CHAPTER THIRTEENManaging Nondeposit Liabilities and Other Sources of Borrowed

Funds

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.

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Key Topics Liability Management Customer Relationship Doctrine Alternative Nondeposit Funds Sources Measuring the Funds Gap Choosing Among Different Funds

Sources Determining the Overall Cost of Funds

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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.

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

The control mechanism to regulate incoming funds is the price of funds

Nondeposit Sources 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

Recent Growth in Nondeposit Sources of Borrowed Funds at FDIC-Insured Institutions

What are the trends?

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Alternative Nondeposit Sources of Funds

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

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Federal Funds Market

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

Types of Fed Funds Loan Agreements

Overnight Loans

Term Loans

Continuing Contracts

Repurchase Agreements

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.

Problem 13-5Happy 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

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Borrowing From the Federal Reserve Bank

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.

The Three Types of Federal Reserve Loans

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

Quick Quiz

•What is liability management?• For what kinds of funding situations are Federal funds best suited?

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Advances from the Federal Home Loan Bank

• 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

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Negotiable CDAn 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.

The Four Types of Negotiable CDs

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.

Problem 13-4Rockfish 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?

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Problem 13-4 (continued)

00.250,31$5,000.250,31$ $5,000,000

InterestPrinciple

days 60in

Rockfish owed

amount Total

00.250,31$0375.360

60000,000,5$

bankby

Corp.Rockfish

owedInterest

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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

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.

Long-Term Nondeposit Sources of Funds

Mortgages to fund the construction of new buildings and capital notes and debentures are examples of long term sources of funds.

The Funds Gap 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

Problem 13-6Rosemary 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

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Nondeposit Funding Sources: Factors to Consider

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

Relative Cost Effective cost =

Non-interest cost = (cost of staff,

transaction, facilities)x funds borrowed

funds investable

costinterest -non cost int Current

Problem 13-9 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.

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Problem 13-9 (continued)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.

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Problem 13-9 (continued)

source thisfrom

raised funds investableNet funds theseaccess to

incurred

costst Noninteres

borrowed

amountson cost

interestCurrent

funds of sources

nondeposit anddeposit

on ratecost Effective

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Million $835

Million $850 x 0.0025 Million $850 x 0.0225 Effective Federal Funds Cost Rate

=

million 835$

million $2.125 million $19.13 = = 2.54%

Problem 13-9 (continued)

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Effective CD Cost Rate

=million $835

million $850 0.0025 million $850 0.024

million $835

million $2.125 million $20.4 = 2.70%=

Effective Eurodollar = Cost Rate

million $835

million $850 0.0035 million $850 0.023

million $835

million $2.975 million 55.19$ = = 2.70%

Problem 13-9 (continued)

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Effective Commercial Paper Cost Rate

=million 835$

million $850 0.0050 million $850 0.0235

= 2.90%=

Effective Cost of Borrowing from the Fed

=million 835$

million $850 0.0025 million $850 0.0325

million 835$

million $2.125 million $27.63 = = 3.56%

million $835

million $4.25 million $19.98

Problem 13-9 (continued)

The cheapest source of all would be borrowing from the federal funds market.

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Quick Quiz 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?

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Summary Customer Relationship Doctrine Sources of Funds

Federal Funds Market Negotiable CDsRepurchase Agreements Eurocurrency Deposits

Federal Reserve Borrowings Commercial PaperHome Loan Banks Capital Notes and Debentures

Choosing Nondeposit SourcesFunds Gap TermCosts Size of borrowing bankRisks Regulations

Problem 13-11Firefly 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

Problem 13-11 (continued)

Firefly's costs in millions of dollars: Amount Interest Other Total Funding Source ($ millions) Costs($) Costs($) Costs($)

Checkable Deposits 200 1.50 5.5 7.00Time & Savings Dep. 400 10.004.0 14.00Money-Mkt. Borrowings 100 3.25 0.5 3.75Stockholders' Equity 100 ----- ----- -----Totals ($) 800 14.7510.0 24.75

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Problem 13-11 (continued)

(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

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Problem 13-11 (continued)

(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%

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