Liability Management

3-6-3 Rule During 1960’s, banking in the USA was said to operate according to the rule. Take deposits at 3%, make mortgage loans at 6%, and be on the golf course at 3 o’clock. Since then, increasing financial market technology and banking deregulation have led to a more complicated environment in terms of search for funds.

Students should be able to Identify different types of liabilities, their risk characteristics, and general trends. Calculate the historical and marginal cost of different sorts of funds. Calculate the weighted costs of funds. Source: Bank Management by Timothy W. Koch and Scott S. Macdonald.

Deposit Liabilities Demand Deposit: Checking account services that permit depositors to write drafts in payment that the bank must honor immediately upon presentation (UK: Current Account) Savings Deposit: Interest bearing funds left indefinitely with a bank with no minimum required maturity. Time Deposit: Interest bearing accounts with stated maturities which may carry penalties in the case of early withdrawal. Negotiable Certificate of Deposit: A type of interest bearing deposit that may be sold any number of times before maturity.

Trends in Demand Deposits in HK

Structure of Liabilities 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.

December 2005, HK Source:

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%.

Historical Cost of Funds, terms. Required Reserve Ratio: Percentages applied to transactions accounts and time deposits to determine the dollar amount of required reserve assets, including vault cash and deposits at the central bank. Float: Dollar amount of checks in process of collection, net of deferred availability amouns, to depositors.

Time Deposits During the 1980’s, Time deposits became the dominant source of funding for HK banks. Time deposits have higher interest rate costs but lower transactions costs. Time deposits are often volatile liabilities i.e. large investments made by depositors who are intensively sensitive to interest rates and risk.

Time deposits and … Interest Rate Risk Time deposits more interest sensitive than core deposits. Must be repriced rapidly when rates change. Liquidity Risk Reliance on volatile deposits makes it easy to have a liquidity shortfall. Credit Risk Vicious cycle. Banks may try to acquire high risk/return assets to pay high deposit costs. Higher credit risk may cause interest costs to rise.

Historical Cost vs. Marginal Cost To consider whether it is profitable to make an additional loan, bank should compare marginal cost with marginal revenue from source of loans. 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.

Costs of independent sources of funds Marginal costs 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 :

Example: Marginal costs of a hypothetical saving account Assume: –market interest rate = 1.9% –servicing costs = 4.1% –acquisition costs = 1.0% of balances –percentage in nonearning assets = 2.0% (2% held in reserves) The estimated marginal cost is 7.14%:

WMC is computed in three stages. 1.Forecasts shares of financing from equity and different kinds of deposits and debt. (w j ) 2.Estimate the marginal cost of each independent source of funds. (k j ) 3.Combine the individual estimates to project the weighted cost, which equals the weighted sum of the component costs across all sources. Each source’s weight (w j ) equals the expected dollar amount of financing from that source divided by the dollar amount of total liabilities and equity and k j equals the single-source j component cost of financing:

(WMC) …the best cost measure for total assets is a weighted marginal cost of funds 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.

Calculate the cost of subordinated debt 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%:

Calculating Yield to Maturity YIELD See Also Returns the yield on a security that pays periodic interest. Use YIELD to calculate bond yield. If this function is not available, and returns the #NAME? error, install and load the Analysis ToolPak add-in. How? On the Tools menu, click Add-Ins. In the Add-Ins available list, select the Analysis ToolPak box, and then click OK. If necessary, follow the instructions in the setup program. Syntax YIELD(settlement,maturity,rate,pr,redemption,frequency,basis) Important Dates should be entered by using the DATE function, or as results of other formulas or functions. For example, use DATE(2008,5,23) for the 23rd day of May, Problems can occur if dates are entered as text.dates are entered as text Settlement is the security's settlement date. The security settlement date is the date after the issue date when the security is traded to the buyer. Maturity is the security's maturity date. The maturity date is the date when the security expires. Rate is the security's annual coupon rate. Pr is the security's price per $100 face value. Redemption is the security's redemption value per $100 face value. Frequency is the number of coupon payments per year. For annual payments, frequency = 1; for semiannual, frequency = 2; for quarterly, frequency = 4.

Targeted return on equity model …investors require higher pretax returns on common stock than on debt issues because of the greater assumed credit risk. Many banks use a targeted return on equity guideline based on the cost of debt plus a premium to evaluate the cost of equity.

Since 2003, HKMA constructs a composite interest rate for use as a base rate

Interbank Market:USA Federal funds are reserve balances at US Federal Reserve Banks that depository institutions can lend to one another. The most common federal funds transaction is an overnight, unsecured loan between two financial institutions.

Hong Kong InterBank Offered Rate: The rate on which one bank deposits money at another reason for short-term lending.

Deposit Protection Scheme Hong Kong will implement a scheme of insurance for bank deposits less than HK$100K. Banks pay some insurance fee and if the bank goes bankrupt, the bank regulator pays depositors up to some limit. Only protects very small depositors, up to 84% of deposits by value are in accounts in excess of $100K

Loan Pricing Price Leadership Model

Below Prime Pricing Traditionally, prime rate is rate offered to a bank’s best commercial borrowers. Recently, banks have been lending at rates below their posted prime interest rate.