Retail Banking: Time Deposit Products

In the previous article we studied that there are two types of deposits that banks use to fund their lending operations. We studied in detail about the different types of demand deposits. However, demand deposits are considered to be vulnerable sources of finance. Depositors are likely to pull out the funds that form a part of demand deposits at the slightest sign of trouble.

To the contrary time deposits form a more stable source of funds. They form the solid foundation based on which banks can continue their lending operations. In this article, we will study about the various types of time deposits products that are offered by banks to their depositors.

Certificate of Deposits

Certificate of Deposits or CD’s as they are colloquially known are the most popular form of time deposits accepted by banks. They are promissory notes that are issued by the banks in lieu of the cash that they have received on account. This means that the bank borrows the money from you for a certain amount of time. Because the maturity of the fixed deposit is known, banks offer a higher rate of interest on them. This is because it is unlikely that the account holder will simply walk in and demand the money. Although, this is possible in case of time deposits as well that the account holder may want to make a withdrawal because of unforeseen circumstances. In such cases, the account holder can withdraw from their account but they may have to completely forego the interest and may also have to pay huge penalties.

Certificates are available in several denominations. Certificates with face value less than $100,000 dollars are called small CD’s whereas if the face value is greater than $100,000 they are called large or jumbo CD’s. Corporations, banks and governments usually invest in jumbo CD’s. It is unlikely for an individual to have that much money in a CD.

Negotiable Certificate of Deposits

Negotiable certificate of deposits, are CD’s which have one additional feature i.e. they have a liquid secondary market. Thus, a person can buy a CD from a bank. However, they do not have to lock in their funds for the entire period. In fact they do not have to lock in their funds even for a day. These certificates can be sold immediately in the secondary market without any major loss of value. However, there may be some transaction costs incurred to sell the certificate and liquidate the money. The transaction costs will be considerably less than what it would cost to go to the bank and withdraw the money after foregoing the interest and paying the penalty.

Negotiable CD’s are usually greater than $100,000 in face value. They are therefore bought and sold by large corporations. This adds even more liquidity to the market because these corporations move their money around often and hence there is a lot of buying and selling that goes around.

Escalating Certificate of Deposits

Escalating certificate of deposit is a special kind of certificate that entices the account holder to keep their money invested for longer and longer periods of time. The bank does so by offering interest rate that goes on escalating each year. For instance, the CD might pay a 4% interest if the money is withdrawn at the end of the first year. However, if the money is not withdrawn, the interest rate may rise and go up to 4.5% for both the years. If the money is still not withdrawn at the end of the second year, the bank may further escalate the interest rate to 5%.

The escalating interest rates obviously have to stabilize at some point in time. However, if the account holder has no immediate need of funds, escalating CD’s are capable of ensuring that their money stays invested with the bank. These kinds of CD’s are largely used by people who are saving for their retirement.

Index Linked Certificate of Deposits

There are some certificates of deposits which can offer investors returns based on the stock market. Thus, if the stock market moves up by a certain percentage so does the interest rate payable on the CD’s. However, if the stock market goes down in value, then the minimum rate payable on the CD’s would still be paid out as interest. Therefore, these kinds of CD’s are very popular amongst investors who prefer to invest in the stock markets. Some of these CD’s also allow investors with the option of switching over from stock market indexed returns to a fixed rate returns. When such options are embedded in the CD, the cost of the CD as well as the minimum investment threshold goes up. The more exotic securities are generally for the bigger investors.

The market for certificate of deposits has also undergone a lot of innovation. Therefore there are many CD’s available today. Some of them offer higher returns whereas some others offer liquidity. Investors can choose amongst them based on the attributes that they consider most valuable.


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