Principal Based CD Early W/D Penalties

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Question:

I've been asked to research what compliance issues there might be with changing our CD early withdrawal penalties from interest based (e.g., 3 months interest) to principal based (e.g., penaltiy is 1% of principal amount at opening or renewal).In what I've been able to find, the only thing I see relates to the Reg D requirements for the penalty to be at least 7 days simple interest if the withdrawal occurs within the first six days to be considered a time deposit. Assuming we can cross that hurdle, are there other compliance issues that I'm missing? UDAAP potential comes to mind, but if we are clear and transparent in disclosing the penalty are there other aspects of UDAAP that could bite us? We are looking at this as a defensive/customer retention tactic. With today's rates so low, and as a result with interest-based early w/d penalties also low, customers have no real downside to locking in higher yields today by putting into long term CDs with the thought that if rates jump significantly in a year, the penalty will be more than offset by moving to a higher yield CD early.I'd be interested in hearing any thoughts. We have heard anecdotally that other banks may be considering or already doing this. Is anyone aware of a bank doing this at this time?

Answer:

There is, of course, the obligatory statement that state deposit laws may affect a bank's ability to impose early withdrawal penalties other than those required by Regulation D.

In essence, traditional early withdrawal penalties have always been based at least indirectly on the principal amount, often the principal amount withdrawn. That is, after all, the nature of the interest penalty (X days' interest on the amount withdrawn). So it's really not too great a leap to base a penalty on the principal amount (either the amount withdrawn early in the case of a partial withdrawal or the balance of the CD prior to withdrawal in the case of a full withdrawal).

I don't see a UDAAP issue if the penalty provision, including how its amount can be determined, is clearly and conspicuously included in the deposit contract and disclosures. Of course, UDAAP is a hard target to define, but I see nothing inherently unfair, deceptive or abusive about a well-disclosed principal penalty.

I will point out, however, that the same chilling effect on early withdrawals might be achieved by increasing the number of month's interest you'd take. For example, if state law doesn't stand in the way, you might simply say you'll impose a penalty of one year's interest. Or you could be even stricter by declaring that early withdrawals won't be permitted (with or without a short list of exceptions).

First published on BankersOnline.com 8/13/12