

The marginal cost of funds is a transfer price from the bank’s treasury.

103.3: Summary of loan pricing formula

b) Pricing of Deposits

For savings account balances, the duration of savings must be calculated. How long do balances stay in the account on average? The savings rate is then determined relative to the treasury rate for this duration. The level relative to this rate will depend among other things on the need for funding.

For term deposits up to one year in tenor, banks determine the deposit rate as a spread over a benchmark rate (e.g. in 2012, the Bank of England benchmark rate was 0.5 percent, 0.25 percent


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for the corresponding rate in the US, 1 percent in Canada, 3 percent (called cash rate) in Australia and 5 percent in South Africa). Typically, these rates will vary across economies reflecting, in part, differential inflation rates.

To demonstrate this method of relative pricing, we refer to Deans and Stewart (2012)* who report for the Australian market, that “the level of the cash rate set by the Reserve Bank is a primary determinant of the level of intermediaries’ funding costs and hence the level of lending rates. It is the short-term interest rate benchmark that anchors the broader interest rate structure for the domestic financial system.”

For longer-term savings (e.g., over a year), a spread over a matching swap rate† and liquidity premium is appropriate when the bank performs its traditional function of maturity transformation – funding longer-term loans with short-term funding. (see, for example, Dermine 2011).‡

Of course swap rates, as an important input to internal treasury rates, have an effect on loan and mortgage rates since they represent the cost of interbank funding. A recent report shows “some lenders are simply falling over themselves to court the best so-called lowest-risk borrowers – so much so that we have seen two-year fixed rates fall by 0.7 percent, and five-year fixed rates by 0.9 percent. This is due to falling ‘swap rates’ – the price at which banks and building societies lend to each other.” (Source: Guardian, 3 August 2012)

We end this module with a brief discussion of typical products in Islamic Banking.

* “Banks’ Funding Costs and Lending Rates” by Cameron Deans and Chris Stewart, Reserve Bank of Australia.

† The swap curve is the market’s expectation for future interest rates and, as such, incorporates future expected rate rises.

‡ Jean Dermine: “Fund Transfer Pricing for Deposits and Loans”, Foundation and Advanced, INSEAD, Fontainebleau (2011).


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Chapter 4: Products in Islamic Banking

The section below provides an overview of Islamic banking.

Islamic banking is consistent with the principles of Islamic law (sharia), and its practical application. Sharia prohibits the payment or acceptance of interest for savings or loans for specific terms, as well as investing in businesses that provide goods or services considered contrary to its principles. Generally, the main principles of sharia-compliant banking are as follows:

• The charging of interest, or riba, is strictly prohibited.

• Sharia does not permit speculation or gambling.

• Investments in certain products, such as alcohol, pork and gambling activities, are prohibited.

• Profit cannot be ensured. What’s more, the Islamic financial institution must assume at least part of the investment risk, so a guaranteed return is not applicable in Islamic finance.

In an Islamic mortgage, instead of lending the buyer money to purchase the item, a bank might buy the item itself from the seller, and re-sell it to the buyer at a profit at a later point, allowing the buyer to pay the bank in instalments in the meantime. However, the bank’s profit cannot be made explicit and therefore there are no additional penalties for late payment. In order to protect itself against default, the bank asks for strict collateral. The goods or land are registered in the name of the lender from the start of the transaction. This arrangement is called murabaha. Another approach is eIjara wa eIqtina, which is similar to real estate leasing. Islamic banks handle loans for vehicles in a similar way (selling the vehicle at a higher-than-market price to the debtor and then retaining ownership of the vehicle until the loan is paid).

An innovative approach applied by some banks for home loans, called musharaka al-mutanaqisa, allows for a floating rate in the form of rental. The bank and borrower form a partnership, both providing capital at an agreed percentage to purchase the property. The partnership entity then rents out the property to the borrower and charges rent. The bank and the borrower will then share the proceeds from this rent, based on the current equity share of the partnership. At the same time, the borrower in the partnership entity also buys the bank’s share of the property at agreed instalments until the full equity is transferred to the borrower and the partnership is ended. If default occurs, both the bank and the borrower receive a proportion of the proceeds


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from the sale of the property based on each party’s current equity. This method allows for floating rates according to the current market rate such as the BLR (base lending rate), especially in a dual-banking system such as Malaysia’s.

In terms of safe keeping or deposits (wadiah), a bank is deemed as a keeper and trustee of funds. A person deposits funds in the bank and the bank guarantees refund of the entire amount of the deposit, or any part of the outstanding amount, when the depositor demands it. The depositor, at the bank’s discretion, may be rewarded with a gift (hibah) as a form of appreciation for the use of funds by the bank.

Discussion Question #5

What are the main differences and similarities between Islamic and conventional products?

Summary

This module considered the common attributes of services, and introduced three additional ones that are unique to financial services. This was the basis of Chapter 1. In Chapter 2, we discussed the different categories of retail banking products from payment accounts to cash management products. We also linked the demand for bank products to stages in the family life cycle as consumer needs evolve through the three stages of wealth - accumulation, consolidation and consumption or transfer. We also showed how the payments space has entered the mobility world, and innovation has increased at a dramatic pace. In Chapter 3, we showed how loans and deposits are typically priced – relative to a benchmark. Finally in Chapter 4, we introduced the typical products in Islamic Banking.


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Multiple Choice Questions

1. In what stage of the life cycle would you expect a consumer to be more interested in the transfer of wealth?

a) Single and 30 years oldb) Married with two children and 35 years oldc) Over 65 years old and retired d) Married with no children and 35 years old

2. Which of the following bank products is used by customers mostly for payments?

a) Term depositb) Current (checking) accountc) Sweep accountd) Savings account

3. Banking products cannot be stored. This attribute is described by which of the following:

a) Intangibilityb) Inseparabilityc) Perishabilityd) Heterogeneity

4. Which attribute of financial services is relatively people-dependent?

a) Heterogeneityb) Perishabilityc) Intangibilityd) Inseparability

5. Financial services have three additional features over other services. Which of the following is not one of them?

a) Transparency of performance b) Uncertainty of performance c) Poor comparability of performance d) Term of performance

6. Which statement is correct?

a) An individual’s tolerance for investment risk increases over his/her life-cycle.b) The highest demand for estate planning products occurs in the retirement/transfer stage.c) An individual is likely to take on the highest investment risk in the wealth accumulation stage. d) The three stages of the family life cycle are in the following time sequence - retirement/wealth transfer, wealth consolidation and wealth accumulation.


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7. A branch manager gets a cost of funding quote from the bank’s treasury department of 2 percent. To meet his/her profit target for a loan, a minimum profit margin of 1 percent is required. Operating cost is estimated to be 1.5 percent and the expected loss - which is a cost of doing business - is estimated to be 2.5 percent for this loan. What is the minimum interest rate the branch manager will charge for this loan?

a) 4 percent b) 6 percent c) 2 percent d) 7 percent

8. Which of the following is typically used by SMEs only for cash management?

a) Current accountb) Sweep account c) Credit line d) Savings account

9. Which statement is incorrect?

a) Deposits are priced on a relative basis – relative to a benchmark rate.b) In Islamic banking, financial products must be Sharia-compliant. This means that gambling is not permitted, although speculation by derivatives is permitted.c) Mortgages are secured loans.d) Credit cards are revolving unsecured loans.

10. Which statement in relation to Islamic banking is incorrect?

a) Interest paid on deposits (riba) is forbidden.b) Speculation is not permitted.c) Investment in certain products such as alcohol is forbidden. d) Investment return is guaranteed.

Answers:

1 2 3 4 5 6 7 8 9 10

c b c a d c d b b d


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