Managing Nondeposit Liabilities and Other Sources of Borrowed Funds
13-2The purpose of this chapter is to learn about the principal nondeposit sources of funds that financial institutions can borrow to help finance their activities and to see how managers choose among various nondeposit fund sources currently available to them.
13-3 Liability Management Customer Relationship Doctrine Alternative Nondeposit Funds Sources Measuring the Funds Gap Choosing Among Different Funds Sources Determining the Overall Cost of Funds
The first priority of the bank is tomake loans to all qualifiedcustomers and if funds are notavailable the bank should seek outthe lowest cost source of funding tomeet customers’ needs.
The bank buys funds in order to satisfy loan requests and reserve requirements It is an interest-sensitive approach to raising bank funds It is flexible – the bank can decide exactly how much they need and for how long The control mechanism to regulate incoming funds is the price of funds
Federal Funds Market Repurchase Agreements Federal Reserve Bank Advances from the Federal Home Loan Bank Negotiable CDs Eurocurrency Deposit Market Commercial Paper Long Term Sources
13-7 Recent Growth in Nondeposit Sources of Borrowed Funds at FDIC-Insured InstitutionsWhat are the trends?
13-8 The usage of nondeposit sources of funds has risen Larger institutions rely on the nondeposit funds market as a key source of short-term money to meet loan demand and unexpected cash emergencies
Immediately available reserves are traded between financial institution and usually returned within 24 hours. Deposits with correspondent banks and demand deposit balances of security dealers and governments can be used for loans to institutions. Most popular source of borrowed funds
Overnight Loans Term Loans Continuing Contracts
Involves the temporary sale ofhigh-quality assets (usuallygovernment securities)accompanied by an agreement tobuy back those assets on a specificfuture date at a predeterminedprice or yield.
Happy Valley Bank borrows $125 millionovernight through a repurchase agreement (RP)collateralized by Treasury bills. The current RPrate is 3.65 percent. How much will the bank payin interest costs due to this borrowing?Interest cost of RP = $125,000,000 x 0.0365 x 1/360= $12,673.61 13-12
A bank with immediate reserveneeds can borrow from the federalreserve. There are three types ofloans for different needs, each withits own interest rate. There arelimitations on borrowing at thefederal reserve discount window.
Primary credit – this loan is available for short terms and to institutions in sound financial condition. Rate is slightly higher than the federal funds rate. Secondary credit – these loans are available at a higher interest rate to institutions not qualifying for primary credit. Monitored by the federal reserve to control excess risk Seasonal credit - these loans cover longer periods than primary credit for small and medium institutions experiencing seasonal swings in deposits and loans
13-15• What is liability management?• For what kinds of funding situations are Federal funds best suited?
13-16• Allows institutions (home mortgage lenders) to use home mortgages as collateral for advances• A way to improve the liquidity of home mortgages and encourage more lenders to provide credit• Number of loans has increased dramatically in recent years• Maturities range from overnight to more than 20 years• FHLB System is composed of 12 regional banks• Has federal charter and can borrow cheaply and pass savings to institutions
An interest-bearing receiptevidencing the deposit of funds inthe bank for a specified period oftime for a specified interest rate. Itis considered a hybrid accountsince it is legally a deposit.
Domestic CDs – issued by domestic banks in the U.S. Euro CDs – dollar denominated CDs issued by banks outside the U.S. Yankee CDs – issued by foreign banks in the U.S. Thrift CDs – issued by large savings and loans and other nonbanks in the U.S.
Rockfish Corporation purchases a 60-daynegotiable CD with a $5 milliondenomination from Bait Bank and Trust,bearing a 3.75 percent annual yield. Howmuch in interest will the bank have to paywhen this CD matures? What amount intotal will the bank have to pay back toRockfish at the end of 60 days? 13-20
Interestowed 60Rockfish Corp. $5,000,000 .0375 $31,250.00 360 by bank T otalamountowed Rockfish P rinciple Interest in 60 days $5,000,000 $31,250.00 $5,031,250.00 13-21
Eurodollars are dollar-denominated deposits placed in banks outside the U.S. Eurocurrency deposits originally were developed in western Europe to provide liquid funds to swap among institutions or lend to customers
Short-term notes with maturities from 3 or 4 days to 9 months issued by well- known companies. Banks cannot issue these directly but affiliated companies can issue them.
Mortgages to fund theconstruction of new buildingsand capital notes anddebentures are examples oflong term sources of funds.
Gap is based on: Current and projected demand and investments the bank desires to make minus Current and expected deposit inflows and other available funds Size of this gap determines need for nondeposit funds
Rosemary Bank of New York expects new deposit inflows next month of$375 million and deposit withdrawals of $500 million. The bankseconomics department has projected that new loan demand will reach$460 million and customers with approved credit lines will need $175million in cash. The bank will sell $480 million in securities, but plans toadd $85 million in new securities to its portfolio. What is the projectedavailable funds gap?Projected funds gap = $460 + $175 + ($85 - $480) – ($375 - $500) = $365 million 13-26
The relative costs of raising funds from each source The risk of each funding source The length of time for which funds are needed The size of the institution Regulations limiting the use of various funding sources
Effective cost = Current int cost non - interest cost investable funds Non-interest cost = (cost of staff, transaction, facilities)x funds borrowed
Banks and other lending affiliates within the holding company of Interstate National Bank are reporting heavy loan demand this week from companies in the southeastern United States that are planning a significant expansion of inventories and facilities before the beginning of the fall season. The holding company and its lead bank plan to raise $850 million in short-term funds this week, of which about $835 million will be used to meet these new loan requests. 13-29
Current annual interest rates on alternative sources of funds are: Market Noninterest Interest Rates Cost Rates Federal Funds 2.25% 0.25% Negotiable CDs 2.40 0.25 Eurodollars 2.30 0.35 Commercial paper 2.35 0.50 Fed. Discount Rate 3.25 0.25Calculate the effective cost rates of each of these sources of funds for Interstate and make a management decision on what sources to use. 13-30
Current interest Noninteres costs t cost on amounts incurredEffectivecost rateon borrowed to access thesefundsdeposit and nondeposit Net investablefunds raised sources of funds from thissourceEffectiveFederal = 0.0225x $850Million 0.0025x $850MillionFunds Cost $835MillionRate $19.13million $2.125million = = 2.54% $835 million 13-31
EffectiveCommercial 0.0235 $850million 0.0050 $850million =Paper Cost $835 millionRate $19.98million $4.25million = = 2.90% $835million Effective Cost of 0.0325 $850million 0.0025 $850million = Borrowing $835 million from the Fed $27.63million $2.125million = = 3.56% $835 million 13-33
The cheapest source of all would beborrowing from the federal fundsmarket. 13-34
13-35 Which institutions are allowed to borrow from the FHLBs? Why were negotiable CDs developed? Suppose a customer purchases a $1 million 90- day CD, carrying a promised 6% annualized yield. How much in interest income will the customer earn when this 90-day instrument matures? What is commercial paper? What types of organizations issue such paper?
Customer Relationship Doctrine Sources of Funds Federal Funds Market Negotiable CDs Repurchase Agreements Eurocurrency Deposits Federal Reserve Borrowings Commercial Paper Home Loan Banks Capital Notes and Debentures Choosing Nondeposit Sources Funds Gap Term Costs Size of borrowing bank Risks Regulations
Firefly Bank and Trust has received $800 million in total funding from thesources listed below with their associated costs also shown. Amount Interest Nonint. Add. Total Funding Source ($ millions) Costs Costs Costs CostsCheckable Deposits 200 0.75% 2.00% .75% 3.50%Time & Savings Deposits 400 2.50% .50% .50% 3.50%Money-Mkt. Borrowings 100 3.25% .25% .25% 3.75%Stockholders Equity 100 13.00% ----- ----- 13.00% 13-37
Fireflys costs in millions of dollars: Amount Interest Other Total Funding Source ($ millions) Costs($) Costs($) Costs($)Checkable Deposits 200 1.50 5.5 7.00Time & Savings Dep. 400 10.00 4.0 14.00Money-Mkt. Borrowings 100 3.25 0.5 3.75Stockholders Equity 100 ----- ----- -----Totals ($) 800 14.75 10.0 24.75 13-38
(a) Calculate Firefly’s weighted average interest cost on total volume funds raised, figured on a before-tax basis?Weighted Average Interest Cost= (Total dollar interest) / (Total deposits and borrowing)= $14.75 million / $700 million= 0.0211 or 2.11%Note: the equity - $100million does not have an interest cost and is not included above 13-39
(b) If the banks earning assets total $700 million, what is its break-even cost rate?Break-even cost rate = (Total funding costs) / (earning assets) = 24.75/700 = 0.0354 or 3.54% 13-40