You offer a very competitive rate only to find out that you are not growing your deposit balances.
How can it be? Shouldn’t money gravitate towards the highest yield?
Not if you consider the impact of behavioral economics.
The Nobel Committee recently gave its seal of approval to the role behavioral economics plays in financial models by awarding the Nobel Prize to Richard Thaler for his work in behavioral economics models. It’s time for the banking industry to get onboard and start incorporating behavioral economics into their financial models for deposit pricing. Ignoring it does not make it go away—your pricing just becomes inaccurate.
A new scientific study shows that the ability of yield to attract money is dynamic rather than static. This means that the same yield, for the same product and in the same competitive environment, can attract balances at one time and not so much on another time. This is the finding of a breakthrough scientific study titled: “Dynamics of Yield Gravity.”
The far-reaching implications of this study, co-authored by myself and Professor Nahum Biger, show that rates and balances of deposits do not operate in a vacuum, and they are greatly impacted by behavioral economics factors.
Thus, any model for forecasting and pricing of deposits must include behavioral economics as a mediating variable. Otherwise, the outcome of the model is likely to be false.
The “Dynamics of Yield Gravity” study shows that the main factor impacting the ability of yield to attract balances (gravitational pull) is the level of money anxiety of consumers.
As illustrated in Figure 1, when money anxiety is lower, the gravitational pull of yield is greater, which is why the “orbiting” deposits balances are closer to the magnetic field of yield. Conversely, when money anxiety is higher, the gravitational pull of yield is weaker and the “orbiting” deposit balances are farther away from the magnetic field of yield.
We can clearly see the changes in the gravitational pull of yield by comparing the behavior of yield and balances of deposits during two time periods—five years prior the beginning of the Great Recession vs. five years during and in the aftermath of the Great Recession.
Figure 2 shows how during the pre-recession period (2003-2007), balances of liquid accounts (checking, savings, and money market) increased by 39.3%. During the same period, average APY of liquid accounts increased by 44.7%. Similarly, balances of term accounts increased by 50.04% and average APY of term accounts increased by 117.0%.
Most importantly, as we will see later, the ratio between the average APY of term accounts (0.48%) and the average APY of liquid accounts (2.78%) was 5.79.
Now let’s compare the behavior of APY and balances of liquid and term accounts to the five-year period that includes the recession and its aftermath (2008-2012). Figure 3 shows how balances of liquid accounts increased by 78.9% , hence twice as much as the increase in the pre-recession period (2X), and balances of term accounts decreased by 22.0%, hence three times different than the pre-recession period (3X).
And here is a critical fact—the ratio between the average APY of term (0.23%) and the average APY of liquid account (1.26%) remained nearly identical to the pre-recession time period at 5.48.
This means that despite the fact that the ratio between APY of liquid accounts and the APY of term accounts remained nearly the same, balances of liquid and term accounts were five times different in the post-recession period compare to the pre-recession period.
So, what caused this phenomenon? What made the gravitational pull of term APY so much weaker compare to liquid APY, even though the ratio between the two remained the same?
The answer may surprise you—it’s money anxiety.
Money anxiety is a common and normative response to economic and financial uncertainty. This is according to the latest survey by the American Psychological Association (Figure 4), which shows that money anxiety tops the categories causing stress and anxiety in the U.S. Moreover, about 7 of 10 people reported having money anxiety on a regular basis, and we can clearly see how the level of money anxiety increased during and in the aftermath of the Great Recession.
Money anxiety is a latent variable and can’t be directly observed or measured. In order to be able to objectively measure it, then, we used a special statistical approach called Structural Equation Modeling (SEM), which is capable of measuring the impact money anxiety has on the financial behavior of people. We tested the money anxiety model using five different “goodness of fit” tests, shown in Figure 5.
Finally, we tested the correlation between the average APY of liquid and term accounts, and balances of liquid and term accounts with the Money Anxiety Index and we found that they all have very strong and highly significant relations to the Money Anxiety Index (Figure 6).
Moreover, we conducted a mediation test and found that money anxiety significantly mediates between APY and balances of both liquid and term accounts.
So how are the dynamics of yield gravity impacting your bank?
Here are two areas you need to be concerned with and what you should do about them:
Implications for interest expense
• Problem: Financial institutions tend to misprice deposits because they do not incorporate behavioral economics factor when forecasting and pricing their deposits.
• Solution: Deposit pricing models should include behavioral economics factors to ensure that interest rates are optimal for the economic environment. Otherwise, unnecessary interest expense can put the financial institutions at risk of low net interest margins.
Implications on term liquidity
• Problem: Diminishing yield gravity during economic slowdown will prevent financial institutions from complying with Basal III Net Stable Funding Ratio (NSFR) requirement of one-year liquidity.
• Solution: Financial institutions can’t rely on yield alone to attract term liquidity during economic slowdown (high money anxiety). Product features and other non-yield incentives should be used instead.
About the author
Dr. Dan Geller is a behavioral economist who pioneered the research and application of behavioral economics to banking services. Through his research firm, Analyticom, he provides banking executives with scientific forecasting and pricing tools.
Geller is the author of the behavioral economics book Money Anxiety, which was named a “must read book” by Business Insider.