MANAGING LIABILITIES AND THE COST OF FUNDS

1. Bank Management,5th edition.Timothy W. Koch and S. Scott MacDonald Copyright © 2003 by South-Western, a division of Thomson Learning MANAGING LIABILITIES AND THE COST OF FUNDS Chapter 12

2. The composition of bank liabilities • There are many different types of liabilities. • Some offer transaction capabilities with relatively low or not interest. • Others offer limited check writing capabilities but pay higher interest rates. • Liabilities with long-term fixed maturities generally pay the highest rates. • Customers who hold each instrument respond differently to interest rate changes.

3. The percentage contribution of various sources of bank funds: a comparison of large versus small banks: 1992 and 2001(% of total assets)

4. The percentage contribution of various sources of bank funds: a comparison of large versus small banks (continued): 1992 and 2001(% of total assets)

5. General decline in core deposits • Transaction accounts have decline in favor of interest bearing MMDA on small time deposits (less than $100,000). • Bank reliance on liabilities other than core deposits, including federal funds purchased, securities sold under agreement to repurchase, Federal Home Loan Bank (FHLB) advances, borrowings from the Federal Reserve, and deposits in foreign offices declined over the period 1992–2001 for large banks but increased for smaller banks. • Except for discount window borrowings, these funds all have large denominations and pay market rates. • They typically have relatively short-term maturities except for some FHLB advances that can extend as long as 20 years. • Banks use the term volatile liabilities to describe purchased funds from rate-sensitive investors • The types of instruments include federal funds purchased, RPs, jumbo CDs, Eurodollar time deposits, foreign deposits, and any other large-denomination purchased liability. • Investors in these instruments will move their funds if other institutions pay higher rates or if it is rumored that the issuing bank has financial difficulties.

6. Average annual cost of liabilities: a comparison of large versus small banks: 2001

7. Increased competition for bank funds • Perhaps the most difficult problem facing bank management is how to develop strategies to compete for funding sources. • First, bank customers have become much more rate conscious. • Second, many customers have demonstrated a strong preference for shorter-term deposits.

8. Information on the best rates is much easier to find today.

9. Characteristics of small denomination liabilities • Instruments under $100,000 are normally held by individual investors and are not actively traded in the secondary market.

10. Accounts with transactions privileges • Most banks offer three different accounts with transactions privileges: • demand deposits (DDAs), • negotiable orders of withdrawal (NOWs) and automatic transfers from savings (ATS), and • money market deposit accounts (MMDAs).

11. Demand deposit accounts …DDAs are non-interest-bearing checking accounts held by individuals, businesses, and governmental units • NOW account’s are DDA’s that pay interest. • Only individuals and nonprofit organizations can hold NOWs. • This is expected to change very soon.

12. Money market deposit accounts MMDAs…similar to interest bearing checking accounts but have limited transactions. • Provide banks an instrument competitive with money market mutual funds offered by large brokerages. • Limited to six transactions per month, of which only three can be checks. • Attractive to the bank because required reserves are zero while required reserves on DDAs and NOWs are 10 percent. • The bank can invest 100 percent of the funds obtained from MMDA but only 90 percent from checking and NOW.

13. Electronic money • Consider carefully the impact of technology in banking – almost all products of the financial services industry can be provided electronically. • You can pay for goods electronically, apply and receive a loan electronically, even invest and transfer funds electronically.

14. It is estimated that cash accounted for 82.3% of the total volume of payments in 2000 • Checks were the second largest in terms of volume at 10.3% • Electronic payments (ATM, credit cards and debit cards) accounted for 7.4% of all payments. • In terms of the value of transactions, however • cash accounted for only 0.3% of the total value of transactions • checks were 10.9% and • electronic payments (AMT, credit cards and debit cards) accounted for 2.9%. • The vast majority of large transactions were wholesale wire transfers such as CHIPS and Fed Wire transactions. • Although cash dominates the “small” payment end of transactions, it represents a very small fraction of the total value of payments.

15. E-cash and e-checks are not Federal Reserve money but rather digital ‘tokens’ somewhat like bus tokens or casino chips, only electronic versions. • Lauren Bielski in an August, 2000 ABA Banking Journal article argues that e-money “…is arguably more of an electronic instruction to pay than true ‘electronic money.’”

16. Electronic money: smart cards • There are basically two types of smart cards: • an intelligent smart card and • a memory card. • An intelligent smart card contains a microchip with the ability to store and secure information, and makes different responses depending on the requirements of the card issuers specific application needs. • Memory type cards simply store information, similar to the stored information on the back of a credit card.

17. Electronic funds transfer (EFT)…an electronic movement of financial data, designed to eliminate the paper instruments normally associated with such fund movement. • There are many types of EFTs including: • ACH, • POS, • ATM, • direct deposit, • telephone bill paying, • automated merchant authorization systems, and • pre-authorized payments.

18. Electronic funds transfer systems • Point of sale (POS) transaction …a sale that is consummated by payment for goods or services received at the point of the sale or a direct debit of the purchase amount to the customer’s checking account. • Automated clearing house (ACH) transaction…an electronically processed payment using a standard data format. • ACH payments are electronic payments of funds and government securities among financial institutions and businesses

19. Internet bill payment, telephone bill payment, automatic deposits, and bank drafts • Although these types of payments seem to be electronic, paper checks are still often written on the customer’s behalf and mailed to the business. • These types of payments will most likely become completely electronic in the near future.

20. Functional cost analysis • The Federal Reserve System conducts a survey called the Functional Cost Analysis Program to collect cost and income data on commercial bank operations. • According to functional cost analysis data, demand deposits are the least expensive source of funds.

21. Functional cost analysis classifies check-processing activities as either deposits (electronic and non-electronic), withdrawals (electronic and non-electronic), transit checks deposited, transit checks cashed, account opened or closed, on-us checks cashed or general account maintenance (truncated and non-truncated) • Electronic transactions…those that occur through automatic deposits, Internet and telephone bill payment, ATM’s and ACH transactions. • Non-electronic …those transactions conducted in person or by mail.

22. Functional cost analysis check-processing • Transit checks depositedare defined as checks drawn on any bank other than the subject bank. • On-us checks cashedare checks drawn on the bank’s customer's account. • Deposits represent checks or currency directly deposited in the customer's account. • Account maintenancerefers to general record maintenance and preparing and mailing a periodic statement. • A truncated accountis a checking account in which the physical check is ‘truncated’ at the bank; i.e., checks are not returned to the customer. • Official check issuedwould be for certified funds. • Net indirect costsare those cost not directly related to the product such as salaries to manage the bank or general overhead cost applicable to all products at the bank.

23. Cost and Revenue Analysis of Selected Transactions Accounts: Banks With Deposits of $50 Million to $200 Million

24. Small time deposits • Small time deposits have denominations under $100,000, specified maturities ranging from seven days to any longer negotiated term. • Banks can control the flow of deposits by offering only products with specific maturities and minimum balances and varying the relative rates paid according to these terms.

25. Service charges • For many years, banks priced check handling services below cost. • While competition may have forced this procedure, it was acceptable because banks paid below-market rates on most deposits. • Because banks now pay market rates on deposits, they want all customers to pay at least what the services cost. • For most customers, service charges and fees for banking services have increased substantially in the 1990s.

26. Individual transaction account pricing

27. Interest cost and net cost of transaction accounts • The average historical cost of funds is a measure of average unit borrowing costs for existing funds. • Average interest cost for the total portfolio is calculated by dividing total interest expense by the average dollar amount of liabilities outstanding. • Average historical interest costs for a single source of funds can be calculated as the ratio of interest expense by source to the average outstanding debt for that source during the period.

28. Interest costs alone, however, dramatically understate the effective cost of transaction accounts. • First, transaction accounts are subject to legal reserve requirements of up to 10 percent of the outstanding balances, invested in non-earning assets (federal reserve deposits or vault cash). • This effectively increases the cost of transactional accounts because a reduced portion of the balances can be invested. • Non transactional accounts have no reserve requirements and hence are cheaper, ceteris paribus, because 100 percent of the funds can be invested. • Second, transaction accounts are subject to processing costs. • Third, certain fees are charged on some accounts to offset noninterest expenses and this reduces the cost of these funds to the bank.

29. Calculating the net cost of transaction accounts • Annual historical net cost of bank liabilities is historical interest expense plus noninterest expense (net of noninterest income) divided by the investable amount of funds: • A regular check account that does not pay interest, has $20.69 in transaction costs charges $7.75 in fees, an average balance of $5,515, 5% float would have a net cost of: Required reserves on transactions account are 10%.

30. Characteristics of large denomination liabilities • In addition to small denomination deposits, banks purchase funds in the money markets. • Money center and large regional banks effect most transactions over the telephone, either directly with trading partners or through brokers. • Smaller banks generally deal directly with customers and have limited access to national and international markets. • Because customers move their investments on the basis of small rate differentials, these funds are labeled ‘hot money’ or volatile liabilities.

31. Jumbo CDs …large, negotiable certificates of $100,000 or more are referred to as jumbo CDs. • Jumbo CDs are: • issued primarily by the largest banks. • purchased by businesses and governmental units. • CDs have grown to be the one of the most popular hot-money, large-source financing used by banks. • have a minimum maturity of 7 days. • interest rates are quoted on a 360-day year. • Insured up to $100,000 per investor per institution. • Banks issue jumbo CDs directly or indirectly through dealers and brokers (brokered deposits).

32. Immediately available funds • Two types of balances are immediately available: • deposit liabilities held at Federal Reserve Banks and • certain ‘collected’ liabilities of commercial banks that may be transferred or withdrawn during a business day on order of the account holder.

33. Federal Funds purchased • The term federal funds is often used to refer to excess reserve balances traded between banks. • This is grossly inaccurate, given reserves averaging as a method of computing reserves, different nonbank players in the market, and the motivation behind many trades. • Most transactions are overnight loans, although maturities are negotiated and can extend up to several weeks. • Interest rates are negotiated between trading partners and are quoted on a 360-day basis.

34. Security repurchase agreements …(RPs or Repos) are short-term loans secured by government securities that are settled in immediately available funds • Technically, the loans embody a sale of securities with a simultaneous agreement to buy them back later at a fixed price plus accrued interest. • In most cases, the market value of the collateral is set above the loan amount when the contract is negotiated. • This difference is labeled the margin.

35. Foreign Office Deposits…most large U.S. commercial banks compete aggressively in international markets • They borrow from and extend credit to foreign-based individuals, corporations, and governments. • In recent years international financial markets and multinational businesses have become increasingly sophisticated to the point where bank customers go overseas for cheaper financing and feel unfettered by national boundaries. • Transactions in short-term international markets often take place in the Eurocurrency market. • Eurocurrency …financial claim denominated in a currency other than that of the country where the issuing institution is located. • The most important Eurocurrency is the Eurodollar

36. Eurodollar liabilities…transactions in short-term international markets take place in the Eurocurrency market. • The term Eurocurrency refers to a financial claim denominated in a currency other than that of the country where the issuing institution is located. • Eurodollar, a dollar-denominated financial claim at a bank outside the United States.

37. The origin and expansion of Eurodollar deposits

38. Individual retirement accounts …savings plans for wage earners and their spouses • The primary attraction of IRAs is their tax benefits. • Each wage earner can invest up to $2,000 of earned income annually in an IRA. • Prior to 1987, the principal contribution was tax-deductible, and any accumulated earnings in the account were tax-deferred until withdrawn. • The Tax Reform Act of 1986 removed the tax-deductibility of contributions for individuals already covered by qualified pension plans if they earned enough income.

39. Federal Home Loan Bank Advances • The FHLB system is a government-sponsored enterprise created to assist in home buying. • The FHLB system is one of the largest U.S. financial institutions, rated AAA (Aaa) because of the government sponsorship. • Any bank can become a member of the FHLB system by buying FHLB stock. • If it has the available collateral, primarily real estate related loans, it can borrow from the FHLB. • The Gramm-Leach-Bliley (GLB) Act of 1999 made is much easier for smaller banks to borrow and these borrows could be used for non-real estate related loans. • GLB allows Banks with less than $500 million in assets to use long-term advances for loans to small businesses, small farms and small agri-businesses. • The act also established a new permanent capital structure for the Federal Home Loan Banks with two classes of stock authorized, redeemable on 6-months and 5-years notice. • FHLB borrowings, or advances, have maturities as short as 1 day or as long as 10 years.

40. Commercial Banks With FHLB Advances 250 4500 $ Billions of FHLB Advances Outstanding Number of Commercial Banks with FHLB Advances 3750 200 3000 150 $ Billions of FHLB Advances Outstanding 2250 Number of CB with FHLB Advances 100 1500 50 750 0 0 Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- 91 92 93 94 95 96 97 98 99 00 01 Greater competition for funds and the authorization of new uses for FHLB advances has resulted in rapid growth in the number of banks with FHLB borrowing and the dollar amount of these borrowings.

41. A recent trend has seen banks use longer-term FHLB advances as a more permanent source of funding. • The interest cost compares favorably with the cost of jumbo CDs and other purchases liabilities. • The range of potential maturities allows banks to better manage their interest rate risk. • The interesting issue is whether these advances are truly a permanent source of funds and thus comparable to core deposits, or whether they are hot money.

42. Measuring the cost of funds • Average historical cost • Versus the marginal cost of funds

43. Average historical net cost …many banks incorrectly use the average historical costs in their pricing decisions • They simply add historical interest expense with noninterest expense (net of noninterest income) and divide by the investable amount of funds to determine the minimum return required on earning assets. • Any profit is represented as a markup • The primary problem with historical costs is that they provide no information as to whether future interest costs will rise or fall. • Pricing decisions should be based on marginal costs compared with marginal revenues.

44. Marginal cost of bank funds • Marginal cost of debt…a measure of the borrowing cost paid to acquire one additional unit of investable funds • Marginal cost of equity capital…a measure of the minimum acceptable rate of return required by shareholders. • Together, the marginal costs of debt and equity constitute the marginal cost of funds, which can be viewed as independent sources or as a pool of funds.

45. Costs of independent sources of funds • Unfortunately, it is difficult to measure marginal costs precisely. • Management must include both the interest and noninterest costs it expects to pay and identify which portion of the acquired funds can be invested in earning assets. • Conceptually, marginal costs may be defined as :

46. Example:Marginal costs of a hypothetical NOW account • Assume: • market interest rate = 2.5% • servicing costs = 4.1% • acquisition costs = 1.0% of balances • deposit insurance costs = 0.25% of balances • percentage in nonearning assets = 15.0% (10% required reserves and 5% float.) • The estimated marginal cost is 9.24%:

47. Cost of debt… the cost of long-term nondeposit debt equals the effective cost of borrowing from each source, including interest expense and transactions costs. • Traditional analysis suggests that this cost is the discount rate, which equates the present value of expected interest and principal payments with the net proceeds to the bank from the issue.

48. Example:Cost of subordinated notes • Assume the bank will issue: • $10 million in par value subordinated notes • paying $700,000 in annual interest and • carrying a 7-year maturity. • It must pay $100,000 in flotation costs to an underwriter. • The effective cost of borrowing (kd), where t equals the time period for each cash flow, is 7.19%:

49. Cost of equity… conceptually, the marginal cost of equity equals the required return to shareholders • It is not directly measurable because dividend payments are not mandatory. • Still, several methods are commonly used to approximate this required return: • Dividend valuation model • Capital asset pricing model (CAPM) • Targeted return on equity model

50. Dividend valuation model…this model discounts the expected cash flows from owning stock in determining a reasonable return to shareholders. • The cost of equity equals the discount rate (required return) used to convert future cash flows to their present value equivalent: • If dividends are expected to grow at a constant rate: where Dt = the dollar value of the expected dividend in period t ke = cost of equity, and t = time period Do = the expected % dividend yield g = the expected growth in earnings, dividend payments, and stock price appreciation.