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Funding the Bank and Managing

Liquidity

Chapter 8

Bank Management, 6th edition. Timothy W. Koch and S. Scott MacDonald Copyright © 2006 by South-Western, a division of Thomson Learning

1

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 2

Effect of Maturing Certificates of Deposit and Loan Use on a Bank’s Deposit Balances at the Federal Reserve

3

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

4

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. 5


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 6


Wholesale Funding

Includes borrowed funds plus large

CDs

Equity Funding

Common stock

Preferred stock

Retained earnings

7


Volatile Liabilities

Funds purchased from rate-sensitive

investors

Federal Funds purchased


Jumbo CDs

Eurodollar time deposits

Foreign Deposits

Investors will move their funds if other

institutions are paying higher rates 8

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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50%

60%

70%

80%

90%

100%

To

tal

De

po

sit

s

Borrowed Funds

Total Deposits

Subordinated Notes

Total Equity

Percent of total funding Percent of total funding

9

Change in the Percentage Contribution of Various

Bank Funding Components, 1992–2004

0%

25%

50%

75%

Total d

eposi

ts h

eld in

dom

estic

offic

es

Transa

ctio

n acc

ounts

Nontr

ansa

ctio

n acc

ounts

Money

mar

ket d

eposi

t acc

ounts (M

MDAs)

Oth

er s

avin

gs dep

osits

Time

deposi

ts o

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an $

100,

000

Vola

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liabili

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Time

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Dep

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reig

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Oth

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orrow

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Subord

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Equity

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To

tal

Assets

)12/31/1992 12/31/1996

12/31/2000 12/31/2004

10

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%

11

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.

12

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

13

Transaction Accounts

Most banks offer three different

transaction accounts

Demand Deposits

DDAs

Negotiable Order of Withdrawal

NOWs

Automatic Transfers from Savings

ATS

14


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

15


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 16


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

17

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 18

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

19

Estimating the Cost of Deposit Accounts

Interest Costs

Legal Reserve Requirements

Check Processing Costs

Account Charges

NSF fees

Monthly fees

Per check fees

20


Transaction Account Cost Analysis

Classifies check-processing as:

Deposits

Electronic

Non-Electronic

Withdrawals

Electronic

Non-Electronic

21



Classifies check-processing as:

Transit Checks

Deposited

Cashed

Account Opened or Closed

On-Us checks cashed

General account maintenance

Truncated

Non-Truncated 22



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

23



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

24



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 25

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

26

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

27

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

28

Calc

ula

tin

g t

he

Aver

age

Net

Cost

of

Dep

osi

t A

ccou

nts

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%

29

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

30


Wholesale Liabilities

Includes:

Jumbo CDs

Federal Funds Purchased

Repurchase Agreements

Eurodollar Time Deposits

Foreign Deposits

31


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) 32


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

33


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

34


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.

35

The Origin and Expansion of Eurodollar Deposits

36


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 37


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 38


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

39


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

40



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 41



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

42


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

43

Commercial Banks with FHLB Advances,

1991–2004

Commercial Banks with FHLB Advances

$50

$100

$150

$200

$250

$300

$350

$400

$450

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

Bil

lio

ns o

f D

oll

ars

of

FH

LB

Ad

van

ces

100

1,100

2,100

3,100

4,100

5,100

Nu

mb

er

of

Ban

ks w

ith

FH

LB

Ad

van

ces

Amount Outstanding (Billions)Number of Banks

44

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

45

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.

46

http://www.frbservices.org/Retail/pdf/2004PaymentResearchReport.pdf

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 47

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

48

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

49

Substitute Check Authorized by Check 21

50

The Check Clearing Process

51

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 52

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

53


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 54


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

55


Costs of Independent Sources of

Funds

All elements in the numerator are

expected costs

56


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

57


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

58


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

7

d

7

1tt

d

59


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 60


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

61


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

62


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 63


Weighted Marginal Cost of Total Funds

Steps to compute WMC

1. 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

64


Weighted Marginal Cost of Total

Funds

Steps to compute WMC

4. 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

1j

jjkwWMC65


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%

66

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

67

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

68

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

69

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 70

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

71

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

72

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

73


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)

74


“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

75


“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

76


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

77


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

78

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

79

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

80


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

81



Changes in reserve requirements

directly affect the amount of legal

required reserves and thus change the

amount of money a bank can lend out

82



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

83


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

84

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

lla

rs

.

85


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

86


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

87

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

88


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% 12/23/2004

All other liabilities 0.00% 12/27/1990

89


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

90


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 91



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 92



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

93

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

94

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



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



Lagged reserve computation period and vault cash application period

Reserve maintenance period

95

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

96

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

97

Correspondent Banking Services

System of interbank relationships in

which the correspondent bank

(upstream correspondent) sells

services to the respondent bank

(downstream correspondent)

98

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 99

Liquidity Planning

Short-Term Liquidity Planning

Objective is to manage a legal reserve

position that meets the minimum

requirement at the lowest cost

100

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

101

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.

102

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

103

The Payments System

Example of the Check Clearing Process

104

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

105

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 106

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

107



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

108



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 109

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

110

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

111

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

112

Pledging Requirements

Collateral is required against four

different liabilities:


Discount window borrowings

Public deposits owned by the U.S.

Treasury or any state or municipal

government unit

FLHB advances

113

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.

114


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.

115


Volatile Deposits

The difference between actual current

deposits and the base estimate of core

deposits

116

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

117

Forecasts of trend, seasonal, and cyclical

components 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

118

Forecasts of trend, seasonal, and cyclical components of deposits and loans Deposit forecast

End of

Month

Trend

Deposits

(2)

Seasonal

Deposit

lndext

(3)

Seasonal

Deposits -

Dec.

Deposits

(4)

Cyclical

Deposits

(5)

Total

January $1,608 99% -$16 -$3 $1,589

February 1,616 102 +32 8 1,656

March 1,623 105 +80 7 1,710

April 1,631 107 +112 10 1,753

May 1,639 101 16 1 1,656

June 1,647 96 -64 - 8 1,575

July 1,655 93 -112 -15 1,528

August 1,663 95 -80 -9 1,574

September 1,671 97 -48 - 4 1,619

October 1,680 101 +16 0 1,696

November 1,688 104 +64 + 3 1,755

December 1,696 100 0 0 1,696

119

Forecasts of trend, seasonal, and cyclical components of deposits and loans Loan forecast

End of

Month

Trend

Loans*

Seasonal

Loan

lndext

Seasonal

Loan-

Dec. Loans

Cyclical

Loans Total

January $1,413 101% $14 $6 $1,433

February 1,427 97 -42 -9 1,376

March 1,440 95 -70 -18 1,352

April 1,454 94 -84 -21 1,349

May 1,467 97 -42 -15 1,410

June 1,481 102 28 -3 1,506

July 1,495 108 112 9 1,616

August 1,510 106 84 17 1,611

September 1,524 103 42 11 1,577

October 1,538 99 -14 5 1,529

November 1,553 98 -28 0 1,525

December 1,568 100 0 0 1,568

120

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 Dloans + Drequired

reserves - forecasted Ddeposits

121

Estimates of Liquidity Needs

End of

Month

DDeposits DRequired

Reserves

DLoans Liquidity

Needs*

January 11.0 1.1 $ 33.0 $42.9

February 56.0 5.6 -24.0 -74.4

March 110.0 11.0 -48.0 -147.0

April 153.0 15.3 -51.0 -188.7

May 56.0 5.6 10.0 -40.4

June -25.0 -2.5 106.0 128.5

July -72.0 -7.2 216.0 280.8

August -26.0 -2.6 211.0 234.4

September 19.0 1.9 177.0 159.9

October 96.0 9.6 129.0 42.6

November 155.0 15.5 125.0 -14.5

December 96.0 9.6 168.0 81.6

122

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. 123

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)

124

Time Frame 0–30

Days 31–90 Days

91–365 Days

Purchased Funds Capacity Federal funds purchased (overnight and term) $20 $20 $30 Repurchase agreements 10 10 10 Negotiable certificates of deposit Local 50 50 60 National 20 20 25 Eurodollar certificates of deposit 20 20 20

Total $120 $120 $145

Additional Funding Sources Reductions in federal funds sold $5 $5 $5 Loan participations 20 20 20 Sale of money market securities 5 5 5 Sale of unpledged securities 10 10 10

Total $40 $40 $40

Potential Funding Sourcesa $160 $160 $185

Potential Extraordinary Funding Needs

50% of outstanding letters of credit 5 10 15 20% of unfunded loan commitments 25 30 35

Total $30 $40 $50

Excess Potential Funding Sources $130 $120 $135

Potential funding sources (millions of dollars)

125

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

126


New Borrowings

Brokerage fees

Required reserves

FDIC insurance premiums

Servicing or promotion costs

Interest expense

127


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

128

William Chittenden edited and updated the PowerPoint slides for this edition.

Funding the Bank and Managing

Liquidity

Chapter 8

Bank Management, 6th edition. Timothy W. Koch and S. Scott MacDonald Copyright © 2006 by South-Western, a division of Thomson Learning

129

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