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Funding the Bank and Managing Liquidity
Chapter 8
Prof. Dr. Rainer StachuletzProf. Dr. Rainer StachuletzBanking Academy of Vietnam Banking Academy of Vietnam Based upon: Bank ManagementBased upon: Bank Management, 6th edition. 6th edition.Timothy W. Koch and S. Scott MacDonaldTimothy W. Koch and S. Scott MacDonald
Prof. Dr. Rainer Stachuletz – Banking Academy of Vietnam - Hanoi
The Relationship Between Liquidity Requirements, Cash, and Funding Sources
The amount of cash that a bank holds is influenced by the bank’s liquidity requirements
The size and volatility of cash requirements affect the liquidity position of the bank Deposits, withdrawals, loan
disbursements, and loan payments affect the bank’s cash balance and liquidity position
Effect of Maturing Certificates of Deposit and Loan Use on a Bank’s Deposit Balances at theFederal Reserve
Recent Trends in Bank Funding Sources
Bank customers have become more rate conscious
Many customers have demonstrated a a strong preference for shorter-term deposits
Core deposits are viewed as increasingly valuable
Bank often issue hybrid CDs to appeal to rate sensitive depositors
Types of Hybrid CDs
Jump Rate (Bump-up) CDs Customers have the option (right) to request a
change in rate one time prior to maturity. Indexed CD
CD rates float with some base rate (index) such that the yield changes as the index changes
CD Special CDs with unusual maturities (13 months or 23
months) in which the bank pays an above market rate. At maturity the CD converts to a traditional 12 month or 2-year CD.
Recent Trends in Bank Funding Sources
Retail Funding Deposit Accounts
Transaction accounts Money market deposit accounts Savings accounts Small time deposits
Borrowed Funding Federal Funds purchased Repurchase agreements Federal Home Loan Bank borrowings
Recent Trends in Bank Funding Sources
Wholesale Funding Includes borrowed funds plus large
CDs Equity Funding
Common stock Preferred stock Retained earnings
Recent Trends in Bank Funding Sources
Volatile Liabilities Funds purchased from rate-sensitive
investors Federal Funds purchased Repurchase agreements Jumbo CDs Eurodollar time deposits Foreign Deposits
Investors will move their funds if other institutions are paying higher rates
Change in Total Deposits, Borrowed Funds, Subordinated Notes, and Total Equity Over Time, 1935–2004
0%
5%
10%
15%
20%
25%
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Borrowed Funds
Total Deposits
Subordinated Notes
Total Equity
Percent of total funding Percent of total funding
Change in the Percentage Contribution of Various Bank Funding Components, 1992–2004
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12/31/1992 12/31/199612/31/2000 12/31/2004
The Percentage Contribution of Various Sources of Bank Funds by Bank Size, 2004
< $100 M $100M - $1B
$1B - $10B
> $10 B All CBs
Number of institutions reporting 3655 3530 360 85 7630
Total deposits 83.68% 80.85% 68.50% 63.47% 66.48% Deposits held in domestic offices 83.67% 80.67% 67.36% 49.93% 49.93% Transaction accounts 26.29% 19.76% 10.03% 6.69% 6.69%
Demand deposits 13.90% 11.48% 7.28% 5.42% 5.42% Nontransaction accounts 57.38% 60.91% 57.33% 43.24% 43.24%
Money market deposit accounts (MMDAs) 10.59% 15.87% 23.47% 23.74% 23.74% Other savings deposits (excluding MMDAs) 9.19% 11.60% 10.42% 7.20% 7.20% Time deposits of less than $100,000 24.97% 19.68% 11.53% 5.08% 5.08% Time deposits of $100,000 or more 12.63% 13.76% 11.91% 7.22% 7.22%
Deposits held in foreign offices 0.01% 0.18% 1.14% 13.55% 13.55% Federal funds purchased & repurchase agreements 0.91% 2.54% 8.17% 7.50% 6.87% Trading liabilities 0.00% 0.00% 0.00% 4.45% 3.33% Other borrowed funds 3.28% 5.73% 10.05% 9.17% 8.75% FHLB advances 3.10% 5.37% 6.77% 2.01% 2.97% Memo: Volatile liabilities 14.69% 18.61% 26.57% 34.96% 31.68% Subordinated debt 0.01% 0.08% 0.40% 1.67% 1.31% All other liabilities 0.60% 0.79% 1.97% 3.76% 3.15% Equity capital 11.52% 10.00% 10.90% 9.95% 10.10%
Deposits held in domestic offices 83.67% 80.67% 67.36% 49.93% 49.93% Noninterest-bearing deposits 14.09% 13.55% 11.89% 11.72% 11.72% Interest-bearing deposits 69.58% 67.12% 55.47% 38.21% 38.21%
Core (retail) deposits 71.04% 66.92% 55.45% 42.71% 42.71% IRAs and Keogh plan accounts 4.17% 3.63% 2.63% 1.61% 1.61% Brokered deposits 1.45% 2.86% 4.35% 4.58% 4.58% Fully insured 1.25% 2.61% 3.52% 2.34% 2.34%
Estimated insured deposits 67.31% 58.43% 41.51% 28.24% 28.24%
Average Annual Interest Cost of Liabilities by Bank Size, 2004
<$100M $100M–
$1B $1B–$10B >$10B All CB
Total interest expense on total liabilities 1.55% 1.56% 1.44% 1.36% 1.34% Interest expense on deposits 1.49% 1.43% 1.22% 1.16% 1.17%
Domestic deposits 1.49% 1.43% 1.22% 1.02% 1.09% MMDAs and savings deposits 0.54% 0.45% 0.35% 0.34% 0.34% Time deposits <$100K 2.36% 2.42% 2.21% 2.21% 2.19% Time deposits >$100K 2.47% 2.59% 2.47% 2.51% 2.45%
Deposits foreign offices 0.57% 1.22% 1.50% 1.67% 1.62% Fed funds purchased 2.55% 3.83% 4.20% 4.96% 4.54% U.S. notes & other borrowed funds 3.60% 3.44% 2.88% 3.01% 2.73% Subordinated notes & deb. 3.91% 4.69% 4.25% 4.80% 4.49%
Source: BankSearch, Highline Data, © Highline Data, LLC.
Characteristics of Retail-Type Deposits
Retail Deposits Small denomination (under $100,000)
liabilities Normally held by individual investors Not actively traded in the secondary
market
Transaction Accounts
Most banks offer three different transaction accounts Demand Deposits
DDAs Negotiable Order of Withdrawal
NOWs Automatic Transfers from Savings
ATS
Transaction Accounts
Demand Deposits Checking accounts that do not pay
interest Held by individuals, business, and
governmental units Most are held by businesses since
Regulation Q prohibits banks from paying explicit interest on for-profit corporate checking accounts
Transaction Accounts
NOW Accounts Checking accounts that pay interest
ATS Accounts Customer has both a DDA and savings
account The bank transfers enough from
savings to DDA each day to force a zero balance in the DDA account
For-profit corporations are prohibited from owning NOW and ATS accounts
Transaction Accounts
Although the interest cost of transaction accounts is very low, the non-interest costs can be quite high Generally, low balance checking
accounts are not profitable for banks due to the high cost of processing checks
Non-Transaction Accounts
Non-transaction accounts are interest-bearing with limited or no check-writing privileges
Money Market Deposit Accounts Pay interest but holders are limited to 6
transactions per month, of which only three can be checks
Attractive to banks because they are not required to hold reserves against MMDAs
Non-Transaction Accounts
Savings Accounts Have no fixed maturity
Small Time Deposits (Retail CDs) Have a specified maturity ranging from
7 days on up Large Time Deposits (Jumbo CDs)
Negotiable CDs of $100,000 or more Typically can be traded in the
secondary market
Estimating the Cost of Deposit Accounts
Interest Costs Legal Reserve Requirements Check Processing Costs Account Charges
NSF fees Monthly fees Per check fees
Estimating the Cost of Deposit Accounts
Transaction Account Cost Analysis Classifies check-processing as:
Deposits Electronic Non-Electronic
Withdrawals Electronic Non-Electronic
Estimating the Cost of Deposit Accounts
Transaction Account Cost Analysis Classifies check-processing as:
Transit Checks Deposited Cashed
Account Opened or Closed On-Us checks cashed General account maintenance
Truncated Non-Truncated
Estimating the Cost of Deposit Accounts
Transaction Account Cost Analysis Electronic Transactions
Conducted through automatic deposits, Internet, and telephone bill payment
Non-Electronic Transactions Conducted in person or by mail
Transit Checks Checks drawn on any bank other than
the bank it was deposited into
Estimating the Cost of Deposit Accounts
Transaction Account Cost Analysis On-Us Checks Cashed
Checks drawn on the bank’s own customer’s accounts
Deposits Checks or currency directly deposited
in the customer's account Account Maintenance
General record maintenance and preparing & mailing a periodic statement
Estimating the Cost of Deposit Accounts
Transaction Account Cost Analysis Truncated Account
A checking account in which the physical check is ‘truncated’ at the bank and the checks are not returned to the customer
Official Check Issued A check for certified funds.
Net Indirect Costs Those costs not directly related to the
product such as management salaries or general overhead costs
Cost and Revenue Accounting Data for Deposit Accounts at FirstBank
Unit Cost Demand Savings Time Income Interest income (estimated earnings credit) 2.6% 2.5% 3.0% Noninterest income (monthly estimates per account) Service charges $ 2.80 $ 0.44 $ 0.11 Penalty fees $ 4.32 $ 0.28 $ 0.27 Other $ 0.63 $ 0.16 $ 0.05 Total noninterestiIncome $ 7.75 $ 0.88 $ 0.42 Expenses Activity charges (unit costs per transaction) Deposit—electronic $ 0.0089 $ 0.0502 $ 0.1650 Deposit—nonelectronic $ 0.2219 $ 0.7777 $ 3.1425 Withdrawal—electronic $ 0.1073 $ 0.4284 $ 0.5400 Withdrawal—nonelectronic $ 0.2188 $ 0.7777 $ 1.4933 Transit check deposited $ 0.1600 $ 0.5686 Transit check cashed $ 0.2562 On-us check cashed $ 0.2412 Official check issued $ 1.02 Monthly overhead expense costs Monthly account maintenance (truncated) $ 2.42 $ 4.10 $ 1.99 Monthly account maintenance (nontruncated) $ 8.60 Net indirect expense $ 4.35 $ 1.81 $ 18.38 Miscellaneous expenses Account opened $ 9.46 $ 33.63 $ 5.78 Account closed $ 5.67 $ 20.18 $ 3.38
Calculating the Average Net Cost of Deposit Accounts
Average Historical Cost of Funds Measure of average unit borrowing
costs for existing funds Average Interest Cost
Calculated by dividing total interest expense by the average dollar amount of liabilities outstanding
Ratio) Reserve Required - (1 x Float of Net Balance Average
Income tNoninteres - Expense tNoninteres Expense Interest
sLiabilitie Bank of Cost Net Average
Calculating the Average Net Cost of Deposit Accounts
Example: A demand deposit account that does
not pay interest has $20.69 in transaction costs charges, $7.75 in fees, an average balance of $5,515, and 5% float would have a net cost of 3.29%
3.29%12.10) - (1 .05) - (1 $5,515
$7.75 - $20.69 $0
Deposit Demand of Cost Net Average
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Low Balance, Low Activity, Truncated
Medium Balance, High Activity, Nontruncated High Balance
Activity
Monthly Income /
Expenses Activity
Monthly Income /
Expenses Activity
Monthly Income /
Expenses Income
Interest income $ 500 $ 0.93 $ 4,589 $ 8.50 $11,500 $ 21.30 on average monthly balance (after float)
Noninterest income (average montly estimates)
Service charges $ 2.80 $ 2.80 $ 2.80 Penalty fees (estimated for account) $ 8.56 $ 6.32 $ 2.01 Other $ 0.63 $ 0.63 $ 0.63 Total noninterest income $ 11.99 $ 9.75 $ 5.44
Total revenue $ 12.92 $ 18.25 $ 26.74 Expenses
Activity charges Deposit—electronic 1 $ 0.01 2 $ 0.02 2 $ 0.02 Deposit—nonelectronic 1 $ 0.22 3 $ 0.67 3 $ 0.67 Withdrawal—electronic 15 $ 1.61 12 $ 1.29 10 $ 1.07 Withdrawal—nonelectronic 3 $ 0.66 14 $ 3.06 8 $ 1.75 Transit check deposited 1 $ 0.16 2 $ 0.32 2 $ 0.32 Transit check cashed 1 $ 0.26 2 $ 0.51 2 $ 0.51 On-us checks cashed 2 $ 0.48 3 $ 0.72 3 $ 0.72 Official check issued $ - $ - $ -
Total activity expense $ 3.40 $ 6.59 $ 5.06
Monthly expenses Monthly account maintenance (truncated) 1 $ 2.42 $ - $ - Monthly account maintenance (nontruncated) - $ - 1 $ 6.60 1 $ 6.60 Net indirect expense $ 4.35 $ 4.35 $ 4.35
Total reoccurring monthly expenses $ 6.77 $ 10.95 $ 10.95
Interest expense $ - $ - $ - Total expense $ 10.17 $ 17.54 $ 16.01
Net revenue per month $ 2.75 $ 0.71 $ 10.73 Average percentage cost (net of service charges and fees) -5.12% 2.38% 1.29%
Average interest cost 0.00% 0.00% 0.00% Average noninterest cost 28.53% 5.36% 1.95% Average noninterest income 33.66% 2.98% 0.66%
Average account balance $ 500 $ 4,589 $ 11,500 Required reserves 10% 10% 10% Float 5% 5% 5%
Characteristics of Large Wholesale Liabilities
Wholesale Liabilities Customers move these investments on
the basis of small rate differentials, so these funds are labeled:
Hot Money Volatile Liabilities Short-Term Non-Core funding
Characteristics of Large Wholesale Liabilities
Wholesale Liabilities Includes:
Jumbo CDs Federal Funds Purchased Repurchase Agreements Eurodollar Time Deposits Foreign Deposits
Characteristics of Large Wholesale Liabilities
Jumbo CDs $100,000 or more Negotiable
Can be traded on the secondary market Minimum maturity of 7 days Interest rates quoted on a 360-day year
basis Insured up to $100,000 per investor per
institution Issued directly or indirectly through a
dealer or broker (Brokered Deposits)
Characteristics of Large Wholesale Liabilities
Jumbo CDs Fixed-Rate Variable-Rate
Jump Rate (Bump-up) CD Depositor has a one-time option until
maturity to change the rate to the prevailing market rate
Callable Zero Coupon Stock Market Indexed
Rate tied to stock market index performance
Characteristics of Large Wholesale Liabilities
Individual Retirement Accounts Each year, a wage earner can make a
tax-deferred investment up to $3,000 of earned income
Funds withdrawn before age 59 ½ are subject to a 10% IRS penalty
This makes IRAs an attractive source of long-term funding for banks
Characteristics of Large Wholesale Liabilities
Foreign Office Deposits Eurocurrency
Financial claim denominated in a currency other than that of the country where the issuing bank is located
Eurodollar Dollar-denominated financial claim at a
bank outside the U.S.
The Origin and Expansion of Eurodollar Deposits
Characteristics of Large Wholesale Liabilities
Federal Funds Purchased The term Fed Funds is often used to refer to
excess reserve balances traded between banks
This is grossly inaccurate, given reserves averaging as a method of computing reserves, different non-bank players in the market, and the motivation behind many trades
Most transactions are overnight loans, although maturities are negotiated and can extend up to several weeks
Interest rates are negotiated between trading partners and are quoted on a 360-day basis
Characteristics of Large Wholesale Liabilities
Repurchase Agreements (RPs or Repos) Short-term loans secured by
government securities that are settled in immediately available funds
Identical to Fed Funds except they are collateralized
Technically, the RPs entail the sale of securities with a simultaneous agreement to buy them back later at a fixed price plus accrued interest
Characteristics of Large Wholesale Liabilities
Repurchase Agreements (RPs or Repos) Most transactions are overnight In most cases, the market value of the
collateral is set above the loan amount when the contract is negotiated.
This difference is labeled the margin The lender’s transaction is referred to
as a Reverse Repo
Characteristics of Large Wholesale Liabilities
Borrowing from the Federal Reserve Discount Window Discount Rate
Policy is to set discount rate 1% (1.5%) over the Fed Funds target for primary (secondary) credit loans
To borrow from the Federal Reserve, banks must apply and provide acceptable collateral before the loan is granted
Eligible collateral includes U.S. government securities, bankers acceptances, and qualifying short-term commercial or government paper
Characteristics of Large Wholesale Liabilities
Borrowing from the Federal Reserve Primary Credit
Available to generally sound depository institutions on a very short-term basis, typically overnight
It serves as a backup source of short-term funds for sound depository institutions
Secondary Credit Available to depository institutions that
are not eligible for primary credit
Characteristics of Large Wholesale Liabilities
Borrowing from the Federal Reserve Seasonal Credit
Designed to assist small depository institutions in managing significant seasonal swings in their loans and deposits
Emergency Credit May be authorized in unusual and exigent
circumstances by the Board of Governors to individuals, partnerships, and corporations that are not depository institutions
Characteristics of Large Wholesale Liabilities
Federal Home Loan Bank Advances The FHLB system is a government-sponsored
enterprise created to assist in home buying The FHLB system is one of the largest U.S.
financial institutions, rated AAA because of the government sponsorship
Any bank can become a member of the FHLB system by buying FHLB stock
If it has the available collateral, primarily real estate related loans, it can borrow from the FHLB
FHLB advances have maturities from 1 day to as long as 20 years
Commercial Banks with FHLB Advances, 1991–2004
Commercial Banks with FHLB Advances
$50$100$150$200$250$300$350$400$450
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2,100
3,100
4,100
5,100
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Amount Outstanding (Billions)Number of Banks
Electronic Money
Intelligent Card Contains a microchip with the ability to store
and secure information Memory Card
Simply store information Debit Card
Online PIN based Transaction goes through the ATM system
Offline Signature based transactions Transaction goes through the credit card
system
Distribution of the Number of Noncash Payments in 2000 and 2003
Check, 57.79%Credit Card,
21.52%
ACH, 8.55%
Offline Debit, 7.31%
Online Debit, 4.14%
EBT, 0.69%
Check, 45.20%
Credit Card, 23.40%
ACH, 11.21%
Offline Debit, 12.68%
Online Debit, 6.53%
EBT, 0.99%
2000 2003
Source: The 2004 Federal Reserve Payments Study, http://www.frbservices.org/Retail/pdf/2004PaymentResearchReport.pdf. Note: Online debit payments are PIN-based, which includes purchases at the point of sale with ATM cards, and offline debit payments, which are signature-based transactions. EBTs are electronic benefits transfers. Data does not include Fedwire or CHIPS wire transfers.
Check 21
Check Clearing for the 21st Century Act Facilitates check truncation by
reducing some of the legal impediments
Foster innovation in the payments and check collection system without mandating receipt of check in electronic form
Improve the overall efficiency of the nation’s payment system
Check 21
Check Truncation Conversion of a paper check into an
electronic debit or image of the check by a third party in the payment system other than the paying bank
Facilitates check truncation by creating a new negotiable instrument called a substitute check
Check 21
Substitute Check The legal equivalent of the original
check and includes all the information contained on the original
Check 21 does NOT require banks to accept checks in electronic form nor does it require banks to create substitute checks It does allow banks to handle checks
electronically instead of physically moving paper checks
Substitute Check Authorized by Check 21
The Check Clearing Process
Check Clearing Process
Banks typically place a hold on a check until it verifies that the check is “good”
Expedited Funds Availability Act Under Reg CC, it states that:
Local check must clear in no more than two business days
Non-local checks must clear in no more than five business days
Government, certified, and cashiers checks must be available by 9 a.m. the next business day
Measuring the Cost of Funds
Average Historical Cost of Funds Many banks incorrectly use the
average historical costs in their pricing decisions
The primary problem with historical costs is that they provide no information as to whether future interest costs will rise or fall.
Pricing decisions should be based on marginal costs compared with marginal revenues
Measuring the Cost of Funds
Marginal Cost of Funds Marginal Cost of Debt
Measure of the borrowing cost paid to acquire one additional unit of investable funds
Marginal Cost of Equity Measure of the minimum acceptable
rate of return required by shareholders Marginal Cost of Funds
The marginal costs of debt and equity
Measuring the Cost of Funds
Costs of Independent Sources of Funds It is difficult to measure marginal costs
precisely Management must include both the interest
and noninterest costs it expects to pay and identify which portion of the acquired funds can be invested in earning assets.
Marginal costs may be defined as :
j Liability of Balance Investable Net
Insurance Costs Acquistion Costs Servicing Rate Interest
j Liability of Cost Marginal
Measuring the Cost of Funds
Costs of Independent Sources of Funds All elements in the numerator are
expected costs
Measuring the Cost of Funds
Costs of Independent Sources of Funds Example:
Market interest rate is 2.5% Servicing costs are 4.1% of balances Acquisition costs are 1.0% of balances Deposit insurance costs are 0.25% of
balances Net investable balance is 85% of the balance
(10% required reserves and 5% float)
9.24% 0.09240.85
0.00250.010.0410.025Cost Marginal
Measuring the Cost of Funds
Cost of Debt Equals the effective cost of borrowing
from each source, including interest expense and transactions costs
This cost is the discount rate, which equates the present value of expected interest and principal payments with the net proceeds to the bank from the issue
Measuring the Cost of Funds
Cost of Debt Example:
Assume the bank will issue: $10 million in par value subordinated notes
paying $700,000 in annual interest and a 7-year maturity.
It must pay $100,000 in flotation costs to an underwriter.
The effective cost of borrowing (kd) is 7.19%:
7.19% k Thus
)k(1
0$10,000,00
)k(1
$700,000$9,900,000
d
7d
7
1tt
d
Measuring the Cost of Funds
Cost of Equity The marginal cost of equity equals the
required return to shareholders It is not directly measurable because
dividend payments are not mandatory. Several methods are commonly used to
approximate this required return: Dividend Valuation Model Capital Asset Pricing Model (CAPM) Target Return on Equity Model
Cost of Debt + Risk Premium
Measuring the Cost of Funds
Preferred Stock Preferred stock acts as a hybrid of debt
and common equity Claims are superior to those of common
stockholders but subordinated to those of debt holders
Preferred stock pays dividends that may be deferred when management determines that earnings are too low.
The marginal cost of preferred stock can be approximated in the same manner as the Dividend Valuation Model however, dividend growth is zero
Measuring the Cost of Funds
Trust Preferred Stock Trust preferred stock is attractive because it
effectively pays dividends that are tax deductible
To issue the securities, a bank or bank holding company establishes a trust company.
The trust company sells preferred stock to investors and loans the proceeds of the issue to the bank
Interest on the loan equals dividends paid on the preferred stock
This loan interest is tax deductible such that the bank effectively gets to deduct dividend payments as the preferred stock
Measuring the Cost of Funds
Weighted Marginal Cost of Total Funds This is the best cost measure for asset-
pricing purposes It recognizes both explicit and implicit
costs associated with any single source of funds
It assumes that all assets are financed from a pool of funds and that specific sources of funds are not tied directly to specific uses of funds
Measuring the Cost of Funds
Weighted Marginal Cost of Total Funds
Steps to compute WMC1. Forecast the desired dollar amount of
financing to be obtained from each individual debt and equity source
2. Estimate the marginal cost of each independent source of funds
3. Combine the individual estimates to project the weighted costs, which equals the sum of the weighted component costs across all sources
Measuring the Cost of Funds
Weighted Marginal Cost of Total Funds
Steps to compute WMC4. Management should combine the
individual estimates to project the weighted cost, where wj equals each source’s weight and kj equals the single-source j component cost of financing such that:
m
1jjjkwWMC
Measuring the Cost of Funds
Example
Liabilities and Equity
(a) Average Amount
(b) Percent of Total
(c) Interest
Cost
(d) Processing
and Acquisition
Costs
(e) Nonearning Percentage
(f) Component
Marginal Costs
(g) Weighted Marginal Cost of Funds (b) x (f)
Demand deposits $ 28,210 31.0% 8.0% 18.0% 9.76% 0.0302 Interest checking $ 5,551 6.1% 2.5% 6.5% 15.0% 10.59% 0.0065 Money market demand accounts $ 13,832 15.2% 3.5% 3.0% 3.0% 6.70% 0.0102 Other savings accounts $ 3,640 4.0% 4.5% 1.2% 1.5% 5.79% 0.0023 Time deposits < $100,000 $ 18,382 20.2% 4.9% 1.4% 1.0% 6.36% 0.0129 Time deposits > $100,000 $ 9,055 10.0% 5.0% 0.3% 0.5% 5.34% 0.0053 Total deposits $ 78,670 86.5% Federal funds purchased $ 182 0.2% 5.0% 0.0% 0.0% 5.00% 0.0001 Other liabilities $ 4,550 5.0% 0.0% 40.0% 0.00%
Total liabilities $ 83,402 91.7%
Stockholders' equity $ 7,599 8.4% 18.9%* 4.0% 19.69% 0.0164 Total liabilities and equity $ 91,001 100.0%
Weighted marginal cost of capital ———————————————————————————-> 8.39%
Funding Sources and Banking Risks
Banks face two fundamental problems in managing liabilities. Uncertainty over: What rates they must pay to retain and
attract funds The likelihood that customers will
withdraw their money regardless of rates
Funding Sources: Liquidity Risk
The liquidity risk associated with a bank’s deposit base is a function of: The competitive environment Number of depositors Average size of accounts Location of the depositor Specific maturity and rate
characteristics of each account
Funding Sources: Liquidity Risk
Interest Elasticity How much can market interest rates change
before the bank experiences deposit outflows?
If a bank raises its rates, how many new funds will it attract?
Depositors often compare rates and move their funds between investment vehicles to earn the highest yields
It is important to note the liquidity advantage that stable core deposits provide a bank
Funding Sources: Interest Rate Risk
Today, many depositors and investors prefer short-term instruments that can be rolled over quickly as interest rates change
Banks must offer a substantial premium to induce depositors to lengthen maturities
Those banks that choose not to pay this premium will typically have a negative one-year GAP
Funding Sources: Interest Rate Risk
One strategy is to compete for aggressively compete for retail core deposits Individual are not as rate sensitive as
corporate depositors and will often maintain their balances through rate cycles as long as the bank provides good service
Funding Sources: Credit and Capital Risk
Changes in the composition and cost of bank funds can indirectly affect a bank’s credit risk by forcing it to reduce asset quality For example, banks that substitute
purchased funds for lost demand deposits will often see their cost of funds rise
Rather than let their interest margins deteriorate, many banks make riskier loans at higher promised yields
While they might maintain their margins in the near-term, later loan losses typically rise with the decline in asset quality
Holding Liquid Assets
Banks hold cash assets to satisfy four objectives:
1. To meet customers’ regular transaction needs
2. To meet legal reserve requirements
3. To assist in the check-payment system
4. To purchase correspondent banking services
Holding Liquid Assets
Banks own four types of liquid assets Vault Cash Demand Deposit Balances at the
Federal Reserve Demand Deposit Balances at private
financial institutions Cash Items in Process of Collection
(CIPC)
Holding Liquid Assets
“Cash Assets” Do not earn any interest Represents a substantial opportunity cost
for banks Banks attempt to minimize the amount of cash
assets held and hold only those required by law or for operational needs
Liquid Assets Can be easily and quickly converted into
cash with minimum loss
Holding Liquid Assets
“Cash Assets” do not generally satisfy a bank’s liquidity needs If the bank holds the minimum amount
of cash assets required, an unforeseen drain on vault cash (perhaps from an unexpected withdrawal) will cause the level of cash to fall below the minimum for legal and operational requirements
Holding Liquid Assets
Assets That Provide Bank Liquidity Cash and due from banks in excess of
requirements Federal funds sold Reverse repurchase agreements Short-term Treasury and agency
obligations High-quality, short-term corporate and
municipal securities
Holding Liquid Assets
For a financial institution that regularly borrows in the financial markets, liquidity takes on the added dimension of the ability to borrow funds at minimum cost or even the ability to issue stock. It explicitly recognizes that such firms can
access cash by: Selling assets New borrowings New stock issues
Bank Liquidity Refers to a bank’s capacity to acquire
immediately available funds at a reasonable price
Objectives of Cash Management
Banks must balance the desire to hold a minimum amount of cash assets while meeting the cash needs of its customers
The fundamental goal is to accurately forecast cash needs and arrange for readily available sources of cash at minimal cost
Reserve Balances at the Federal Reserve Bank
Banks hold deposits at the Federal Reserve because: The Federal Reserve imposes legal
reserve requirements and deposit balances qualify as legal reserves
To help process deposit inflows and outflows caused by check clearings, maturing time deposits and securities, wire transfers, and other transactions
Reserve Balances at the Federal Reserve Bank
Required Reserves and Monetary Policy The purpose of required reserves is to
enable the Federal Reserve to control the nation’s money supply
The Fed has three distinct monetary policy tools:
Open market operations Changes in the discount rate Changes in the required reserve ratio
Reserve Balances at the Federal Reserve Bank
Required Reserves and Monetary Policy Changes in reserve requirements
directly affect the amount of legal required reserves and thus change the amount of money a bank can lend out
Reserve Balances at the Federal Reserve Bank
Required Reserves and Monetary Policy For example, a required reserve ratio of 10%
means that a bank with $100 in demand deposits outstanding must hold $10 in legal required reserves in support of the DDAs
The bank can thus lend out only 90% of its DDAs
If the bank has exactly $10 in legal reserves, the reserves do not provide the bank with liquidity
If the bank has $12 in legal reserves, $2 is excess reserves, providing the bank with $2 in immediately available funds
Reserve Balances at the Federal Reserve Bank
Impact of Sweep Accounts on Required Reserve Balances Under Reg. D, banks have reserve
requirements of 10% on demand deposits, ATS, NOW, and other checkable deposit (OCD) accounts
MMDAs are considered personal saving deposits and have a zero required reserve requirement ratio.
Sweep accounts are accounts that enable depository institutions to shift funds from OCDs, which are reservable, to MMDAs or other accounts, which are not reservable
Growth of Sweep Transaction Deposits into MMDAs: 1994–2004
0
100
200
300
400
500
600
700
Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04
Monthly Averages of Initial Amounts Cumulative Total
Bil
lio
ns
of
Do
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rs
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Reserve Balances at the Federal Reserve Bank
Sweep Accounts Two Types
Weekend Program Reclassifies transaction deposits as
savings deposits at the close of business on Friday and back to transaction accounts at the open on Monday
On average, this means that for three days each week, the bank does not need to hold reserves against those balances
Reserve Balances at the Federal Reserve Bank
Sweep Accounts Two Types
Threshold Account The bank’s computer moves the customer’s
DDA balance into an MMDA when the dollar amount reaches some minimum and returns funds as needed
The number of transfers is limited to 6 per month, so the full amount of funds must be moved back into the DDA on the sixth transfer of the month
Meeting Legal Reserve Requirements
Required reserves can be met over a two-week period
There are three elements of required reserves: The dollar magnitude of base liabilities The required reserve fraction The dollar magnitude of qualifying
cash assets
Meeting Legal Reserve Requirements
Type of Deposit Percentage
Effective Date of Applicable Percentages
Net transactions Accounts Exempt amt. $ 7.00 mill 0.00% 12/23/2004 Up to $ 47.60 mill 3.00% 12/23/2004 Over $ 47.60 mill 10.00% 12/23/2004All other liabilities 0.00% 12/27/1990
Meeting Legal Reserve Requirements
Historical Problems with Reserve Requirements Historically, reserve requirements
varied with the type of bank charter and each bank’s geographic location
Currently, banks use a lagged reserve account (LRA) system
Reserves are held for a two-week period against deposit liabilities held for the two-week period ending almost three weeks earlier
Meeting Legal Reserve Requirements
Lagged Reserve Accounting Computation Period
Consists of two one-week reporting periods beginning on a Tuesday and ending on the second Monday thereafter
Maintenance Period Consists of 14 consecutive days
beginning on a Thursday and ending on the second Wednesday thereafter
Meeting Legal Reserve Requirements
Lagged Reserve Accounting Reserve Balance Requirements
The balance to be maintained in any given maintenance period is measured by: Reserve requirements on the
reservable liabilities calculated as of the computation period that ended 17 days prior to the start of the maintenance period
Less vault cash as of the same computation period
Meeting Legal Reserve Requirements
Lagged Reserve Accounting Reserve Balance Requirements
Both vault cash and Federal Reserve Deposits qualify as reserves
The portion that is not met by vault cash is called the reserve balance requirement
Reserve Requirement Percentages for Depository Institutions
Type of Deposit Percentage
Effective Date of Applicable Percentages
Net transactions accounts Exempt amt. $ 7.0 mill 0.0% 12/23/2004 Up to $ 47.6 mill 3.0% 12/23/2004 Over $ 47.6 mill 10.0% 12/23/2004 All other liabilities 0.0% 12/27/1990
Relationship between the Reserve Maintenance and Base Computation Periods under Lagged Reserve Accounting
Sun Mon Tue Wed Thu Fri Sat
8-Aug 9-Aug 10-Aug 11-Aug 12-Aug 13-Aug 14-Aug
15-Aug 16-Aug 17-Aug 18-Aug 19-Aug 20-Aug 21-Aug
22-Aug 23-Aug 24-Aug 25-Aug 26-Aug 27-Aug 28-Aug
29-Aug 30-Aug 31-Aug 1-Sep 2-Sep 3-Sep 4-Sep
5-Sep 6-Sep 7-Sep 8-Sep 9-Sep 10-Sep 11-Sep
12-Sep 13-Sep 14-Sep 15-Sep 16-Sep 17-Sep 18-Sep
19-Sep 20-Sep 21-Sep 22-Sep 23-Sep 24-Sep 25-Sep
Lagged reserve computation period and vault cash application period
Reserve maintenance period
Report of Reversible Liabilities and Offsetting Asset Balances
Balances at Close of Business Day (millions of dollars) Lagged Computation Tue Wed Thu Fri Sat Sun Mon Tue Wed Thu Fri Sat Sun Mon
Period 10-Aug 11-Aug 12-Aug 13-Aug 14-Aug 15-Aug 16-Aug 17-Aug 18-Aug 19-Aug 20-Aug 21-Aug 22-Aug 23-Aug
Two- Week Total
Daily Average
DDAs 992 995 956 954 954 954 989 996 960 959 958 958 958 990 $ 13,573 $ 969.50 Auto trans from savings 0 0 0 0 0 0 0 0 0 0 0 0 0 0 $ 0.0 $ 0.0 NOW and Super NOW 221 221 222 223 223 223 223 224 225 225 225 225 225 225 $ 3,130 $ 223.57 Deductions: $ 0.0 $ 0.0 DD bal from U.S. dep. 163 281 190 186 186 186 159 159 274 178 182 182 182 164 $ 2,672 $ 190.86 CIPC 96 96 78 78 78 78 95 98 92 79 81 81 81 88 $ 1,199 $ 85.64 Net trans. accounts 954 839 910 913 913 913 958 963 819 927 920 920 920 963 $ 12,832 $ 916.57 Vault Cash 28 30 31 33 33 33 38 30 31 32 32 32 32 36 $ 451 $ 32.21
Required Reserves Report, August 10–23
Reservable Liabilities for
Daily Avg. Deposit
Liab. ($mill) Reserve
Percentage
Daily Avg. Requirement
($ mill)
Aug 10–23 Net trans. accounts Exempt up to $ 7.0 mill 7.00 0.0% $0.000 Over 7 up to $ 47.6 mill $ 40.60 3.0% $1.218 Over $ 47.6 mill $ 868.97 10.0% $86.897 Total $ 916.57 Gross reserve requirement $88.115 Daily average vault cash $32.214 Net reserve requirement $55.901 Reserve carry-forward (from prior period) ($ 2.276) Minimum reserves to be maintained with Federal Reserve $58.177
Maximum reserves to be maintained $61.702
(0.04 x 88.115) + 58.177 If a surplus carry forward of $ 1.500 Minimum reserves to be maintained with Federal Reserve $54.401 Carry forward (4% of gross reserve requirement) $3.525 Maximum reserves to be maintained $57.926 (0.04 x 88.115) + 54.401
Correspondent Banking Services
System of interbank relationships in which the correspondent bank (upstream correspondent) sells services to the respondent bank (downstream correspondent)
Correspondent Banking Services
Common Correspondent Banking Services Check collection, wire transfer, coin and
currency supply Loan participation assistance Data processing services Portfolio analysis and investment advice Federal funds trading Securities safekeeping Arrangement of purchase or sale of securities Investment banking services International financial transactions
Liquidity Planning
Short-Term Liquidity Planning Objective is to manage a legal reserve
position that meets the minimum requirement at the lowest cost
Short-Term Liquidity Planning
Below are some of the factors that affect the bank’s legal reserve position
Factors Increasing Reserves Factors Decreasing Reserves Nondiscretionary Yesterday's immediate cash letter Deferred availability items Excess from local clearinghouse Deposits from U.S. Treasury
Nondiscretionary Remittances charged Deficit in local clearinghouse Treasury tax and loan account calls Maturing certificates of deposit, Eurodollars not rolled over
Discretionary Currency/coin shipped to Federal Reserve Security sales Borrowing from Federal Reserve Federal funds purchased Securities sold under agreement to repurchase Interest payments on securities New certificates of deposit, Eurodollar issues
Discretionary Currency and coin received from Federal Reserve Security purchases Payment on loans from Federal Reserve Federal funds sold Securities purchased under agreement to resell
Managing Float
During any single day, more than $100 million in checks drawn on U.S. commercial banks is waiting to be processed Individuals, businesses, and
governments deposit the checks but cannot use the proceeds until banks give their approval, typically in several days.
Checks in process of collection, called float, are a source of both income and expense to banks.
The Payments System
Payments between banks can be made either by check or electronically Checks drawn against transactions
accounts are presented to the customer’s bank for payment and ultimately “cleared” by reducing the bank’s deposit balance at the Federal Reserve or a correspondent bank
Payments made electronically directly and immediately alter balances held at Federal Reserve Banks
The Payments System
Example of the Check Clearing Process
The Payments System
Electronic Funds Transfer Networks Fedwire
Operated by the Federal Reserve Clearinghouse Interbank Payments
System (CHIPS) Operated by New York Clearing House Typically handles Eurodollar transfers
or foreign exchange trading
Liquidity versus Profitability
There is a short-run trade-off between liquidity and profitability The more liquid a bank is, the lower are
its return on equity and return on assets, all other things equal
In a bank’s loan portfolio, the highest yielding loans are typically the least liquid
The most liquid loans are typically government-guaranteed loans
The Relationship Between Liquidity, Credit, and Interest Rate Risk
Liquidity risk for a poorly managed bank closely follows credit and interest rate risk Banks that experience large deposit
outflows can often trace the source to either credit problems or earnings declines from interest rate gambles that backfired
Potential liquidity needs must reflect estimates of new loan demand and potential deposit losses
The Relationship Between Liquidity, Credit, and Interest Rate Risk
New Loan Demand Unused commercial credit lines
outstanding Consumer credit available on bank-
issued cards Business activity and growth in the
bank’s trade area The aggressiveness of the bank’s loan
officer call programs
The Relationship Between Liquidity, Credit, and Interest Rate Risk
Potential deposit losses are affected by: The composition of liabilities Insured versus uninsured deposits Deposit ownership between: money fund
traders, trust fund traders, public institutions, commercial banks by size, corporations by size, individuals, foreign investors, and Treasury tax and loan accounts
Large deposits held by any single entity Seasonal or cyclical patterns in deposits The sensitivity of deposits to changes in the
level of interest rates
Traditional Aggregate Measures of Liquidity Risk
Asset Liquidity Measures The most liquid assets mature near
term and are highly marketable Any security or loan with a price above
par, in which the bank could report a gain at sale, is viewed as highly liquid
Liquidity measures are normally expressed in percentage terms as a fraction of total assets
Traditional Aggregate Measures of Liquidity Risk
Highly Liquid Assets Cash and due from banks in excess of
required holdings Federal funds sold and reverse RPs. U.S. Treasury securities and agency
obligations maturing within one year Corporate obligations and municipal
securities maturing within one year and rated Baa and above
Loans that can be readily sold and/or securitized
Pledging Requirements
Not all of a bank’s securities can be easily sold Like their credit customers, banks are
required to pledge collateral against certain types of borrowings
U.S. Treasuries or municipals normally constitute the least-cost collateral and, if pledged against debt, cannot be sold until the bank removes the claim or substitutes other collateral
Pledging Requirements
Collateral is required against four different liabilities: Repurchase agreements Discount window borrowings Public deposits owned by the U.S.
Treasury or any state or municipal government unit
FLHB advances
Liability Liquidity Measures
Liability Liquidity The ease with which a bank can issue
new debt to acquire clearing balances at reasonable costs.
Measures typically reflect a bank’s asset quality, capital base, and composition of outstanding deposits and other liabilities.
Liability Liquidity Measures
The following measures are commonly used: Total equity to total assets Risk assets to total assets Loan losses to net loans Reserve for loan losses to net loans The percentage composition of deposits Total deposits to total liabilities Core deposits to total assets Federal funds purchased and RPs to total
liabilities Commercial paper and other short-term
borrowings to total liabilities.
Liability Liquidity Measures
Volatile Deposits The difference between actual current
deposits and the base estimate of core deposits
Longer-Term Liquidity Planning
Projections are separated into: Base Trend Short-Term Seasonal Cyclical
Liquidity Needs Equals
Forecasted change in loans + change in required reserves – forecasted change in deposits
Forecasts of trend, seasonal, and cyclicalcomponents of deposits and loans reference balance sheet.
Assets Liabilities
Cash and due from banks $ 160 Transaction accounts and nonnegotiable deposits
$1,600
Loans 1,400 Certificates of deposit and other borrowing
280
Investment securities 400 Stockholders' equity 120 Other assets 40 Total $2,000 Total $2,000
Forecasts of trend, seasonal, and cyclicalcomponents of deposits and loansDeposit forecast
Forecasts of trend, seasonal, and cyclicalcomponents of deposits and loansLoan forecast
Monthly liquidity needs
The bank’s monthly liquidity needs are estimated as the forecasted change in loans plus required reserves minus the forecast change in deposits: Liquidity needs =
Forecasted loans + required reserves - forecasted deposits
Estimates of Liquidity Needs
Liquidity GAP measures
Management can supplement this information with projected changes in purchased funds and investments with specific loan and deposit flows.
The bank can calculate a liquidity GAP by classifying potential uses and sources of funds into separate time frames according to their cash flow characteristics.
The Liquidity GAP for each time interval equals the dollar value of uses of funds minus the dollar value of sources of funds.
0–30 Days 31–90 Days 91–365 Days Potential Uses of Funds Add: Maturing time deposits Small time deposits 5.5 8.0 34.0 Certificates of deposit over $100,000 40.0 70.0 100.0 Eurodollar deposits 10.0 10.0 30.0 Plus: Forecast new loans Commercial loans 60.0 112.0 686.0 Consumer loans 22.0 46.0 210.0 Real estate and other loans 31.0 23.0 223.0 Minus: Forecast net change in transactional accounts Demand deposits - 6.5 105.5 10.0 NOW accounts 0.4 5.5 7.0 Money market deposit accounts 1.6 3.0 6.0 Total uses $173.0 155.0 1,260.0 Potential Sources of Funds Add: Maturing investments Money market instruments 8.0 16.5 36.5 U.S. Treasury and agency securities 7.5 10.5 40.0 Municipal securities 2.5 1.0 12.5 Plus: Principal payments on loans 80.0 262.0 903.0 Total sources 98.0 290.0 992.0 Periodic Liquidity GAP 75.0 -135.0 268.0 Cumulative Liquidity GAP 75.0 - 60.0 208.0
Liquidity gap estimates (millions of dollars)
Potential funding sources (millions of dollars)
Considerations in Selecting Liquidity Sources
Asset Sales Brokerage fees Securities gains or losses Foregone interest income Any increase or decrease in taxes Any increase or decrease in interest
receipts
Considerations in Selecting Liquidity Sources
New Borrowings Brokerage fees Required reserves FDIC insurance premiums Servicing or promotion costs Interest expense
Considerations in Selecting Liquidity Sources
The costs should be evaluated in present value terms because interest income and expense may arise over time
The choice of one source over another often involves an implicit interest rate forecast
Prof. Dr. Rainer Stachuletz edited and updated the PowerPoint slides for this edition.
Funding the Bank and Managing Liquidity
Chapter 8
Bank ManagementBank Management, 6th edition.6th edition.Timothy W. Koch and S. Scott MacDonaldTimothy W. Koch and S. Scott MacDonaldCopyright © 2006 by South-Western, a division of Thomson Learning