Internal Banking all Grown Up

Susan Fitzgerald (Prager & Co.)James Matteo (University of Virginia)Chris Malins (University of Washington)

January 2012

INTERNAL BANKSAkin to academic medical centers:

“You see one internal bank, you’ve seen one internal bank”

Agenda:

• Definition/History

• Components/Issues

• Survey of internal banks

• Lessons learned

• Case Study: University of Virginia

• Case Study: University of Washington

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WHAT IS THE INTERNAL BANK?Definition – The adoption of one or more banking practices such as cash management, investment management, and debt management to (1) facilitate the flow of resources from external sources to internal uses and/or (2) create unrestricted resources.

General objectives for the Internal Bank:

Centrally manage financial resources

Loans

Investments

Cash balances

Create predictability in capital costs (and working capital returns) for budgeting and planning

Generate funds that can be used for a variety of purposes

Optimize capital financing sources to ensure attractive long-term risk adjusted cost of capital to overall enterprise

Provide a vehicle for working capital/liquidity management

Numerous institution-specific considerations involved in establishing and managing the Internal Bank.

Objectives for the Internal Bank must be determined by the Treasury or the Board

Policy and procedures for management of the Bank must be established

3

EVOLUTION OF THE CENTRAL BANK

Project Specific

Borrowing

Central Bank for Debt

Management

Merging of Debt and Liquidity

Management

Increasingly Sophisticated Management and Oversight

4

KEY DECISION POINTS

• Objectives for funds• Recycling to limit external debt• Redeployment for strategic initiatives• Equity in campus facilities

• Components:• Debt• Working Capital• Other Investments

• Operations:• Funding the bank• Establishing and adjusting the blended rate• Establishing and adjusting the payout rate• Rules for internal loans• Investment of funds• Ongoing monitoring and management

• Reporting:• Internal• Financial statements

• Governance: Board involvement?

5

CASH MANAGEMENT/INVESTMENTS

Cash Management / Investing

Endowment Working Capital Internal Bank Cash

Capi

tal S

ourc

es Debt Service

Internal Bank

Project Funds/Internal Loans

• What are the investment considerations for Internal Bank funds?

• Duration

• Liquidity

• How will the Internal Bank reserves be viewed by member institutions?

• Will operating working capital and internal bank cash be co-mingled?

Discussion Questions

6

PROJECT FUNDS/INTERNAL LOANS

Project 1 Project 2 Project 3

Internal Bank

Capi

tal S

ourc

es Debt Service

Cash Management / Investing

• What is the process/procedures for internal loan origination? What approvals are necessary?

• What is the structure of internal loans? Is there a uniform methodology?

• Principal and interest frequency?

• How are items like capitalized interest and costs structured?

• What is the rate charged to internal loans?

• Pass-thru rate? If equity funded, what is cost of capital assumption?

• Single/blended rate? If so, what is the setting methodology/calculation? How often is rate analyzed? How/when was rate adopted? How often has rate been reset? Are there loans included in the bank but excluded from blended rate?

Discussion Questions

Project Funds/Internal Loans

7

REPORTING AND MANAGING

Outflows Inflows

Fiscal YearBeginning

Balance External DS Expenses Internal DSReinvestment

EarningsEnding

Balance PV @ 3.85%

2011 - (910,329) (80,731) 1,631,097 7,620 647,657 636,686 2012 647,657 (3,565,081) (161,462) 5,633,586 63,287 2,617,986 2,476,592 2013 2,617,986 (7,941,029) (161,462) 11,889,465 204,614 6,609,573 6,016,818 2014 6,609,573 (9,360,467) (161,462) 13,958,203 382,815 11,428,662 10,011,411 2015 11,428,662 (9,498,026) (161,462) 14,105,469 573,632 16,448,275 13,865,218 2016 16,448,275 (9,498,026) (161,462) 14,105,469 770,334 21,664,589 17,573,701 2017 21,664,589 (9,498,026) (161,462) 14,105,469 974,744 27,085,314 21,142,341 2018 27,085,314 (9,498,026) (161,462) 14,105,469 1,187,164 32,718,459 24,576,411 2019 32,718,459 (9,498,026) (161,462) 14,105,469 1,407,909 38,572,348 27,880,986 2020 38,572,348 (9,498,026) (161,462) 14,105,469 1,637,303 44,655,632 31,060,949 2021 44,655,632 (9,498,026) (161,462) 14,105,469 1,875,687 50,977,299 34,120,998 2022 50,977,299 (9,498,026) (161,462) 14,105,469 2,123,412 57,546,691 37,065,656 2023 57,546,691 (9,498,026) (161,462) 14,105,469 2,380,845 64,373,517 39,899,274 2024 64,373,517 (9,498,026) (161,462) 14,105,469 2,648,365 71,467,862 42,626,040 2025 71,467,862 (9,498,026) (161,462) 14,105,469 2,926,369 78,840,212 45,249,981 2026 78,840,212 (9,498,026) (161,462) 14,105,469 3,215,267 86,501,460 47,774,977 2027 86,501,460 (9,498,026) (161,462) 14,105,469 3,515,486 94,462,926 50,204,757 2028 94,462,926 (9,498,026) (161,462) 14,105,469 3,827,469 102,736,376 52,542,913 2029 102,736,376 (9,498,026) (161,462) 14,105,469 4,151,679 111,334,035 54,792,899 2030 111,334,035 (9,498,026) (161,462) 14,105,469 4,488,592 120,268,608 56,958,041

Simple Excel spreadsheet can monitor and model

• Outflows: Debt Service and other Expenses

• Inflows: Payments under internal loans

• Reinvestment earnings

• Ending balance

• Sensitivity to changes in blended rate charged to internal loan or changes in assumptions of reinvestment earnings

8

REPORTING AND MANAGING:FINANCIAL STATEMENTS

Operating StatementRevenues

Internal Loan Interest 26,000 25,000 Investment Income 2,000 4,000

Total Revenues 28,000 29,000

ExpensesExternal Interest 26,000 26,000 Other 1,000 1,000

Increase in Bank Equity 1,000 2,000

Balance SheetAssets

Cash and Investments 46,000 50,000 Internal Loans Receivable 398,000 395,000

Total Assets 444,000 445,000

LiabilitiesLong-Term Debt 321,000 320,000 Commercial Paper 100,000 100,000

Total Liabilities 421,000 420,000

Equity 23,000 25,000

Blended Rate Component:

A blended, or single rate, is established to be charged to all internal loans.

Generally, the initial blended rate is established based on external cost of capital

plus certain administrative and interest rate buffers.

The rate is reviewed annually based on the actual and projected performance of

Internal Bank revenues and resources.

Internal Loan Component:

Procedures developed for application, approval, and tracking of loans.

Loan structures are independent of funding sources.

Internal loan program is presented to schools and divisions.

External Debt Component:

Model to track actual and expected debt service and costs taking into account

timing and risk in debt portfolio.

9

SURVEY OF INTERNAL BANKS IN HIGHER ED: PURPOSE

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

Take Deposits

Op. Portf. Investment

Fund Common Benefits

External/Internal Debt

Source: Treasury Leadership Group Survey, 2010

10

SURVEY OF INTERNAL BANKS IN HIGHER ED: COMMON BENEFITS

0% 5% 10% 15% 20% 25% 30% 35% 40% 45%

Central administration

President/Provost

Capital project funding

Strategic initiatives

Source: Treasury Leadership Group Survey, 2010

11

SURVEY OF INTERNAL BANKS IN HIGHER EDUCATION: INVESTMENT STRATEGIES

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1 2 3 4 5 6 7 8 9 10

Cash/MM Fixed Income Endowment Other

Source: Treasury Leadership Group Survey, 2010

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Constant evolution Written objectives, policies, procedures Ongoing communication―Administrative―Departmental―Governing body Consistency of application How often to change blended rate/payout rate Alterations to investment profiles/risk tolerance of

the bank How to treat certain borrowings and “one offs”:

taxable debt? Refinancing savings? Discipline

LESSONS LEARNED

13

Case Study: University of Virginia

Presenter: Jim Matteo

UVA INTERNAL BANK - OBJECTIVES

Centrally manage financial resources and risks Provide settlement function for cash flows with

endowment

Generate unrestricted resources

Providing units with a full range of services:

Loans

Investments

Cash Balance Tracking

15

UVA INTERNAL BANK - OPERATING PROCEDURES

Bank Activities include debt management, investment management, and cash management.

Internal Bank serves as a settlement agent Executive management involvement is increasing. No

board involvement at this time Distribution of unrestricted resources the biggest

item to be considered

16

UVA INTERNAL BANK - COMPONENTS

17

UVA INTERNAL BANK - FINANCIAL STATEMENTSBalance Sheetas of June 30, 2011

Assets

Cash

Investments - Short Term Internal Bank

Investments - Short Term CRP

Investments - Long Term Internal Bank

Investments - Long Term CRP

Investments - Restricted Debt Proceeds

Internal Loans Receivable

Internal Loans Receivable - Working Capital

Direct Loans Receivable (VCBA & State Issued)

Total Assets

Liabilities

Commercial Paper

Long Term Debt

Bond Premium or Discount

Build America Bonds rebate

Internal Investment Program Deposits

Due to Construction Projects

Due to Departments

Total Liabilities

Equity

Retained Earnings - CRP

Retained Earnings - Internal Bank

Distributions - Internal Bank

Net Assets

Total Net Assets and Liabilities 18

UVA INTERNAL BANK - FINANCIAL STATEMENTSIncome Statementfor the twelve months ended June 30, 2010

Revenues

Income on Bank Deposits

Escrowed Income

Income on ST Investments - IB

Restricted Income on Invested Bond Proceeds

Unrealized Gain/(Loss) on Investments

Unrealized Gain/(Loss) on Investments Restricted - CRP

Internal Loan Income Restricted - CRP

Internal Loan Income - Working Capital

BABS Subsidy

Total Revenues

Expenses

Bank Fees

UVIMCO Management Fee

UVIMCO Incentive Fee

PFM Management Fee

Debt Issuance Fees

Debt Maintenance Fees

Amortizations of Bond Premium

Interest Expense - External Debt

Interest Expense - Internal Investment Program

Operational Expenses

Total Expenses

Net Income

19

UVA INTERNAL BANK - FINANCIAL STATEMENTSStatement of Cash Flowsfor the twelve months ended June 30, 2010

Cash Flows from Operating Activities

Net Income

Unrealized Gain on Investments

Net Cash Flows Provided/(Used) by Operating Activities

Cash Flows from Financing Activities

Increase in Bond Premium/Discount

Decrease in Amounts Due to Departments

Decrease in Due to Construction Projects

Increase in Long-term Debt

Increase in Short-term debt

Decrease in Build America Bond rebate

Decrease in Internal Investment Program Deposits

Net Cash Flows Provided/(Used) in Financing Activities

Cash Flows from Investing Activities

Increase in Internal Loans ReceivableDecrease in Direct Loans ReceivableDecrease in ST Investments

Increase in LT Investments

Increase in Restricted Investments - CRP

Increase in Restricted Investments - Debt Proceeds

Net Cash Flows Provided/(Used) by Investing Activities

Decrease in Cash and Cash Equivalents

Cash and equivalents, July 1

Cash and equivalents, December 31

20

UVA INTERNAL BANK - MODELING

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UVA INTERNAL BANK - MODELING

ReturnStandard Deviation

Target Endowment Weight 100.00% 75.00% Cash/Short Term Investments 0.00% 0.0%Long Term Investments 7.50% 10.0%

Minimum Initial Payout $10,000,000 $10,000,000 Internal Loans Receivable 4.74% 0.0%Capital Reserve Ratio 25.00% 10.00% Commercial Paper 0.12% 0.0%Payout Over X Years 10 10 Long Term Debt 4.17% 0.0%Payout Deferred for X Years 1 1 Internal Investment Program Deposits 0.00% 0.0%Payout Increase Limit Amount 20.00% 10.00% Due to Departments 0.00% 0.0%

Discretionary Payout Yes YesDiscretionary Payout Over X Years 10 -Discretionary Payout Threshold - $10,000,000

Stochastic Returns Yes YesDiscount Rate for PV Calculations 7.50% 7.50%

Treasury Operations Modeling - Consolidated

Assumption CRP IB

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

$250 $467 $684 $900 $1,117 $1,333 $1,550 $1,767

Probability

$MM Present Value

Present Value of Wealth Created

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

2010 2015 2020 2025 2030 2035

Probability

Year

Probability of Negative Equity Value

$0

$50

$100

$150

$200

$250

$300

$350

$400

$450

2010 2015 2020 2025 2030 2035 2040

Annual Payout $MM

Year

Annual Distribution Amount

99%

95%

75%

50%

25%

5%

1%

22

UVA INTERNAL BANK - MODELING

-$20,000,000

$0

$20,000,000

$40,000,000

$60,000,000

$80,000,000

$100,000,000

$120,000,000

$140,000,000

$160,000,000

2010 2015 2020 2025 2030 2035 2040

Annu

al P

ayou

t

Year

Annual Payout

DiscretionaryPayout

-$500,000,000

$0

$500,000,000

$1,000,000,000

$1,500,000,000

$2,000,000,000

$2,500,000,000

$3,000,000,000

$3,500,000,000

$4,000,000,000

2010 2015 2020 2025 2030 2035

Asse

ts

Year

AssetsCash/Short Term Investments Long Term InvestmentsInvestments - Restricted Debt Proceeds Internal Loans ReceivableInternal Loans Receivable - Working Capital Direct Loans Receivable (VCBA & State I

$0

$500,000,000

$1,000,000,000

$1,500,000,000

$2,000,000,000

$2,500,000,000

2010 2015 2020 2025 2030 2035

Liab

ilitie

s

Year

LiabilitiesDue to Departments Due to Construction ProjectsInternal Investment Program Deposits Build America Bonds RebateBond Premium or Discount Long Term DebtCommercial Paper

$0

$200,000,000

$400,000,000

$600,000,000

$800,000,000

$1,000,000,000

$1,200,000,000

$1,400,000,000

$1,600,000,000

$1,800,000,000

$2,000,000,000

2010 2015 2020 2025 2030 2035 2040

Equi

ty

Year

Equity

Equity

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UVA INTERNAL BANK - GOVERNANCE

Treasury Management responsible for operation of the bank

Executive Management is getting involved in operation and distribution guidelines

Financial Statements are produced for CFO Statements are used for internal management only

24

Case Study: University of Washington

Presenter: Chris Malins

OVERVIEW

Central bank began operations on 7/1/2008 Cost of funds at 5.5% General Revenue credit used for all university

borrowing Statutory authority to issue debt for all purposes

granted in 2007 Annual audited financial statements $10m in rate stabilization at 6/30/2011

26

OBJECTIVES & DECISION MAKING

Program Goals• Achieve lowest risk-adjusted cost of capital for the institution• Provide stable and predictable rate for internal borrowers

Decision MakingDebt Advisory Committee meets quarterly• Reviews credit markets, debt strategy and structure for upcoming bond issues• Membership includes Washington Deputy State Treasurer, UW’s financial advisors, UW Investments team members, and underwriter representatives

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OPERATING STRUCTURE

Internal Debt Portfolio

External Debt Portfolio

UW Internal Borrower

Rate Stabilization

Account / Program Costs

External Debt Market

Capital

Debt Service

Internal Debt

Service

Internal Loan

Funding

External Debt

Service

Capital

Internal Lending Program

28

INITIAL CHALLENGES AND OPPORTUNITIES

Creating the basic structure of the bank Institutional buy-in Strong policy Up-leveling key decisions Accounting and reporting

29

CURRENT CHALLENGES AND OPPORTUNITIES

State reporting Managing expectations and communicating the

message to borrowing units in a low interest rate environment

The role of the Treasury Office in decision-making Projects that wouldn't otherwise be financeable

can now be approved Need for additional resources

Staffing Modeling

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CURRENT CHALLENGES AND OPPORTUNITIES (CONTINUED)

Diversifying the debt portfolio through variable rate debt Making the case to senior management and

regents Policy amendment

Decisions made when starting a bank can make huge differences down the line Cash flow neutral to refundings generated

“windfall” revenues to the bank which are especially needed as the capital plan is funded.

Higher initial rate

31

FUTURE CHALLENGES AND OPPORTUNITIES

The “debt deluge” and its impacts on the future Institutional challenges and market forces could

increase UW’s cost of capital Federal funds reliance Widening credit spreads and overall rate

increases Stewardship of rate stabilization account Policy for excess funds

Use to fund future projects (equity and/or loan) Lower the rate to reduce reserve over time Rebate to departments

The asset side

32

FUTURE CHALLENGES AND OPPORTUNITIES (CONTINUED)

Higher assurance bank sufficiency measures Off the shelf model Homegrown model

Ongoing disclosure and credit review “early warning” system Project early warning vs. institutional risk

management Reporting that drives decision-making

Board level Senior leadership

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Appendix

School 1― Two banks effective July 1, 2010:

― The University Bank manages all non-endowed cash and investments ― The Capital Bank is somewhat of a 'debt pool' and manages amortization schedules, capital plans, swap issues, debt

structure, and market risk and defines the appropriate rate to charge divisions and schools for allocated outstanding debt

― Capital Bank started with minimal assets on July 1, 2010― ‘Assets' of the Capital Bank are claims on cash managed in the University Bank (i.e., the Capital Bank will not have real

cash and investments)

School 2― Bank was funded by GO debt and school cash balances and is used to make internal loans to schools and centers― The bank’s assets are these internal loans, investment in intermediate treasuries, the endowment and cash. ― Now implementing statements on the bank

School 3― Bank includes debt, investment, and cash management― Bank is designed to be self-sustaining ― Funding is derived from fees and positive spreads between the cost/return on funds and the interest received/paid from

or to units

School 4― Internal Bank is primarily funded with externally issued debt ― Secondary funding sources include: spread between blended rate and actual portfolio rate; dedicated institutional

allocation of a portion of overhead receipts; and a portion of operating assets (liability)

INTERNAL BANKS IN HIGHER EDUCATION

35

School 5― The bank operates between four offices – CFO (approvals), Financial Services(Investment and Debt Management,

Controller (Accounting) and Resource Planning (Analysis) ― The bank is self-sustaining through spread management

School 6― “Internal Bank” has enhanced and expanded long-term structures for managing internal/external debt and cash

operations/projections ― The “Bank” provides policies and tools for aggregating data for analyses, decision-making and managerial refinements

School 7― Operating Bank: self-sustaining with approved depts/schools/units receiving interest on avg. cash balances based on 3m

T-bills― Capital Bank: Beginning deposit of quasi endowment. Self-sustaining with monitoring of minimum balance ($100mm).

Internal borrowers pay level amortization. External debt managed on a portfolio basis. Bank receives some annual unrestricted spending from endowment. Long term invested with endowment and short term needs invested in the operating bank. All debt part of bank

School 8― School has a debt bank, and separately working capital fund balances are managed by the management company and

cross invested into the merged pool ― President has the discretion to determine % of working capital fund balances are invested in Merged Pool (between 70

and 90%)― Fund holders receive a guaranteed money market return, excess returns are deposited 1st into a buffer = 35% of fund

balances, then into funds functioning as endowment controlled by the President ― These funds are typically used to co-invest or provide seed funding for new strategic initiatives

INTERNAL BANKS IN HIGHER EDUCATION

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1. This presentation is for your internal use alone, for the limited purpose of assisting an evaluation of your potential interest in the strategies described, and is confidential as to third parties (with the exception that there is no limit on any disclosure of the US tax treatment or tax structure of any transaction). This material may not be given to third parties without our prior written consent. Information regarding values should not be relied on for maintaining books and records.

2. This presentation is not contractual, not a research report nor an offer to buy or sell or a solicitation of an offer to buy or sell any security or interest. Contractual obligations will be created only by formal written agreement. Information regarding pricing, interest rates, and transaction costs is preliminary and indicative only. We invite inquiry into the assumptions underlying future projections and other forward looking statements in the presentation.

3. Except as compelled by applicable law we make no warranty, express or implied of any nature as to any information or technique herein and do not guarantee satisfactory results. In no event may we be liable for any special or consequential damages that may be incurred in using the data provided. Before entering into any transaction, you must independently determine the economic risks, and your institution’s ability to assume the risks. Senior management should be involved in or informed as to this process.

4. Risk assessment of derivative products is complex. One must also consider the implications of accounting and financial disclosure rules such as the FASB requirements for mark-to-market procedures or the extensive GASB reporting requirements.

5. We are not lawyers, accountants or tax specialists; you should seek and rely on independent advice as to such matters from properly qualified firms or individuals.

DISCLAIMERS

INTERNAL LOAN TERM SHEET EXAMPLE

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