Bank Deposit Agreement
What is a Bank Deposit Agreement?
How Does a Bank Deposit Agreement Work?
Bank deposit agreements are similar to guaranteed investment contracts (GICs) except that they are issued by banks rather than insurance companies. The issuer (the bank) guarantees the investor's return of principal and pays a fixed or variable rate of interest until the end of the contract. In the meantime, the bank attempts to earn a higher return on the investment than it has agreed to pay to the investor. In general, a bank deposit agreement's return increases with the length and size of the investment.
Bank deposit agreements are not the same as certificates of deposit (CDs) for two reasons. First, bank deposit agreements allow the investor to make deposits over a period of time, whereas a CD requires one lump-sum investment. Any deposits made during the bank deposit agreement's deposit window (usually a few months) receive the guaranteed rate for the duration of the contract. There are often minimum and maximum requirements about how much money can be invested during the window.
Second, bank deposit agreements allow for withdrawals under certain circumstances before the contract expires (for example, if the owner retires, becomes disabled, is fired, or experiences some sort of hardship, or if the corporate sponsor of the pension plan buying the bank deposit agreement suffers some sort of financial distress).
Like GICs, there is a wide variety of bank deposit agreements out there, and they generally carry administrative service fees, investment management fees, and fees to compensate for credit or early withdrawal risk.
Why Does a Bank Deposit Agreement Matter?
The biggest risks associated with bank deposit agreements are interest rate risk and liquidity risk. When interest rates are falling, there may be more bank deposit agreement investments than the bank might be able to invest profitably. When rates are increasing, there may be fewer investments and more withdrawals, which pressures the bank into keeping much of the funds liquid. Also, bank deposit agreements with fixed rates are vulnerable to inflation--for example, there is a possibility that purchasing a five-year bank deposit agreement will eliminate the opportunity to earn higher returns if interest rates rise during the holding period. These risks do elevate the overall risk of the bank itself, which is why bank examiners evaluate bank deposit agreement funding and bank policies and practices related to bank deposit agreement activity.
Like GICs, most bank deposit agreement customers are pension plans. By and large, investors indirectly purchase bank deposit agreements by participating in their 401(k) or other pension plans at work, but some financial institutions do offer bank deposit agreements to individual investors. In either case, bank deposit agreements are mostly buy-and-hold investments that have no secondary market. They typically return more than savings accounts and Treasuries because the FDIC does not insure them nor are they backed by the full faith and credit of the U.S. government. Instead, bank deposit agreements are backed by the creditworthiness of their banks and are still considered relatively safe (and thus low-return) investments.