1. Managing Nondeposit Liabilities
Chapter Thirteen
Managing Nondeposit Liabilities

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

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

4. Liability Management and 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 business recession, regulators found that many mortgage lenders went overboard in approving loans, falling well below normal industry standards with little or no documentation

5. Liability Management and the Customer Relationship Doctrine (continued)
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

6. TABLE 13–1 Sample Use of Nondeposit Funds Sources to Supplement Deposits and Make Loans

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

8. TABLE 13–2 Recent Growth in Nondeposit Sources of Borrowed Funds at FDIC-Insured Banks and Thrifts

9. TABLE 13–3 The Relationship between the Size of Banks and Their Use of Nondeposit Borrowings (2007 figures for FDIC-insured banks)

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

11. Alternative Nondeposit Sources of Funds (continued)
Repurchase Agreements (RPs) as a Source of Funds
Less popular than Fed funds and more complex
Viewed as collateralized Fed funds transactions
With RPs, the purchaser of Fed funds provides collateral in the form of marketable securities, reducing the credit risk
Most domestic RPs are transacted across the Fed Wire system
An RP transaction is often for overnight funds
It may be extended for days, weeks, or even months
Major innovation in the RP market was the invention of General Collateral Finance (GCF) RPs

12. Alternative Nondeposit Sources of Funds (continued)
Borrowing from Federal Reserve Banks
The Fed will make the loan through its discount window by crediting the borrowing institution’s reserve account
Each loan made by the Federal Reserve banks must be backed by collateral acceptable to the Fed
Several types of loans are available from the Fed’s 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
Secondary Credit
These loans are available at a higher interest rate to institutions not qualifying for primary credit
Seasonal Credit
These loans cover longer periods than primary credit for small and medium institutions experiencing seasonal swings in deposits and loans

13. Alternative Nondeposit Sources of Funds (continued)
Advances from Federal Home Loan Banks
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
Federal Home Loan Bank (FHLB) System has 12 regional banks
Has federal charter and can borrow cheaply and pass savings on to institutions

14. Alternative Nondeposit Sources of Funds (continued)
Development and Sale of Large Negotiable CDs
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
Types of Negotiable CDs
Domestic CDs.
Euro CDs
Yankee CDs
Thrift CDs
Fixed-rate CDs
Variable-rate CDs

15. Alternative Nondeposit Sources of Funds (continued)
Development and Sale of Large Negotiable CDs
Interest rates on fixed-rate CDs are quoted on an interest- bearing basis and the rate is computed assuming a 360-day year
Represent the majority of all large negotiable CDs issued
Example
Suppose a depository institution promises an 8 percent annual interest rate to the buyer of a $100,000 six-month (180-day) CD
The depositor will have the following at the end of six months

16. Alternative Nondeposit Sources of Funds (continued)
The Eurocurrency Deposit Market
Eurocurrency deposits were developed originally in Western Europe to provide liquid funds that could be swapped among multinational banks or loaned to the banks’ largest customers
Eurodollars are dollar-denominated deposits placed in bank offices outside the United States
Because they are denominated on the receiving banks’ books in dollars rather than in the currency of the home country and consist of accounting entries in the form of time deposits, they are not spendable on the street like currency
Most Eurodollar deposits are fixed-rate time deposits
Floating-rate CDs (FRCDs) and floating-rate notes (FRNs) were introduced in an effort to protect banks and their Eurodepositors from the risk of fluctuating interest rates
The Eurocurrency market is the largest unregulated financial marketplace in the world

17. Alternative Nondeposit Sources of Funds (continued)
Commercial Paper Market
Commercial paper consists of short-term notes, with maturities normally ranging from three or four days to nine months, issued by well-known companies to raise working capital
Industrial Paper – purchase inventories
Finance Paper – Issued by finance companies and financial holding companies
The notes are generally sold at a discount from face value through security dealers or through direct contact with the issuing company
This funds source tends to be high in volume and moderate in cost but also volatile in available capacity and subject to credit risk
Recently foreign banks have accelerated their mining of both European and American paper markets despite the pressures of the Great Recession

18. Alternative Nondeposit Sources of Funds (continued)
Long-Term Nondeposit Funds Sources
The nondeposit sources of funds discussed to this point are mainly short-term borrowings
However, many financial firms also tap longer-term nondeposit funds stretching well beyond one year
Examples include mortgages issued to fund the construction of buildings and capital notes and debentures
These longer-term nondeposit funds sources have remained relatively modest over the years due to regulatory restrictions and the augmented risks associated with long-term borrowing
Also, because most assets and liabilities held by depository institutions are short- to medium-term, issuing long-term indebtedness creates a significant maturity mismatch

19. Choosing among Alternative Nondeposit Sources
The demand for nondeposit funds is determined basically by the size of the gap between the institution’s total credit demands and its deposits and other available monies
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 the need for nondeposit funds

20. Choosing among Alternative Nondeposit Sources (continued)
Nondeposit Funding Sources: Factors to Consider
The relative costs of raising funds from each source
The risk (volatility and dependability) of each funding source
The length of time (maturity or term) for which funds are needed
The size of the institution that requires more funds
Regulations limiting the use of alternative funds sources

21. Choosing among Alternative Nondeposit Sources (continued)
A good formula for doing cost comparisons among alternative sources of funds

22. Quick Quiz What is liability management?
What advantages and risks does the pursuit of liability management bring to a borrowing institution?
What is the customer relationship doctrine, and what are its implications for fund-raising by lending institutions?
What are the principal advantages to the borrower of funds under an RP agreement?
What are the advantages of borrowing from the Federal Reserve banks or other central bank? Are there any disadvantages?
How is a discount window loan from the Federal Reserve secured? Is collateral really necessary for these kinds of loans?
Why were negotiable CDs developed?
What is the available funds gap?
What factors must the manager of a financial institution weigh in choosing among the various nondeposit sources of funding available today?