CDs face changing interest rate environment

Interest rate changes may impact certificate of deposit sales.

“If rates begin to decline – there could be a delay in that happening – but if they begin to decline, banks … at that point maybe could have a preference for other types of deposits, shorter-term deposits, where let’s say deposits that pay significantly lower interest rates like savings deposits or other forms, money market accounts, etc., versus the CD [certificates of deposit],” said Manuel Lasaga, president of Stratinfo and clinical professor in the Finance Department at Florida International University.

The role of deposits is to enable banks to make loans, said Mr. Lasaga. Deposits are vital for financial institutions to play their role as a lender to the economy.

CDs create an advantage for banks, explained Mr. Lasaga.

“The advantage to a bank of a CD is that it has a penalty for early withdrawal,” he said. “When a customer of a bank invests in a CD, let’s say six months, that depositor is most likely going to keep those funds for the six months because there will be a penalty for early [withdrawal] so it gives banks a steady source of funding…. They can basically have more comfort in terms of those funds remaining in the bank during the duration of the CD.”

Another advantage is easy renewal of CDs, said Mr. Lasaga. However CDs “do offer a higher interest rate than savings accounts or other types of deposits…. Let’s say if interest rates begin to rise and look to continue rising in the future, for banks it’s also a good way to hedge against higher cost of deposits in the future. So, that is basically an interest rate play that banks can also play in terms of the use of the CD.”

Banks will always rely on CDs because it is an important instrument, said Mr. Lasaga. Banks need to have enough variety of funding “so that they’ll be able to support their lending business with these funds, and the CD plays a significant role. Whether a bank is going to rely more on CDs or less will depend on interest rates today, what the bank thinks interest rates are likely to be in the near future.”

When interest rates increased last year, said Mr. Lasaga, banks became more aggressive in funding through CDs in order to lock in the interest rates. “When a bank makes a loan, that’s a five-year loan or a 10-year loan, and the interest rates on the deposits they have begun to rise, that reduces the profitability of the bank from making those loans. That’s where they have to always maintain a balance in terms of their deposits to try to prevent the cost of their deposits moving up quickly if there is a trend for rates to go up.”