Liabilities Management Outline –Structure of bank liabilities Deposit sources of funds Nondeposit sources of funds –Balance sheet structure of bank liabilities –Managing bank liabilities Formulating pricing policy Deposit pricing matrix The pricing committee Components of the pricing decision Profitability and deposit pricing Lending and deposit costs Customer relationship pricing Estimating the costs of bank funds

Structure of bank liabilities Deposit sources of funds –Core deposits of regular bank customers. –Purchased deposits are acquired on a nonpersonal basis from the financial market at competitive interest rates. –Categories of deposits accounts: demand deposits, small time and savings deposits (or savings certificates or retail CDs), large time deposits (negotiable certificates of deposit or NCDs). –Deregulation: DIDMCA of 1980 (NOW accounts), Garn-St Germain Act of 1982 (MMDAs) to compete with MMMFs, and DIDC (Super NOW accounts in 1983). –Liability management is based on purchased funds. –Eurodollar deposits are dollar-denominated deposits in a bank outside of the U.S. (not FDIC insured). –Brokered deposits

Structure of bank liabilities

Deposit sources of funds –Brokered deposits occur when large deposits are split into $100,000 pieces and placed with different banks to obtain 100% insurance. DIDMCA of 1980 raised deposit insurance limits from $40,000 to $100,000 per account, which encompassed large NCDs. FDIC Improvement Act of 1991 prohibits depository institutions from using brokered deposits unless well or adequately capitalized. Brokered deposits were used by failing savings and loan associations in the 1980s to cover earnings losses. –IRA and Keogh plans are personal pension plans that individuals may use to defer federal income taxes on contributions and subsequent investment earnings. Roth IRAs allowed under the Taxpayer Relief Act of Banks act as custodians and gain a stable, long-term source of deposit funds. Other financial service firms are very competitive.

Structure of bank liabilities Nondeposit sources of funds –Federal funds: Short-term, unsecured transfers of immediately available funds between depository institutions for on business day (i.e., overnight loans). –Repurchase agreements: Secured, one-day loans in which claim to the collateral is transferred. For example, a bank sells securities to a corporate client and promises to repurchase the next day. –Discount window advances: Banks can borrow from the 12 regional Federal Reserve banks by this means (subject to Regulation A rules). –Federal Home Loan Bank borrowings: Under FIRREA of 1989, the FHLB can provide discount window services to not only savings and loans (as in the past) but banking institutions.

Structure of bank liabilities Nondeposit sources of funds –Bankers’ acceptances: time drafts drawn on a bank by either an exporter or importer to finance international business transactions. The bank may discount the acceptance in the money market to (in effect) finance the transaction. –Commercial paper: short-term, unsecured promissory note sold by large companies with strong credit ratings. Banks can use their holding companies to issue this short-term debt instrument. –Capital notes and debentures: Senior debt capital that is not federally insured and considered subordinate to bank deposits. Recent changes to encourage bank issuance and improve market discipline of banks.

Balance sheet structure of bank liabilities As bank size decreases (increases), greater emphasis is placed on retail deposits (managed liabilities). Sweep programs increased in popularity in the 1990s (i.e., funds are moved from transactions accounts with reserve requirements to savings accounts with no such requirements). Banks had difficulty retaining core deposits in the 1990s due to the low interest rates in this period. Depositors sought higher yields in money and capital markets. Banks increased mutual fund offerings to customers, which was greatly enhanced by the Financial Services Modernization Act of 1999.

Managing bank liabilities Formulating pricing policy –Written document that contains the pricing details of deposit services (e.g., service fees and minimum balance requirements, deposits costs and volumes, credit availability and compensating balance requirements, customer relationship pricing, promotional pricing of new products, and other marketing elements such as product differentiation.). Deposit pricing matrix –Explicit (interest) and implicit (noninterest) pricing of deposits. –Deregulation of interest rates on deposits in early 1980s shifted banks to more explicit and less implicit pricing. The pricing committee –Staffed by employees throughout the bank.

Managing bank liabilities Components of the pricing decision –Factors affecting the pricing decisions on consumer deposits: Wholesale cost of funds Pricing strategy of competitors Interest elasticity (or responsiveness) of consumer demand Past deposit flows for various kinds of consumer accounts Maturity structure of deposits Profitability and deposit pricing –Cost/revenue analysis Minimize total costs Maximize total revenues Set marginal costs equal to marginal revenues Breakeven points define the range of profitable output levels

Managing bank liabilities Lending and deposit costs –Compensating balances –Tie-in arrangements between deposit and loan services Customer relationship pricing –Relationship banking to meet total financial needs of customers –Promotional pricing to introduce new products –Other marketing elements related to pricing Product differentiation Distribution or physical delivery of deposit services to the public

Managing bank liabilities Estimating the cost of bank funds –Average costs (dollar costs of funds/dollar amount of funds) Weighted-average cost of funds Average costs of alternative sources of funds should be the same in theory (due to a bank using the cheapest source until its price rises to other sources’ average costs) Historical cost analyses to identify problems and opportunities –Marginal costs (incremental costs of an additional dollar of funds) Minimum yield on bank investments in loans and securities that must be earned to avoid a loss in equity share values Do not use the marginal cost of any particular source of funds as the cutoff rate on investment decisions Use the marginal cost of the entire mix of funds as a cutoff criterion in investment decisions Marginal cost of funds not best cutoff for long-run investment decisions. In this case use the marginal cost of capital based on long-term debt and equity costs.

Managing bank liabilities Less costly sources of funds declines have higher risk, which is consistent with higher bank profits as risk increases. Cost of Funds Risk of Funds