Chapter Twelve Funding the Bank

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Key Issues Depository Institutions Are Faced With: 1.Where can funds be raised at lowest possible cost? 2.How can management ensure that there are enough deposits to support lending and other services the public demands? 12-2

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Deposit Accounts Transaction (Payment or Demand) Deposits ▫ Making Payment on Behalf of Customers ▫ One of The Oldest Services ▫ Provider is Required to Honor Any Withdrawals Immediately Nontransaction (Savings or Thrift) Deposits ▫ Longer-Term ▫ Higher Interest Rates Than Transaction Deposits ▫ Generally Less Costly to Process and Manage 12-3

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Transaction Deposit An Account Used Primarily to Make Payments for Purchases of Goods and Services 12-4

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Transaction Deposits Noninterest-Bearing Demand Deposits ▫ Interest Was Prohibited by Glass-Steagall Act ▫ One of the Most Volatile and Unpredictable Sources of Funds ▫ Most Deposits are Held by Business Firms Interest-Bearing Demand Deposits ▫ Negotiable Orders of Withdrawal (NOW)- hybrid savings instrument ▫ Money Market Deposit Account (MMDA) and Super NOW due to Garn-St Germain Depository Institution Act of

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Nontransaction (Savings or Thrift) Deposit An Account Whose Primary Purpose is to Encourage the Bank Customer to Save Rather than Make Payments 12-6

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Savings or Thrift Deposits Passbook Savings Account Statement Savings Deposit Time Deposit (CD) Individual Retirement Account (IRA) - The Economic Recovery Tax Act of1981 Keogh Deposit – have tax benefits Roth IRA – The Tax Relief Act of 1997 Allows Non-Tax-Deductible Contributions Default Option Retirement Plans – The Pension Protection Act of

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Interest Rates on Deposits Depend On: The Maturity of the Deposit The Size of the Offering Institution The Risk of the Offering Institution Marketing Philosophy and Goals of the Offering Institution 12-8

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. The Changing Composition of Deposits in the US 12-9

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Core Deposits A Stable Base of Funds that is Not Highly Sensitive to Movements in Market Interest Rates (Low Interest- Rate Elasticity) and Which Tend to Remain with the Bank 12-10

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Pricing Deposit-Related Services The Glass-Steagall Act of 1933 – Federal Limits on Interest Rates Paid on Deposits – why? Nonprice Competition The Depository Institutions Deregulation Act of 1980 ▫ Cost-Plus Pricing ▫ Marginal Cost of Deposits ▫ Conditional Pricing ▫ Relationship Pricing 12-11

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Cost Plus Profit Deposit Pricing 12-12

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. The Marginal Cost Approach: Historical Average Cost Approach Determines the Bank’s Cost of Funds by Looking at the Past. It Looks at What Funds the Bank Has Raised to Date and What those Funds Have Cost 12-13

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Pooled Funds Approach Determine the Bank’s Cost of Funds by Looking at the Future. What minimum Rate of Return is the Bank Going to Have to Earn on Any Future Loans and Securities to Cover the Cost of all New Funds Raised? 12-14

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Using Marginal Cost to Set Interest Rates on Deposits Many Financial Analysts Would Argue That the Added Cost (Not Weighted Average Cost) of Bringing New Funds into the Bank Should Be Used to Price Deposits

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Market Penetration Deposit Pricing The Method of Selling Deposits That Usually Sets Low Prices and Fees Initially to Encourage Customers to Open an Account and Then Raises Prices and Fees Later On

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Conditional Pricing Schedule of Fees were Low If Customer Stayed Above Some Minimum Balance - Fees Conditional On How the Account Was Used Conditional Pricing Based On One or More Of the Following Factors ▫ The Number of Transactions Passing Through the Account ▫ The Average Balance Held in the Account During the Period ▫ The Maturity of the Deposit 12-17

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Upscale Target Pricing Bank Aggressively Goes After High- Balance, Low-Activity Accounts. Bank Uses Carefully Designed Advertising to Target Established Business Owners and Managers and Other High Income Households

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Relationship Pricing The Bank Prices Deposits According to the Number of Services Purchased or Used. The Customer May Be Granted Lower Fees or Have Some Fees Waived If Two or More Services are Used

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Nondeposit Sources of Funds Federal Funds Market Repurchase Agreements Federal Reserve Bank Advances from the Federal Home Loan Bank Negotiable CDs Eurocurrency Deposit Market Commercial Paper Long Term Sources 13-20

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Recent Growth in Nondeposit Sources of Borrowed Funds at FDIC-Insured Institutions What are the trends? 13-21

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Alternative Nondeposit Sources of Funds 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 13-22

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Federal Funds Market Immediately Available Reserves Are Traded Between Financial Institution 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

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Fed Funds Loan Agreements Overnight Loans ▫ Negotiated via wire or telephone, returned the next day ▫ Normally not secured by specific collateral, although might 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 13-25

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Repurchase Agreements Can be Thought of as Collateralized Fed Funds Transactions; More Complex; Less Exposure to Credit Risk Involves the Temporary Sale of High-Quality Assets (usually Government Securities) Accompanied by an Agreement to Buy Back Those Assets On a Specific Future Date At a Predetermined Price or Yield 13-26

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Borrowing from the Fed: The Three Types of Loans at the Discount Window Primary Credit – This Loan is Available for Short Terms and to Institutions in Sound Financial Condition. Rate is Slightly Higher than the Federal Funds Rate (Why? See the “Real Banks, Real Decisions” box). Secondary Credit – These Loans are Available at a Higher Interest Rate to Institutions not Qualifying for Primary Credit. Monitored by the Federal Reserve to Control Excess Risk Seasonal Credit - These loans Cover Longer Periods Than Primary Credit for Small and Medium Institutions Experiencing Seasonal Swings in Deposits and Loans 13-27

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Advances from the Federal Home Loan Bank Allows Institutions (Home Mortgage Lenders) to Use Home Mortgages as Collateral for Advances A Way to Improve the Liquidity of Home Mortgages and Encourage more Lenders to Provide Credit Number of Loans has Increased Dramatically in Recent Years Maturities Range from Overnight to More than 20 Years FHLB Has 12 Regional Banks Has Federal Charter and Can Borrow Cheaply and Pass Savings to Institutions 13-28

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Negotiable CD An Interest-Bearing Receipt Evidencing the Deposit of Funds in the Bank for a Specified Period of Time for a Specified Interest Rate. It is Considered a Hybrid Account Since it is Legally a Deposit 13-29

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. The Four Types of Negotiable CDs Domestic CDs – Issued By Domestic Banks in the U.S. Euro CDs – Dollar Denominated CDs Issued Outside the U.S. Yankee CDs – Issued By Foreign Banks in the U.S. Thrift CDs – Issued By Large Savings and Loans and Other Nonbanks in the U.S

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Eurocurrency Deposit Market Eurodollars are Dollar-Denominated Deposits Placed in Banks Outside the U.S. Eurocurrency Deposits Originally Were Developed in Western Europe to Provide Liquid Funds to Swap Among Institutions or Lend to Customers Labeled ‘Liabilities to Foreign Branches’ When a Foreign Branch Lends Eurodeposits to its Home Office 13-31

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Commercial Paper Short-Term Notes With Maturities from 3 or 4 Days to 9 Months Issued By Well-Known Companies. Two Types ▫ Industrial Paper- -Purchase Inventories ▫ Finance Paper – Issued by Finance Companies and Financial Holding Companies Banks Cannot Issue These Directly But Affiliated Companies Can Issue Them

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Long-Term Nondeposit Sources of Funds Mortgages to Fund the Construction of New Buildings and Capital Notes and Debentures are Examples of Long Term Sources of Funds 13-33

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. The Funds Gap Gap is Based on: ▫ Current and Projected Demand and Investments the Bank Desires to Make ▫ Current and Expected Deposit Inflows and Other Available Funds Size of This Gap Determines Need for Nondeposit Funds 13-34

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Nondeposit Funding Sources: Factors to Consider The Relative Costs of Raising Funds From Each Source The Risk of Each Funding Source The Length of Time for Which Funds are Needed The Size of the Institution Regulations Limiting the Use of Various Funding Sources 13-35