Managing Nondeposit Liabilities Chapter Thirteen Managing Nondeposit Liabilities Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Key Topics Liability Management Customer Relationship Doctrine 13-2 Key Topics Liability Management Customer Relationship Doctrine Alternative Nondeposit Funds Sources Measuring the Funds Gap Choosing among Different Funds Sources Determining the Overall Cost of Funds Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

13-3 Introduction The traditional source of funds for most depository institutions is the deposit account But what does management do to find new money when deposit volume is inadequate to support all loans and investments these institutions would like to make? In this chapter we explore yet another important nondeposit source of funding – selling IOUs in the money and capital markets for periods of time that may stretch from overnight to several years Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Liability Management and the Customer Relationship Doctrine 13-4 Liability Management and the Customer Relationship Doctrine The Customer Relationship Doctrine The first priority of a lending institution is to make loans to all those customers from whom the lender expects to receive positive net earnings Thus, lending decisions often precede funding decisions All loans and investments whose returns exceed their cost and whose quality meets the lending institution’s credit standards should be made If enough deposits are not immediately available to cover these loans and investments, then management should seek out the lowest-cost source of borrowed funds available to meet its customers’ credit needs During the collapse of the subprime mortgage market in the 2007-2009 business recession, regulators found that many mortgage lenders went overboard in approving loans, falling well below normal industry standards with little or no documentation Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

13-5 Liability Management and the Customer Relationship Doctrine (continued) Liability Management During the 1960s and 1970s, the customer relationship doctrine spawned the liquidity management strategy known as liability management The bank buys funds in order to satisfy loan requests and reserve requirements It is an interest-sensitive approach to raising bank funds It is flexible – The bank can decide exactly how much they need and for how long The control mechanism to regulate incoming funds is the price of funds Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

13-6 TABLE 13–1 Sample Use of Nondeposit Funds Sources to Supplement Deposits and Make Loans Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Alternative Nondeposit Sources of Funds 13-7 Alternative Nondeposit Sources of Funds Federal Funds Market Repurchase Agreements Borrowing from Federal Reserve Banks Advances from the Federal Home Loan Bank Negotiable CDs Eurocurrency Deposit Market Commercial Paper Long-Term Nondeposit Funds Sources The usage of nondeposit sources of funds has risen Larger institutions rely on the nondeposit funds market as a key source of short-term money to meet loan demand and unexpected cash emergencies Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

13-8 TABLE 13–2 Recent Growth in Nondeposit Sources of Borrowed Funds at FDIC-Insured Banks and Thrifts Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

13-9 TABLE 13–3 The Relationship between the Size of Banks and Their Use of Nondeposit Borrowings (2007 figures for FDIC-insured banks) Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Alternative Nondeposit Sources of Funds (continued) 13-10 Alternative Nondeposit Sources of Funds (continued) Federal Funds Market Borrowing from Federal Reserve Banks Immediately available reserves are traded between financial institutions and usually returned within 24 hours Deposits with correspondent banks and demand deposit balances of security dealers and governments can be used for loans to institutions Types of Fed Funds Loan Agreements Overnight Loans Negotiated via wire or telephone, returned the next day Normally not secured by specific collateral Term Loans Longer term Fed funds contracts (several days, weeks, or months) Continuing Contracts Automatically renewed each day Normally between smaller respondent institutions and their larger correspondents Copyright © 2013 The McGraw-Hill Companies, Inc. Permission required for reproduction or display.