Copyright © 2000 by Harcourt, Inc. All rights reserved. 20-1 Chapter 20 Deposit and Liability Management.

Copyright © 2000 by Harcourt, Inc. All rights reserved.

20-1

Chapter 20Deposit and Liability Management


20-2

Factors To Consider In Deposit and Liability Management

The type of business a depository is in. Depositors have become more sophisticated

and less loyal to a financial institution.• Retail CDs have become more interest-sensitive

and must be competitively priced. The need to estimate the marginal cost of

funds, often used as the basis for loan pricing.


20-3

The ability to engage in national advertising to attract funds across the country and more competition for funds.• Proximity to a depository is not essential with

ATM networks.• Cyberbanks, direct banks, and interstate banks

engage in deposit and check cashing activities nationwide.

The greater use of nondeposit funds with the decline in deposits at banks and thrifts.• Bank deposit financing has fallen from 92% of

assets in 1950 to 70% of assets in 1996.


20-4

Deposits as a Percentage of Total Liabilities

Commercial banks 76%

• Over $1 billion in assets 71%

• Under $100 million in assets 97% Savings institutions 78%

• Over $1 billion in assets 73%

• Under $100 million in assets 94% Credit Unions 88%


20-5

Deposit Structure for FDIC-Insured Commercial Banks, 1996

Total $3.197 trillion; 85% are domestic deposits. As a percent of domestic deposits:

• Transactions accounts 29%• Nontransactions accounts 71%• Insured deposits 63%

– Under $100 million 83%– Over $1 billion 55%

• IRAs and Keogh Plans 4.75%• Brokered Deposits 1.48%• Jumbo CDs maturing in < 1 year 82%• Retail CDs maturing in < 1 year 72%


20-6

Objectives of Liability Management

To help manage the reserve position. To help meet loan demand and promote

growth. To balance the maturity and interest rate

sensitivity of liabilities with those of the asset portfolio.


20-7

Discretionary Liabilities

The Fed’s discount window and borrowing from other regulators

Federal funds purchased Issuance of repurchase agreements Large CDs Liabilities collateralized by the institution’s

assets Eurodollar deposits


20-8

Federal Funds Purchased

Suitable for reserve requirement management. Lending institutions instruct the Fed or its

correspondent bank to transfer agreed-upon balances to the borrowing institution through the Fedwire.

Because Fed fund transactions are usually overnight loans, the transaction is reversed the next day, including one day’s interest calculated at the Fed funds rate.


20-9

Fed funds are readily available, but the cost is difficult to forecast because the rate changes daily.

The characteristics of Fed funds make them an inappropriate source to fund loan demand or to pursue growth.


20-10

Negotiable CDs

They are large-denomination ($100,000 or greater) time deposits with minimum maturities of 7 days.

A secondary market exists for these CDs. Most are issued directly to customers, although

some large institutions issue them to dealers which then sell them to other investors.

The amount over $100,000 is not federally insured.


20-11

Institutions in financial difficulty find this source of funds may either increase in cost or evaporate.


20-12

Eurodollar Deposits

They are time deposits denominated in dollars but held in banks outside the United States, including foreign branches of U.S. banks.

They are typically created when a domestic customer transfers funds on deposit in the U.S. to a foreign bank or branch.

They are nonnegotiable. They are not subject to reserve requirements.


20-13

A premium is demanded as protection against the lack of deposit insurance and against country risk.

• Eurodollar CD rates will be higher than the rates on domestic CDs.


20-14

Repurchase Agreements

They are the “sale” of marketable securities by an institution, with an agreement to purchase at a specific future date.

Repos are not subject to reserve requirements as long as the securities pledged against the repos are U.S. government or government agency securities.

Because repos are backed by high-quality securities, the rate on repos is lower than the Fed funds rate and the negotiable CD rate.


20-15

If the collateral is transferred elsewhere for safekeeping, the rate paid on the repo will be lower because:

• it increases the cost to the depository; and

• it reduces the risk to the investor.

Because they have collateral backing, they are not considered deposits and therefore are not federally insured.


20-16

Mortgage-backed Bonds

They are debt obligations backed by an institution’s expected cash flows from its general mortgage portfolio.

They are issued at slight premiums over the Treasury bond rate because of the high quality of the collateral.

Usually issued with minimum face value of $100 million.

Pooling has increased the participation of small thrifts in this form of liability management.


20-17

Deposit Notes

They are a medium-term source of financing (2 to 5 years).

Deposit notes receive deposit insurance protection up to $100,000.

Deposit notes are evaluated by rating agencies.• They carry lower interest rates than negotiable CDs issued

by the same institutions. Although rated, they are not negotiable. Rating makes them attractive to investors like

insurance companies.


20-18

Bank Notes

They are a medium-term source of financing (2 to 5 years).

They carry no agency rating. They are completely uninsured. They can be traded in secondary markets. The lack of insurance means that they pay a

higher rate than deposit notes issued by the same institution.


20-19

Factors Influencing the Use of Liability Management

Institutions relying on hot money or confidence-sensitive funds for liquidity needs are employing an aggressive strategy.

• Confidence-sensitive money is any source of funds sensitive to loss of confidence either in a particular institution or in the banking system in general.

• Funds that move quickly in response to yield differences are often called hot money or money at a price.


20-20

The choice of aggressive strategy is influenced by:• the size of the institution; and• the financial strength of the institution.

Smaller institutions are less likely to be aggressive because they lack a large enough capital base or securities portfolio to support liability management operations.

When a financial institution’s financial condition deteriorates, investors demand large risk premiums, and eventually may withdraw all funds.


20-21

Noninterest Competition: The Use of Implicit Payments

Implicit payments take the form of gifts or free account-related services given to depositors in lieu of explicit interest.

Depository institutions have used implicit interest since the removal of Reg Q to attract funds when they don’t want to raise explicit rates.

Implicit interest payments result in an increase in fixed costs, increasing operating leverage.


20-22

With revenues varying as the level of interest rates changes, increased operating leverage results in greater variation in the operating income of a depository than if the institution paid explicit interest, a variable cost.


20-23

Issues to Consider in the Acquisition of Funds in a Deregulated Environment

The broad choice between wholesale and retail fund sources

The balance between deposits and nondeposit liabilities and the mix of deposit sources

The cost and pricing of accounts and services


20-24

Items to Consider in Making the Choice of Wholesale Versus Retail Funds

More retail funds than wholesale funds are available in financial markets.

Wholesale funds are more rate-sensitive and confidence-sensitive than retail funds.

The cost of attracting retail funds is higher than for wholesale funds due to the cost of operating branching networks.

The planned use of the funds.


20-25

Items to Consider in Choosing the Mix of Fund Sources

The cost of core deposits and the sensitivity of their cost in a changing interest rate environment compared with other sources of funds.

The maturity and stability of different deposit categories.

The strategy for marketing other financial services to depositors.


20-26

Items to Consider in Establishing Deposit Pricing

The explicit interest rate to be offered. The cost incurred in servicing each account. The division of costs between explicit and

implicit interest. The effect of one deposit account’s price on

the customer’s acceptance of other accounts and services.


20-27

Strategies for Setting Explicit Rates

Offer rates similar to key competitors or market leaders.

Estimate the cost of alternative sources of wholesale funds.


20-28

Cost Incurred for Specific Account Related Services

Pricing should be related to the costs incurred by the institutions.

The Fed provides a functional cost analysis (FCA) service.

Many institutions have instituted cost accounting systems and use data to price services.

If the cost of providing a service exceeds the value to the recipient, elimination of the service should be considered.


20-29

Estimating the Marginal Cost of a Deposit Account (MCD)

RR)-(1

DISIMCD

where:I= current market interest rate on type of deposit accountS= servicing costs of deposits expressed as percentage of

each dollar acquiredDI= deposit insurance premium expressed as percentage

of each insured dollarRR= Fed reserve requirement on type of deposit account


20-30

Suppose an institution’s managers have decided to pursue a retail banking strategy. They have

determined that the current market interest rate on NOW accounts is 6.5% and the cost of servicing a

basic NOW account is 3.4%. Also Fed reserve requirements on transactions accounts are 10 percent, and the deposit insurance premium is

0.254%. What is the marginal cost of the deposit account?


20-31

RR)-(1

DISIMCD

)10.1(

00254.034.065..1128 or 11.28%


20-32

A similar analysis can be performed for each fund source customarily used by the institution and a weighted average of these costs can be estimated.

The weighted average marginal cost of deposits and liabilities is one of the main determinants of required lending rates.

Marginal costs are also used in deciding how to price accounts to attract the quantity of desired deposits.


20-33

Items to Consider in Determining the Combination of Explicit and Implicit Interest

A conditionally free account is one for which no service charges are imposed under certain conditions.• The customer determines the mix of implicit and

explicit interest by the way the account is managed. A buydown account is one for which the

customer selects the desired additional services in exchange for a lower explicit rate of interest.


20-34

Pricing and Customer Relationships

Institutions may consider their total relationship when setting prices on accounts customers view as important in the selection of a primary financial institution.

Customer relations have led to tiered pricing which offers higher explicit rates as a customer’s balance increases beyond a threshold level.


20-35

Truth in Savings (1989)

It requires depositories to publish the fees, service charges, and annual yields associated with each account.

11APY N365

POPMT

where:PMT= amount of interest received during the period

minus service chargesPO= amount invested by the customerN= number of days over which interest is earned


20-36

Suppose a customer purchases a 91-day, $10,000 share CD on which her credit union offers a stated

annual rate of 3%. Interest will be paid at the end of the 91-days, with a $2 service charge on the account.

What is the APY?

Quarterly interest: (0.03 ÷ 4) = 0.0075 or 0.75%

Interest received: ($10,000×0.0075) =$75

Net payment: $75 - $2 =$73

1000,10$

73$111APY91

365

N365

POPMT

.029603 or 2.9603%

Copyright © 2000 by Harcourt, Inc. All rights reserved. 20-1 Chapter 20 Deposit and Liability Management.

Documents

source of funds

fed funds rate

characteristics of fed

marginal cost of funds

direct banks

interstate banks

greater time deposits

percent of domestic