Retail deposit profitability during the last few years has been subject to conflicting forces.

On the one hand, generally declining interest rates have reduced the value of core funds and the transfer credits received for them.

On the other hand, retail banks have responded by cutting rates on NOWs, savings accounts, and, to some extent, on money-market accounts by much more than in the past.

Although the second circumstance has helped to mute the influence of the first, it also has contributed to an outflow of funds. From 1992 through 1995, total core deposits at the largest representative money-center and superregional banks declined on an acquisition-adjusted basis at a compound annual rate of 1%, while NOW accounts shrank at an annual rate of 9%.

A question being posed in many banks is whether the campaign to buttress short-term retail profits by reducing deposit rates and widening deposit margins has, in fact, served the long-term interest of shareholders.

The answer depends on, among other things:

1. Whether the net outflow of funds is temporary or permanent - that is, is the observed disintermediation a case of lost balances or customers? And if the latter, how many were profitable or potentially profitable? (To be sure, our analysis suggests that Highly rate-sensitive customers are usually not the most profitable.)

2. The amount of high-margin money (for example, NOWs and savings) that has shifted to lower-margin accounts (for example, short-term CDs).

3. Whether past deposit-rate reductions constrain future pricing freedom. For example, if deposit rates are close to their implicit floors, it may be impossible for banks to reduce them further if the general level of market rates falls. Conversely, to stem deposit outflows, rates could be forced higher even if market rates remained stable - and might have to increase more than one-for-one should market rates actually rise.

4. The amount of funds that has flowed to competitors - bank and nonbank - that were less aggressive in reducing deposit rates.

5. The impact of the loss of core money on the need for, and cost of, wholesale money. It should be noted that an outflow of core money can affect the overall cost of funds in two ways - first, by increasing the need for intrinsically higher-cost wholesale money; and second, by raising the per-dollar cost of that wholesale money should the market become concerned about the institution's eroding liquidity position.

Depending on the influence of the above variables, the deposit-rate reductions of the past few years might not have been an unalloyed benefit. For example, they might have resulted in:

*Diminished profit expectations for the nondeposit-gathering part of the retail bank (point 1).

*Less of a boon to the deposit-gathering business than is thought (points 2 and 3).

*A strengthening of competitor positions (point 4).

*A secular increase in the demand for and cost of borrowed money (point 5).

The combination of some or all of these effects could negate the benefits of aggressive deposit-rate reductions.

In deciding whether to lower deposit rates, and on what deposit types, the better-managed banks begin by measuring the effect on the deposit- gathering business itself.

This involves calculating the elasticity of customer demand with respect to relative price changes - that is, price changes relative to those of competitors - and also the cross-elasticities (the increase or decrease in the demand for some deposit types resulting from changes in the relative pricing of others).

Customer demand for most deposit types is almost completely inelastic with respect to relative pricing differences of plus or minus 10 to 20 basis points. In other words, volume won't change very much. Larger pricing differences will, however, influence volume measurably.

Whether to risk the volume losses that result from relatively low prices depends initially on the net income effects. In turn, these are related most importantly to the deposit's spread, term, and size.

In thin-spread commodity-type products it often pays to trade volume losses for increased spread. In higher-spread products, income is generally maximized by doing the reverse, giving up spread for volume.

Since a deposit's variable expenses are largely independent of its size and its term, the larger the deposit and the longer its term, the larger is the proportion of spread income that can be carried to the bottom line.

This suggests that a bank should consider below-the-market pricing for primarily thin-spread, short-term, and small deposit accounts - for example, some CDs.

Clearly, however, the complex ramifications of a lowering of deposit rates reinforce the need for a thorough net-present-value analysis of any such initiative, both with respect to its impact on deposit profitability per se and with respect to the effect on overall institutional results.

If such an analysis shows that, for some institutions, the campaign to buttress short-term retail profits by lowering deposit rates has proven counterproductive, the chief reason may turn on the rupturing of total customer relationships (point 1).

A bank's shareholder value is simply the resultant of a set of cash flows - some positive and some negative. Recently bankers have discovered the potential for greatly increasing the positive cash flows while reducing the negative ones.

By employing a technique that we call customer-knowledge- based management, banks are beginning to pinpoint the better sales prospects and gear up to serve many more of their needs far more cost effectively than in the past.

Further, some are starting to use their customer data to measure the impact of discrete pricing initiatives on the flow of deposit funds. Armed with such analyses, they will be better able to estimate the overall effect of future pricing changes.

In defense of past pricing changes, it should be noted that the situation of a few years ago did not encourage much hope for increasing customer profitability. In particular, the lack of integrated customer data meant banks were largely uninformed about which customers to target with what "value propositions" - that is, individualized combinations of product, service, and delivery options. Hence it was natural to focus on boosting returns in traditional ways - by increasing deposit spreads.

It is a measure of the rapid pace of change in financial services that this type of thinking has been rendered largely obsolete within just the past year.

Mr. Zizka is a managing vice president of First Manhattan Consulting Group, New York. His associate Sanford Rose contributed to this article.

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