Bank Management, 5th edition. Management Timothy W. Koch and S.

Scott MacDonald
Copyright 2003 by South-Western, a division of Thomson Learning

MANAGING LIABILITIES AND THE COST OF FUNDS Chapter 12

The composition of bank liabilities

There are many different types of liabilities.

Some offer transaction capabilities with relatively low or not interest. Others offer limited check writing capabilities but pay higher interest rates. Liabilities with long-term fixed maturities generally pay the highest rates. Customers who hold each instrument respond differently to interest rate changes.

The percentage contribution of various sources of bank funds: a comparison of large versus small banks: 1992 and 2001 (% of total assets)

The percentage contribution of various sources of bank funds: a comparison of large versus small banks (continued): 1992 and 2001 (% of total assets)

General decline in core deposits

Transaction accounts have decline in favor of interest bearing

MMDA on small time deposits (less than $100,000). Bank reliance on liabilities other than core deposits, including federal funds purchased, securities sold under agreement to repurchase, Federal Home Loan Bank (FHLB) advances, borrowings from the Federal Reserve, and deposits in foreign offices declined over the period 19922001 for large banks but increased for smaller banks. Except for discount window borrowings, these funds all have large denominations and pay market rates. They typically have relatively short-term maturities except for some FHLB advances that can extend as long as 20 years. Banks use the term volatile liabilities to describe purchased funds from rate-sensitive investors The types of instruments include federal funds purchased, RPs, jumbo CDs, Eurodollar time deposits, foreign deposits, and any other large-denomination purchased liability. Investors in these instruments will move their funds if other institutions pay higher rates or if it is rumored that the issuing bank has financial difficulties.

Average annual cost of liabilities: a comparison of large versus small banks: 2001
Banks with Assets from $3 to $10 Billion 2001 1.71% 2.15 4.94 5.06 0.56 3.60% 3.57 5.16 1.93 3.86 Banks with Assets from $10 to $25 Million 2001 1.63% 2.79 5.40 5.53 NA 4.29% 1.27 1.37 NA 4.31

Liabilities Transaction accounts MMDAS and other savings deposits Large CDs All other time deposits Foreign office deposits Total interest-bearing deposits Federal funds & RPs Other borrowed funds Subordinated notes and bonds All interest-bearing funds

SOURCE: Uniform Bank Performance Report.

Increased competition for bank funds

Perhaps the most difficult problem facing

bank management is how to develop strategies to compete for funding sources.

First, bank customers have become much more rate conscious. Second, many customers have demonstrated a strong preference for shorter-term deposits.

Information on the best rates is much easier to find today.

Characteristics of small denomination liabilities

Instruments under $100,000 are normally

held by individual investors and are not actively traded in the secondary market.

Accounts with transactions privileges

Most banks offer three different accounts

with transactions privileges:

1. 2. 3.

demand deposits (DDAs), negotiable orders of withdrawal (NOWs) and automatic transfers from savings (ATS), and money market deposit accounts (MMDAs).

Demand deposit accounts DDAs are non-interest-bearing checking

accounts held by individuals, businesses, and governmental units
NOW accounts are DDAs that pay interest.

Only individuals and nonprofit organizations can hold NOWs.

This is expected to change very soon.

Money market deposit accounts MMDAs

similar to interest bearing checking accounts but have limited transactions.
Provide banks an instrument competitive with

money market mutual funds offered by large brokerages. Limited to six transactions per month, of which only three can be checks. Attractive to the bank because required reserves are zero while required reserves on DDAs and NOWs are 10 percent.

The bank can invest 100 percent of the funds obtained from MMDA but only 90 percent from checking and NOW.

Electronic money
Consider carefully the impact of

technology in banking almost all products of the financial services industry can be provided electronically.
You can pay for goods electronically,

apply and receive a loan electronically, even invest and transfer funds electronically.

It is estimated that cash accounted for 82.3% of the total volume of payments in 2000
Checks were the second largest in terms of volume at

10.3% Electronic payments (ATM, credit cards and debit cards) accounted for 7.4% of all payments. In terms of the value of transactions, however

cash accounted for only 0.3% of the total value of transactions checks were 10.9% and electronic payments (AMT, credit cards and debit cards) accounted for 2.9%.

The vast majority of large transactions were

wholesale wire transfers such as CHIPS and Fed Wire transactions. Although cash dominates the small payment end of transactions, it represents a very small fraction of the total value of payments.

E-cash and e-checks are not Federal Reserve money but rather digital tokens somewhat like bus tokens or casino chips, only electronic versions.
Lauren Bielski in an August, 2000 ABA

Banking Journal article argues that emoney is arguably more of an electronic instruction to pay than true electronic money.

Electronic money: smart cards

There are basically two types of smart

cards:

1. 2.

an intelligent smart card and a memory card.

An intelligent smart card contains a

microchip with the ability to store and secure information, and makes different responses depending on the requirements of the card issuers specific application needs. Memory type cards simply store information, similar to the stored information on the back of a credit card.

Electronic funds transfer (EFT)

an electronic movement of financial data, designed to eliminate the paper instruments normally associated with such fund movement.
There are many types of EFTs including:

ACH, POS, ATM, direct deposit, telephone bill paying, automated merchant authorization systems, and pre-authorized payments.

Electronic funds transfer systems

Point of sale (POS) transaction

a sale that is consummated by payment for goods or services received at the point of the sale or a direct debit of the purchase amount to the customers checking account. Automated clearing house (ACH) transaction an electronically processed payment using a standard data format.

ACH payments are electronic payments of funds and government securities among financial institutions and businesses

Internet bill payment, telephone bill payment, automatic deposits, and bank drafts
Although these types of payments seem to be

electronic, paper checks are still often written on the customers behalf and mailed to the business. These types of payments will most likely become completely electronic in the near future.

Functional cost analysis

The Federal Reserve System conducts a

survey called the Functional Cost Analysis Program to collect cost and income data on commercial bank operations. According to functional cost analysis data, demand deposits are the least expensive source of funds.

Functional cost analysis classifies checkprocessing activities as either deposits (electronic and non-electronic), withdrawals (electronic and non-electronic), transit checks deposited, transit checks cashed, account opened or closed, on-us checks cashed or general account maintenance (truncated and non-truncated)
Electronic transactions

those that occur through automatic deposits, Internet and telephone bill payment, ATMs and ACH transactions. Non-electronic those transactions conducted in person or by mail.

Functional cost analysis check-processing

Transit checks deposited are defined as checks drawn

on any bank other than the subject bank. On-us checks cashed are checks drawn on the banks customer's account. Deposits represent checks or currency directly deposited in the customer's account. Account maintenance refers to general record maintenance and preparing and mailing a periodic statement. A truncated account is a checking account in which the physical check is truncated at the bank; i.e., checks are not returned to the customer. Official check issued would be for certified funds. Net indirect costs are those cost not directly related to the product such as salaries to manage the bank or general overhead cost applicable to all products at the bank.

Cost and Revenue Analysis of Selected Transactions Accounts: Banks With Deposits of $50 Million to $200 Million

Income Interest Income (estimated 7.5% earnings credit) Non-Interest Income Service Charges Penalty Fees Other Total Non-Interest Income Expenses Activity Charges Deposit - Electronic Deposit - Non Electronic Withdrawal - Electronic Withdrawal - Non Electronic Transit Check Deposited Transit Check Cashed Account Opened Account Closed On-Us Checks Cashed Account Maintenance (Truncated) monthly Account Maintenance (Non truncated) monthly Official check issued Total Activity Expense Net Indirect Expense Total Non-Interest Expense Interest Expense Total Expense Net Income (expense) Before Earnings Credit Net Revenue Per Month

Demand Accounts Monthly Income / Unit Cost Expenses $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ 0.0089 0.2219 0.1073 0.2188 0.1600 0.2562 9.46 5.67 0.2412 2.42 8.60 1.02 $ $ $ $ $ $ $ $ $ $ $ 29.47 2.80 4.32 0.63 7.75 0.02 0.66 0.43 3.63 1.71 0.50 0.20 0.07 0.42 1.67 7.03

Savings Accounts Monthly Income / Unit Cost Expenses $ $ $ $ $ $ $ $ $ $ $ $ $ 0.0502 0.7777 0.4284 0.7777 0.5686 33.63 20.18 4.10 $ $ $ $ $ $ $ $ 34.04 0.44 0.28 0.16 0.88 0.01 0.46 0.07 0.39 1.09 0.53 0.26 3.56

Time Deposits Monthly Income / Unit Cost Expenses $ $ $ $ $ $ $ $ $ $ $ $ 0.1650 3.1425 0.5400 1.4933 5.78 3.38 1.99 $ $ $ $ $ $ $ 121.84 0.11 0.27 0.05 0.42 0.1296 2.2016 0.2840 0.5875 1.73 1.02 1.99 7.94 18.38 26.32 69.79 96.11 (95.69) 26.16

$ 16.34 $ 4.35 $ 20.69 1.25% $ 5.38 $ 26.07 $ $ (18.32) 11.15

$ 6.37 $ 1.81 $ 8.18 2.96% $ 13.45 $ 21.63 $ (20.75) $ 13.29

$ $ $ 5.18% $ $ $ $

Average Account Balance $5,515.00 $5,557.00 a Average Annual Net Cost 4.66% 4.57% Average Interest Cost 1.37% 2.96% Average Non-interest Cost 5.27% 1.80% Average Non-interest Income 1.97% 0.19% a Required reserves are assumed to be 10 percent for demand accounts and zero for others. Float is assumed to be 5 percent for demand accounts, 2 percent for savings accounts and zero for time accounts.

$19,495.00 5.89% 4.30% 1.62% 0.03%

Source: Functional Cost and Profit Analysis, Based on data furnished by participating banks in twelve Federal Reserve Districts, 1999 National Average Report,

Small time deposits

Small time deposits have denominations

under $100,000, specified maturities ranging from seven days to any longer negotiated term. Banks can control the flow of deposits by offering only products with specific maturities and minimum balances and varying the relative rates paid according to these terms.

Service charges
For many years, banks priced check handling

services below cost. While competition may have forced this procedure, it was acceptable because banks paid below-market rates on most deposits. Because banks now pay market rates on deposits, they want all customers to pay at least what the services cost. For most customers, service charges and fees for banking services have increased substantially in the 1990s.

Individual transaction account pricing

Interest cost and net cost of transaction accounts

The average historical cost of funds is a

measure of average unit borrowing costs for existing funds.

Average interest cost for the total portfolio is calculated by dividing total interest expense by the average dollar amount of liabilities outstanding. Average historical interest costs for a single source of funds can be calculated as the ratio of interest expense by source to the average outstanding debt for that source during the period.

Interest costs alone, however, dramatically understate the effective cost of transaction accounts.
1.

First, transaction accounts are subject to legal reserve requirements of up to 10 percent of the outstanding balances, invested in non-earning assets (federal reserve deposits or vault cash).

This effectively increases the cost of transactional accounts because a reduced portion of the balances can be invested. Non transactional accounts have no reserve requirements and hence are cheaper, ceteris paribus, because 100 percent of the funds can be invested.

1. 2.

Second, transaction accounts are subject to processing costs. Third, certain fees are charged on some accounts to offset noninterest expenses and this reduces the cost of these funds to the bank.

Calculating the net cost of transaction accounts

Annual historical net cost of bank liabilities is

historical interest expense plus noninterest expense (net of noninterest income) divided by the investable amount of funds:
Net Cost of Bank Liabilitie s = Interest Expense + Noninteres t Expense - Noninteres t Income Average Balance net of float x (1 - required reserve ratio)

A regular check account that does not pay interest,

has $20.69 in transaction costs charges $7.75 in fees, an average balance of $5,515, 5% float would have a net cost of:
% net cost of regular checking = $0 + $20.69 - $7.75 x12 = 4.66% $5,515 x. 0.95 x 0.90

Required reserves on transactions account are 10%.

Characteristics of large denomination liabilities

In addition to small denomination deposits, banks

purchase funds in the money markets. Money center and large regional banks effect most transactions over the telephone, either directly with trading partners or through brokers. Smaller banks generally deal directly with customers and have limited access to national and international markets. Because customers move their investments on the basis of small rate differentials, these funds are labeled hot money or volatile liabilities.

Jumbo CDs

large, negotiable certificates of $100,000 or more are referred to as jumbo CDs.

Jumbo CDs are: issued primarily by the largest banks. purchased by businesses and governmental units. CDs have grown to be the one of the most

popular hot-money, large-source financing used by banks.

have a minimum maturity of 7 days. interest rates are quoted on a 360-day year. Insured up to $100,000 per investor per institution.

Banks issue jumbo CDs directly or indirectly

through dealers and brokers (brokered deposits).

Immediately available funds

Two types of balances are immediately

available:
1. 2.

deposit liabilities held at Federal Reserve Banks and certain collected liabilities of commercial banks that may be transferred or withdrawn during a business day on order of the account holder.

Federal Funds purchased

The term federal 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 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.

Security repurchase agreements

(RPs or Repos) are short-term loans secured by government securities that are settled in immediately available funds
Technically, the loans embody a sale of

securities with a simultaneous agreement to buy them back later at a fixed price plus accrued interest. 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.

Foreign Office Deposits

most large U.S. commercial banks compete aggressively in international markets

They borrow from and extend credit to foreign-based

individuals, corporations, and governments.

In recent years international financial markets and multinational businesses have become increasingly sophisticated to the point where bank customers go overseas for cheaper financing and feel unfettered by national boundaries.

Transactions in short-term international markets often

take place in the Eurocurrency market. Eurocurrency financial claim denominated in a currency other than that of the country where the issuing institution is located. The most important Eurocurrency is the Eurodollar

Eurodollar liabilities

transactions in short-term international markets take place in the Eurocurrency market.

The term Eurocurrency refers to a financial

claim denominated in a currency other than that of the country where the issuing institution is located.
Eurodollar, a dollar-denominated financial

claim at a bank outside the United States.

The origin and expansion of Eurodollar deposits

Individual retirement accounts

savings plans for wage earners and their spouses

The primary attraction of IRAs is their tax

benefits. Each wage earner can invest up to $2,000 of earned income annually in an IRA.

Prior to 1987, the principal contribution was taxdeductible, and any accumulated earnings in the account were tax-deferred until withdrawn.

The Tax Reform Act of 1986 removed the tax-

deductibility of contributions for individuals already covered by qualified pension plans if they earned enough income.

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 (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.

The Gramm-Leach-Bliley (GLB) Act of 1999 made is much easier for smaller banks to borrow and these borrows could be used for non-real estate related loans. GLB allows Banks with less than $500 million in assets to use long-term advances for loans to small businesses, small farms and small agri-businesses. The act also established a new permanent capital structure for the Federal Home Loan Banks with two classes of stock authorized, redeemable on 6-months and 5-years notice.

FHLB borrowings, or advances, have maturities as short as 1

day or as long as 10 years.

Greater competition for funds and the authorization of new uses for FHLB advances has resulted in rapid growth in the number of banks with FHLB borrowing and the dollar amount of these borrowings.
Commercial Banks With FHLB Advances
$ Billions of FHLB Advances Outstanding
250
$ Billions of FHLB Advances Outstanding

4500
Number of Commercial Banks with FHLB Advances

200 150 100 50 0

3750 3000 2250 1500 750 0

Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec91 92 93 94 95 96 97 98 99 00 01

Number of CB with FHLB Advances

A recent trend has seen banks use longer-term FHLB advances as a more permanent source of funding.
The interest cost compares favorably with the

cost of jumbo CDs and other purchases liabilities.

The range of potential maturities allows banks to better manage their interest rate risk. The interesting issue is whether these advances are truly a permanent source of funds and thus comparable to core deposits, or whether they are hot money.

Measuring the cost of funds

Average historical cost Versus the marginal cost of funds

Average historical net cost

many banks incorrectly use the average historical costs in their pricing decisions
They simply add historical interest expense

with noninterest expense (net of noninterest income) and divide by the investable amount of funds to determine the minimum return required on earning assets.

Any profit is represented as a markup

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.

Marginal cost of bank funds

Marginal cost of debt

a measure of the borrowing cost paid to acquire one additional unit of investable funds Marginal cost of equity capital a measure of the minimum acceptable rate of return required by shareholders. Together, the marginal costs of debt and equity constitute the marginal cost of funds, which can be viewed as independent sources or as a pool of funds.

Costs of independent sources of funds

Unfortunately, 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.
Conceptually, marginal costs may be defined
Marginal Cost = Interst Rate + Servicing costs + Acquisiti on costs + Insurance 1 - % of funds in nonearning assets

as :

Example:
Assume:

Marginal costs of a hypothetical NOW account

market interest rate = 2.5% servicing costs = 4.1% acquisition costs = 1.0% of balances deposit insurance costs = 0.25% of balances percentage in nonearning assets = 15.0% (10% required reserves and 5% float.)

The estimated marginal cost is 9.24%:

0.025 + 0.041 + 0.01 + 0.0025 marginal cost = = 0.0924 0.85

Cost of debt
the cost of long-term nondeposit debt equals the effective cost of borrowing from each source, including interest expense and transactions costs.
Traditional analysis suggests that 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.

Example: Cost of subordinated notes

Assume the bank will issue: $10 million in par value subordinated notes paying $700,000 in annual interest and carrying a 7-year maturity. It must pay $100,000 in flotation costs to an underwriter. The effective cost of borrowing (kd), where t

equals the time period for each cash flow, is 7.19%: 7 $700,000 $10,000,00 0 $9,900,000 = + t 7 (1 + kd ) (1 + kd ) t=1 or kd = 7.19%

Cost of equity

conceptually, the marginal cost of equity equals the required return to shareholders
It is not directly measurable because

dividend payments are not mandatory. Still, several methods are commonly used to approximate this required return:
1. 2. 3.

Dividend valuation model Capital asset pricing model (CAPM) Targeted return on equity model

Dividend valuation model

this model discounts the expected cash flows from owning stock in determining a reasonable return to shareholders.
The cost of equity equals the discount rate (required

return) used to convert future cash flows to their present value equivalent: where Dt = the dollar value of the Dt expected dividend in period t P= t ke = cost of equity, and t =1 (1 + k e ) t = time period

If dividends are expected to grow at a constant rate:

D0 (1 + g) ke = +g P

Do = the expected % dividend yield g = the expected growth in earnings, dividend payments, and stock price appreciation.

Example:

Cost of Bank Stock

A banks stock currently trades at:

$24 per share and pays a $1 annual dividend. analysts forecasts the banks annual dividends will increase by an average 10 percent annually.

The estimated equity cost is 14.58%:

$1.10 ke = + 0.10 $24 = 14.58%

Capital asset pricing model (CAPM)

this model relates market risk, measured by Beta ( ), to shareholders required returns.
Formally, the required return to shareholders (ke')

equals the riskless rate of return (rf) plus a risk premium (r) on common stock reflecting nondiversifiable market risk:

k = rf + e

The risk premium equals the product of a securitys

Beta and the difference between the expected return on the market portfolio (km) and the expected riskless rate of return (rf). Beta measures a stocks historical price volatility relative to the price volatility of the market portfolio as: Covariance [individua l security(i ) return, market return] i = Variance(m arket return)

Estimate the required return to shareholders for individual securities

Banks can use historical estimates

and a projection of the market premium (km' - rf) to estimate the required return to shareholders for individual securities:

k i = rf + i (k m - rf ) e,

Example:
CAPM estimate for the banks cost of equity
Assume:

a banks estimate equals 1.42 assume the differential between the market return (km) and risk-free return (rf) is expected to average 5 percent, with the Treasury bill rate expected to equal 6 percent

The CAPM estimate for the banks cost of

equity is: ke = 0.06 + 1.42 (0.05) = 13.1%

This cost of equity should be converted to a

pretax equivalent, 19.85,% assuming a 34%

Targeted return on equity model

investors require higher pretax returns on common stock than on debt issues because of the greater assumed credit risk.
Many banks use a targeted return on equity

guideline based on the cost of debt plus a premium to evaluate the cost of equity.
Targeted net income Targeted ROE = Stockholde rs Equity

This return is then converted to a pretax

equivalent yield.

Targeted income before taxes Pretax required return = Stockholde rs Equity

It assumes that the market value of bank

equity equals the book value of equity.

Cost of preferred stock:

Preferred stock has characteristics of debt and

common equity. It represents ownership with investors claims superior to those of common stockholders but subordinated to those of debtholders. Like common stock, preferred stock pays dividends that may be deferred when management determines that earnings are too low. The marginal cost of preferred stock (kp) can be approximated in the same manner as the return on common equity; however, dividend growth is zero:

kp =

Dp Pp

where Dp = contractual dividend payment, Pp = net price of preferred stock,

Trust preferred stock

a hybrid form of equity capital at banks

Trust preferred stock is recent innovation in capital

financing. 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 after tax cost of trust preferred stock would be:

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.

ktp =

D tp (1 t) Ptp

where Dtp = contractual dividend payment on trust preferred, Ptp = net price of trust preferred stock,

Weighted marginal cost of total funds:

the best cost measure for asset-pricing purposes is a weighted marginal cost of funds (WMC)
This measure 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.

WMC is computed in three stages.

1.

2. 3.

First, management must forecast the desired dollar amount of financing to be obtained from each individual debt source and equity. Second, management must estimate the marginal cost of each independent source of funds. Finally, management should combine the individual estimates to project the weighted cost, which equals the sum of the weighted component costs across all sources. Each sources weight (wj) equals the expected dollar amount of financing from that source divided by the dollar amount of total liabilities and equity and kj equals the single-source j component cost of m financing: WMC = wk

j=1

Forecast of the weighted marginal cost of funds

projected figures for community state bank
(g) Weighted (d) Processing (f) Marginal Component Cost of (a) (b) (c) and (e) Average Percent Interest Acquisition Nonearning Marginal Funds Costs (b) x (f) Amount of Total Cost Costs Percentage
$ $ $ $ $ $ $ $ $ $ 28,210 5,551 13,832 3,640 18,382 9,055 78,670 182 4,550 83,402 31.0% 6.1% 15.2% 4.0% 20.2% 10.0% 86.5% 0.2% 5.0% 91.7% 2.5% 3.5% 4.5% 4.9% 5.0% 5.0% 8.0% 6.5% 3.0% 1.2% 1.4% 0.3% 0.0% 0.0% 18.0% 15.0% 3.0% 1.5% 1.0% 0.5% 0.0% 40.0% 4.0% 9.76% 10.59% 6.70% 5.79% 6.36% 5.34% 5.00% 0.00% 19.69% 0.0302 0.0065 0.0102 0.0023 0.0129 0.0053 0.0001

Liabilities and Equity

Demand deposits Interest checking Money market demand accounts Other savings accounts Time deposits < $100,000 Time deposits > $100,000 Total deposits Federal funds purchased Other liabilities Total liabilities Stockholders' equity Total liabilities and equity

$ 7,599 $ 91,001

8.4% 18.9%* 100.0%

0.0164

Weighted marginal cost of capital ->

8.39%

Revised forecast of the weighted cost of funds

Weighted Component Marginal Average Percent Interest Marginal Cost of Costs Amount of Total Cost Funds
$ $ $ $ $ $ $ $ $ $ 25,890 6,461 12,831 3,640 19,383 10,465 78,670 182 4,550 83,402 28.5% 7.1% 14.1% 4.0% 21.3% 11.5% 86.5% 0.2% 5.0% 91.7% 4.0% 4.8% 5.8% 6.3% 6.5% 6.5% 9.8% 12.4% 8.0% 7.1% 7.8% 6.8% 6.5% 0.0% 19.7% 0.0278 0.0088 0.0113 0.0028 0.0166 0.0079 0.0001 0.0000 0.0164

Liabilities and Equity

Demand deposits Interest checking Money market demand accounts Other savings accounts Time deposits < $100,000 Time deposits > $100,000 Total deposits Federal funds purchased Other liabilities Total liabilities Stockholders' equity Total liabilities and equity

$ 7,599 $ 91,001

8.4% 18.9%* 100.0%

Weighted marginal cost of capital ->

9.16%

Banks face two fundamental problems in managing liabilities:

1. Uncertainty over what rates they must pay to

retain and attract funds and

2. Uncertainty over the likelihood that

customers will withdraw their money regardless of rates.

Funding sources and interest rate risk:

During the 1980s, most banks experienced

a shift in composition of liabilities away from demand deposits into interest-bearing time deposits and other borrowed funds. This shift reflects three phenomena
1. 2. 3.

the removal of Regulation Q interest rate ceilings, a volatile interest rate environment and the development of new deposit and money market products.

The cumulative effect was to increase the

interest sensitivity of funding operations.

Reducing interest rate risk

one widely recognized strategy to reduce interest rate risk and the long-term cost of bank funds is to aggressively compete for retail core deposits.
Individuals are generally not as rate sensitive

as corporate depositors. Once a bank attracts deposit business, many individuals will maintain their balances through rate cycles as long as the bank provides good service and pays attention to them. Such deposits are thus more stable than money market liabilities.

Funding sources and liquidity risk

The liquidity risk associated with all liabilities

has risen in recent years. Depositors often simply compare rates and move their funds between investment vehicles to earn the highest yields. The liquidity risk facing any one bank depends on the competitive environment. Again, it is important to note the liquidity advantage that stable core deposits provide an acquiring bank.

Funding sources and credit risk

Changes in the composition and cost of bank

funds can indirectly affect a banks credit risk by forcing it to reduce asset quality.

Example, banks that have substituted purchased funds for lost demand deposits have seen 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.

Funding sources and bank safety

Changes in the composition and cost of bank

funds have clearly lowered traditional earnings.

This decrease slows capital growth and increases leverage ratios.

Borrowing costs will ultimately increase

unless noninterest income offsets this decline or banks obtain new external capital.

Bank safety has thus declined in the aggregate.

Risk characteristics

when a bank is perceived to have asset quality problems, uninsured customers move their deposits.
Banks with asset quality problems must pay substantial premiums to attract funds or rely on regulatory agencies to extend emergency credit. Liquidity risk associated with a banks deposit base is a function of many factors, including: 1. the number of depositors, 2. average size of accounts, 3. location of the depositor, and 4. specific maturity and rate characteristics of each account. Equally important is the interest elasticity of customer demand for each funding source.

Borrowing from the Federal Reserve.

Federal Reserve Banks are authorized to

make loans to depository institutions to help them meet reserve requirements. DIDMCA opened borrowing to any depository institution that offers transactions accounts subject to reserve requirements. The borrowing facility is called the discount window.

Discount window loans directly increase a member banks reserve assets.

Federal Reserve policies distinguish among three types of loans.

1. Short-term adjustment loans made to banks experiencing unexpected deposit outflow or overdrafts caused by computer problems 2. Seasonal borrowing privilege small banks are permitted to borrow if they can demonstrate that they experience systematic and predictable deposit withdrawals or new loan demand 3. Extended credit loans granted to banks experiencing more permanent deposit outflows, typically associated with a run on the bank

Federal Deposit Insurance

The Banking Act of 1933 established the FDIC and authorized federal insurance for bank deposits up to $2,500, today the amount has been set at $100,000. The Financial Institution Reform, Recovery, and Enforcement Act of 1989 (FIRREA) authorized the issuance of bonds to finance the bailout of the FSLIC and resources to close problem thrifts. The Act also created two new insurance funds: 1. Savings Association Insurance Fund (SAIF) 2. Bank Insurance Fund (BIF). It further created the Resolution Trust Corporation to handle failed thrifts.

Federal Deposit Insurance (continued)

The Federal Deposit Insurance Corp.

Improvement Act (FDICIA) authorized: Risk-based deposit insurance premiums ranging from $0.0 to $0.27 per $100, depending on a banks capital position. At the end 2001, the FDIC insurance fund exceeded the minimum 1.25% of insured deposits, which meant that well capitalized banks paid no insurance premium. At the end of 2001, over 92% of all banks were considered well capitalized. Most expect that the economic problems of the early 2000s will mean that banks are again assessed insurance premiums.

When an insured bank fails, the FDIC has five basic options
1. Purchase and Assumption

1.

1. 1.

1.

Bids are accepted by healthy banks for the failed banks good loans and other assets Open bank assistance An acquiring bank is provided financial assistance by the FDIC in acquiring a failing bank Insured deposit assumption or transfer Insured deposits are transferred to a health bank Bridge Bank The FDIC will operate the bank for a short period of time until it can find the appropriate buyer Payout option The FDIC immediately (one week) pays depositors the full amount of their insured funds

Bank Management, 5th edition. Management Timothy W. Koch and S. Scott MacDonald
Copyright 2003 by South-Western, a division of Thomson Learning

MANAGING LIABILITIES AND THE COST OF FUNDS Chapter 12