FREE NEWSLETTER: Econintersect sends a nightly newsletter highlighting news events of the day, and providing a summary of new articles posted on the website. Econintersect will not sell or pass your email address to others per our privacy policy. You can cancel this subscription at any time by selecting the unsubscribing link in the footer of each email.

posted on 22 September 2015

Do Better Bank Services Have A Hidden Cost?

from Liberty Street Economics

-- this post authored by Dong Beom Choi and Ulysses Velasquez

You walk into a bank branch, check in hand. You find yourself in a well-lit space with modern furnishings, and you help yourself to a cup of freshly brewed coffee, courtesy of the bank. Neatly dressed assistants in uniform stand in a row, ready to attend to customers at a moment's notice, and in fact, one of them approaches you to help you deposit your check. Having finished your business, you leave feeling reassured that such a customer-oriented organization is diligently tending to your hard-earned money. But what could possibly be missing?

Extraneous services and benefits provided by bank branches - a welcoming environment, convenient location, and attentive bank representatives - help to increase customer satisfaction. As a customer, you appreciate these services and might become a "loyal" customer of that bank. As a depositor, however, since you did not purchase anything from the bank, you might wonder why it would provide such services to win your loyalty? One answer could lie in the bank's pursuit of cheaper, more stable funding.

Benefits of Core Deposits

Core deposits by customers in a bank's local market are a stable, and thus desirable, source of funds for banks. They are also cheaper and less price-sensitive ("elastic") than other funding sources such as large certificates of deposit (CDs), since core depositors care less about the interest they earn and more about convenience and the services offered by the bank. Banks, therefore, hope to attract core deposits both to lower their funding costs and to reduce liquidity risks (that is, the risk of depositor withdrawals).

Of course, because the supply of core deposits is less interest-rate-elastic than other funding sources, banks have to provide better services to attract more core deposits. Beyond free coffee, these services may include conveniently located branches, a large ATM network, and user-friendly online banking. These nonpecuniary benefits increase depositors' switching costs (that is, the cost of switching to another bank), making depositors a "sticky" or stable source of funds. The rub, though, is that a bank needs to incur higher operating costs to attract more core deposits, so the tradeoff is between lower interest expenses and lower noninterest expenses.

Do the Data Agree?

This all seems plausible (to us, at least), but does it show up in the data?

To investigate, we looked at the relationships between a bank's service quality (proxied by noninterest expenses) and its core deposit ratio, funding costs, and liquid asset holdings. We used regulatory data from 1995 to 2014 and focused on "community banks" (942 banks as of the fourth quarter of 2014) with asset size of less than $1 billion. We measured the scale of service quality using noninterest expenses divided by total assets. As the charts below demonstrate, a higher noninterest expense profile is associated with more core deposits, lower funding costs, and fewer liquid assets. One interpretation, consistent with our reasoning above, is that a bank that provides better services attracts more core deposits, lowers its funding costs, and, because it faces lower liquidity risk, holds fewer liquid assets.

Service Quality and Core Deposits, Funding Costs, and Liquid Assets

Are They Also Lending Better?

Since the more service-oriented banks hold fewer liquid assets, they must be doing more lending. So, do "services" also help promote bank profitability by widening interest margins? Do they even improve asset performance by allowing more investments in "infrastructure" (for example, more loan officers)? In fact, higher noninterest expenses are significantly and positively associated with higher interest income and higher net interest margins (see chart below).

Service Quality and Interest Income and Margins

But could this high interest income be a result of better underwriting, or simply higher risk-taking? It seems to be the latter; as shown below, higher operating costs are positively related to nonperforming loans (NPL) and net charge-offs (NCO).

Service Quality and Loan Quality

Cheaper Funding but Riskier Lending. What Are We Missing?

So it seems that banks with higher operating costs do attract more core deposits and pay less for their funding, but they also make lower-quality loans, on average. How can we reconcile these findings? Of course, our analysis only documents correlations and more careful study is required for definitive conclusions. For example, there could be reverse causality; perhaps high levels of nonperforming loans are causing higher operating costs owing to the costs of additional loan monitoring and time spent restructuring (see this paper for some evidence). Or our simple bivariate comparisons may be omitting other important variables that are associated with operating expenses and loan losses.

That said, it is still curious that banks with lower funding costs seem to have riskier loan portfolios. If this correlation is robust, we suspect that in the end it might be driven by lax market discipline. Because core deposits are stickier, they may be less sensitive to bank risk-taking, either because they are insured or because the services provide nonpecuniary benefits as well as increase depositors' switching costs. Weak market discipline means banks could be taking more risks on the asset side while paying less for their funding. Your loyalty might not come for free.


The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.


About the Authors


Dong Beom Choi is an economist in the Federal Reserve Bank of New York's Research and Statistics Group.


Ulysses Velasquez is a senior research analyst in the Group.

>>>>> Scroll down to view and make comments <<<<<<

Click here for Historical News Post Listing

Make a Comment

Econintersect wants your comments, data and opinion on the articles posted. You can also comment using Facebook directly using he comment block below.

Econintersect Contributors


Print this page or create a PDF file of this page
Print Friendly and PDF

The growing use of ad blocking software is creating a shortfall in covering our fixed expenses. Please consider a donation to Econintersect to allow continuing output of quality and balanced financial and economic news and analysis.

Take a look at what is going on inside of
Main Home
Analysis Blog
The Job Guarantee, Wage-Price Inflation And Alternative Solutions: Part 2
The Job Guarantee, Wage-Price Inflation And Alternative Solutions: Part 1
News Blog
Number Of Migrant Deaths 2016 Highest Ever Recorded
Astronomers To Peer Into A Black Hole For First Time With New Event Horizon Telescope
The U.S. Spends More On Defense Than All Other NATO Members Combined
What We Read Today 22 March 2017
February 2017 Headline Existing Home Growth Pace Slows
Trucking Data Mixed In February 2017
A Physical Therapist Explains The Best Time To Stretch
Bank Supervision And The Central Bank: An Integrated Mission
How Might Changes In Federal Policies Boost Innovation And Productivity?
Gauging Firm Optimism In A Time Of Transition
Infographic Of The Day: The Global War On Cash
Early Headlines: Asia Stocks Down, Dollar Down, Oil, Gold Flat, GOP Health Care, NASA Funded, EU Depressions, Brexit Fin Service Moves, Japan Exports Surge, Brazil's Bad Meat And More
Ancient Rome vs. Ancient China
Investing Blog
Bull Market Still Intact ... For Now Technical Summary 20 March 2017
Opinion Blog
Might The GOP Impeach Their Own President?
Economics Isn't Ideology-free And It's Misleading To Suggest It Is
Precious Metals Blog
These Gold Stocks Will Produce Much Bigger Gains Than Gold Itself
Live Markets
22Mar2017 Market Close: Stocks Closed Mixed, Oil Continues Decline, And Gold Trends Higher As The Dollar Index Remains Under 100
Amazon Books & More

.... and keep up with economic news using our dynamic economic newspapers with the largest international coverage on the internet
Asia / Pacific
Middle East / Africa
USA Government



Analysis Blog
News Blog
Investing Blog
Opinion Blog
Precious Metals Blog
Markets Blog
Video of the Day


Asia / Pacific
Middle East / Africa
USA Government

RSS Feeds / Social Media

Combined Econintersect Feed

Free Newsletter

Marketplace - Books & More

Economic Forecast

Content Contribution



  Top Economics Site Contributor TalkMarkets Contributor Finance Blogs Free PageRank Checker Active Search Results Google+

This Web Page by Steven Hansen ---- Copyright 2010 - 2017 Econintersect LLC - all rights reserved