Banks offer a variety of different types of accounts for different purposes. Accounts such as checking and transaction accounts are designed for, as the name suggests, transactions. But they usually don’t pay any interest. Savings accounts are designed for saving money. Hence banks offer inducements and expect the deposits not to move very often.
Term deposits and CDs are different to savings accounts. Basically, both of these instruments are the same. The allow you to deposit a cash in the bank for a fixed term and for a fixed interest rate. They both also have penalties for withdrawing early. The key difference is that CDs are freely negotiable while term deposits are not. That means you can sell a CD before it matures to another party, who then becomes the owner of the CD. Likewise, you can purchase a CD from someone else.
The first thing to understand about how deposit accounts work is to understand yield curves. Quite simply, a yield curve is a given interest rate for each point in time, put into a nice little graph for ease of viewing. Usually, the further out you go, the higher the interest rate you get on your deposit.
As the term gets longer, you receive a higher interest rate on your deposits. The longer your money is tied up without the ability to access it, the higher ‘reward’ you would want to receive.
The simple answer to that is because of the way bank liquidity requirements operate. Without delving deep into the arcane rules of bank capital requirements, banks have to hold a certain amount of capital for different types of assets. For example, if they hold a government bond, they have to hold 0% capital.
But for a mortgage it might be 8% (that is, for a $500,000 mortgage, the bank has to have $40,000 in capital set aside). As banks have to make a certain return on capital for their investors (say 10%), then they have to “make” $40,000 x 10% = $4,000 off the $500,000 mortgage. Hence, one component of the interest they charge.
Likewise, banks have to hold capital for liquidity purposes (liquidity is how easily an asset is turned into cash). The less liquid, the more capital required. When you withdraw cash from the bank, it has to find the money to pay you. When it comes to bank accounts, a savings account is considered to the “permanent” in nature. That is, it doesn’t have a maturity date and hence carries a very low liquidity charge. A term deposit or CD on the other hand has a defined maturity date and hence a higher liquidity charge. If it costs the bank more in capital, then you will get a lower return.
This may seem a little counter-intuitive. You withdraw funds from a savings account at any point in time but you can’t withdraw funds from a CD or term deposit without penalty. However, banks have found that deposits are generally “sticky”. That is, they don’t get withdrawn as often as you might think. Banks also offer inducements such as bonus interest on accounts where a small deposit is made each month.