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Managing Nondeposit Liabilities and
 Other Sources of Borrowed Funds
13-2




The 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 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.
   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 Institutions




What 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 of
high-quality assets (usually
government securities)
accompanied by an agreement to
buy back those assets on a specific
future date at a predetermined
price or yield.
Happy Valley Bank borrows $125 million
overnight through a repurchase agreement (RP)
collateralized by Treasury bills. The current RP
rate is 3.65 percent. How much will the bank pay
in 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 reserve
needs can borrow from the federal
reserve. There are three types of
loans for different needs, each with
its own interest rate. There are
limitations on borrowing at the
federal 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
17
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.
   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-day
negotiable CD with a $5 million
denomination from Bait Bank and Trust,
bearing a 3.75 percent annual yield. How
much in interest will the bank have to pay
when this CD matures? What amount in
total will the bank have to pay back to
Rockfish at the end of 60 days?


                                         13-20
Interestowed
                          60
Rockfish Corp. $5,000,000     .0375 $31,250.00
                          360
    by bank
 T otalamount
owed 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 the
construction of new buildings
and capital notes and
debentures are examples of
long 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 bank's
economics department has projected that new loan demand will reach
$460 million and customers with approved credit lines will need $175
million in cash. The bank will sell $480 million in securities, but plans to
add $85 million in new securities to its portfolio. What is the projected
available 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          0.25

Calculate 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       incurred
Effectivecost rateon
                            borrowed     to access thesefunds
deposit and nondeposit
                              Net investablefunds raised
   sources of funds
                                    from thissource
Effective
Federal = 0.0225x $850Million 0.0025x $850Million
Funds Cost               $835Million
Rate       $19.13million $2.125million
          =                                      = 2.54%
                         $835 million

                                                               13-31
Effective CD       0.024 $850million 0.0025 $850million
               =
Cost Rate                       $835million
                   $20.4million $2.125million
               =                              = 2.70%
                          $835million

Effective    0.023 $850million 0.0035 $850million
Eurodollar =
                         $835million
Cost Rate
             $19.55 million $2.975million
           =                              = 2.70%
                     $835million


                                                    13-32
Effective
Commercial 0.0235 $850million 0.0050 $850million
             =
Paper Cost                      $835 million
Rate
                 $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 be
borrowing from the federal funds
market.




                                  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 $800 million in total funding from the
sources listed below with their associated costs also shown.
                            Amount Interest Nonint. Add. Total
   Funding Source           ($ millions) Costs Costs Costs Costs
Checkable 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
Firefly's costs in millions of dollars:

                               Amount          Interest   Other         Total
   Funding Source             ($ millions)     Costs($)   Costs($)     Costs($)
Checkable Deposits    200                     1.50      5.5          7.00
Time & Savings Dep.   400                    10.00      4.0         14.00
Money-Mkt. Borrowings 100                     3.25      0.5          3.75
Stockholders' Equity  100                        -----      -----           -----
Totals ($)            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 bank's 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

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Ch13 bb

  • 1. Managing Nondeposit Liabilities and Other Sources of Borrowed Funds
  • 2. 13-2 The 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.
  • 3. 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
  • 4. 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.
  • 5. 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
  • 6. 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
  • 7. 13-7 Recent Growth in Nondeposit Sources of Borrowed Funds at FDIC-Insured Institutions What are the trends?
  • 8. 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
  • 9.  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
  • 10.  Overnight Loans  Term Loans  Continuing Contracts
  • 11. Involves the temporary sale of high-quality assets (usually government securities) accompanied by an agreement to buy back those assets on a specific future date at a predetermined price or yield.
  • 12. Happy Valley Bank borrows $125 million overnight through a repurchase agreement (RP) collateralized by Treasury bills. The current RP rate is 3.65 percent. How much will the bank pay in interest costs due to this borrowing? Interest cost of RP = $125,000,000 x 0.0365 x 1/360= $12,673.61 13-12
  • 13. A bank with immediate reserve needs can borrow from the federal reserve. There are three types of loans for different needs, each with its own interest rate. There are limitations on borrowing at the federal reserve discount window.
  • 14. 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
  • 15. 13-15 • What is liability management? • For what kinds of funding situations are Federal funds best suited?
  • 16. 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
  • 17. 17
  • 18. 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.
  • 19. 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.
  • 20. Rockfish Corporation purchases a 60-day negotiable CD with a $5 million denomination from Bait Bank and Trust, bearing a 3.75 percent annual yield. How much in interest will the bank have to pay when this CD matures? What amount in total will the bank have to pay back to Rockfish at the end of 60 days? 13-20
  • 21. Interestowed 60 Rockfish Corp. $5,000,000 .0375 $31,250.00 360 by bank T otalamount owed Rockfish P rinciple Interest in 60 days $5,000,000 $31,250.00 $5,031,250.00 13-21
  • 22.  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
  • 23.  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.
  • 24. Mortgages to fund the construction of new buildings and capital notes and debentures are examples of long term sources of funds.
  • 25. 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
  • 26. Rosemary Bank of New York expects new deposit inflows next month of $375 million and deposit withdrawals of $500 million. The bank's economics department has projected that new loan demand will reach $460 million and customers with approved credit lines will need $175 million in cash. The bank will sell $480 million in securities, but plans to add $85 million in new securities to its portfolio. What is the projected available funds gap? Projected funds gap = $460 + $175 + ($85 - $480) – ($375 - $500) = $365 million 13-26
  • 27. 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
  • 28. Effective cost = Current int cost non - interest cost investable funds   Non-interest cost = (cost of staff, transaction, facilities)x funds borrowed 
  • 29. 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
  • 30. 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 0.25 Calculate 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
  • 31. Current interest Noninteres costs t cost on amounts incurred Effectivecost rateon borrowed to access thesefunds deposit and nondeposit Net investablefunds raised sources of funds from thissource Effective Federal = 0.0225x $850Million 0.0025x $850Million Funds Cost $835Million Rate $19.13million $2.125million = = 2.54% $835 million 13-31
  • 32. Effective CD 0.024 $850million 0.0025 $850million = Cost Rate $835million $20.4million $2.125million = = 2.70% $835million Effective 0.023 $850million 0.0035 $850million Eurodollar = $835million Cost Rate $19.55 million $2.975million = = 2.70% $835million 13-32
  • 33. Effective Commercial 0.0235 $850million 0.0050 $850million = Paper Cost $835 million Rate $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
  • 34. The cheapest source of all would be borrowing from the federal funds market. 13-34
  • 35. 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?
  • 36. 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
  • 37. Firefly Bank and Trust has received $800 million in total funding from the sources listed below with their associated costs also shown. Amount Interest Nonint. Add. Total Funding Source ($ millions) Costs Costs Costs Costs Checkable 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
  • 38. Firefly's costs in millions of dollars: Amount Interest Other Total Funding Source ($ millions) Costs($) Costs($) Costs($) Checkable Deposits 200 1.50 5.5 7.00 Time & Savings Dep. 400 10.00 4.0 14.00 Money-Mkt. Borrowings 100 3.25 0.5 3.75 Stockholders' Equity 100 ----- ----- ----- Totals ($) 800 14.75 10.0 24.75 13-38
  • 39. (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
  • 40. (b) If the bank's 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