Bank Management, 6th edition. Timothy W. Koch and S. Scott MacDonald Copyright 2006 by South-Western, a division of Thomson Learning

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1 Bank Management, 6th edition. Timothy W. Koch and S. Scott MacDonald Copyright 2006 by South-Western, a division of Thomson Learning Funding the Bank and Managing Liquidity Chapter 8 William Chittenden edited and updated the PowerPoint slides for this edition. 1

2 The Relationship Between Liquidity Requirements, Cash, and Funding Sources The amount of cash that a bank holds is influenced by the bank s liquidity requirements The size and volatility of cash requirements affect the liquidity position of the bank Deposits, withdrawals, loan disbursements, and loan payments affect the bank s cash balance and liquidity position 2

3 Effect of Maturing Certificates of Deposit and Loan Use on a Bank s Deposit Balances at the Federal Reserve 3

4 Recent Trends in Bank Funding Sources Bank customers have become more rate conscious Many customers have demonstrated a a strong preference for shorter-term deposits Core deposits are viewed as increasingly valuable Bank often issue hybrid CDs to appeal to rate sensitive depositors 4

5 Types of Hybrid CDs Jump Rate (Bump-up) CDs Customers have the option (right) to request a change in rate one time prior to maturity. Indexed CD CD rates float with some base rate (index) such that the yield changes as the index changes CD Special CDs with unusual maturities (13 months or 23 months) in which the bank pays an above market rate. At maturity the CD converts to a traditional 12 month or 2-year CD. 5

6 Recent Trends in Bank Funding Sources Retail Funding Deposit Accounts Transaction accounts Money market deposit accounts Savings accounts Small time deposits Borrowed Funding Federal Funds purchased Repurchase agreements Federal Home Loan Bank borrowings 6

7 Recent Trends in Bank Funding Sources Wholesale Funding Includes borrowed funds plus large CDs Equity Funding Common stock Preferred stock Retained earnings 7

8 Recent Trends in Bank Funding Sources Volatile Liabilities Funds purchased from rate-sensitive investors Federal Funds purchased Repurchase agreements Jumbo CDs Eurodollar time deposits Foreign Deposits Investors will move their funds if other institutions are paying higher rates 8

9 Change in Total Deposits, Borrowed Funds, Subordinated Notes, and Total Equity Over Time, Percent of total funding 100% Total Deposits 90% 80% 70% 60% 50% '38 '44 Total Deposits Total Equity '50 '56 '62 '68 '74 '80 Borrowed Funds Subordinated Notes '86 '92 Percent of total funding 25% '98 '04 20% 15% 10% 5% 0% Borrowed Funds, Sub. Notes and Total Equity 9

10 Change in the Percentage Contribution of Various Bank Funding Components, Percent of Total Funding (Total Assets) 75% 50% 25% 0% Transaction accounts Total deposits held in domestic offices Nontransaction accounts Other savings deposits Money market deposit accounts (MMDAs) Time deposits of less than $100,000 12/31/ /31/ /31/ /31/2004 Volatile liabilities Deposits held in foreign offices Time deposits of $100,000 or more Other borrowed funds Subordinated debt Equity capital 10

11 The Percentage Contribution of Various Sources of Bank Funds by Bank Size, 2004 < $100 M $100M - $1B - > $10 B All CBs $1B $10B Number of institutions reporting Total deposits 83.68% 80.85% 68.50% 63.47% 66.48% Deposits held in domestic offices 83.67% 80.67% 67.36% 49.93% 49.93% Transaction accounts 26.29% 19.76% 10.03% 6.69% 6.69% Demand deposits 13.90% 11.48% 7.28% 5.42% 5.42% Nontransaction accounts 57.38% 60.91% 57.33% 43.24% 43.24% Money market deposit accounts (MMDAs) 10.59% 15.87% 23.47% 23.74% 23.74% Other savings deposits (excluding MMDAs) 9.19% 11.60% 10.42% 7.20% 7.20% Time deposits of less than $100, % 19.68% 11.53% 5.08% 5.08% Time deposits of $100,000 or more 12.63% 13.76% 11.91% 7.22% 7.22% Deposits held in foreign offices 0.01% 0.18% 1.14% 13.55% 13.55% Federal funds purchased & repurchase agreements 0.91% 2.54% 8.17% 7.50% 6.87% Trading liabilities 0.00% 0.00% 0.00% 4.45% 3.33% Other borrowed funds 3.28% 5.73% 10.05% 9.17% 8.75% FHLB advances 3.10% 5.37% 6.77% 2.01% 2.97% Memo: Volatile liabilities 14.69% 18.61% 26.57% 34.96% 31.68% Subordinated debt 0.01% 0.08% 0.40% 1.67% 1.31% All other liabilities 0.60% 0.79% 1.97% 3.76% 3.15% Equity capital 11.52% 10.00% 10.90% 9.95% 10.10% Deposits held in domestic offices 83.67% 80.67% 67.36% 49.93% 49.93% Noninterest-bearing deposits 14.09% 13.55% 11.89% 11.72% 11.72% Interest-bearing deposits 69.58% 67.12% 55.47% 38.21% 38.21% Core (retail) deposits 71.04% 66.92% 55.45% 42.71% 42.71% IRAs and Keogh plan accounts 4.17% 3.63% 2.63% 1.61% 1.61% Brokered deposits 1.45% 2.86% 4.35% 4.58% % Fully insured 1.25% 2.61% 3.52% 2.34% 2.34% Estimated insured deposits 67.31% 58.43% 41.51% 28.24% 28.24%

12 Average Annual Interest Cost of Liabilities by Bank Size, 2004 <$100M $100M $1B $1B $10B >$10B All CB Total interest expense on total liabilities 1.55% 1.56% 1.44% 1.36% 1.34% Interest expense on deposits 1.49% 1.43% 1.22% 1.16% 1.17% Domestic deposits 1.49% 1.43% 1.22% 1.02% 1.09% MMDAs and savings deposits 0.54% 0.45% 0.35% 0.34% 0.34% Time deposits <$100K 2.36% 2.42% 2.21% 2.21% 2.19% Time deposits >$100K 2.47% 2.59% 2.47% 2.51% 2.45% Deposits foreign offices 0.57% 1.22% 1.50% 1.67% 1.62% Fed funds purchased 2.55% 3.83% 4.20% 4.96% 4.54% U.S. notes & other borrowed funds 3.60% 3.44% 2.88% 3.01% 2.73% Subordinated notes & deb. 3.91% 4.69% 4.25% 4.80% 4.49% Source: BankSearch, Highline Data, Highline Data, LLC. 12

13 Characteristics of Retail-Type Deposits Retail Deposits Small denomination (under $100,000) liabilities Normally held by individual investors Not actively traded in the secondary market 13

14 Transaction Accounts Most banks offer three different transaction accounts Demand Deposits DDAs Negotiable Order of Withdrawal NOWs Automatic Transfers from Savings ATS 14

15 Transaction Accounts Demand Deposits Checking accounts that do not pay interest Held by individuals, business, and governmental units Most are held by businesses since Regulation Q prohibits banks from paying explicit interest on for-profit corporate checking accounts 15

16 Transaction Accounts NOW Accounts Checking accounts that pay interest ATS Accounts Customer has both a DDA and savings account The bank transfers enough from savings to DDA each day to force a zero balance in the DDA account For-profit corporations are prohibited from owning NOW and ATS accounts 16

17 Transaction Accounts Although the interest cost of transaction accounts is very low, the non-interest costs can be quite high Generally, low balance checking accounts are not profitable for banks due to the high cost of processing checks 17

18 Non-Transaction Accounts Non-transaction accounts are interestbearing with limited or no checkwriting privileges Money Market Deposit Accounts Pay interest but holders are limited to 6 transactions per month, of which only three can be checks Attractive to banks because they are not required to hold reserves against MMDAs 18

19 Non-Transaction Accounts Savings Accounts Have no fixed maturity Small Time Deposits (Retail CDs) Have a specified maturity ranging from 7 days on up Large Time Deposits (Jumbo CDs) Negotiable CDs of $100,000 or more Typically can be traded in the secondary market 19

20 Estimating the Cost of Deposit Accounts Interest Costs Legal Reserve Requirements Check Processing Costs Account Charges NSF fees Monthly fees Per check fees 20

21 Estimating the Cost of Deposit Accounts Transaction Account Cost Analysis Classifies check-processing as: Deposits Electronic Non-Electronic Withdrawals Electronic Non-Electronic 21

22 Estimating the Cost of Deposit Accounts Transaction Account Cost Analysis Classifies check-processing as: Transit Checks Deposited Cashed Account Opened or Closed On-Us checks cashed General account maintenance Truncated Non-Truncated 22

23 Estimating the Cost of Deposit Accounts Transaction Account Cost Analysis Electronic Transactions Conducted through automatic deposits, Internet, and telephone bill payment Non-Electronic Transactions Conducted in person or by mail Transit Checks Checks drawn on any bank other than the bank it was deposited into 23

24 Estimating the Cost of Deposit Accounts Transaction Account Cost Analysis On-Us Checks Cashed Checks drawn on the bank s own customer s accounts Deposits Checks or currency directly deposited in the customer's account Account Maintenance General record maintenance and preparing & mailing a periodic statement 24

25 Estimating the Cost of Deposit Accounts Transaction Account Cost Analysis Truncated Account A checking account in which the physical check is truncated at the bank and the checks are not returned to the customer Official Check Issued A check for certified funds. Net Indirect Costs Those costs not directly related to the product such as management salaries or general overhead costs 25

26 Cost and Revenue Accounting Data for Deposit Accounts at FirstBank Unit Cost Demand Savings Time Income Interest income (estimated earnings credit) 2.6% 2.5% 3.0% Noninterest income (monthly estimates per account) Service charges $ 2.80 $ 0.44 $ 0.11 Penalty fees $ 4.32 $ 0.28 $ 0.27 Other $ 0.63 $ 0.16 $ 0.05 Total noninterestiincome $ 7.75 $ 0.88 $ 0.42 Expenses Activity charges (unit costs per transaction) Deposit electronic $ $ $ Deposit nonelectronic $ $ $ Withdrawal electronic $ $ $ Withdrawal nonelectronic $ $ $ Transit check deposited $ $ Transit check cashed $ On-us check cashed $ Official check issued $ 1.02 Monthly overhead expense costs Monthly account maintenance (truncated) $ 2.42 $ 4.10 $ 1.99 Monthly account maintenance (nontruncated) $ 8.60 Net indirect expense $ 4.35 $ 1.81 $ Miscellaneous expenses Account opened $ 9.46 $ $ Account closed $ 5.67 $ $ 3.38

27 Calculating the Average Net Cost of Deposit Accounts Average Historical Cost of Funds Measure of average unit borrowing costs for existing funds Average Interest Cost Average Calculated by dividing total interest expense by the average dollar amount of liabilities outstanding Net Cost of Bank Liabilities Interest Expense Noninteres t Expense - Noninteres t Income Average Balance Net of Float x (1- Required Reserve Ratio) 27

28 Calculating the Average Net Cost of Deposit Accounts Example: A demand deposit account that does not pay interest has $20.69 in transaction costs charges, $7.75 in fees, an average balance of $5,515, and 5% float would have a net cost of 3.29% Average Net Cost of Demand Deposit $0 $ $5,515 (1-.05) $7.75 (1-.10) % 28

29 Calculating the Average Net Cost of Deposit Accounts Low Balance, Low Activity, Truncated Medium Balance, High Activity, Nontruncated High Balance Monthly Income / Expenses Monthly Income / Expenses Monthly Income / Expenses Activity Activity Activity Income Interest income on average monthly balance (after float) $ 500 $ 0.93 $ 4,589 $ 8.50 $11,500 $ Noninterest income (average montly estimates) Service charges $ 2.80 $ 2.80 $ 2.80 Penalty fees (estimated for account) $ 8.56 $ 6.32 $ 2.01 Other $ 0.63 $ 0.63 $ 0.63 Total noninterest income $ $ 9.75 $ 5.44 Total revenue $ $ $ Expenses Activity charges Deposit electronic 1 $ $ $ 0.02 Deposit nonelectronic 1 $ $ $ 0.67 Withdrawal electronic 15 $ $ $ 1.07 Withdrawal nonelectronic 3 $ $ $ 1.75 Transit check deposited 1 $ $ $ 0.32 Transit check cashed 1 $ $ $ 0.51 On-us checks cashed 2 $ $ $ 0.72 Official check issued $ - $ - $ - Total activity expense $ 3.40 $ 6.59 $ 5.06 Monthly expenses Monthly account maintenance (truncated) 1 $ 2.42 $ - $ - Monthly account maintenance (nontruncated) - $ - 1 $ $ 6.60 Net indirect expense $ 4.35 $ 4.35 $ 4.35 Total reoccurring monthly expenses $ 6.77 $ $ Interest expense $ - $ - $ - Total expense $ $ $ Net revenue per month $ 2.75 $ 0.71 $ Average percentage cost (net of service charges and fees) -5.12% 2.38% 1.29% Average interest cost 0.00% 0.00% 0.00% Average noninterest cost 28.53% 5.36% 1.95% Average noninterest income 33.66% 2.98% 0.66% Average account balance $ 500 $ 4,589 $ 29 11,500 Required reserves 10% 10% 10% Float 5% 5% 5%

30 Characteristics of Large Wholesale Liabilities Wholesale Liabilities Customers move these investments on the basis of small rate differentials, so these funds are labeled: Hot Money Volatile Liabilities Short-Term Non-Core funding 30

31 Characteristics of Large Wholesale Liabilities Wholesale Liabilities Includes: Jumbo CDs Federal Funds Purchased Repurchase Agreements Eurodollar Time Deposits Foreign Deposits 31

32 Characteristics of Large Wholesale Liabilities Jumbo CDs $100,000 or more Negotiable Can be traded on the secondary market Minimum maturity of 7 days Interest rates quoted on a 360-day year basis Insured up to $100,000 per investor per institution Issued directly or indirectly through a dealer or broker (Brokered Deposits) 32

33 Characteristics of Large Wholesale Liabilities Jumbo CDs Fixed-Rate Variable-Rate Jump Rate (Bump-up) CD Depositor has a one-time option until maturity to change the rate to the prevailing market rate Callable Zero Coupon Stock Market Indexed Rate tied to stock market index performance 33

34 Characteristics of Large Wholesale Liabilities Individual Retirement Accounts Each year, a wage earner can make a tax-deferred investment up to $3,000 of earned income Funds withdrawn before age 59 ½ are subject to a 10% IRS penalty This makes IRAs an attractive source of long-term funding for banks 34

35 Characteristics of Large Wholesale Liabilities Foreign Office Deposits Eurocurrency Financial claim denominated in a currency other than that of the country where the issuing bank is located Eurodollar Dollar-denominated financial claim at a bank outside the U.S. 35

36 The Origin and Expansion of Eurodollar Deposits 36

37 Characteristics of Large Wholesale Liabilities Federal Funds Purchased The term Fed 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 non-bank 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 37

38 Characteristics of Large Wholesale Liabilities Repurchase Agreements (RPs or Repos) Short-term loans secured by government securities that are settled in immediately available funds Identical to Fed Funds except they are collateralized Technically, the RPs entail the sale of securities with a simultaneous agreement to buy them back later at a 38 fixed price plus accrued interest

39 Characteristics of Large Wholesale Liabilities Repurchase Agreements (RPs or Repos) Most transactions are overnight 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 The lender s transaction is referred to as a Reverse Repo 39

40 Characteristics of Large Wholesale Liabilities Borrowing from the Federal Reserve Discount Window Discount Rate Policy is to set discount rate 1% (1.5%) over the Fed Funds target for primary (secondary) credit loans To borrow from the Federal Reserve, banks must apply and provide acceptable collateral before the loan is granted Eligible collateral includes U.S. government securities, bankers acceptances, and qualifying short-term commercial or government paper 40

41 Characteristics of Large Wholesale Liabilities Borrowing from the Federal Reserve Primary Credit Available to generally sound depository institutions on a very short-term basis, typically overnight It serves as a backup source of shortterm funds for sound depository institutions Secondary Credit Available to depository institutions that are not eligible for primary credit 41

42 Characteristics of Large Wholesale Liabilities Borrowing from the Federal Reserve Seasonal Credit Designed to assist small depository institutions in managing significant seasonal swings in their loans and deposits Emergency Credit May be authorized in unusual and exigent circumstances by the Board of Governors to individuals, partnerships, and corporations that are not depository institutions 42

43 Characteristics of Large Wholesale Liabilities 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 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 FHLB advances have maturities from 1 day to as long as 20 years 43

44 Commercial Banks with FHLB Advances, Billions of Dollars of Advances $450 $400 $350 $300 $250 $200 $150 $100 $50 Commercial Banks with FHLB Advances Amount Outstanding (Billions) Number of Banks ,100 4,100 3,100 2,100 1, Number of Banks with 44 Advances

45 Electronic Money Intelligent Card Contains a microchip with the ability to store and secure information Memory Card Simply store information Debit Card Online PIN based Transaction goes through the ATM system Offline Signature based transactions Transaction goes through the credit card system 45

46 Distribution of the Number of Noncash Payments in 2000 and Offline Debit, 7.31% ACH, 8.55% Online Debit, 4.14% EBT, 0.69% Offline Debit, 12.68% Online Debit, 6.53% EBT, 0.99% ACH, 11.21% Check, 45.20% Credit Card, 21.52% Check, 57.79% Credit Card, 23.40% Source: The 2004 Federal Reserve Payments Study, Note: Online debit payments are PIN-based, which includes purchases at the point of sale with ATM cards, and offline debit 46 payments, which are signature-based transactions. EBTs are electronic benefits transfers. Data does not include Fedwire or CHIPS wire transfers.

47 Check 21 Check Clearing for the 21 st Century Act Facilitates check truncation by reducing some of the legal impediments Foster innovation in the payments and check collection system without mandating receipt of check in electronic form Improve the overall efficiency of the nation s payment system 47

48 Check 21 Check Truncation Conversion of a paper check into an electronic debit or image of the check by a third party in the payment system other than the paying bank Facilitates check truncation by creating a new negotiable instrument called a substitute check 48

49 Check 21 Substitute Check The legal equivalent of the original check and includes all the information contained on the original Check 21 does NOT require banks to accept checks in electronic form nor does it require banks to create substitute checks It does allow banks to handle checks electronically instead of physically moving paper checks 49

50 Substitute Check Authorized by Check 21 50

51 The Check Clearing Process 51

52 Check Clearing Process Banks typically place a hold on a check until it verifies that the check is good Expedited Funds Availability Act Under Reg CC, it states that: Local check must clear in no more than two business days Non-local checks must clear in no more than five business days Government, certified, and cashiers checks must be available by 9 a.m. the 52 next business day

53 Measuring the Cost of Funds Average Historical Cost of Funds Many banks incorrectly use the average historical costs in their pricing decisions 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 53

54 Measuring the Cost of Funds Marginal Cost of Funds Marginal Cost of Debt Measure of the borrowing cost paid to acquire one additional unit of investable funds Marginal Cost of Equity Measure of the minimum acceptable rate of return required by shareholders Marginal Cost of Funds The marginal costs of debt and equity 54

55 Measuring the Cost of Funds Costs of Independent Sources of Funds 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. Marginal costs may be defined as : Marginal Cost of Liability j Interest Rate Servicing Costs Acquistion Costs Net Investable Balance of Liability j Insurance 55

56 Measuring the Cost of Funds Costs of Independent Sources of Funds All elements in the numerator are expected costs 56

57 Measuring the Cost of Funds Costs of Independent Sources of Funds Example: Market interest rate is 2.5% Servicing costs are 4.1% of balances Acquisition costs are 1.0% of balances Deposit insurance costs are 0.25% of balances Net investable balance is 85% of the balance (10% required reserves and 5% float) Marginal Cost % 57

58 Measuring the Cost of Funds Cost of Debt Equals the effective cost of borrowing from each source, including interest expense and transactions costs 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 58

59 Measuring the Cost of Funds Cost of Debt Example: Assume the bank will issue: $10 million in par value subordinated notes paying $700,000 in annual interest and a 7- year maturity. It must pay $100,000 in flotation costs to an underwriter. The effective cost of borrowing (k d ) is 7.19%: $9,900,000 Thus k d 7 $700,000 t (1 k ) t % d $10,000, (1 k ) d 59

60 Measuring the Cost of Funds Cost of Equity The marginal cost of equity equals the required return to shareholders It is not directly measurable because dividend payments are not mandatory. Several methods are commonly used to approximate this required return: Dividend Valuation Model Capital Asset Pricing Model (CAPM) Target Return on Equity Model Cost of Debt + Risk Premium 60

61 Measuring the Cost of Funds Preferred Stock Preferred stock acts as a hybrid of debt and common equity Claims are superior to those of common stockholders but subordinated to those of debt holders Preferred stock pays dividends that may be deferred when management determines that earnings are too low. The marginal cost of preferred stock can be approximated in the same manner as the Dividend Valuation Model however, 61 dividend growth is zero

62 Measuring the Cost of Funds Trust Preferred Stock Trust preferred stock is 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 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 62

63 Measuring the Cost of Funds Weighted Marginal Cost of Total Funds This is the best cost measure for asset-pricing purposes It 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 63

64 Measuring the Cost of Funds Weighted Marginal Cost of Total Funds Steps to compute WMC 1. Forecast the desired dollar amount of financing to be obtained from each individual debt and equity source 2. Estimate the marginal cost of each independent source of funds 3. Combine the individual estimates to project the weighted costs, which equals the sum of the weighted component costs across all sources 64

65 Measuring the Cost of Funds Weighted Marginal Cost of Total Funds Steps to compute WMC 4. Management should combine the individual estimates to project the weighted cost, where w j equals each source s weight and k j equals the single-source j component cost of financing such that: m WMC w j k j 65 j 1

66 Measuring the Cost of Funds Example (d) Processing and Acquisition Costs (f) Component Marginal Costs (g) Weighted Marginal Cost of Funds (b) x (f) (a) (b) (c) (e) Average Percent Interest Nonearning Liabilities and Equity Amount of Total Cost Percentage Demand deposits $ 28, % 8.0% 18.0% 9.76% Interest checking $ 5, % 2.5% 6.5% 15.0% 10.59% Money market demand accounts $ 13, % 3.5% 3.0% 3.0% 6.70% Other savings accounts $ 3, % 4.5% 1.2% 1.5% 5.79% Time deposits < $100,000 $ 18, % 4.9% 1.4% 1.0% 6.36% Time deposits > $100,000 $ 9, % 5.0% 0.3% 0.5% 5.34% Total deposits $ 78, % Federal funds purchased $ % 5.0% 0.0% 0.0% 5.00% Other liabilities $ 4, % 0.0% 40.0% 0.00% Total liabilities $ 83, % Stockholders' equity $ 7, % 18.9%* 4.0% 19.69% Total liabilities and equity $ 91, % Weighted marginal cost of capital -> 8.39% 66

67 Funding Sources and Banking Risks Banks face two fundamental problems in managing liabilities. Uncertainty over: What rates they must pay to retain and attract funds The likelihood that customers will withdraw their money regardless of rates 67

68 Funding Sources: Liquidity Risk The liquidity risk associated with a bank s deposit base is a function of: The competitive environment Number of depositors Average size of accounts Location of the depositor Specific maturity and rate characteristics of each account 68

69 Funding Sources: Liquidity Risk Interest Elasticity How much can market interest rates change before the bank experiences 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 vehicles to earn the highest yields It is important to note the liquidity advantage that stable core deposits provide a bank 69

70 Funding Sources: Interest Rate Risk Today, many depositors and investors prefer short-term instruments that can be rolled over quickly as interest rates change Banks must offer a substantial premium to induce depositors to lengthen maturities Those banks that choose not to pay this premium will typically have a negative one-year GAP 70

71 Funding Sources: Interest Rate Risk One strategy is to compete for aggressively compete for retail core deposits Individual are not as rate sensitive as corporate depositors and will often maintain their balances through rate cycles as long as the bank provides good service 71

72 Funding Sources: Credit and Capital Risk Changes in the composition 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 72

73 Holding Liquid Assets Banks hold cash assets to satisfy four objectives: 1. To meet customers regular transaction needs 2. To meet legal reserve requirements 3. To assist in the check-payment system 4. To purchase correspondent banking services 73

74 Holding Liquid Assets Banks own four types of liquid assets Vault Cash Demand Deposit Balances at the Federal Reserve Demand Deposit Balances at private financial institutions Cash Items in Process of Collection (CIPC) 74

75 Holding Liquid Assets Cash Assets Do not earn any interest Represents a substantial opportunity cost for banks Banks attempt to minimize the amount of cash assets held and hold only those required by law or for operational needs Liquid Assets Can be easily and quickly converted into cash with minimum loss 75

76 Holding Liquid Assets Cash Assets do not generally satisfy a bank s liquidity needs If the bank holds the minimum amount of cash assets required, an unforeseen drain on vault cash (perhaps from an unexpected withdrawal) will cause the level of cash to fall below the minimum for legal and operational requirements 76

77 Holding Liquid Assets Assets That Provide Bank Liquidity Cash and due from banks in excess of requirements Federal funds sold Reverse repurchase agreements Short-term Treasury and agency obligations High-quality, short-term corporate and municipal securities 77

78 Holding Liquid Assets For a financial institution that regularly borrows in the financial markets, liquidity takes on the added dimension of the ability to borrow funds at minimum cost or even the ability to issue stock. It explicitly recognizes that such firms can access cash by: Selling assets New borrowings New stock issues Bank Liquidity Refers to a bank s capacity to acquire immediately available funds at a reasonable price 78

79 Objectives of Cash Management Banks must balance the desire to hold a minimum amount of cash assets while meeting the cash needs of its customers The fundamental goal is to accurately forecast cash needs and arrange for readily available sources of cash at minimal cost 79

80 Reserve Balances at the Federal Reserve Bank Banks hold deposits at the Federal Reserve because: The Federal Reserve imposes legal reserve requirements and deposit balances qualify as legal reserves To help process deposit inflows and outflows caused by check clearings, maturing time deposits and securities, wire transfers, and other transactions 80

81 Reserve Balances at the Federal Reserve Bank Required Reserves and Monetary Policy The purpose of required reserves is to enable the Federal Reserve to control the nation s money supply The Fed has three distinct monetary policy tools: Open market operations Changes in the discount rate Changes in the required reserve ratio 81

82 Reserve Balances at the Federal Reserve Bank Required Reserves and Monetary Policy Changes in reserve requirements directly affect the amount of legal required reserves and thus change the amount of money a bank can lend out 82

83 Reserve Balances at the Federal Reserve Bank Required Reserves and Monetary Policy For example, a required reserve ratio of 10% means that a bank with $100 in demand deposits outstanding must hold $10 in legal required reserves in support of the DDAs The bank can thus lend out only 90% of its DDAs If the bank has exactly $10 in legal reserves, the reserves do not provide the bank with liquidity If the bank has $12 in legal reserves, $2 is excess reserves, providing the bank with $2 in immediately available funds 83

84 Reserve Balances at the Federal Reserve Bank Impact of Sweep Accounts on Required Reserve Balances Under Reg. D, banks have reserve requirements of 10% on demand deposits, ATS, NOW, and other checkable deposit (OCD) accounts MMDAs are considered personal saving deposits and have a zero required reserve requirement ratio. Sweep accounts are accounts that enable depository institutions to shift funds from OCDs, which are reservable, to MMDAs or other accounts, which are not reservable 84

85 Growth of Sweep Transaction Deposits into MMDAs: Monthly Averages of Initial Amounts Cumulative Total Billions of Dollars Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 85

86 Reserve Balances at the Federal Reserve Bank Sweep Accounts Two Types Weekend Program Reclassifies transaction deposits as savings deposits at the close of business on Friday and back to transaction accounts at the open on Monday On average, this means that for three days each week, the bank does not need to hold reserves against those balances 86

87 Reserve Balances at the Federal Reserve Bank Sweep Accounts Two Types Threshold Account The bank s computer moves the customer s DDA balance into an MMDA when the dollar amount reaches some minimum and returns funds as needed The number of transfers is limited to 6 per month, so the full amount of funds must be moved back into the DDA on the sixth transfer of the month 87

88 Meeting Legal Reserve Requirements Required reserves can be met over a two-week period There are three elements of required reserves: The dollar magnitude of base liabilities The required reserve fraction The dollar magnitude of qualifying cash assets 88

89 Meeting Legal Reserve Requirements Type of Deposit Percentage Effective Date of Applicable Percentages Net transactions Accounts Exempt amt. $ 7.00 mill 0.00% 12/23/2004 Up to $ mill 3.00% 12/23/2004 Over $ mill 10.00% 12/23/2004 All other liabilities 0.00% 12/27/

90 Meeting Legal Reserve Requirements Historical Problems with Reserve Requirements Historically, reserve requirements varied with the type of bank charter and each bank s geographic location Currently, banks use a lagged reserve account (LRA) system Reserves are held for a two-week period against deposit liabilities held for the two-week period ending almost three weeks earlier 90

91 Meeting Legal Reserve Requirements Lagged Reserve Accounting Computation Period Consists of two one-week reporting periods beginning on a Tuesday and ending on the second Monday thereafter Maintenance Period Consists of 14 consecutive days beginning on a Thursday and ending on the second Wednesday thereafter 91

92 Meeting Legal Reserve Requirements Lagged Reserve Accounting Reserve Balance Requirements The balance to be maintained in any given maintenance period is measured by: Reserve requirements on the reservable liabilities calculated as of the computation period that ended 17 days prior to the start of the maintenance period Less vault cash as of the same computation period 92

93 Meeting Legal Reserve Requirements Lagged Reserve Accounting Reserve Balance Requirements Both vault cash and Federal Reserve Deposits qualify as reserves The portion that is not met by vault cash is called the reserve balance requirement 93

94 Reserve Requirement Percentages for Depository Institutions Type of Deposit Percentage Effective Date of Applicable Percentages Net transactions accounts Exempt amt. $ 7.0 mill 0.0% 12/23/2004 Up to $ 47.6 mill 3.0% 12/23/2004 Over $ 47.6 mill 10.0% 12/23/2004 All other liabilities 0.0% 12/27/

95 Relationship between the Reserve Maintenance and Base Computation Periods under Lagged Reserve Accounting Sun Mon Tue Wed Thu Fri Sat 8-Aug 9-Aug 10-Aug 11-Aug 12-Aug 13-Aug 14-Aug 15-Aug 16-Aug 17-Aug 18-Aug 19-Aug 20-Aug 21-Aug 22-Aug 23-Aug 24-Aug 25-Aug 26-Aug 27-Aug 28-Aug 29-Aug 30-Aug 31-Aug 1-Sep 2-Sep 3-Sep 4-Sep 5-Sep 6-Sep 7-Sep 8-Sep 9-Sep 10-Sep 11-Sep 12-Sep 13-Sep 14-Sep 15-Sep 16-Sep 17-Sep 18-Sep 19-Sep 20-Sep 21-Sep 22-Sep 23-Sep 24-Sep 25-Sep Lagged reserve computation period and vault cash application period Reserve maintenance period 95

96 Report of Reversible Liabilities and Offsetting Asset Balances Balances at Close of Business Day (millions of dollars) Lagged Computation Tue Wed Thu Fri Sat Sun Mon Tue Wed Thu Fri Sat Sun Mon Two- Week Total Daily Average Period 10-Aug 11-Aug 12-Aug 13-Aug 14-Aug 15-Aug 16-Aug 17-Aug 18-Aug 19-Aug 20-Aug 21-Aug 22-Aug 23-Aug DDAs $ 13,573 $ Auto trans from savings $ 0.0 $ 0.0 NOW and Super NOW $ 3,130 $ Deductions: $ 0.0 $ 0.0 DD bal from U.S. dep $ 2,672 $ CIPC $ 1,199 $ Net trans. accounts $ 12,832 $ Vault Cash $ 451 $

97 Required Reserves Report, August Reservable Liabilities for Daily Avg. Deposit Liab. ($mill) Reserve Percentage Daily Avg. Requirement ($ mill) Aug Net trans. accounts Exempt up to $ 7.0 mill % $0.000 Over 7 up to $ 47.6 mill $ % $1.218 Over $ 47.6 mill $ % $ Total $ Gross reserve requirement $ Daily average vault cash $ Net reserve requirement $ Reserve carry-forward (from prior period) ($ 2.276) Minimum reserves to be maintained with Federal Reserve $ Maximum reserves to be maintained $ (0.04 x ) If a surplus carry forward of $ Minimum reserves to be maintained with Federal Reserve $ Carry forward (4% of gross reserve requirement) $3.525 Maximum reserves to be maintained $ (0.04 x )

98 Correspondent Banking Services System of interbank relationships in which the correspondent bank (upstream correspondent) sells services to the respondent bank (downstream correspondent) 98

99 Correspondent Banking Services Common Correspondent Banking Services Check collection, wire transfer, coin and currency supply Loan participation assistance Data processing services Portfolio analysis and investment advice Federal funds trading Securities safekeeping Arrangement of purchase or sale of securities Investment banking services International financial transactions 99

100 Liquidity Planning Short-Term Liquidity Planning Objective is to manage a legal reserve position that meets the minimum requirement at the lowest cost 100

101 Short-Term Liquidity Planning Below are some of the factors that affect the bank s legal reserve position Factors Increasing Reserves Nondiscretionary Yesterday's immediate cash letter Deferred availability items Excess from local clearinghouse Deposits from U.S. Treasury Discretionary Currency/coin shipped to Federal Reserve Security sales Borrowing from Federal Reserve Federal funds purchased Securities sold under agreement to repurchase Interest payments on securities New certificates of deposit, Eurodollar issues Factors Decreasing Reserves Nondiscretionary Remittances charged Deficit in local clearinghouse Treasury tax and loan account calls Maturing certificates of deposit, Eurodollars not rolled over Discretionary Currency and coin received from Federal Reserve Security purchases Payment on loans from Federal Reserve Federal funds sold Securities purchased under agreement to resell 101

102 Managing Float During any single day, more than $100 million in checks drawn on U.S. commercial banks is waiting to be processed Individuals, businesses, and governments deposit the checks but cannot use the proceeds until banks give their approval, typically in several days. Checks in process of collection, called float, are a source of both income and expense to banks. 102

103 The Payments System Payments between banks can be made either by check or electronically Checks drawn against transactions accounts are presented to the customer s bank for payment and ultimately cleared by reducing the bank s deposit balance at the Federal Reserve or a correspondent bank Payments made electronically directly and immediately alter balances held at Federal Reserve Banks 103

104 The Payments System Example of the Check Clearing Process 104

105 The Payments System Electronic Funds Transfer Networks Fedwire Operated by the Federal Reserve Clearinghouse Interbank Payments System (CHIPS) Operated by New York Clearing House Typically handles Eurodollar transfers or foreign exchange trading 105

106 Liquidity versus Profitability There is a short-run trade-off between liquidity and profitability The more liquid a bank is, the lower are its return on equity and return on assets, all other things equal In a bank s loan portfolio, the highest yielding loans are typically the least liquid The most liquid loans are typically government-guaranteed loans 106

107 The Relationship Between Liquidity, Credit, and Interest Rate Risk Liquidity risk for a poorly managed bank closely follows credit and interest rate risk Banks that experience large deposit outflows can often trace the source to either credit problems or earnings declines from interest rate gambles that backfired Potential liquidity needs must reflect estimates of new loan demand and potential deposit losses 107

108 The Relationship Between Liquidity, Credit, and Interest Rate Risk New Loan Demand Unused commercial credit lines outstanding Consumer credit available on bankissued cards Business activity and growth in the bank s trade area The aggressiveness of the bank s loan officer call programs 108

109 The Relationship Between Liquidity, Credit, and Interest Rate Risk Potential deposit losses are affected by: The composition of liabilities Insured versus uninsured deposits Deposit ownership between: money fund traders, trust fund traders, public institutions, commercial banks by size, corporations by size, individuals, foreign investors, and Treasury tax and loan accounts Large deposits held by any single entity Seasonal or cyclical patterns in deposits The sensitivity of deposits to changes in the level of interest rates 109

110 Traditional Aggregate Measures of Liquidity Risk Asset Liquidity Measures The most liquid assets mature near term and are highly marketable Any security or loan with a price above par, in which the bank could report a gain at sale, is viewed as highly liquid Liquidity measures are normally expressed in percentage terms as a fraction of total assets 110

111 Traditional Aggregate Measures of Liquidity Risk Highly Liquid Assets Cash and due from banks in excess of required holdings Federal funds sold and reverse RPs. U.S. Treasury securities and agency obligations maturing within one year Corporate obligations and municipal securities maturing within one year and rated Baa and above Loans that can be readily sold and/or securitized 111

112 Pledging Requirements Not all of a bank s securities can be easily sold Like their credit customers, banks are required to pledge collateral against certain types of borrowings U.S. Treasuries or municipals normally constitute the least-cost collateral and, if pledged against debt, cannot be sold until the bank removes the claim or substitutes other collateral 112

113 Pledging Requirements Collateral is required against four different liabilities: Repurchase agreements Discount window borrowings Public deposits owned by the U.S. Treasury or any state or municipal government unit FLHB advances 113

114 Liability Liquidity Measures Liability Liquidity The ease with which a bank can issue new debt to acquire clearing balances at reasonable costs. Measures typically reflect a bank s asset quality, capital base, and composition of outstanding deposits and other liabilities. 114

115 Liability Liquidity Measures The following measures are commonly used: Total equity to total assets Risk assets to total assets Loan losses to net loans Reserve for loan losses to net loans The percentage composition of deposits Total deposits to total liabilities Core deposits to total assets Federal funds purchased and RPs to total liabilities Commercial paper and other short-term borrowings to total liabilities. 115

116 Liability Liquidity Measures Volatile Deposits The difference between actual current deposits and the base estimate of core deposits 116

117 Longer-Term Liquidity Planning Projections are separated into: Base Trend Short-Term Seasonal Cyclical Liquidity Needs Equals Forecasted change in loans + change in required reserves forecasted change in deposits 117

118 Forecasts of trend, seasonal, and cyclical components of deposits and loans reference balance sheet. Assets Liabilities Cash and due from banks $ 160 Transaction accounts and nonnegotiable deposits $1,600 Loans 1,400 Certificates of deposit and other borrowing 280 Investment securities 400 Stockholders' equity 120 Other assets 40 Total $2,000 Total $2,

119 Forecasts of trend, seasonal, and cyclical components of deposits and loans Deposit forecast End of Month Trend Deposits (2) Seasonal Deposit lndext (3) Seasonal Deposits - Dec. Deposits (4) Cyclical Deposits (5) Total January $1,608 99% -$16 -$3 $1,589 February 1, ,656 March 1, ,710 April 1, ,753 May 1, ,656 June 1, ,575 July 1, ,528 August 1, ,574 September 1, ,619 October 1, ,696 November 1, ,755 December 1, ,

120 Forecasts of trend, seasonal, and cyclical components of deposits and loans Loan forecast End of Month Trend Loans* Seasonal Loan lndext Seasonal Loan- Dec. Loans Cyclical Loans Total January $1, % $14 $6 $1,433 February 1, ,376 March 1, ,352 April 1, ,349 May 1, ,410 June 1, ,506 July 1, ,616 August 1, ,611 September 1, ,577 October 1, ,529 November 1, ,525 December 1, ,

121 Monthly liquidity needs The bank s monthly liquidity needs are estimated as the forecasted change in loans plus required reserves minus the forecast change in deposits: Liquidity needs = Forecasted Dloans + Drequired reserves - forecasted Ddeposits 121

122 Estimates of Liquidity Needs End of Month DDeposits DRequired Reserves DLoans Liquidity Needs* January $ 33.0 $42.9 February March April May June July August September October November December

123 Liquidity GAP measures Management can supplement this information with projected changes in purchased funds and investments with specific loan and deposit flows. The bank can calculate a liquidity GAP by classifying potential uses and sources of funds into separate time frames according to their cash flow characteristics. The Liquidity GAP for each time interval equals the dollar value of uses of funds minus the dollar value of sources of funds. 123

124 Liquidity gap estimates (millions of dollars) 0 30 Days Days Days Potential Uses of Funds Add: Maturing time deposits Small time deposits Certificates of deposit over $100, Eurodollar deposits Plus: Forecast new loans Commercial loans Consumer loans Real estate and other loans Minus: Forecast net change in transactional accounts Demand deposits NOW accounts Money market deposit accounts Total uses $ ,260.0 Potential Sources of Funds Add: Maturing investments Money market instruments U.S. Treasury and agency securities Municipal securities Plus: Principal payments on loans Total sources Periodic Liquidity GAP Cumulative Liquidity GAP

125 Potential funding sources (millions of dollars) 0 30 Days Time Frame Days Days Purchased Funds Capacity Federal funds purchased (overnight and term) $20 $20 $30 Repurchase agreements Negotiable certificates of deposit Local National Eurodollar certificates of deposit Total $120 $120 $145 Additional Funding Sources Reductions in federal funds sold $5 $5 $5 Loan participations Sale of money market securities Sale of unpledged securities Total $40 $40 $40 Potential Funding Sourcesa $160 $160 $185 Potential Extraordinary Funding Needs 50% of outstanding letters of credit % of unfunded loan commitments Total $30 $40 $ Excess Potential Funding Sources $130 $120 $135

126 Considerations in Selecting Liquidity Sources Asset Sales Brokerage fees Securities gains or losses Foregone interest income Any increase or decrease in taxes Any increase or decrease in interest receipts 126

127 Considerations in Selecting Liquidity Sources New Borrowings Brokerage fees Required reserves FDIC insurance premiums Servicing or promotion costs Interest expense 127

128 Considerations in Selecting Liquidity Sources The costs should be evaluated in present value terms because interest income and expense may arise over time The choice of one source over another often involves an implicit interest rate forecast 128

129 Bank Management, 6th edition. Timothy W. Koch and S. Scott MacDonald Copyright 2006 by South-Western, a division of Thomson Learning Funding the Bank and Managing Liquidity Chapter 8 William Chittenden edited and updated the PowerPoint slides for this edition. 129