1. Managing Nondeposit Liabilities and Other Sources of Borrowed Funds 13 July 2009

2. FINBANK SY 08-09 Term 2 Ms. Kashmirr C. Ibañez Customer Relationship Doctrine The first priority of the bank is to make loans to all qualified customers and if funds are not available the bank should seek out the lowest cost source of funding to meet customers’ needs.

3. FINBANK SY 08-09 Term 2 Ms. Kashmirr C. Ibañez Liability Management 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

4. FINBANK SY 08-09 Term 2 Ms. Kashmirr C. Ibañez Liability Management Buying funds by selling liabilities in the money market Using price as control lever to regulate volume and timing of incoming funds Competitive marketplace:  Individual firms cannot ultimately set the price they pay for borrowed funds.

5. FINBANK SY 08-09 Term 2 Ms. Kashmirr C. Ibañez Nondeposit Sources of Funds Federal Funds Market Repurchase Agreements Federal Reserve Bank Negotiable CDs Commercial Paper

6. FINBANK SY 08-09 Term 2 Ms. Kashmirr C. Ibañez Federal Funds Market Deposits held by U.S. Banks at federal reserve banks, deposits with correspondent banks and demand deposit balances of security dealers and governments can be used for loans to institutions Types of fed funds loans  Overnight Loans  Term Loans  Continuing Contracts

7. FINBANK SY 08-09 Term 2 Ms. Kashmirr C. Ibañez Repurchase Agreements Repurchase (RP) / reverse repurchase (RRP) agreements.  The BSP purchases/sells government securities from a bank with a commitment to sell it back/buy it back at a specified future date at a predetermined rate.  Temporary effect Outright purchases and sales of securities.  An outright contract involves direct purchase/sale of government security by the BSP from/to the market  Permanent effect

8. FINBANK SY 08-09 Term 2 Ms. Kashmirr C. Ibañez Borrowing From the Federal Reserve Bank A bank with immediate reserve needs can borrow from the federal reserve. 3 types of credit  Adjustment credit – this loan is only for a few days and is to provide immediate aid in meeting reserve requirements  Seasonal credit – this loan has a longer maturity than the adjustment credit loan and is for banks with seasonal swings in deposits and loans  Extended credit – this loan is for banks experiencing longer-term funding problems

9. FINBANK SY 08-09 Term 2 Ms. Kashmirr C. Ibañez Negotiable CD An interest-bearing receipt evidencing the deposit of funds in the bank for a specified period of time for a specified interest rate. It is considered a hybrid account since it is legally a deposit Types of CDs  Domestic CDs  Euro CDs  Yankee CDs  Thrift CDs

10. FINBANK SY 08-09 Term 2 Ms. Kashmirr C. Ibañez Eurocurrency Deposit Market 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

11. FINBANK SY 08-09 Term 2 Ms. Kashmirr C. Ibañez Commercial Paper 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.

12. FINBANK SY 08-09 Term 2 Ms. Kashmirr C. Ibañez Long-Term Nondeposit Sources of Funds Mortgages to fund the construction of new buildings Capital notes and debentures

13. Computation of the cost of borrowing I=PRT Example: suppose a depository institution promises an 8% annual interest rate to the buyer of a $100,000 6-month CD. What is the amount due to the customer? Amount due to the customer = Principal + Interest =100K+100K*(180/360)*0.08 =$104,000 FINBANK SY 08-09 Term 2 Ms. Kashmirr C. Ibañez

14. FINBANK SY 08-09 Term 2 Ms. Kashmirr C. Ibañez The Funds Gap Current and projected loans and investments the bank desires to make current and expected deposit inflows Less Current and expected deposit inflows and other available funds

15. AFG: an example Suppose a KB has new loan requests that meets its quality standards of $150 million; it wishes to purchase $75 million in new Treasury securities and it expects drawings on its credit lines from its best corporate customers of $135 million. Deposits and other customer funds received today total $185 million, and those expected in the coming week will bring in another $100 million. What is the bank’s AFG? AFG = (150+75+135)-(185+100) AFG = $75 FINBANK SY 08-09 Term 2 Ms. Kashmirr C. Ibañez

16. FINBANK SY 08-09 Term 2 Ms. Kashmirr C. Ibañez Factors to Consider When Choosing Nondeposit Sources of Funds 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 bank Regulations limiting the use of various funding sources

17. FINBANK SY 08-09 Term 2 Ms. Kashmirr C. Ibañez Factor: Relative costs Where:

18. An example: Relative costs Suppose that Fed funds are currently trading at an interest of 6%. Moreover, management estimates that the marginal noninterest cost, in the form of personnel expenses and transaction fees, from raising additional monies in the Fed funds market is 0.25%. Suppose that a depository institution will need $25MM to fund the loan it plans to make today, of which only $24 MM an be fully invested due to other immediate cash demands. What is the effective annualized cost rate for Fed funds? FINBANK SY 08-09 Term 2 Ms. Kashmirr C. Ibañez

19. An example: Relative costs Current interest cost on fed funds = 0.06 * 25MM = $1.5 MM Noninterest cost to access Fed funds = 0.0025 * 25MM = $0.063 MM Net investable funds raised = $25MM – $1 MM = $24 MM Effective annualized Fed funds cost rate = (1.5MM + 0.063 MM)/$24 MM FINBANK SY 08-09 Term 2 Ms. Kashmirr C. Ibañez