RETAIL BANKING

Course Code 103 - Products ACADEMY

RETAIL BANKING I

103.

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Products
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NO
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Course Code 103

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Products
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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
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(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).
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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).

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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?

Y
OP
TC
NO
DO

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Chapter 1:

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Attributes of Financial Services
in Retail Banking
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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:
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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
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(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 Lacks Physical Form

Services

Inseparability Co-creation

Perishability No Storage & Finite Life

Heterogeneity People Dependent

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103.1: Four attributes of services

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

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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
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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.
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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.
DO

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.

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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

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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:

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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.
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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.
DO

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Chapter 2:

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Retail Bank Products/Services –
Categories and Functions
OP
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We begin this chapter with an open question that is based on an interesting perspective on bank
products.*
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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?
DO

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

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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

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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
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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

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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
DO

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

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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.

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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.
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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.
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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
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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

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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

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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
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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
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(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
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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

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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

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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
TC
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.
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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
DO

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,

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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.

OP
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.
TC
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
NO

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.
DO

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

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services, appraisers and others. Banks take on the role of distributors or advisors, and carry these
products in their suite of offerings.

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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.
TC
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
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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.
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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:

Accumulate Consolidate Retire/Transfer

Y
Wealth

OP
TC
NO

Single Married Married Approaching Retirement

with children retirement

103.2: Family life cycle demographic segmentation

First Stage – Wealth Accumulation

DO

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?

Y
OP
TC
NO
DO

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Chapter 3:

Y
Pricing of Retail Banking Products

OP
TC
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:
NO

Interest Income Interest Expense

NIS =
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
DO

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.

Y
Suppose that:

OP
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;
TC
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
NO

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
DO

(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).‡

Y
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

OP
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.
TC
NO
DO

* “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:

Y
Products in Islamic Banking

OP
TC
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
NO

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.
DO

• 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?

Y
Summary

OP
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
TC
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.
NO
DO

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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 old
b) Married with two children and 35 years old
c) 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?

Y
a) Term deposit
b) Current (checking) account
c) Sweep account

OP
d) Savings account

3. Banking products cannot be stored. This attribute is described by which of the following:
a) Intangibility
TC
b) Inseparability
c) Perishability
d) Heterogeneity
NO

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

a) Heterogeneity
b) Perishability
c) Intangibility
d) Inseparability
DO

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 account

Y
b) Sweep account
c) Credit line
d) Savings account

OP
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
TC
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?

NO

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.
DO

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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