McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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Prudence Wood
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1 Funding the Bank

2 Key Issues Depository Institutions Are Faced With: Where can funds be raised at lowest possible cost? 2. How can management ensure that there are enough deposits to support lending and other services the public demands?

3 12-3 Types of Deposit Accounts Transaction (Payment or Demand) Deposits Making Payment on Behalf of Customers One of The Oldest Services Provider is Required to Honor Any Withdrawals Immediately Nontransaction (Savings or Thrift) Deposits Longer-Term Higher Interest Rates Than Transaction Deposits Generally Less Costly to Process and Manage

4 12-4 Transaction Deposit An Account Used Primarily to Make Payments for Purchases of Goods and Services

5 12-5 Types of Transaction Deposits Noninterest-Bearing Demand Deposits Interest Was Prohibited by Glass-Steagall Act One of the Most Volatile and Unpredictable Sources of Funds Most Deposits are Held by Business Firms Interest-Bearing Demand Deposits Negotiable Orders of Withdrawal (NOW)- hybrid savings instrument Money Market Deposit Account (MMDA) and Super NOW due to Garn-St Germain Depository Institution Act of 1982

6 12-6 Nontransaction (Savings or Thrift) Deposit An Account Whose Primary Purpose is to Encourage the Bank Customer to Save Rather than Make Payments

7 12-7 Types of Savings or Thrift Deposits Passbook Savings Account Statement Savings Deposit Time Deposit (CD) Individual Retirement Account (IRA) - The Economic Recovery Tax Act of1981 Keogh Deposit have tax benefits Roth IRA The Tax Relief Act of 1997 Allows Non- Tax-Deductible Contributions Default Option Retirement Plans The Pension Protection Act of 2006

8 12-8 Interest Rates on Deposits Depend On: The Maturity of the Deposit The Size of the Offering Institution The Risk of the Offering Institution Marketing Philosophy and Goals of the Offering Institution

9 The Changing Composition of Deposits in the United States

10 12-10 Core Deposits A Stable Base of Funds that is Not Highly Sensitive to Movements in Market Interest Rates (Low Interest-Rate Elasticity) and Which Tend to Remain with the Bank

11 12-11 Pricing Deposit-Related Services The Glass-Steagall Act of 1933 Federal Limits on Interest Rates Paid on Deposits why? Nonprice Competition The Depository Institutions Deregulation Act of 1980 Cost-Plus Pricing Marginal Cost of Deposits Conditional Pricing Relationship Pricing

12 12-12 Cost Plus Profit Deposit Pricing Unit Price Charged the Customer for Each Service = Operating Expense Per Unit of Deposit Service + Estimating Overhead Expense Allocated to the Deposit Function + Planned Profit from Each Service Unit Sold

13 12-13 The Marginal Cost Approach: Historical Average Cost Approach Determines the Bank s Cost of Funds by Looking at the Past. It Looks at What Funds the Bank Has Raised to Date and What those Funds Have Cost

14 12-14 Pooled Funds Approach Determine the Bank s Cost of Funds by Looking at the Future. What minimum Rate of Return is the Bank Going to Have to Earn on Any Future Loans and Securities to Cover the Cost of all New Funds Raised?

15 12-15 Using Marginal Cost to Set Interest Rates on Deposits Many Financial Analysts Would Argue That the Added Cost (Not Weighted Average Cost) of Bringing New Funds into the Bank Should Be Used to Price Deposits.

16 Using Marginal Cost to Choose the Interest Rate to Offer Customers on Deposits

17 12-17 Market Penetration Deposit Pricing The Method of Selling Deposits That Usually Sets Low Prices and Fees Initially to Encourage Customers to Open an Account and Then Raises Prices and Fees Later On.

18 12-18 Conditional Pricing Schedule of Fees were Low If Customer Stayed Above Some Minimum Balance - Fees Conditional On How the Account Was Used Conditional Pricing Based On One or More Of the Following Factors The Number of Transactions Passing Through the Account The Average Balance Held in the Account During the Period The Maturity of the Deposit

19 Example of the Use of Conditional Deposit Pricing by Two Banks Serving the Same Market Area

20 12-20 Upscale Target Pricing Bank Aggressively Goes After High-Balance, Low-Activity Accounts. Bank Uses Carefully Designed Advertising to Target Established Business Owners and Managers and Other High Income Households.

21 12-21 Relationship Pricing The Bank Prices Deposits According to the Number of Services Purchased or Used. The Customer May Be Granted Lower Fees or Have Some Fees Waived If Two or More Services are Used.

22 Factors in Household and Business Customers Choice of a Financial Firm for Their Deposit Accounts (ranked from most important to least important)

23 13-23 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

24 Recent Growth in Nondeposit Sources of Borrowed Funds at FDIC-Insured Banks and Thrifts

25 13-25 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

26 13-26 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.

27 13-27

28 13-28 Types of Fed Funds Loan Agreements Overnight Loans Negotiated via wire or telephone, returned the next day Normally not secured by specific collateral, although might Term Loans Longer term Fed funds contracts (several days, weeks, or months) Continuing Contracts Automatically renewed each day Normally between smaller respondent institutions and their larger correspondents

29 13-29 Repurchase Agreements Can be Thought of as Collateralized Fed Funds Transactions; More Complex; Less Exposure to Credit Risk 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

30 13-30 Borrowing from the Fed: The Three Types of Loans at the 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 (Why? See the Real Banks, Real Decisions box). 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

31 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 Has 12 Regional Banks Has Federal Charter and Can Borrow Cheaply and Pass Savings to Institutions 13-31

32 13-32 Negotiable CD 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

33 13-33 The Four Types of Negotiable CDs Domestic CDs Issued By Domestic Banks in the U.S. Euro CDs Dollar Denominated CDs Issued 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.

34 13-34 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 Labeled Liabilities to Foreign Branches When a Foreign Branch Lends Eurodeposits to its Home Office

35 13-35 Commercial Paper Short-Term Notes With Maturities from 3 or 4 Days to 9 Months Issued By Well-Known Companies. Two Types Industrial Paper- -Purchase Inventories Finance Paper Issued by Finance Companies and Financial Holding Companies Banks Cannot Issue These Directly But Affiliated Companies Can Issue Them.

36 13-36 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

37 13-37 Gap is Based on: The Funds Gap Current and Projected Demand and Investments the Bank Desires to Make Current and Expected Deposit Inflows and Other Available Funds Size of This Gap Determines Need for Nondeposit Funds

38 13-38 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

Chapter 2 Government Policies and Regulation

Chapter 2 Government Policies and Regulation Multiple Choice 1. Historically, a commercial bank was defined as a firm that: a. accepted NOW accounts and made consumer loans. b. accepted demand deposits