FINC 4320

1. FINC 4320 Managing Liabilities and the Cost of Funds Fall 2004

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. 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.

4. 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.

5. 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.

6. 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.

7. 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%.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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 :

13. 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%:

14. Weighted marginal cost of total funds: • …the best cost measure for asset-pricing purposes is a weighted marginal cost of funds (WMC) • This measure recognizes both explicit and implicit costs associated with any single source of funds. • It assumes that all assets are financed from a pool of funds and that specific sources of funds are not tied directly to specific uses of funds.

15. WMC is computed in three stages. • First, management must forecast the desired dollar amount of financing to be obtained from each individual debt source and equity. • Second, management must estimate the marginal cost of each independent source of funds. • Finally, management should combine the individual estimates to project the weighted cost, which equals the sum of the weighted component costs across all sources. • Each source’s weight (wj) equals the expected dollar amount of financing from that source divided by the dollar amount of total liabilities and equity and kj equals the single-source j component cost of financing:

16. Forecast of the weighted marginal cost of funds…projected figures for Community State Bank

17. Banks face two fundamental problems in managing liabilities: Funding Cost Funding Risk • Uncertainty over what rates they must pay to retain and attract funds and • Uncertainty over the likelihood that customers will withdraw their money regardless of rates.

18. Funding sources and interest rate risk: • During the 1980’s, most banks experienced a shift in composition of liabilities away from demand deposits into interest-bearing time deposits and other borrowed funds. • This shift reflects three phenomena • the removal of Regulation Q interest rate ceilings, • a volatile interest rate environment and • the development of new deposit and money market products. • The cumulative effect was to increase the interest sensitivity of funding operations.

19. Reducing interest rate risk • … one widely recognized strategy to reduce interest rate risk and the long-term cost of bank funds is to aggressively compete for retail core deposits. • Individuals are generally not as rate sensitive as corporate depositors. • Once a bank attracts deposit business, many individuals will maintain their balances through rate cycles as long as the bank provides good service and pays attention to them. • Such deposits are thus more stable than money market liabilities.

20. Funding sources and liquidity risk • The liquidity risk associated with all liabilities has risen in recent years. • Depositors often simply compare rates and move their funds between investment vehicles to earn the highest yields. • The liquidity risk facing any one bank depends on the competitive environment. • Again, it is important to note the liquidity advantage that stable core deposits provide an acquiring bank.

21. Other issues with funding sources • Changes in the composition and cost of bank funds have clearly lowered traditional earnings. • This decrease slows capital growth and increases leverage ratios. • Borrowing costs will ultimately increase unless noninterest income offsets this decline or banks obtain new external capital. • Bank safety can thus decline.

22. Risk characteristics and funding costs • …when a bank is perceived to have asset quality problems, uninsured customers move their deposits. • Bank’s with asset quality problems must pay substantial premiums to attract funds or rely on regulatory agencies to extend emergency credit. • Liquidity risk associated with a bank’s deposit base is a function of many factors, including: • the number of depositors, • average size of accounts, • location of the depositor, and • specific maturity and rate characteristics of each account. • Equally important is the interest elasticity of customer demand for each funding source.

23. Borrowing from the Federal Reserve. • Federal Reserve Banks are authorized to make loans to depository institutions to help them meet reserve requirements. • DIDMCA opened borrowing to any depository institution that offers transactions accounts subject to reserve requirements. • The borrowing facility is called the discount window. • Discount window loans directly increase a member bank’s reserve assets.

24. Federal Reserve borrowings: three types of loans. • Short-term adjustment loans…made to banks experiencing unexpected deposit outflow or overdrafts caused by computer problems • Seasonal borrowing privilege…small banks are permitted to borrow if they can demonstrate that they experience systematic and predictable deposit withdrawals or new loan demand • Extended credit…loans granted to banks experiencing more permanent deposit outflows, typically associated with a run on the bank