Which cost of funds measurement should a bank use ? -The historical average cost of funds is useful in assessing past performance. -The marginal cost specific funds be helpful in deciding which form of funds the bank should try to attract, and to measure all marginal cost. - The weighted average projected cost of funds as an estimation of the marginal cost of funding my be acceptable as assets pricing guides

Risk Associated With Raising Funds How bank sources of funds affect the primary financial risk of banking, liquidity risk, interest risk, credit risk, and capital risk. The liquidity risk associated with a bank’s deposit (Funds) base is a function of: 1-The competitive environment 2-Number of depositors 3-Average size of accounts 4- Location of the depositor 5- Specific maturity and rate characteristics of each account

In summary, there are two factors caused the liquidity risk associated with withdrawal of funds. 1- Does the bank have the earning ability to pay competitive rates. 2- Does the bank have recognized quality that will enable it to use the needed amounts of impersonal,purchased deposits or funds Interest Elasticity - How much can market interest rates change before the bank face 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 to earn the highest yields -It is important to note the liquidity advantage that stable core deposits provide a bank

Interest rate risk associated with funding Interest rate risk associated with a bank sources of fund Its depends on the interest sensitivity of the assets financed by these funds. The bank management must compare the interest sensitivity over time of all sources of funds with the interest sensitivity over time of the assets financed by these funds.

Funding Sources: Credit and Capital Risk Changes in the structure 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

Introduction to basic funding strategies this refers to using the marketing concept to determine consumer needs and then communicating to the consumer how the bank will serve these needs, then the following strategies is important for acquiring fund 1- Delivery systems The appropriate delivery systems for a bank obviously depends on the types of customers the bank wants,. One change that will affect the funding strategic of most bank in dramatic changes in the system for delivering bank services. 2- Market segmentation Market segmentation is the isolation of certain sectors of the total market and the certain of new products uniquely designed for this sector that no immediate competition exists. 3- product Differentiation and image 4- product attraction 5- Product development

Chapter 5 Managing the Security Portfolio - management efforts on loans. - Managing investment securities is typically a secondary role, especially at smaller banks. -Historically, small banks have purchased securities and held them to maturity. Large banks, in contrast, not only buy securities for their own portfolios, but they also: - Manage a securities trading account -Manage an underwriting subsidiary that helps municipalities issue debt in the money and capital markets

Assets Priority Model There are four traditional priorities for the banks uses their funds. 1- the bank must use a fraction of their deposit funds to satisfy legal reserve requirements. 2- the bank use funds to make adequate provisions for their liquidity needs. 3- To serve the loan demands in their market areas. 4- Banks invest whatever funds remain after they serve the first three priorities, in their securities portfolio.

The banks invest the residual use of funds in securities portfolio. In recession and period of slow economic growth, when loan demands and interest rates tend to be at low levels, most banks accumulate large amounts of excess funds and invest them in securities. In the boom period, when loan demand and interest rates tend to be at high levels,banks usually are short of funds and do not have excess funds to purchase securities. - in period of high loan demand, the banks may be forced to sell securities at a loss in order to finance loan growth.

Objectives of the Investment Portfolio 1- Manage interest rate risk. Securities permit banks to adjust interest rate sensitivity very quickly. 2- Liquidity management : ( source of liquidity and reduce liquidity risk). Commercial banks purchase debt securities to help meet liquidity requirements. Securities with maturities under one year can be readily sold for cash near par value and are classified as liquid investments In reality, most securities selling at a premium can also be quickly converted to cash, regardless of maturity, because management is willing to sell them

3- to make income production for yield. investment securities must pay a reasonable return for the risks assumed The return may come in the form of price appreciation, periodic coupon interest, and interest-on-interest The return may be fully taxable or exempt from taxes 4- manage credit risk.(diversification ) - Investment securities are very flexible instruments for managing a bank’s overall interest rate risk exposure - Banks can select terms that meet their specific needs -They can readily sell the security if their needs change 5- Total return (to measure the effectiveness of securities portfolio management in terms of both interest earnings and capital gains. 6- Manage risk-based Capital. 7- Securities gains

Accounting for Investment Securities FASB 115 requires security holdings to be divided into three categories 1- Held-to-Maturity (HTM) 2- Trading 3- Available-for-Sale The distinction between investment motives is important because of the accounting treatment of each

Accounting for Investment Securities –A change in interest rates can dramatically affect the market value of a security The difference between market value and the purchase price equals the unrealized gain or loss on the security; assuming a purchase at par: Unrealized Gain/Loss = Market Value – Par Value

Accounting for Investment Securities Assume interest rates increase and bond prices fall: Held-to-Maturity Securities There is no impact on either the balance sheet or income statement Trading Securities The decline in value is reported as a loss on the income statement Available-for-Sale Securities The decline in value reduces the value of bank capital