Why Do Big Banks Pay Less Interest on Savings?

Do consumers incorrectly perceive their money is safer or does it have more to do with convenience and other products large institutions offer?

There are many advantages for big banks these days, given their implicit government guarantee. They achieve lower borrowing costs and are more attractive as counterparties for some financial products like swaps. Some of their advantages may change with new financial reform, some may not. An article from Reuters Breakingviews asserts that the relatively lower interest rates big banks pay their savings accountholders is another luxury that the government guarantee provides. The article contends this is because consumers see big banks as safer. I don't really agree, but we'll know soon if this thesis is right.

This article's assertion presents a sort of extremely pessimistic view about Americans' rationality. Since the FDIC insures all deposits up to $250,000, if you've got less money than that in a savings account, then it doesn't matter at all if the government guarantees your bank's existence. All that matters is that it guarantees your deposits -- and it does so long as it's FDIC-insured.

Still, the article provides strong evidence that there's quite a distinction in savings interest rates between big and small banks:

The interest rates paid on those deposits vary widely. In the fourth quarter of 2009, institutions with more than $100 billion of assets paid an average of 0.77 percent annual interest on deposits, according to F.D.I.C. data. By comparison, institutions with less than $10 billion of assets paid an average of 1.73 percent. That difference -- nearly 1 percentage point -- is one measure of the benefit that big banks enjoy from implicit government backing. They can pay less for deposits to customers happy with this assurance.

So, if Americans are stupid and think that a bank failing will mean their savings will be lost, then the article's thesis is right: big bank' protection from bankruptcy drives their lower savings interest rates. After all, few Americans have savings accounts larger than $250,000 (or $500,000 for a married couple with a joint-account). That's an awful lot of cash to have in a savings account. And unless you've got more than that in an account, it's irrational to worry about your bank failing. But the article then goes on to argue its point:

Big banks might argue that lower deposit funding costs reflect other advantages. For example, they offer more services and the convenience of more branches and A.T.M.'s than smaller banks. But that was the case before the government stepped in to save giant banks from the damage inflicted by subprime mortgages starting in 2007. Figures from the F.D.I.C. show that banks in all size categories paid 3.6 percent to 3.65 percent on deposits in the last quarter of 2006.

I'd like to see some data from well before 2006 (and I tried getting it from the FDIC, who tells me that they don't track it, so I'm not sure how the article managed to get this data from that source). I wonder if there could be another reason to blame having to do with the housing bubble. For example, maybe the desire to originate as many mortgages as possible up to 2006 could have driven parity in savings interest rates for all banks at that time. Even big banks wanted all of the deposits they could get so they could write more mortgages. Indeed, some of the bigger banks were offering extremely high-yielding savings accounts to attract more deposits. (I should know; I had one with one of the biggest banks out there that paid something like 5% in 2006.)

So instead, I suspect that the current disparity has more to do with the other advantages the article mentions. I know that's why I use a large financial institution, despite the fact that I despise most big banks. I don't want to deal with the inconvenience of a less robust offering of services or branches/ATMs. And sadly, I have less than $250,000 in my savings account, so I would have no fear of any smaller bank failing that is FDIC insured.

Of course, the article's thesis will be easy enough to test in the months that come. When financial regulation passes it will likely provide a non-bank resolution authority to end the too-big-to-fail problem. Then, even irrational banking consumers should realize that big banks can now also fail, and this perceived safety as a reason for choosing big banks for your savings will be eliminated. At that time, we should see better parity between big and small bank savings interest rates. If we don't (and I don't think we will), then it is those additional advantages like more locations and greater convenience that drives the variance in rates after all.