Chapter Thirteen Managing Nondeposit Liabilities Copyright © 2013 The McGraw-Hill Companies, Inc....

Chapter Thirteen

Managing Nondeposit Liabilities

Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

McGraw-Hill/IrwinBank Management and Financial Services, 7/e

© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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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Introduction

• The traditional source of funds for most depository institutions is the deposit account

• But what does management do to find new money when deposit volume is inadequate to support all loans and investments these institutions would like to make?

• In this chapter we explore yet another important nondeposit source of funding – selling IOUs in the money and capital markets for periods of time that may stretch from overnight to several years

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Liability Management and the Customer Relationship Doctrine• The Customer Relationship Doctrine

▫ The first priority of a lending institution is to make loans to all those customers from whom the lender expects to receive positive net earnings

• Thus, lending decisions often precede funding decisions▫ All loans and investments whose returns exceed their cost and whose

quality meets the lending institution’s credit standards should be made• If enough deposits are not immediately available to cover these loans

and investments, then management should seek out the lowest-cost source of borrowed funds available to meet its customers’ credit needs

• During the collapse of the subprime mortgage market in the 2007-2009 business recession, regulators found that many mortgage lenders went overboard in approving loans, falling well below normal industry standards with little or no documentation

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Liability Management and the Customer Relationship Doctrine (continued)• Liability Management▫ During the 1960s and 1970s, the customer relationship doctrine

spawned the liquidity management strategy known as 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

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TABLE 13–1 Sample Use of Nondeposit Funds Sources to Supplement Deposits and Make Loans

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Alternative Nondeposit Sources of Funds

• Federal Funds Market• Repurchase Agreements• Borrowing from Federal Reserve Banks• Advances from the Federal Home Loan Bank• Negotiable CDs• Eurocurrency Deposit Market• Commercial Paper• Long-Term Nondeposit Funds Sources

• 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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TABLE 13–2 Recent Growth in Nondeposit Sources of Borrowed Funds at FDIC-Insured Banks and Thrifts

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TABLE 13–3 The Relationship between the Size of Banks and Their Use of Nondeposit Borrowings (2007 figures for FDIC-insured banks)

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Alternative Nondeposit Sources of Funds (continued) • Federal Funds Market

▫ Borrowing from Federal Reserve Banks▫ Immediately available reserves are traded between financial institutions

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▫ Types of Fed Funds Loan Agreements▫ Overnight Loans▫ Negotiated via wire or telephone, returned the next day▫ Normally not secured by specific collateral

▫ 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

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Alternative Nondeposit Sources of Funds (continued) • Repurchase Agreements (RPs) as a Source of Funds▫ Less popular than Fed funds and more complex▫ Viewed as collateralized Fed funds transactions▫ With RPs, the purchaser of Fed funds provides collateral in the

form of marketable securities, reducing the credit risk▫ Most domestic RPs are transacted across the Fed Wire system▫ An RP transaction is often for overnight funds▫ It may be extended for days, weeks, or even months

▫ Major innovation in the RP market was the invention of General Collateral Finance (GCF) RPs

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Alternative Nondeposit Sources of Funds (continued) • Borrowing from Federal Reserve Banks

▫ The Fed will make the loan through its discount window by crediting the borrowing institution’s reserve account

▫ Each loan made by the Federal Reserve banks must be backed by collateral acceptable to the Fed

▫ Several types of loans are available from the Fed’s discount window▫ Primary Credit▫ This loan is available for short terms and to institutions in sound financial

condition▫ Rate is slightly higher than the federal funds rate

▫ Secondary Credit▫ These loans are available at a higher interest rate to institutions not

qualifying for primary credit▫ Seasonal Credit▫ These loans cover longer periods than primary credit for small and

medium institutions experiencing seasonal swings in deposits and loans

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Alternative Nondeposit Sources of Funds (continued) • Advances from Federal Home Loan Banks ▫ 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▫ Federal Home Loan Bank (FHLB) System has 12 regional banks▫ Has federal charter and can borrow cheaply and pass savings on

to institutions

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Alternative Nondeposit Sources of Funds (continued) • Development and Sale of Large Negotiable CDs ▫ 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▫ Types of Negotiable CDs▫ Domestic CDs.▫ Euro CDs▫ Yankee CDs▫ Thrift CDs▫ Fixed-rate CDs▫ Variable-rate CDs

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Alternative Nondeposit Sources of Funds (continued) • Development and Sale of Large Negotiable CDs ▫ Interest rates on fixed-rate CDs are quoted on an interest-

bearing basis and the rate is computed assuming a 360-day year▫ Represent the majority of all large negotiable CDs issued▫ Example▫ Suppose a depository institution promises an 8 percent annual

interest rate to the buyer of a $100,000 six-month (180-day) CD▫ The depositor will have the following at the end of six months

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Alternative Nondeposit Sources of Funds (continued) • The Eurocurrency Deposit Market

▫ Eurocurrency deposits were developed originally in Western Europe to provide liquid funds that could be swapped among multinational banks or loaned to the banks’ largest customers

▫ Eurodollars are dollar-denominated deposits placed in bank offices outside the United States▫ Because they are denominated on the receiving banks’ books in dollars

rather than in the currency of the home country and consist of accounting entries in the form of time deposits, they are not spendable on the street like currency

▫ Most Eurodollar deposits are fixed-rate time deposits▫ Floating-rate CDs (FRCDs) and floating-rate notes (FRNs) were

introduced in an effort to protect banks and their Eurodepositors from the risk of fluctuating interest rates

▫ The Eurocurrency market is the largest unregulated financial marketplace in the world

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Alternative Nondeposit Sources of Funds (continued) • Commercial Paper Market

▫ Commercial paper consists of short-term notes, with maturities normally ranging from three or four days to nine months, issued by well-known companies to raise working capital▫ Industrial Paper – purchase inventories▫ Finance Paper – Issued by finance companies and financial holding

companies▫ The notes are generally sold at a discount from face value through

security dealers or through direct contact with the issuing company▫ This funds source tends to be high in volume and moderate in cost but

also volatile in available capacity and subject to credit risk▫ Recently foreign banks have accelerated their mining of both European

and American paper markets despite the pressures of the Great Recession

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Alternative Nondeposit Sources of Funds (continued) • Long-Term Nondeposit Funds Sources ▫ The nondeposit sources of funds discussed to this point are

mainly short-term borrowings ▫However, many financial firms also tap longer-term

nondeposit funds stretching well beyond one year▫ Examples include mortgages issued to fund the construction

of buildings and capital notes and debentures▫ These longer-term nondeposit funds sources have remained

relatively modest over the years due to regulatory restrictions and the augmented risks associated with long-term borrowing

▫Also, because most assets and liabilities held by depository institutions are short- to medium-term, issuing long-term indebtedness creates a significant maturity mismatch

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Choosing among Alternative Nondeposit Sources• The demand for nondeposit funds is determined basically

by the size of the gap between the institution’s total credit demands and its deposits and other available monies

• Gap is based on:▫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 the need for nondeposit funds

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Choosing among Alternative Nondeposit Sources (continued)• Nondeposit Funding Sources: Factors to Consider

1. The relative costs of raising funds from each source2. The risk (volatility and dependability) of each funding

source3. The length of time (maturity or term) for which funds are

needed4. The size of the institution that requires more funds5. Regulations limiting the use of alternative funds sources

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Choosing among Alternative Nondeposit Sources (continued)• A good formula for doing cost comparisons among alternative

sources of funds

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Quick Quiz

• What is liability management?• What advantages and risks does the pursuit of liability management bring

to a borrowing institution?• What is the customer relationship doctrine, and what are its implications

for fund-raising by lending institutions?• What are the principal advantages to the borrower of funds under an RP

agreement?• What are the advantages of borrowing from the Federal Reserve banks or

other central bank? Are there any disadvantages? • How is a discount window loan from the Federal Reserve secured? Is

collateral really necessary for these kinds of loans?• Why were negotiable CDs developed?• What is the available funds gap?• What factors must the manager of a financial institution weigh in choosing

among the various nondeposit sources of funding available today?

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Chapter Thirteen Managing Nondeposit Liabilities Copyright © 2013 The McGraw-Hill Companies, Inc....

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