Rethinking CD early withdrawal penalties

What would happen to investor demand in the bond market if U.S. Treasuries were subject to early withdrawal penalties similar to bank certificates of deposit?.The results of a recent poll conducted on LinkedIn were illuminating:About 76 percent of respondents believed added penalties would be terrible for bonds, 12 percent thought no one would care, and 12 percent suggested investors would like penalties.This poll sparked a lively conversation on the difference between CDs and U.S. Treasuries. For bankers, it illustrates how a single CD feature may prevent significant deposit dollars from coming to banks.Bonds with withdrawal penalties would be terrible?CDs and bonds are both time investments. They can be compared in terms of their exit “options.” For CDs, we call that option an early withdrawal penalty.Typically, CD penalties are a fixed number of months’ interest, and the exact amount is chosen without reference to the financial impact of early withdrawal on the institution. CDs’ penalty is arbitrary and punitive; treasuries’ exit options are market-driven.Selling a fixed-income security also has a potential benefit, especially during falling interest rates. If you have a 5 percent bond, and new bond rates for a similar term are at 4 percent, the market is willing to compensate the bond owner for selling (or exiting, or withdrawing early).It’s not just that people can sell treasures that makes them advantageous; it’s they can sell them for a benefit. Adding CD penalties to treasuries would then be two strikes against them. This is why 76 percent of respondents on LinkedIn agreed: It “would be terrible for bonds” if they had withdrawal penalties. Demand from discretionary investors would decline, probably meaningfully, if their versatility were diminished so much.The case for changeIf early withdrawal penalties “would be terrible for bonds,” are they terrible for CDs now? Comments on the poll results highlight several compelling reasons for banks to reconsider their approach to CD early withdrawal penalties:Market efficiency: The current CD penalty structure in bonds “would destroy the whole funding market, mortgage market, and risk-free rate calculations,” one commenter said.Customer expectations: Many respondents suggested customers accept the current CD structure simply because they don’t know any other way.Mutual benefits: A well-designed early withdrawal structure could benefit both the bank and the depositor simultaneously, creating a win-win situation.A solution: ask the question the other wayWhat would happen to depositor demand for a bank’s CDs if they allowed appropriately-priced early withdrawal, similar to U.S. Treasuries?The approach would allow banks to offer early withdrawal bonuses when interest rates fall, aligning the institution’s and the depositor’s interests. CDs would then:Offer early withdrawal amounts calculated based on the present value of future cash flows, similar to how bonds are priced in the secondary market.Provide depositors a bonus only when incentivized early withdrawal (for high-rate CDs) was advantageous for the bank.Increase customers’ ability to manage their money flexibly without facing punitive penalties.Add an interest expense management tool for bank executives.What concerns/challenges does this approach create?Some commenters noted that educating customers about this new product could be challenging.A bank would need a reproducible process that ensures the early withdrawal amount reported to a customer was never incorrect. Beyond that, allowing for appropriately priced withdrawal is a matter of effectively communicating the option. Depositors can then decide to execute the option or not, just as with a bond.Regarding regulatory considerations, current regulations allow flexibility in setting early withdrawal terms for CDs kept open for longer than six days.It’s not a matter of ability. Banks can offer more withdrawal options. Depositors are waiting for banks that will.Neil Stanley is CEO/founder of The CorePoint, which provides a cohesive program of training, deposit practices, and technology designed to drive deposit profitability.