1. Chapter 10: Funding the Bank 1

2. The Relationship Between Liquidity Requirements, Cash, and Funding Sources Amount of cash a bank holds is influenced by bank’s liquidity requirements. Size and volatility of cash requirements affects liquidity position of bank. – Transactions that reduce cash force bank to replenish cash assets by issuing new debt or selling assets. – Transactions that increase cash provide new investible funds. Banks with ready access to borrowed funds can enter into more transactions as they can borrow quickly and at low cost to meet cash requirements. 2

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4. Recent Trends in Bank Funding Sources Retail funding is considered funding bank receives from consumers and noninstitutional depositors. – Transactions accounts, money-market demand accounts, savings accounts and small time deposits. Borrowed or wholesale funding consists of federal funds purchased, repurchase agreements, FHLB borrowings and other borrowings such as institutional CDs in amounts over $250,000 Equity-related funding consists of subordinated debt, common and preferred stock and retained earnings. 4

5. Recent Trends in Bank Funding Sources Following slides show: – Between December 2007 and June 2013 deposit funds increased from 65% to 75% of total assets and wholesale funding fell from 24% to just 13% of assets. 5

6. Recent Trends in Bank Funding Sources In 2013 small commercial banks (less than $100 million in assets) relied much more on deposits and much less on wholesale funds than larger banks. Banks with more than $1 billion relied more on wholesale funds. 6

7. Recent Trends in Bank Funding Sources In comparison with commercial banks, savings institutions operate with proportionately fewer deposits and more wholesale funds, reflecting heavier concentration in real estate assets and greater use of FHLB financing. 7

8. Recent Trends in Bank Funding Sources Volatile (purchased) liabilities describe funds obtained from interest-sensitive investors. – Federal funds purchased, repurchase agreements, jumbo CDs, Internet and brokered CD’s, Eurodollar time deposits, foreign deposits and any other large purchased liability. – Investors will move their funds if other institutions are paying higher rates or hear rumors that the bank has financial difficulties. FHLB increases collateral requirements for problem institutions reducing the banks’ liquidity. 8

9. Recent Trends in Bank Funding Sources Most banks prefer to obtain as much funding as possible from core deposits: – Stable deposits that customers are less likely to withdraw when interest rates on competing investments rise. – Includes: transactions accounts, MMDAs, savings accounts and small CDs. Customers typically choose banks on basis of convenience but electronic banking is changing this model. 9

10. Characteristics of Retail-Type Deposits Retail Deposits: – Small denomination (under $250,000) liabilities. – Normally held by individual investors. – Not actively traded in the secondary market. 10

11. Transaction Accounts Most banks offer three different accounts: – Demand deposits accounts (DDA) are non-interest bearing checking accounts held by individuals, businesses and government units. – Interest-bearing checking and automatic transfers from savings (ATS) accounts are checking accounts that pay interest. With ATS, customer has both a DDA and a savings account. Bank forces a zero balance in the DDA at the end of each day. Often labeled as sweep accounts. 11

12. Transaction Accounts Money-market demand accounts not transaction accounts because number of transactions is limited. Banks price interest-checking and savings accounts on competitive conditions without restriction. – Some limit number of checks that can be written without fees and impose minimum balance requirements. The interest cost of transaction accounts is low, but the non-interest costs can be quite high. – Due to high cost of check processing, low balance checking accounts are not profitable without fees. 12

13. Nontransactional Accounts Interest-bearing accounts with limited or no check- writing privileges. Money market deposit accounts (MMDA) are time deposits that limit depositors to six transactions per month (only three can be checks). – Attractive to banks because no required reserves and limited check processing reduce effective cost to bank. Savings accounts have no fixed maturity. – Not as prevalent in banks today, as MMDAs and small time deposits have replaced them. 13

14. Nontransactional Accounts Small time deposits have balances under $250,000, a specified maturity of 7 days or more and interest penalties for early withdrawal. – Economic difference between time deposits below $50,000 and those between $50,000 and $250,000. – Larger deposits act more like jumbo CDs and are very rate-sensitive. Large time deposits (jumbo CDs) of $100,000 or more whose value changes as CD rates changes. – Negotiable and typically traded in the secondary market. 14

15. Estimating the Cost of Deposit Accounts Cost includes: – Interest which may be as low as zero or a fraction of 1%. – Legal reserve requirements which can equal as much as 10% of the outstanding balance. – Processing costs which are substantial when deposit customers have a large number of transactions. Cost analysis data indicate demand deposits are the least expensive source of funds. – Profitability depends on average balance, number of transactions and fees collected. 15

16. Estimating the Cost of Deposit Accounts Additional fees include overdraft protection or NSF fees (represent a risk charge). – Overdrafts are an extension of credit. Cost analysis classifies check-processing activities as: – Deposits or withdrawals: Electronic transactions occur through automatic deposits, Internet and telephone payments, ATMs and ACH transactions. Nonelectronic transactions are handled in person or by mail. – Transit checks deposited or cashed: Transit checks are checks from any other bank. 16

17. Estimating the Cost of Deposit Accounts Cost analysis classifies check-processing activities as: – Accounts opened or closed. – “On-us” checks cashed: Checks drawn on the bank’s customers’ accounts. – General account maintenance: General record maintenance and preparing statements. With a truncated account checks are not returned to the customer. An official check would be issued for certified funds. – Net indirect costs are costs not directly related to the product such as general overhead or manager salaries. 17

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20. Estimating the Cost of Deposit Accounts Banks pay market rates on deposits and want customers to pay at least what the service costs. – Has led to relationship pricing in which service charges decline and interest rates increase with larger balances. – Banks have unbundled services and price each separately. – Some charge for services once considered courtesies such as check cashing, balance inquiry and in person banking. – Has led to a caste system of banking. Large depositors receive highest rates, pay the lowest fees and receive personal attention from their banker. Small depositors earn lower rates, if any, pay higher fees and receive less personal service. 20

21. 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. Average net cost of bank liabilities: 21

22. Calculating the Average Net Cost of Deposit Accounts Example: – If a demand deposit account does not pay interest, has $18.69 in transaction costs charges, $10.15 in fees, an average balance of $8,750, 5% float and 10% reserve requirement, the average net cost would be: 22

23. Characteristics of Large Wholesale Deposits Banks must pay market rates and can attract funds by paying a small premium over current market. Customers move these investments on the basis of small rate differentials. – These funds are labeled hot money, volatile liabilities or short-term non-core funding. – Include jumbo CDs, federal funds purchased, RPs, Eurodollar time deposits, foreign deposits and any other large-denomination purchased liability. 23

24. Jumbo CDs (CDs) Large, negotiable certificates of $100,000 or more. – Minimum maturity of 7 days. – Interest rates quoted on a 360-day year basis. – Insured up to $250,000 per investor per institution. Considered risky and traded accordingly. – Can be issued directly or through dealers or brokers (brokered deposits). – Brokers provide small banks access to purchased funds. – Packaged in $250,000 increments so deposits are fully insured. 24

25. Jumbo CDs (CDs) Bank regulators argue brokered CDs are often abused. – Based on link between brokered deposits and problem/failed banks that use CD funds to speculate on high-risk assets. – If bank fails, FDIC must pay insured depositors. Community banks rely on CDARS as a form of extended deposit insurance. – Effectively allows a bank to offer full deposit insurance in excess of $250,000 through transfers to other banks. 25

26. Jumbo CDs (CDs) When managers expect rates to rise, try to lengthen CD maturities prior to rate move. – Opposite occurs when rates are expected to fall. Types of CDs: – Fixed-rate: Typically 1, 3 or 6 month maturities. Today maturities of up to 5 years are common. – Variable-rate: Longer maturities with rates renegotiated at specified intervals. Jump rate (bump-up) CD gives the depositor a one-time option until maturity to change the rate to the prevailing market rate. 26

27. Jumbo CDs (CDs) Types of CDs (cont’d): – CD specials: Carry high initial rates for an odd number of months in an attempt to attract new funds with a high, but temporary, initial interest cost. – Callable: Allow banks to repay the depositor principal if rates fall after a specified deferment period (i.e. 2 years). – Zero coupon: Sold at a steep discount from par and appreciate to face value at maturity. Rate boards are venues for selling nonbrokered CDs via the internet to institutional investors. 27

28. Individual Retirement Accounts (IRAs) IRAs are savings plans for wage earners and their spouses. – Each year, a wage earner can make a tax- deferred investment of earned income subject to IRS rules. – Funds withdrawn before age 59 ½ are subject to a 10% IRS penalty. Makes IRAs an attractive source of long-term funding that can be used to balance the rate sensitivity of longer-term assets. 28

29. Foreign Office Deposits Eurocurrency: – Financial claim denominated in a currency other than that of the country where the issuing bank is located. Eurodollar: – Most important Eurocurreny. Dollar-denominated financial claim at a bank outside the U.S. Eurodollar deposits: – Dollar-denominated depots in banks outside the U.S. 29

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31. Borrowing Immediately Available Funds Federal Funds Purchased: – The term federal funds is often used to refer to excess reserve balances traded between banks. Grossly inaccurate, given reserves averaging as a method of computing reserves, different nonbank 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. – Formal definition of federal funds is unsecured short-term loans that are settled in immediately available funds. 31

32. Borrowing Immediately Available Funds Security Repurchase Agreements (RPs or Repos): – Short-term loans secured by government securities that are settled in immediately available funds. – Identical to federal funds except they are collateralized. – Sale of securities with a simultaneous agreement to buy them back later at a fixed price plus accrued interest. – Market value of collateral is set above the loan amount. This difference is the margin. 32

33. Structured Repurchase Agreements Normal repos are bullet repos with a fixed rate over a set maturity with no options. Structured repo agreements: – embeds an option (call, put, swap, cap, floor, etc.) in the instrument to either lower its initial cost to the borrower or better help the borrower match the risk and return profile of an investment. A callable repo allows the deposit holder to terminate (call) the CD prior to maturity. 33

34. Borrowing from the Federal Reserve Borrowing facility is the discount window. Fixed, discount rate set by district Federal Reserve Banks. – Policy is to lend to most institutions at 1% and 1.5% over the current federal funds target rate. – Four distinct lending programs: Primary credit is available to sound depository institutions on a short-term basis to meet short-term funding needs. Secondary credit is available to those not eligible for primary credit. Generally overnight at a rate above the primary rate. Seasonal credit is designed to assist small depository institutions significant seasonal swings in their loans and deposits. Emergency credit may be authorized in unusual circumstances to non-depository individuals, partnerships and corporations. 34

35. Other Borrowing from the Federal Reserve Term Auction Facility: – Allows banks to bid for an advance from the local Federal Reserve Bank that will generally have a 28-day maturity. – Banks must post collateral and cannot prepay the loan. Term Securities Lending Facility: – Open Market Trading Desk of the Federal Reserve Bank of New York makes loans to primary securities dealers. – Allows dealers to trade relatively illiquid mortgage- backed securities for Treasury securities they can readily pledge as collateral against borrowings, creating liquidity. 35

36. Federal Home Loan Bank Advances FHLB system is a government-sponsored enterprise created to assist in home buying. FHLBs among the largest U.S. financial institutions. Borrowings rated AAA due to government sponsorship. Bank can become a member by buying FHLB stock. Banks can borrow from the FHLB if it has available collateral, primarily real estate-related loans. Advances have maturities from 1 day to 20 years. 36

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38. Electronic Money Intelligent Card: – Contains microchip that can store and secure information. – Makes different responses depending on requirements of card issuer’s specific application needs. Memory Card: – Simply stores information, similar to that on the back of a credit card. Wireless transactions using computers and mobile devices are increasingly used in the United States. – Examples include PayPal and Square. 38

39. Electronic Money Trillions of dollars of digital transactions each day. – Wholesale electronic payments using wire transfers account for over 3/4 of the value of transactions. Electronic Funds Transfer (EFT): – Electronic movement of financial data, designed to eliminate the paper instruments. Includes ACH, POS, AMT, direct deposit, telephone bill paying, automated merchant authorization and preauthorized payments. Point of sale (POS) is a sale consummated by payment for goods or services received or a direct debit of the purchase amount. Automated clearinghouse (ACH) transaction is an electronically processed payment using a standard data format. 39

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41. Check 21 Purposes of Check Clearing for the 21st Century Act: – To facilitate check truncation by reducing some of the legal impediments. – To foster innovation in the payments and check collection system without mandating receipt of check in electronic form. – To improve the overall efficiency of the nation’s payment system. 41

42. Check 21 Check truncation is the conversion of paper check into electronic debit or image of check by a party in the payment system other than the paying bank. Substitute check is the legal equivalent of original check. Banks not required to accept checks in electronic form or create substitute checks. – Check 21 allows banks to handle checks electronically instead of physically moving paper checks which should make processing more efficient and less expensive. 42

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44. Check 21 Check Clearing Process: – Banks typically place a hold on a check until it verifies that check writer has enough funds on deposit to cover it. – Federal Reserve follows a timetable indicating how long a bank must wait before it can receive credit on deposited items. – Most checks clear in one to three days. 44

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46. The Average Historical Cost of Funds Many banks incorrectly use the average historical costs in their pricing decisions. – Primary problem with historical costs is they provide no information as to if future interest costs will rise or fall. – When interest rates rise, average historical cost understates the actual cost of issuing new debt. When rates fall the opposite is true. – Pricing decisions should be based on marginal costs compared with marginal revenues. 46

47. The 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. – Especially useful in pricing decisions. 47

48. Costs of Independent Sources of Funds Difficult to measure marginal costs precisely. – Must include both interest and noninterest costs expected to be paid and identify which portion of the acquired funds can be invested in earning assets. – Formula for measuring explicit marginal cost of a single source of bank liability: 48

49. Costs of Independent Sources of Funds Example: – Market interest rate = 0.2% – Servicing costs = 2.8% of balances – Acquisition costs = 0.15% of balances – Deposit insurance costs = 0.25% of balances – Investable balance = 85% (10% required reserves, 5% float) Estimated marginal cost of obtaining additional interest checking balances: 49

50. Cost of Debt Marginal cost of different types of debt varies according to the magnitude of each type of liability. – High-volume transactions accounts have substantial servicing costs and highest reserve requirements and float. – Purchased funds pay higher rates but smaller transaction costs and zero reserve requirements (greater investable balances). Cost of long-term non deposit debt equals effective cost of borrowing from each source. – This 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. 50

51. Cost of Equity The marginal cost of equity equals the required return to shareholders. – Not directly measurable because dividend payments are not mandatory but several methods are used: Dividend Valuation Model: The cost of equity equals the discount rate (required return) used to convert future cash flows to their present value equivalent. Capital Asset Pricing Model (CAPM): Required return to shareholders equals the riskless rate of return plus a risk premium on common stock reflecting nondiversifiable market risk. Targeted Return on Equity Model. Cost of debt plus a premium to evaluate the cost of equity. Assumes book value = market value. 51

52. Cost of Preferred Stock Preferred stock has characteristics of debt and common equity. – Claims are superior to those of common stockholders but subordinated to those of debt holders. – Dividends may be deferred when earnings are low. – Marginal cost can be approximated using the dividend valuation model except that dividend growth is zero. Trust preferred stock is a hybrid form of equity capital. – Effectively pays dividends that are tax deductible. 52

53. Weighted Marginal Cost of Total Funds Best cost measure for asset-pricing purposes. – Recognizes both explicit and implicit costs associated with any single source of funds. Computed in three stages: – Forecast desired dollar amount of financing to be obtained from each individual debt and equity sources. – Estimate marginal cost of each source of funds. – Combine the estimates to project the weighted cost: 53

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55. Funding Sources and Banking Risks Banks face two fundamental problems in managing liabilities. They are uncertainty over: – what rates they must pay to retain and attract funds. – likelihood customers will withdraw money regardless of rates. Basic fear is vulnerability to a liquidity crisis from unanticipated withdrawals and depositors and lenders refusing to provide funds. – Banks must have the capacity to borrow in financial markets to replace deposits outflows and remain solvent. 55

56. Funding Sources: Liquidity Risk Liquidity risk of deposit base is a function of: – Number and location of depositors. – Average size of accounts. – Specific maturity and rate characteristics of each account. – Competitive environment. Interest elasticity of customer demand for each funding source is equally important. – How much can interest rates change before bank experiences deposit outflows? – If a bank raises its rates, how many new funds will it attract? 56

57. Funding Sources: Interest Rate Risk Many depositors and investors prefer short- term instruments that can be rolled over quickly as interest rates change. – Banks must offer premiums to lengthen maturities. – Many banks have chosen not to pay premiums and reprice liabilities more frequently than in the past. One strategy is to aggressively compete for retail core deposits. – Once a bank attracts deposit business, many will maintain those balances as long as bank provides good service. 57

58. Funding Sources: Credit Risk During financial crisis many failed banks relied on FHLB advances and jumbo CDs to fund operations. – Many banks financed loan growth with wholesale funds. Did funding sources or choice of loans cause the failures? – Inappropriate use of advances and CDs to fund overly speculative loans caused the problems. – Link between funding sources and credit risk tied to reasonableness of business plans, credit analysis when making loans, and monitoring of credit risk. 58