FIN 3200 Lecture 8: Managing Non-Deposit Liabilities

Liability Management

Key Areas

• Liability Management

• Customer Relationship Doctrine

• Alternative Non-deposit Funds Sources

• Measuring the Funds Gap

• Choosing among Different Funds Sources

• Determining the Overall Cost of Funds

Introduction to Liability Management

Liability management involves strategies for borrowing institutions to manage their funding sources. This pursuit presents both advantages and risks.

It also brings up the customer relationship doctrine and its implications for fundraising by lending institutions.

Rationale for Banks' Non-Deposit Liabilities

• Regulations: Banks hold a portion of deposits as reserves with the central bank.

• Inflation: Rising prices may reduce the lending power of a given stock of deposits.

• Profit Motive: Banks aim to earn profit margins by gaining interest income on loans that exceeds deposit interest payouts. Banks target growth and find demand for loans attractive.

Customer Relationship Doctrine

The priority is to make loans to customers expected to generate positive net earnings. Lending decisions often precede funding decisions. All loans and investments should exceed their cost and meet credit standards.
Banks invest in good projects from customers assessed as "creditworthy".

Example of a Bank's Balance Sheet

Assets

• Loans. New loans to be made: 100,000,000

Liabilities and Equity

• Deposits. Newly deposited funds expected today: 50,000,000

• Non-deposit funds sources:

  • Federal funds purchased 19,000,000

  • Borrowings of Eurodollars abroad 20,000,000

  • Securities sold under agreements to repurchase (RPS) 3,000,000

  • Borrowings from a nonbank subsidiary of the bank's holding company that sold commercial paper in the money market +8,000,000

• Total new deposit and non-deposit funds raised to cover the new loans 100,000,000

The ratio of non-deposit liabilities to deposit liabilities reflects the pace of credit growth.

When deposit liabilities are "sticky", a bank's balance sheet will be filled with non-deposit liabilities from the money or capital market.

Banks increasingly turn to non-deposit funding sources (or "wholesale funding").

Non-Deposit Liabilities

The demand for non-deposit funds depends on the gap between an institution's total credit demands and its available deposits.

• Gap is based on:

  • Current and projected demand and investments.

  • Current and expected deposit inflows and available funds.

• The size of this gap determines the need for non-deposit funds.

The Funding Gap

The funding gap is the difference between current and projected credit and deposit flows.

• If credit needs exceed deposit flows, the bank must attract more deposits or use non-deposit sources.

• If credit requirements are below available resources, the bank must find profitable investment avenues for the surplus.

Funding Gap Example

Assume the bank projects:

• New credit demand: G100 million

• Drawdowns of loans already approved: G300 million

• New deposits inflows: G300 million

• Planned investments in government/corporate securities: G200 million\n
  The projected funding gap would be:

• Need for funds = 100 + 300 + 200 = G600 million

• Deposit funds expected = G300 million

• The funding gap is expected to be G300 million

Liability Management

If deposits are insufficient to cover loans and investments, management seeks the lowest-cost source of borrowed funds.

During the 2007-2009 recession, mortgage lenders approved loans below industry standards with little documentation.

In the 1960s and 1970s, the customer relationship doctrine led to liability management.

The bank buys funds to satisfy loan requests and reserve requirements.

It is flexible, allowing the bank to decide the amount and duration.

The control mechanism to regulate incoming funds is the price of funds.

Non-Deposit Sources of Funds

• Borrowing from the central bank.

• Inter-bank borrowing.

• Repurchase Agreements.

• Advances from the Federal Home Loan Bank.

• Negotiable CDs.

• Eurocurrency Market.

• Commercial Paper.

• Long-Term Non-deposit Funds Sources.

Alternative Non-Deposit Sources of Funds

The usage of non-deposit sources has risen. Larger institutions rely on the non-deposit funds market to meet loan demand and cash emergencies.

Borrowing from the Central Bank

The central bank is the lender of "last resort." Commercial banks borrow from the central bank because:

• They lack sufficient assets to dispose of.

• They are unable to borrow from other commercial banks.

• Simplicity of the process.

• The process of borrowing from the central bank carries stigma.

Banks borrow from the central bank to meet the reserve requirement, and to satisfy loan requests.

Borrowing from the Central Bank

Banks access the 'discount window' of the central bank to prevent failures due to liquidity constraints.
Borrowing banks must be solvent.
Deposits with correspondent banks and demand deposit balances of security dealers and governments can be used for loans to institutions.
The discount rate (interest rate on the loan) is typically higher than the rate banks charge each other.

Types of Loan Agreements from Central Bank

• Overnight Loans: Negotiated via wire or telephone; returned the next day; typically unsecured.

• Term Loans: Longer-term contracts (days, weeks, or months).

• Continuing Contracts: Automatically renewed each day.

Types of Loans from Central Bank's Discount Window

• Primary Credit: Short-term loans for institutions in sound financial condition; rate is slightly higher than the federal funds rate.

• Secondary Credit: Loans at a higher interest rate for institutions not qualifying for primary credit.

• Seasonal Credit: Longer-term loans for small to medium institutions experiencing seasonal swings in deposits and loans.

The central bank makes the loan through its discount window by crediting the borrowing institution's reserve account.

Borrowing from Other Banks

Banks borrow from each other. Banks with excess cash lend to improve interest income, and banks with insufficient cash borrow to meet immediate demand.
This market in the U.S. is the federal funds market.
The interest rate is the federal funds rate.
Most loans are overnight loans, with some maturities up to one week.
Banks commonly use this option to meet reserve requirement shortfalls.

Repurchase Agreements (RP)

This funding source is less popular than inter-bank borrowing.
Used mostly for overnight funds, but can be extended for days, weeks, or months.
The lender provides cash to a borrower against collateral (securities e.g. government or corporate bonds, treasury bills) which may be of greater value than the cash provided.
More liquid securities are preferred.

Repurchase Agreements (RP)

If the borrower defaults, the lender takes control of the collateral.
The agreement involves an interest rate called the "repo rate". Higher perceived risk attracts a higher repo rate.
The interest cost is calculated as:

Interest\ cost\ of\ RP = Amount\ borrowed \times Current\ Repo\ rate \times (Number\ of\ days\ in\ RP\ borrowing/360\ days)

Under this agreement, the seller legally repurchases the securities from the buyer at loan maturity in a single transaction.

Risks with Repurchase Agreements

• The seller may fail to purchase the security at the maturity date. The buyer must keep the security and liquidate it to recover the cash lent.

• The security may have lost value. This is mitigated by over-collateralization.

• If the value of the security rises, the borrower faces credit risk as the creditor may not sell them back. This can be addressed through under-collateralization.

Advances from Federal Home Loan Banks

Allows institutions (home mortgage lenders) to use home mortgages as collateral for advances.
Improves the liquidity of home mortgages and encourages more lenders to provide credit.
The number of loans has increased dramatically in recent years.
Maturities range from overnight to more than 20 years.
Has a federal charter and can borrow cheaply, passing savings on to institutions.

Negotiable Certificates of Deposits (CDs)

Banks develop and sell large negotiable certificates of deposits (CDs) to raise cash.
These are time-deposit financial products.
They are interest-bearing receipts evidencing the deposit of funds in the bank for a specified period of time at a specified interest rate.
CDs are considered a hybrid product since they are legally deposits.

Negotiable Certificates of Deposits

Interest rates are negotiable.
The instrument can be sold at a discount to its face value, or interest is paid.
Participants are usually wealthy individuals and institutions with excess cash looking for investment opportunities (corporations, insurance companies, pension funds, etc.).
They tend to be low-risk investments, insured by the FDIC for up to 250,000 per depositor per bank.

Negotiable Certificates of Deposits

These instruments are not callable (banks cannot redeem them prior to maturity).
Examples:

• Zero-coupon certificate of deposit: purchased at a discounted rate and does not pay interest periodically but as a lump sum at maturity.

• Yankee certificate of deposit: issued in the U.S. by the branch of a foreign bank; usually cannot be cashed in before maturity.

Types of Negotiable CDs:

• Variable-rate CDs.

• Fixed-rate CDs: Represent the majority of CDs. Interest rates are quoted on an interest-bearing basis and computed assuming a 360-day year.

Negotiable Certificates of Deposit 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:

Amount\ due\ CD\ customer = Principal + Principal \times (Days\ to\ maturity/360\ days) \times annual\ rate\ of\ interest

= $100,000+ $100,000 \times (180/360) \times 0.08 = $ 104,000

Negotiable Certificates of Deposit

The holder of the CD agrees to keep money in the account for a set period of time.
When the CD reaches its maturity date, it can be redeemed for the initial principal investment plus any interest earned.
If the holder attempts to withdraw money before the CD's maturity date, they will face a penalty that can prevent the payment of interest.
The term of CDs can range from one month to five years.
The longer the term, the higher the interest rate.
They tend to earn higher rates than on savings accounts and therefore may not be the first-choice option for banks.

The Eurocurrency Market

The money market for borrowing and lending currencies held in the form of deposits in banks located outside the countries in which those currencies are issued as legal tender.
The Eurocurrency market is a market for bank time deposits and loans denominated in a currency other than that of the country in which the bank is located.
International banking facilities in the U.S. have the following features: no reserve requirements, no interest ceilings on deposits; minimum maturity of two business days for nonbank deposits; nonbank transactions can be in minimum amounts of 100,000; foreign residency required for loans and deposits.

The Eurocurrency Market

Eurocurrency deposits were developed originally in Western Europe to provide liquid funds for multinational banks or loans to their largest customers.
Because they are denominated on the receiving banks' books in dollars rather than in the currency of the home country, they are not spendable like currency.
Most Eurodollar deposits are fixed-rate time deposits.
Eurodollars are dollar-denominated deposits placed in bank offices outside the United States.

The Eurocurrency Market

Most Eurodollar deposits are fixed-rate time deposits.
Floating-rate CDs and floating-rate notes were introduced to protect banks and their Euro depositors from fluctuating interest rates.
The Eurocurrency market is the largest unregulated financial marketplace in the world.
They tend to have smaller eurocurrency spreads because: It is a wholesale market (typically operates in units of 1 million); It services large and well-known clients. It therefore has low overhead cost and no deposit insurance.

Commercial Paper Market

Commercial paper is issued by banks (and large corporations) to raise cash (and working capital).
It is a money market instrument with maturities ranging from three or four days to nine months.
Usually issued at a discount from face value and reflects prevailing market interest rates.
They can be sold through security dealers or through direct contact with buyers.
Types: (1) Industrial Paper - purchase inventories by corporations; (2) Finance Paper - Issued by finance companies and financial holding companies.

Commercial Paper Market

It is an unsecured form of promissory note that pays a fixed rate of interest.
It meets short-term funding needs of the bank.
It is attractive as it helps the bank avoid the hurdles and expense of applying for loans.
The rates offered tend to rise along with economic growth.
They tend not to be insured. They are backed by the financial strength of the issuer. Many issuers of commercial paper tend to purchase insurance as a form of backup against loss.
This funds source tends to be high in volume and moderate in cost but also volatile in available capacity and subject to credit risk.

Long-term Non-Deposit Sources of Funds

The non-deposit sources of funds discussed to this point are mainly short-term borrowings.
However, many financial firms also tap longer-term non-deposit funds stretching well beyond one year.
Examples include mortgages issued to fund the construction of buildings and debentures (fixed-interest loan certificates).
These longer-term non-deposit 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.

Other Sources of Funds

• Banks can also pursue less popular and non-traditional funding sources:

• They may decide to issue shares.

• They may tap non-traditional sources such as the International Finance Corporation.

Choosing Non-Deposit Sources of Funds

If the bank decides to use non-deposit sources of funding to fill the funding gap, it will have to consider the following factors:

• The relative costs of raising funds from each source.

• The risk (volatility and dependability) of each funding source.

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

• The size of the institution that requires more funds.

• Regulations limiting the use of alternative funds sources.

Choosing Non-Deposit Sources of Funds

The relative costs of raising funds from each source:

• Managers should compare the prevailing interest rate among the various options. The inter-bank rate is likely to be the cheapest rate and should therefore be included in the list of source prices to be compared.

• The actual cost for raising funds extends however beyond the interest rate.

• The cost includes such things as time spent seeking new funding sources when necessary, and the cost of using any brokers.

Calculating Non-Deposit Costs

A useful formula is:

(current\ interest\ cost\ on\ amounts\ to\ be\ borrowed + noninterest\ costs\ incurred\ to\ access\ those\ funds) / net\ investable\ funds\ raised\ from\ this\ source

Where:

1. Current interest cost on amounts to be borrowed = Prevailing interest rate x Amount of funds borrowed.

2. Noninterest cost to access funds = (estimated cost representing staff time, facilities, transaction costs) x Amount of funds borrowed.

3. Net investable funds raised = Total amount borrowed less legal reserve requirement deposit, insurance assessments, and funds placed in nonearning assets.

Choosing Non-Deposit Sources of Funds

The risk of each funding source:

• Management should consider interest rate risk and credit availability risk.

• Interest rate risk is the volatility of credit costs. Interest rates fluctuate, especially in a perfect market where the rates are determined by the interaction between demand and supply forces. The shorter the maturity period, the more the volatility.

• Credit availability risk is the risk associated with the unavailability of credit. There are times when lenders have limited loans to offer due to strict credit conditions. In such cases, lenders prefer to offer loans to their favorable and loyal clients or even increase the interest rates for the loans.

Choosing Non-Deposit Sources of Funds

The length of time funds are needed:

• The required credit may not be immediately available at the time of need.

• Therefore, the institution managers should evaluate the urgency with which the credit is required and chose the appropriate source.

Choosing Non-Deposit Sources of Funds

The size of the borrowing institution:

• Most money market loans have a standard trading unit of 1 million. This denomination exceeds the borrowing requirements for the smallest financial institutions. However, the central bank discount window and the fed funds market make smaller denominations appropriate for small institutions.

Regulations on Non-Deposit Funds

• The federal and state regulations may limit factors such as amount, frequency, and use of borrowed funds. For example, the maturity of CDs in the United States should be at least seven days, while the depository institutions exhibiting substantial risk of failure may have its borrowing from the discount window been limited by the federal reserve bank.

Choosing Non-Deposit Sources of Funds

Other factors held constant, management will seek out the lowest cost of non-deposit funding sources available.

Assume the following scenario:

Choosing Non-Deposit Sources of Funds

Assume that the bank wants to raise G400 million, of which G300 million will meet the loans and investment commitments expected.

The effective cost of funds will be = [(market\ rate \times 400) + (cost\ of\ access \times 400)/300]

The effective annual cost of each funding source be in our example is calculated row by row.

Choosing Non-Deposit Sources of Funds

Banks compare the effective cost of each possible type of funds with the cost of getting fresh deposits in the market and the yield it expects to earn on deployment of the funds into loans and investments.
Banks can also consider a mix of various sources of funds, subject to availability and other factors previously stated.
Banks will tend to use the lowest-cost source of funds or the lowest cost source combination.

Hurdle Rate of Return

The hurdle rate of return is the minimum rate of return on an investment required by a manager. The hurdle rate of return is equivalent to:

All\ expected\ operating\ costs/Funds\ available\ to\ place\ in\ earning\ assets

It tells the minimum earning rate (%) the bank must earn (before taxation) on all its funds invested in meeting the expected new funding cost.
The hurdle rate is calculated based on a given example.

Non-Deposit Sources: Cost and Risk

Borrowings from the market are generally perceived to be more costly than deposit funds.
Where borrowings are undertaken, banks tend to be exposed to market risk (cost of borrowing and availability may fluctuate).
Lenders who do not have insurance protection are likely to seek interest rates that are commensurate with the risk profile of the borrowing bank and would generally expect the bank to match market interest rates.

Non-Deposit Sources: Cost and Risk

Apart from the consideration of cost, wholesale funding is not without risk.
Non-deposit sources lack the stability of deposit sources.
Therefore, banks must develop the capability to access the appropriate type of funds at short notice and to repay on time.
This implies that these banks would have to ensure back up measures, such as short-term investment in government securities, which can be sold at short notice. Such measures may affect the banks' profitability since liquid securities yield lower returns.

Non-Deposit Sources: Cost and Risk

Banks may also have to invest in personnel with the requisite expertise in managing sourcing and repayment of such funds in the market.
On the other hand, such wholesale borrowings may be cheaper at the margin than deposits, even if the rates paid on non-deposit funds are actually higher. One reason would be the lower transaction costs for raising bulk wholesale funds, which banks often raise with a mere phone call. In doing so, banks save on branch, personnel and system costs.

Exercise

Examine the balance sheet of any two commercial banks in Guyana. What pattern in non-deposit liabilities do you see? What is the ratio of deposit to non-deposit liabilities?