MODELING MAXIMUM RETAIL DEPOSIT RATES

Historically, the majority of commercial banks have employed a pricing strategy for deposit rates that revolves around analysing the rates offered by their competitors. Such analysis is utilized as a standard to inform and adjust their own deposit rate offerings. The existing academic literature reveals a significant deficiency in the development of pricing models for deposits. While certain authors have contributed with insights into essential elements that ought to be taken into account when formulating such models, they have not proposed a practical model suitable for implementation within banking institutions. Therefore, this thesis seeks to take a step forward on deposit pricing models. The first step towards reaching such a model is, naturally, to understand the maximum rate - or ceiling rate- that can’t be exceeded whenever the bank is to engage in a deposit operation. This rate should be understood as the break-even rate, beyond which the deposit transaction becomes unprofitable for the bank. So, this thesis will present a methodology that banks can apply in order to compute this ceiling rate, for retail deposits, at any moment. It is essential to adjust the ceiling rate based on the liquidity circumstances faced by banks. In scenarios characterized by low liquidity, banks tend to increase their deposit rates, viewing deposits as a cost-effective source of liquidity. In contrast, during periods of high liquidity, usually accompanied by a low loan-to-deposit ratio, banks may find it challenging, in part due to their risk appetite, to deploy their excess liquidity into lending activities. Consequently, this often results in a decrease in deposit rates, as the need to secure further funding diminishes. The objective of this thesis is to develop a model for ceiling rates under conditions of varying liquidity, addressing both high and low liquidity situations. Additionally, in the context of high liquidity, a supplementary methodology will be introduced that attempts to employ stochastic calculus to formulate an explicit equation for determining ceiling rates, using only the deposit amount and maturity as the necessary inputs.