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Speech to Functional Cost Cooperators at
Evansville, Indiana, September 16, 1969
Marion, Illinois, September 17, 1969
Federal Reserve Bank of St. Louis, September 18, 1969

Cost accounting data represent an improvement over
what bankers previously had for self analysis. From the viewpoint of the individual bank, however, the data fall short of
the optimum, because they measure average cost and returns
rather than cost of handling an additional account or returns
from additional loans and investments (Marginal Cost Chart).
Many bank costs per unit handled tend to decline
as bank size increases.

If the decline in operating cost is

sufficient to offset sizable increases in interest on time
and savings deposits or decreases in service charges and rates
charged on loans, a bank could, by paying higher rates or by
reducing service charges, increase its market area by making
its lending and depositing functions more attractive to
potential customers.

It could, at the same time, increase

One thing to remember in bank market analysis is that
all banks combined have only limited control over total bank

The national totals are largely determined by monetary

policy. Monetary authorities permit bank deposits to grow by
increasing bank reserves as the economy expands.


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This does not mean, however, that an individual
bank should operate as though its loans and deposits are

Banking is a competitive business. One bank can

get business at the expense of another.

Savings can be bid

away from nonbank agencies and bank credit can be expanded
at the expense of nonbank financial agencies if such savings
are obtained.
As most bankers already know, convenience is
extremely important in determining a bank's customers. In
a study by this Bank in 1966, more than half of all the
small firms questioned indicated that convenience was the
main reason for choosing a particular bank.

Further rein-

forcing this conclusion is the fact that almost three-fourths
of the small firms in Metropolitan St. Louis banked less than
three miles from the location of the firm (bank market chart).
The individual bank market can thus be visualized
as a circle with the bank office as the center and all roads
or streets leading to and from the bank as radii of the circle.
The size of the circle can be measured with reasonable accuracy
by the use of customer surveys. The size of the circle for
most banks is not very large, but it can be changed by pricing
and marketing policies.


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The question of prime interest to bankers is:
What can I do to enhance the market area of my bank?
words, how do we get from here to here? (Chart)

In other

We can discuss

this question from the standpoint of functional cost data.
Given the incentive for customers to bank at the nearest
banking office, any bank under competitive conditions determines to some extent the size of its market when it sets prices
on its saleable products and on the deposits it purchases.
Individual banks are neither limited in sources of funds nor
uses for funds.

Pricing of Inputs and Products Important
Without belittling the impact of advertising,
educational programs, and the personal qualities of the bank's
staff, pricing is an important factor in determining the size
of a bank's market area.

For example, if two banks are operating

five miles apart, and all their marketing efforts and prices
are equal, their respective market areas will probably extend
to about midway between the banks.

On the other hand, if the

pricing policies of one bank are more favorable to customers,
its market area is likely to exceed half the distance between
the two banks.


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With the impact of bank pricing on market areas
recognized, we can draw some further inferences concerning
the cost analysis data.

For example, lower cost of acquir-

ing deposits from the cost analysis context may be considered
a favorable factor.

This is not, however, necessarily true.

We could reduce the cost to zero by paying a zero rate on
all time deposits and setting service charges high enough to
cover all deposit servicing costs.

A bank following this

practice, however, would probably experience unfavorable

Its growth would cease or lag that of competitive

Deposits would decline, and profits would likely


Under competitive conditions it is obvious that

banks should purchase deposits.

What is not so obvious is

the rate that should be paid for them.

The rate paid is one

determinant of the size of the bank's market.
same time a cost factor.

It is at the

If a bank is maximizing profits,

the amount paid for deposits will be determined largely by
demand for loan funds (opportunities for income) in its
market area.
Net portfolio yields may be analyzed in a manner
similar to that of deposits.
upon as favorable.

High yields on loans are looked

Again, however, this is not necessarily true.


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The elasticity of loan demand will determine the lending rate
which is most profitable to a given bank, and such a rate may
be only average or below average, depending on loan demand.
If lower rates on loans cause an increase in the size of the
market area, and a more than proportionate increase in loans
outstanding, this could lead to higher profits despite lower
net yields.
I have used these examples to point out some pitfalls
in making bank policy on the basis of apparent conclusions
drawn from cost accounting data. What conclusions can be
drawn from the data which will justify bank policy changes?
First, we have the more obvious conclusions which
relate to internal operating efficiencies.

These include

comparisons of the operating expense for the various functions.
If per unit handling costs are high, they obviously require
analysis and answers. Conclusions relative to such expense,
however, must be drawn with care.
Part of the sample with which comparisons are made
in your cost analyses may be located in vastly different labor

Comparisons of unit costs in low wage areas with

those in high wage areas can be misleading.

All banks must

pay a competitive wage and salary rate to get and hold qualified
help, even though costs of its various functions are higher than


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In high labor cost areas additional automation of

functions may be a more desirable means of reducing costs
than attempts to hold wage and salary rates down.
Next we have the less obvious uses which may be
made of the data.

For example, the bank with relatively low

expenses for servicing demand deposit accounts and relatively
high service charges per item might increase net income substantially by offering some concessions in the service charges
and thereby enlarging its market area.

If new accounts can

be gained in this effort, they should be profitable to such
a bank in view of declining marginal costs for servicing
checking accounts.

Similar concessions by competitive banks

with higher costs will be difficult to make.

Under such

conditions a bank might profitably expand its market area
and realize growth both from an expanded market plus further
growth within its current market area.
Conversely, a bank with high servicing costs on
demand deposits and relatively low charges may be getting an
excess of small non-profit accounts.
be taking losses at the margin.

In other words, it may

It might find an increase

in service charges profitable, despite some loss in footings.
A bank operating in an area of high loan demand
will likely find it profitable to increase its market area


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through higher bids for deposits.

This will narrow the profit

margin, but the larger volume of business obtained may be the
most profitable operating level for the bank.
In summary, the use of functional cost data in market
analysis offers some interesting possibilities.


decisions must still be made as the data do not provide precise

The size of market that provides the most profitable

level of operation for a bank is the key to appropriate decision

Credit and demand deposit customers prefer to bank at

nearby banking offices.

More favorable pricing, however, will

overcome some reluctance to bank at more distant points.
deposits move quite freely over longer distances.



banking by mail is becoming more acceptable with the improvements in communication.

The cost accounts provide data from

which judgments relative to these problems can be made.
theless, the accounts do not provide final answers.


They only

serve as signposts to attract attention to possible problems
and potential opportunities.