PRICING OF THE PRODUCT

Transcription

1 PRICING OF THE PRODUCT L E A R N I N G O B J E C T I V E S After completing this chapter you should be able to: 1. understand the concept and function of front office. 2. describe the concept and function of mid office. 3. understand the concept and function of back office. 4. understand the meaning of dealers and roles and responsibilities. Unit 6: Pricing of the Product LH 4 Deposit pricing-cost plus margin deposit product, Market penetration, Conditional, Relationship, Upscale target pricing. Loan pricing, Base interest rate, Risk based pricing. C H A P T E R O V E R V I E W The purpose of this chapter is to give the reader the idea about the concept and function of front office, mid office and back office, meaning of dealers, dealers room. The chapter ends with a discussion of roles and responsibilities of dealers.

2 144 T R E A S U R Y M A N A G E M E N T DEPOSITS Deposits are the vital input in banking and principal source of capital to fund bank loans and security purchases and help generate profits to support long term growth. They are the different items on a bank s balance sheet than other business firm s balance sheet. The ability of a bank s management and staff to attract various deposits from businesses and consumers is an important measure of the bank s acceptance by the public. Deposits are the raw material for bank loans and thus represent the ultimate source of bank profits and growth. Deposits generate cash reserves, and it is out of the excess cash reserves a bank holds that new loans are created. The collection of the deposit with the lowest possible cost is the important indicator of the management effectiveness. If the sufficient deposits are collected then the bank can loans to the customers. INTEREST RATES OFFERED ON DIFFERENT TYPES OF DEPOSITS A different type of deposits carries a different interest rate. In general, the longer the maturity of a deposit, the greater the yield that must be offered to depositors, because of the time value of money. Savings deposits are subject to immediate withdrawal by the customer, the interest rate offered by the bank is the lowest of all deposits. On the other hand, certificate of deposits of a year or longer to maturity often carry the higher interest rates that bank offer. The size and risk exposure of the offering banks also pay an important role in determining the interest rates. For example, Nepal Standard Chartered Bank Nepal and Nabil Bank Ltd are able to offer deposits at the lowest interest rates due to their greater size and strength. On the other hand, the new banks offer higher interest rate due to the high risk and small in size. The other factors are marketing philosophy and goals of the offering bank. COMPOSITION OF BANK DEPOSITS The most readily salable deposits banks that offered to the public have been time and savings deposits. The best mix of deposits would generally prefer a high proportion of demand deposits and low yielding time and savings deposits. These accounts are among the least expensive of all bank sources of funds and often include a substantial percentage of core deposits. Many core

3 P R I C I N G O F T H E P R O D U C T Chapter deposits have an effective maturity often spanning several years. Thus, the availability of a large block of core deposits increases the duration of a bank s liabilities and makes the institution less vulnerable to swings in interest rates. However, the combination of inflation, deregulation, stiff competition, and better educated customers has resulted in a dramatic shift in the mix of deposits banks are able to sell. Due to high competition between banks, Nepalese banks also offer various scheme to attract the customers. PRICING DEPOSIT RELATED SERVICES Recent deregulation of the banking industry has encouraged bankers to think creatively about their deposit pricing policies. The most popular of these deposit pricing approaches is the setting of price schedules where the fee the customer is assessed is conditional on the degree to which he/she uses a particular deposit service. This approach gives customers more options in choosing the particular deposit plan they find the least expensive and signals to banker information about the customer s money using habits. In a financial marketplace, bank management must decide if it wishes to attract more deposits and hold all those it currently has by offering depositors at least the market determined price. The deposit pricing models are discussed in the following section. ILLUSTRATION 1 COST-PLUS DEPOSIT PRICING In cost plus profit pricing, a estimates all the operating and overhead costs incurred in providing each deposit service unit and adds in a margin for profit to compensate the bank s shareholders for placing their funds at the bank s disposal. The price of deposit services can be calculated from the following cost plus profit deposit pricing formula: Unit price charged Operating expense Estimated overhead Planned profit the customer for = per unit of + expense allocated to the + from each deposit each deposit service deposit service bank s deposit function service unit sold Deposits are usually priced separately from loans and other bank services and each deposit service is often priced high enough to recover all or most of the cost of providing that service. A bank determines from an analysis of its cost accounting figures that for each Rs 1,000 minimum balance checking account it sells, account processing and other operating costs will average Rs 4 per

4 146 T R E A S U R Y M A N A G E M E N T month and overhead expenses will run an average of Rs per month. The bank hopes to achieve a profit margin on these particular costs of 8 percent of total monthly costs. What monthly fee should it charge a customer who opens one of these checking accounts? Here given: Minimum balance = Rs 500; operating costs = Rs 4 per month; overhead expenses = Rs 1.15 per month; profit margin = 8 percent on total monthly costs; monthly fee =? We have, Unit price charged the customer for each deposit service = Operating expense per unit of deposit service + Estimated overhead Planned profit expense allocated to the + from each deposit bank s deposit function service unit sold = Rs 4 + Rs (8% of Rs 5.15 i.e. Rs 4 + Rs 1.15) = Rs Therefore the monthly fee is Rs per month. The bank must charge Rs to earn 8 percent profit on total costs. POOLED FUNDS APPROACH The cost plus deposit pricing demands an accurate calculation of the cost of each deposit service. This approach considers the cost of each type of deposits i.e. the weighted average cost of all bank funding sources. This requires the banker (1) to calculate the cost rate of each source of bank funds (adjusted for reserves required by the central bank, deposit insurance fees, and float); (2) to multiply each cost rate by the relative proportion of bank funds coming from that particular source; and (3) to sum all resulting products to derive the weighted average cost of bank funds. This is called pooled funds approach because it is based on the weighted average cost of all bank funding sources. This method determines the 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. Step 1: Calculate the cost rate of each source of bank funds Interest and noninterest fund raising costs Cost rate for related deposits = (1 reserve requirement in fraction) Interest and noninterest fund raising costs Cost rate for owner s capital = 1 Step 2: Calculate the proportion of the bank funds Related eposits Proportion of related deposits = Total funds raised Proportion of owner s capital = Owner's capital Total funds raised Step 3: Multiply result of step 1 and step 2 to get the weighted average before tax cost

5 P R I C I N G O F T H E P R O D U C T Chapter ILLUSTRATION 2 We have, Weighted average cost = Proportion of deposit cost rate of deposit + Proportion of owner s capital cost rate of owner s capital The pooled funds approach provides bank managers with a way to calculate the effects of any change in bank funding costs or deposit prices. Suppose a bank has raised a total of Rs 200 million, including Rs 50 million in checkable deposits, Rs 100 million in time and savings deposits, Rs 25 million borrowed from the money market, and Rs 25 million from its owners in the form of equity capital. Suppose that interest and non-interest costs spent to attract the checkable deposits total 8 percent of the amount of these deposits, while thrift deposits and money market borrowings each cost the bank 9 percent of funds raised in interest and non-interest expenses. Owners equity is the most expensive funding source for most banks; assume that equity capital costs the bank an estimated 20 percent of any new equity raised. Suppose reserve requirements, deposit insurance fees, and uncollected balances (float) reduce the amount of money actually available to the bank for investing in interest bearing assets by 14 percent for checkbook deposits, 4 percent for thrift deposits, and 2 percent for borrowings in the money market. What is the bank s weighted average before tax cost of funds? Here given: Total amount raised = Rs 200 million; Amount of checkable deposits = Rs 50 million; Amount in time and savings deposits = Rs 100 million; Borrowed from money market = Rs 25; Amount of equity capital = Rs 25 million; interest and non interest cost for checkable deposits = 8%; interest and non interest cost for time and savings and money market borrowings = 9%; Cost of equity capital = 20%; reserve required for checkable deposit = 14%; reserve required for thrift deposits = 4%; reserve for borrowings in the money market = 2%; bank s weighted average before tax cost of funds =? Weightage average before tax cost of funds Checkbook deposits = + + = Total funds raised Time and savings depsoits Total funds raised Interest and noninterest fund raising costs 100 percent Percentage reserve requirements and float Owner's capital Interest and noninterest costs Total funds raised 100 percent Rs 50 million Rs 200 million 8 percent (100 percent - 14 percent) Rs 100 million + Rs 200 million 9 percent (100 percent - 4 percent) Rs 25 million + Rs 200 million 9 percent (100 percent - 2 percent) Rs 25 million + Rs 200 million 20 percent 100 percent = = or percent of funds raised Interest and noninterest fund raising costs 100 percent Percentage reserve requirements and float

6 148 T R E A S U R Y M A N A G E M E N T The bank management earn at least a before tax rate of return of percent on its portfolio of loans and other earnings assets. If the bank can earn more from its loans and investments than percent before taxes, the extra return (less tax) will flow to the stockholders in the form of increased dividends and into retained earnings to strengthen the bank s capital. MARGINAL COST PRICING Marginal cost is the added cost of bringing in new funds. Marginal cost pricing set the price at a level just sufficient to attract new deposits and still earn a profit on the last rupee of new funds raised It is more realistic than weighted average cost to price the deposits and other bank funds sources. If the interest rates are declining, the added cost of raising new money may fall well below the average cost over all funds raised by the bank. Some loans and investments that looked unprofitable when compare to average cost will now look quite profitable when measured against the lower marginal interest cost. If interest rates are on the rise, the marginal cost of today s new money may substantially exceed the bank s average cost of funds. If bank books new loans based on average cost, they may be highly unprofitable when measured against the higher marginal cost of raising new funds. The new loan yield represents marginal revenue, the added operating revenue the bank will generate by making new loans from the new deposits. The marginal cost of money deposit rate from one level to another and the marginal cost rate is the percentage cost of the volume of additional funds coming into the bank. The marginal cost rate must be compare with the expected additional revenue (marginal revenue) the bank expects to earn from investing its new deposits. Marginal cost and marginal cost rate is calculated as follows: Marginal cost* = New interest rate total funds raised at new rate Old interest rate total funds raised at old rate Change in total cost Marginal cost rate = Additional funds raised The marginal cost approach provides valuable information to bank managers about the setting deposit interest rates and decide in expanding the its deposit base. When the profits to fall, management needs either to find new sources of funding with lower marginal costs or to identify new loans and investments promoting greater marginal revenues or both. * Marginal cost also known as change in total cost and alternative formula is:

7 P R I C I N G O F T H E P R O D U C T Chapter ILLUSTRATION 3 Current marginal cost previous marginal cost. Sunrise Bank Limited finds that it can attract the following amounts of deposits if it offers new depositors and those rolling over their maturing certificate of deposits the interest rates indicated below: Expected volume of new deposits Rate of interest offered depositors Rs 5 million 5.0% Rs 10 million 6.0 Rs 15 million 7.0 Rs 18 million 8.0 Rs 22 million 9.0 Management anticipates being able to invest any new deposits raised in loans yielding 10 percent. How far should the bank go in raising its deposit rate in order to maximize total profits (excluding interest costs)? Expected volume of new deposits Interest rate on deposits Total interest cost on deposits Marginal cost = Current total interest cost Previous interest cost Marginal cost rate Marginal revenue Diff. in marginal revenue and marginal cost rate Total profits earned (after interest cost)* (1) (2) (3) = (1) (2) (4) (5) = (4)/ deposits (6) (7) = (6) (5) Rs 5 5% Rs 0.25 Rs % 10% 5% Rs % % 10% 3% % % 10% 1% % % 10% 3% % % 10% 3.5% 0.22 The Sunrise Bank Limited must issue Rs 15 million in deposits for maximum profits after interest cost i.e. Rs 0.45 million. Working note: *Total profits = New deposit Marginal revenue rate New deposit Marginal cost rate For 5 million deposits: Total profit = = Rs 0.25 For 10 million deposits: Total profit = = Rs 0.40 For 15 million deposits: Total profit = = Rs 0.45 For 18 million deposits: Total profit = = Rs 0.36 For 22 million deposits: Total profit = = Rs 0.22 (8)

8 150 T R E A S U R Y M A N A G E M E N T MARKET PENETRATION DEPOSIT PRICING This method does not emphasize profits and cost recovery, at least in the short run. The method offer high interest rates and low fees well below the market standards in order to bring in as many new customers as possible. Initially customers are encourage to opening an account and then raise prices and fees later on. Management hopes that the resulting larger deposit volume and the associated loan business brought in will offset a lower profit margin. Market penetration pricing is a strategy aimed primarily at rapidly growing markets in which a bank is determined to capture the largest possible market share. PRICE SCHEDULES TO SEGMENT DEPOSIT Under this method, interest rate the customer may earn and the fees are conditional on the intensity of use of deposit services and the balance in the account. So, it is called conditional pricing. The bank sets up a schedule of fees in which the customer pays a low fee or even no fee if the deposit balance remains above some minimum level; but higher fee is assessed if the average balance falls below that minimum. Thus, the customer pays a price conditioned on how he/she uses the deposit. UPSCALE TARGET PRICING Upscale target pricing setting of prices and fees on deposit accounts in an effort to attract those customers who hold high balances and purchase the bank services. They use carefully designated advertising programs to target established professionals (e.g., doctors and lawyers), business owners and managers, and other high income households with services and service fees that build in high profit margins. Other deposit accounts, especially the low balance, high activity ones, may be priced to break even or they may be discouraged altogether through higher prices. RELATIONSHIP PRICING The price of the deposit depends on the number of services the customer uses. The customers who buy two or more bank services may be granted lower deposit fees or have some fees waived compared to the fees charged customers having only a limited relationship to the bank. The selling of

9 P R I C I N G O F T H E P R O D U C T Chapter multiple services increases the customer s dependence on the bank and makes it harder for that customer to go elsewhere because of strong relationship between customer and bank. Thus, relationship pricing promotes grater customer loyalty and makes the customer less sensitive to the interest rates offered on deposits or the prices posted on the banking services by competing financial service firms. LOAN PRICING BANK GOAL DEPOSIT PRICING This deposit pricing is used to protect and increase the bank profitability rather than to simply add more customers, take make shares away from competitors, or even drive less desirable customers away. BASE INTEREST RATE The base rate is a rate set by a bank below which it cannot lend. Banks currently use a number of methods to calculate their base rates, such as using their average, blended or marginal cost of funding. Base rate = Cost of fund + Cost of CRR + Cost of SLR + Cost of operating expense + Return on assets = Working notes 1. Cost of funds = Monthly average cost of fund (LCY deposits + Borrowings) Cost of maintaining compulsory 5% Average cost of funds 2. Cost of CRR = Average deployable fund 3. Cost of SLR Cost of maintaining SLR (Cost of funds - Average return of government securities) Average cost of fund Average deployable fund Net cost of maintaining SLR = Annualized operating cost 85% 4. Cost of operating expense = Average deployable fund 5. Return on assets = Flat 0.75%

10 152 T R E A S U R Y M A N A G E M E N T ILLUSTRATION 4 Kanchanjanga Commercial bank has estimated the following elements of interest rates. Cost of fund 3.07% Cost of CRR 0.21% Cost of SLR 0.03% Cost of operating expense 2.02% Calculate the base interest rate for the bank. Base rate = Cost of fund + Cost of CRR + Cost of SLR + Cost of operating expense + Return on assets = 3.07% % % % % = 6.08% RISK BASED PRICING SELF CORRECTION PROBLEMS ILLUSTRATION 5 EIN Bank finds that it can attract the following amounts of deposits if it offers new depositors and those rolling over their maturing CDs the interest rates indicated below: Expected volume of new deposits Rate of interest offered depositors Rs 5 million 5.0% 15 million million million million 7.0 Management anticipates being able to invest any new deposits raised in loans yielding 8 percent. How far should the bank go in raising its deposit rate in order to maximize total profits (excluding interest costs)?

11 P R I C I N G O F T H E P R O D U C T Chapter Expected volume of new deposits Interest rate on deposits Total interest cost on deposits Marginal cost = Current total interest cost Previous interest cost Marginal cost rate Marginal revenue Diff. in marginal revenue and marginal cost rate Total profits earned (after interest cost)* (1) (2) (3) = (1) (2) (4) (5) = (4)/ deposits (6) (7) = (6) (5) Rs % 8% 3% Rs % 2.25% % 0.125% % 1.67% % 8% 10% 0.23 The bank should issue Rs 19 million in deposits for maximum profits after interest cost i.e. Rs 0.38 million. Working note: *Total profits = New deposit Marginal revenue rate New deposit Marginal cost rate For 5 million deposits: Total profit = = Rs 0.15 For 15 million deposits: Total profit = = Rs For 19 million deposits: Total profit = = Rs 0.38 For 22 million deposits: Total profit = = Rs 0.33 For 23 million deposits: Total profit = = Rs 0.23 (8) ILLUSTRATION 6 EIN Bank finds that it can attract the following amounts of deposits if it offers new depositors and those rolling over their maturing certificates of deposits (CDs) the interest rates indicated below: Expected volume of new deposits Rate of interest offered depositors Rs. 10 million 5.0% 20 million million million million 9.0 Management anticipates being able to invest any new deposits raised in loans yielding 8 percent. How far should the bank go in raising its deposit rate in order to maximize total profits (excluding interest costs)? Expected volume of new deposits Interest rate on deposits Total interest cost on deposits Marginal cost = Current total interest cost Previous interest cost Marginal cost rate Marginal revenue Diff. in marginal revenue and marginal cost rate Total profits earned (after interest cost)* (1) (2) (3) = (1) (2) (4) (5) = (4)/ deposits (6) (7) = (6) (5) (8)

12 154 T R E A S U R Y M A N A G E M E N T Rs 10 5% Rs 0.5 Rs % 8% 3% Rs % % 8% 1% % % 8% 1% % % 8% 3% % % 8% 5% 0.50 EIN bank must issue Rs 20 million in deposits for maximum profits after interest cost i.e. Rs 0.40 million. Working note: *Total profits = New deposit Marginal revenue rate New deposit Marginal cost rate For 10 million deposits: Total profit = = Rs 0.30 For 20 million deposits: Total profit = = Rs 0.40 For 30 million deposits: Total profit = = Rs 0.30 For 40 million deposits: Total profit = = Rs 0.00 For 50 million deposits: Total profit = = Rs 0.50 ILLUSTRATION 7 Kamal maintains a savings deposit with Sabina National Bank. This past year Kamal received Rs in interest earnings from his savings account. His savings deposit had the following average balance each month: January Rs 400 July Rs 350 February 250 August 425 March 300 September 550 April 150 October 600 May 225 November 625 June 300 December 300 What was the annual percentage yield (APY) earned on Kamal s account? Here given: Interest received = Rs Annual percentage yield (APY) =? We have, Interest earned APY = Average daily balance = Rs = Or, 3.28% Rs Working notes: Daily average balance = ( ) / 12 = Rs ILLUSTRATION 8 Silverton Bank plans to launch a new deposit campaign next week in hopes of bringing in from Rs 100 million to Rs 600 million in new deposit money, which it expects to invest at an 8.75 percent yield. Management believes that an offer rate on new deposits of 5.75 percent would attract Rs 100 million in new deposits and rollover funds. To attract Rs 200 million the bank would probably be forced to offer 6.25 percent. The bank s forecast suggests that Rs 300 million might be available at 6.8 percent,

13 P R I C I N G O F T H E P R O D U C T Chapter Rs 400 million at 8.2 percent, and Rs 600 million at 9 percent. What volume of deposits should the bank try to attract to ensure that marginal cost does not exceed marginal revenue? Expected volume of new deposits Interest rate on deposits Total interest cost on deposits Marginal cost = Current total interest cost Previous interest cost Marginal cost rate Marginal revenue Diff. in marginal revenue and marginal cost rate Total profits earned (after interest cost)* (1) (2) (3) = (1) (2) (4) (5) = (4)/ deposits (6) (7) = (6) (5) Rs % Rs 5.75 Rs % 8.75% 3% Rs % % 8.75% 2% % % 8.75% 0.85% % % 8.75% 3.65% % % 8.75% 1.85% 1.5 EIN bank must issue Rs 300 million in deposits for maximum profits after interest cost i.e. Rs 5.85 million. Working note: *Total profits = New deposit Marginal revenue rate New deposit Marginal cost rate For 100 million deposits: Total profit = = Rs 3 For 200 million deposits: Total profit = = Rs 5 For 300 million deposits: Total profit = = Rs 5.85 For 400 million deposits: Total profit = = Rs 2.20 For 600 million deposits: Total profit = = Rs 1.5 (8) ILLUSTRATION 9 A depositor leaves her funds in the amount of Rs. 5,000 in a credit union deposit account for a full year but then withdraws Rs 1,000 after 270 days. At the end of the year the credit union pays her Rs. 300 in interest. What is this depositor s daily average balance and APY? Here given: Deposit amount = Rs. 5,000 for full year; Withdraws Rs. 1,000 after 270 days; Interest earned at the end of year = Rs. 300; Daily average balance =? We have, Daily average balance = Rs. 5, Rs. 4, = Rs. 4, Interest earned APY = Average daily balance = Rs.300 = or, 6.33% Rs.4, Working note: Remaining deposit for 95 days = Rs 5,000 Rs 1,000 = Rs 4,000

14 156 T R E A S U R Y M A N A G E M E N T ILLUSTRATION 10 A bank customer takes out a CD from his principal bank for 90 days in the amount of Rs. 2,500 and earns Rs. 99 in interest for the 90-day period. What is the depositor s APY? Given, Number of days held = 90 days; Amount deposited = Rs. 2,500; Amount of interest earned = Rs. 99; Amount deposited = Rs. 2,500 daily APY = ( 1 + Amount of interest earned Daily average balance ) Working note: = ( Rs Rs.2,500 ) Average daily balance = 365 days in term = = 17.06% Rs. 2, = Rs. 2,500 SUMMARY This chapter discussed a treasury function of the banks. The key concepts covered are listed below. 1. Treasury Management includes a firm's collections, disbursements, concentration, investment and funding activities. TRUE FALSE QUESTIONS Indicate whether the following statements are True or False. Support your answer with reasons. 1. The principal purpose of asset/liability management has been to increase the size of the firm as measured by total assets. Ans: 1. F; 2. T; 3. F; 4. T; 5. T; 6. F; 7. T; 8. F; 9. T; 10. T; 11. F; 12. T; 13. T; 14. F; 15. F THEORETICAL QUESTIONS 1. What are the major types of deposit plans banks offer today? 2. What are core deposits and why are they so important in banking today? 3. How has the composition of bank deposits changed in recent years? 4. Which deposits are the least costly for banks? The most costly? 5. What is lifeline banking? What pressures does it impose on bank managers?

15 P R I C I N G O F T H E P R O D U C T Chapter NUMERICAL PROBLEMS Problem 1 A bank determines from an analysis of its cost accounting figures that for each Rs.500 minimum balance checking account it sells, account processing and other operating costs will average Rs per month and overhead expenses will run an average of Rs per month. The bank hopes to achieve a profit margin on these particular costs of 10 percent of total monthly costs. What monthly fee should it charge a customer who opens one of these checking accounts? Ans: Rs Problem 2 Nepal Merchant Bank finds that its basic checking account, which requires a Rs 400 minimum balance, costs the bank an average of Rs per month in servicing costs (including labor and computer time) and Rs 1.18 per month in overhead expenses. The bank also tries to build in a Rs 0.50 per month profit margin on these accounts. What monthly fee should the bank charge each customer? Further analysis of customer accounts reveals that for each Rs 100 in average balance maintained in its checking accounts, the bank saves about 5 percent in operating expenses associated with each account. For a customer who consistently maintains an average balance of Rs 1,000 per month, how much should the bank charge this customer and still protect its profit margin? Ans: Rs 4.81 and Rs Problem 3 Use the APY formula required by the Truth and Savings Act for the following calculation. Suppose that a customer holds a savings deposit for a year. The balance in the account stood at Rs. 2,000 for 180 days and Rs. 100 for the remaining days in the year. If the bank paid this depositor Rs in interest earnings for the year, what APY did this customer receive? Ans: % Problem 4 Krishna maintains a savings deposit with Lumbini Bank. This past year Krishna received Rs 15 in interest earnings from his savings account. His savings deposit had the following average balance each month: January Rs 400 July Rs 350 February 250 August 425 March 300 September 550 April 150 October 600 May 225 November 625 June 300 December 300

16 158 T R E A S U R Y M A N A G E M E N T What was the annual percentage yield (APY) earned on Krishna s account? Ans: 4.022% Problem 5 Nepal Bank Limited quotes an APY of 7 percent on a one year money market CD sold to one of the small businesses in town. The firm posted a balance of Rs 2,500 for the first 90 days of the year, Rs 3,000 over the next 180 days, and Rs 2,750 for the remainder of the year. How much in total interest earnings did this small business customer receive for the year? Ans: Rs Problem 6 Suppose a bank has raised a total of Rs 400 million, including Rs 100 million in checkable deposits, Rs 200 million in time and savings deposits, Rs 50 million borrowed from the money market, and Rs 50 million from its owners in the form of equity capital. Suppose that interest and non-interest costs spent to attract the checkable deposits total 10 percent of the amount of these deposits, while thrift deposits and money market borrowings each cost the bank 11 percent of funds raised in interest and non-interest expenses. Owners s equity is the most expensive funding source for most banks; assume that equity capital costs the bank an estimated 22 percent of any new equity raised. Suppose reserve requirements, deposit insurance fees, and uncollected balances reduce the amount of money actually available to the bank for investing in interest bearing assets by 15 percent for checkbook deposits, 5 percent for thrift deposits, and 2 percent for borrowings in the money market. What is the bank s weighted average before tax cost of funds? Ans: 12.88% Problem 7 Suppose Nabil bank expects to raise Rs 25 million in new deposits by offerings its depositors and interest rate of 7 percent. Management estimates that if the bank offers a 7.50 percent interest rate, it can raise Rs 50 million in new deposit money. At 8 percent Rs 75 million is expected to flow in, while a posted deposit rate of 8.5 percent will bring in a projected Rs 100 million. Finally, if the bank promises an estimated 9 percent yield, management projects that Rs 125 million in new funds will appear in the form of new deposits. Management believes it can invest the new deposit money at a yield of 10 percent. Required: a. Total interest cost of new funds raised. b. Marginal cost of new deposit money. c. Marginal cost rate of additional funds. d. Difference between revenue and marginal cost rate.

17 P R I C I N G O F T H E P R O D U C T Chapter e. Total profits earned after interest cost. f. The volume of deposits the bank tries to attract. Ans: e. Rs 0.75,1.25,1.50,1.50, and 1.25 respectively Problem 8 Sunrise Bank finds that it can attract the following amounts of deposits if it offers new depositors and those rolling over their maturing CDs the interest rates indicated below: Expected volume of new deposits Rate of interest offered depositors Rs 5 million 5.0% 15 million million million million 9.0 Management anticipates being able to invest any new deposits raised in loans yielding 9 percent. How far should the bank go in raising its deposit rate in order to maximize total profits (excluding interest costs)? Ans: Profit after interest costs = Rs 0.20; Rs 0.45; Rs 0.38; Rs 0.22; and Rs 0 respectively Problem 9 Himalayan Bank plans to launch a new deposit campaign next week in hopes of bringing in from Rs 100 million to Rs 600 million in new deposit money, which it expects to invest at an 8.75 percent yield. Management believes that an offer rate on new deposits of 5.75 percent would attract Rs 100 million in new deposits and rollover funds. To attract Rs 200 million the bank would probably be forced to offer 6.25 percent. The bank s forecast suggests that Rs 300 million might be available at 6.8 percent, Rs 400 million at 7.4 percent, Rs 500 million at 8.2 percent, and Rs 600 million at 9 percent. What volume of deposits should the bank try to attract to ensure that marginal cost does not exceed marginal revenue? Ans: 300 deposits Problem 10 Everest bank finds that it can attract the following amounts of deposits if it offers new depositors and those rolling over their maturing certificates of deposits the interest rates indicated below: Expected volume of new deposits Rate of interest offered depositors Rs. 20 million 5.0% 40 million million million million 9.0

18 160 T R E A S U R Y M A N A G E M E N T Management anticipates being able to invest any new deposits raised in loans yielding 8 percent. How far should the bank go in raising its deposit rate in order to maximize total profits (excluding interest costs)? Ans: Profit after interest costs = Rs 0.60; Rs 0.80; Rs 0.60; Rs 0; and Rs 1 respectively -