Customers don’t always optimize their choices to maximize yield.

If you look at how your deposit portfolios behave, it is self evident that Customers are not always choosing options that maximize yield on their funds. Here are some examples:

• Autorenewal to same term, regardless of current rates.
• Renewal to the same term when another term offers a better rate.
• Renewal to a different term, when a competitor may offer a better rate.
• Parking money in Money Market until a CD reinvestment decision is made.

We see these sub-optimal economic choices happening all the time. Customers are not optimizing their choices using price as the only criteria. They must be considering something else other than rate when they make these decisions.

We believe the hidden factor is Friction.

The notion of friction in transaction economics is not new. For decades behavior theory has recognized that choices are not free, there is a cost side to the optimization equation that influences outcomes.

In our banking world, there are many kinds of friction. The effort required to research alternatives. The effort required to execute transactions, open a new account, switch products or start a new relationship with another Institution. The cognitive cost of evaluating available options, benefits and costs to arrive at an acceptable decision.

We’re not suggesting every Customer sits down with a calculator and a PhD in options theory to figure out what to do with their money. Nonetheless what we see in data suggests Customers are optimizing decisions from a perspective that considers factors beyond price, whether undertaken consciously or subconsciously,

If moving between alternatives had no cost, Decision Spaces would effectively disappear. Every Customer would continuously evaluate every available option and immediately move to the one offering the highest perceived benefit. We know that does not happen. Customers routinely renew to the same term, leave funds in lower-yielding products, postpone decisions and accept outcomes that appear economically suboptimal. The fact that they do tells us there must be a cost to continuing the search for better alternatives. That cost may be operational, cognitive, informational or transactional. Whatever form it takes, the effect is the same. Friction creates boundaries around groups of options and makes those boundaries meaningful.

Friction creates Decision Space Boundaries.

You may have noticed that the examples we listed at the beginning of this article each appear as Decision Spaces in the framework. That is no accident. Each of those choices happen within a specific set of available options. To acquire access to more options, the Customer must do something, incur a friction cost, or in the language of the framework, they have to cross a decision boundary.

Consider Autorenewal as an example. Customers who elect to automatically renew to the same product, same term over and over again have made a choice to accept whatever rate is on offer at maturity. They benefit from an automated administrative process that reduces the friction of renewal to near zero.

No contrast that with another Customer who doesn’t auto-renew. They have chosen to enter a different Decision Space. They have to look at the rate sheet and decide if they want to stay in the same term or consider switching term on renewal. Staying in the same term is easier, since they already considered the implications of committing to that term when they bought the maturing CD. Switching to a different term requires consideration of a different commitment time frame, and that means more cognitive load, more friction.

Individuals assess costs and benefits subjectively. What one person considers important another may consider trivial. Decisions have a materiality component. But it isn’t just materiality in the financial sense that matters. It is how the individual evaluates costs and benefits that determines the outcome.

Understanding this opens up some interesting opportunities for management.

The first opportunity is recognizing that Decision Space Boundaries exist and crossing them has a cost to the Customer. We can influence the decision to cross any boundary with an incentive. And that incentive only needs to be sufficient to overcome the friction of the boundary itself. In operational terms, we have low cost leverage at the boundary, and we can use that leverage to influence outcomes to help meet our funding requirements.

The second opportunity is more subtle. We can manage the boundaries themselves, and the option sets available within each decision space. We create the option sets. We can change the boundaries. We can design Decision Spaces.

The Customer decides.