Chapter 4: Managing Noninterest Income and Noninterest Expense

Chapter 4: Managing Noninterest Income and Noninterest Expense
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Issues in Interest Income and Interest Expense
Sharp increase in net interest margins (NIM) from to 1992 with a reversal of the trend since then. NIMs increased sharply again from the beginning of the financial crisis in 2008 until 2010 due primarily to the Federal Reserve’s extraordinarily low interest rate policy. Competition again heated up and the temporary increase in NIM fell again. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

NIM have been decreasing since 1992 due to a reversal of factors that led to the sharp increase. Where there are profits, competition follows. Popularity of mutual funds and stocks led to funds being moved out of FDIC-insured deposits. Deregulation and innovation put pressure on loan rates and deposit costs. Refinancing of loans at lower rates reduced yields. Increased number of competitors, financial sector combinations and regulatory changes. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Larger institutions have de-emphasized lending in favor of fees from loan securitization and offering a variety of fee-based products and services. Smaller banks have continued to be much more dependent on lending and their NIM. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Noninterest Income Sources of Noninterest Income
Deposit service charges Fiduciary activities Trading, venture capital and securitization income Investment banking, advisory, brokerage and underwriting fees and commissions Insurance commissions Net servicing fees Net gains/losses on loan sales Other net gains/losses and other noninterest income © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Noninterest Income © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Noninterest Income Biggest contributors are deposit service charges and other noninterest income. Stable sources of revenue but difficult to increase over time due to visibility and unpopularity with customers. Larger banks rely more on noninterest income than their smaller counterparts. Large institutions have greater amounts and wider variety of sources of noninterest income. Nondeposit fees and trading revenue are highly cyclical because they depend on capital market activity. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Noninterest Income © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Deposit Service Fees Deregulation encouraged “unbundling” of products and charging for individual services rather than offering them for free. Intense competition through the mid-2000’s led to bundling, “free checking” and no-fee debit and credit cards. Regulatory burden from Dodd-Frank Act has reversed this trend and banks are again beginning to charge for non-interest bearing checking accounts. NSF and Overdraft fees are relatively inelastic © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Deposit Service Fees © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Deposit Service Fees Critical decision is to determine the appropriate fee- based business mix. Many institutions offer mortgage banking services. When rates are low firms earn substantial origination fees from new loans and mortgage refinancing. When rates are high, origination fees decrease but serving revenues increase. Many large banks prefer the huge potential fee income from nonmortgage businesses which can also be volatile due to economic changes. NSF and Overdraft fees are relatively inelastic © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Noninterest Expense Five components:
Personnel expense Occupancy expense Goodwill impairment Other intangible amortization Other operating expense The sum of these five components is called overhead. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Key Ratios Burden (Net Overhead Expense)
Burden = Noninterest Expense – Noninterest Income Net noninterest margin = Burden/Average Total Assets The smaller these measures, the better the bank has performed. Efficiency ratio = Noninterest Expense/(Net Interest Income + Noninterest Income) Larger banks tend to have lower (better) efficiency ratios because they generate more noninterest income. Low efficiency ratios do not always lead to higher ROEs. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Key Ratios © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Key Ratios Operating Risk Ratio = (Noninterest Expense - Noninterest Income)/Net Interest Margin Lower is better because proportionally more income comes from fees. Productivity Ratios: Asset per employee = Average Assets/Number of Full- time Employees Average personnel expense = Personnel Expense/Number of Full-time Employees © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Key Ratios For community banks, two related ratios provide useful information about productivity. Dollar amount of loans per employee = Average Loans / Number of Full-Time Employees Net income per employee = Net Income / Number of Full- time Employees © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Which Lines of Business and Customers are Profitable?
Line-of-Business Profitability Analysis Risk-Adjusted Return on Capital (RAROC): Risk-adjusted income / Capital Return on Risk Adjusted Capital (RORAC): Income / Allocated-risk Capital Concept is to identify some measure of return generated by a line of business and compare that return with the allocated capital. Either the income may be adjusted for risk or the capital measure may be adjusted for risk. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Which Lines of Business and Customers are Profitable?
Customer Profitability Analysis Used to evaluate whether net revenue from an account meets a bank’s profit objective. General rule is that 20% of a firm’s customers contribute about 80% of profits. Objective is to identify the 20% (high value customers) and determine their needs in order to protect and promote revenue. Next level (value and average customers) represent the second biggest strategic opportunity for the firm. With low-value and high-maintenance customers the goal is to increase profitability to encourage them to find services elsewhere. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Customer Profitability Analysis

Appropriate comparison is: If revenues exceeds expenses + target profit, account generates a return in excess of minimum required return. If revenues equals expenses + target profit, account just meets the minimum required return. If revenues exceed expenses but are less than expenses + target profits, account is profitable but does not meet the minimum required rate of return. If revenues are less than expenses, account is unprofitable. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Expense Components: Noncredit services expense are obtained by multiplying cost x activity. Credit services costs include interest cost of financing loans and loan administration expenses. Business expense risk represents actual cash expenses and noncash expenses and provisions for losses. Transaction risk is the risk inherent from fraud, theft, error, computing system integrity, internal controls and delays in processing, clearing and settling payment transactions. Default is the greatest risk with respect to credit services. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Revenue Components Investment Income from Deposit Balances Noninterest (Fee) Income Loan Interest © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Aggregate Profitability Results From Customer Profitability Analysis
Profitable customers maintain multiple relationships with the bank such as substantial loans and investment business. Unprofitable customers tend to “shop” for the lowest price or do not use multiple products. Should encourage banks to offer product bundles based on the size of the bank’s relationships. Banks who want to increase revenues should identify perceived value of services by customers and price them accordingly. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

What Is The Appropriate Business Mix?
Some fee income comes from relatively stable services and lines of business, while other fees are highly volatile. Deposit service charges should be balanced with fess from other lines of business or products with higher growth potential. Potential fees is the motivation behind banks’ acquiring or merging with insurance companies. Community banks do not have the same opportunities to enter investment banking and specialty intermediation. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Community banks do not have the same opportunities to enter investment banking and specialty intermediation. Many work with bankers’ banks in the same area to offer services they could not offer independently. Many depository institutions offer mortgage products. Many commercial banks are offering new services such as remote deposit service and mobile banking. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Some managers view volatile fees as permanent sources of income although they are not. Demonstrated by reduction in mortgage activity when interest rates increased and the stock market crash. Some banks view fee business on a transaction basis. They originate loans to distribute or sell which leads to reduced interest rates and even reduced loan standards. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Strategies for Managing Noninterest Expense
Depository institutions are high-cost producers relative to money market funds and commercial paper and bond markets. Noninterest expense is too high and earnings are too low. Are there too many banks, credit unions and other financial institutions in the U.S.? If banks combined operations, expense would decrease. This has motivated much of the bank merger activity. Manage costs in line with strategic objectives. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost Management Strategies
Expense Reduction Employee reduction, temporary workers and outsourcing Operating Efficiencies Reduce costs while maintaining the existing level of products and services Increase output but maintain current expenses Improve workflow Economies of scale exist when average costs decrease as output increases. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Revenue Enhancement Involves changing the pricing of specific products and services but maintaining a sufficiently high volume of business so that total revenue increases. Closely linked to the concept of price elasticity. Identify products with price-inelastic demand. Price increase lowers demand but the decrease in demand is less than the increase in price. Contribution growth allocates resources to best improve overall long-term profitability. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 5: The Performance of Nontraditional Banking Companies

The Performance of Nontraditional Banking Companies
Goldman Sachs: The world’s premier investment bank for many years. Converted to financial holding company in 2008 in response to the global credit crisis. Mutual of Omaha Bank Subsidiary of Mutual of Omaha and run as in independent company. BMW Bank of North America Industrial loan corporation (ILC) owned by BMW Financial Services, a division of BMW North America. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Disappearance of Large Investments Banks
Financial Services Modernization Act (1999): Allowed commercial and investment banks to merge. Encouraged consolidation and new business expansion. Investment Banking Activities: Securities underwriting Advisory services Market making Propriety trading and investing © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Securities Underwriting and Advisory Services
Investment banks assist with stocks and bonds issues. First-time placement called an Initial Public Offering (IPO). Advisory Services: Numerous fee-based services that assist managing risks. Providing advice concerning mergers and acquisitions and spin- offs of lines of business. Managing investable assets, pension funds and investments. Making risk management decisions involving the uses of foreign currencies, commodities, and derivatives. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Market Making Investment bank may be willing to buy securities from participants who want to sell and sell to participants who want to buy. Profit from the bid-ask spread. Additional profit from the difference between the yield on the securities owned and the interest paid on debt. Bank acts as a broker and does not take ownership of the underlying security. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Proprietary Trading and Principal Investing
Proprietary trading occurs when an investment bank commits its own funds to take a risk position in a security, commodity or asset. Hopes to profit later by reversing the trade. Principal investing occurs when the bank takes a position in a security, derivative or stock with the expectation to hold the position for some time, perhaps even years, before trading out of it. In this context, investment banks have operated as hedge funds or private equity funds. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Hedge Fund: An investment fund that is limited to a small number of sophisticated investors. The fund’s managers take positions that are of any type and not subject to regulation. Managers generally charge a 2 percent fee applied to the amount of assets under management plus a 20 percent performance fee equal to 20 percent of the profit generated during a year. This fee structure generates an extraordinary profit for the managers with limited downside risk. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Private Equity Fund: Accept investments from institutional investors in the form of limited partnership investments. The funds use the proceeds to buy companies and make other investments, but usually have a longer investment horizon than hedge funds when entering transactions. Fund managers earn a management fee plus a percentage (usually 20 percent) of profits in excess of some minimum rate of return. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Goldman Sachs Group and Goldman Sacs Bank USA
Goldman Group was a $939 billion organization at the end of 2012. Separates operations into four segments: Investment banking Institutional client services Investing and lending Investment management © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Goldman Group and Goldman Bank Balance Sheets
Financial instruments owned include cash and derivative securities. Collateralized agreements: Borrowed securities and other financial instruments purchased under an agreement to resell at a later date. Profit from earning interest on these securities net of interest paid on their financing. Collateralized financings consist of securities loaned and instruments sold under agreements to repurchase. These figures should be netted as they reflect transactions designed to generate interest income net of financing costs. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Goldman Group and Goldman Bank Balance Sheets
Receivables: Amounts owed to Goldman by brokers, firm customers, and counterparties to derivative and other contracts. These amounts might be matched with the payables to the same groups listed under liabilities. Unsecured borrowings: Represent “hot money” that can not be relied on to be rolled over in a crisis situation. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Key Performance Ratios
Generating returns comparable to Goldman has been difficult for most banks. Earnings were generally higher than almost all other large financial institutions. Events in 2008 demonstrated that Goldman’s business model was not sustainable. Severe liquidity crisis in 2008 due to housing market collapse and declines in the values of assets owned. Stock price fell from $240 to under $70. Goldman reported its first quarterly loss in since it began trading as a public company. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Risks Faced by Goldman Sachs
Credit crisis of 2007–2009 caused money and capital markets to stop functioning normally. Commercial paper market froze and large institutions were hesitant to lend to each other. Goldman faced a potential run on the firm as lenders were hesitant to roll over debts and Goldman was unable to sell a sufficient volume of assets to readily access cash. Management decided to covert to a financial holding company which allowed access to more stable core deposits for its funding. On the negative side, Goldman agreed to be regulated by the Federal Reserve as a bank. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Goldman Group’s Risk Profile
Risks listed in Goldman’s 2007 annual report: Increasing and/or high rates and widening credit spreads. Market fluctuations that may adversely affect the value of large trading and investment positions. Declines in the number and size of securities under- writings and mergers and acquisitions that may lower revenues. Declines in equity values that may lower asset management fees. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Risks listed in Goldman’s 2007 annual report: Possible decline in the volume of transactions executed by the firm as a specialist or market maker. An increase in market volatility that may cause the firm to reduce its proprietary trading. Each of these risk factors appeared to be to the detriment of Goldman Group in 2008. Goldman holds many different types of securities, some of which are difficult to value. Under FASB 157, they are required to classify assets as Level 1, Level 2, or Level 3. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Accounting for Fair Market Value of Securities Under FASB 157
Level 1 Assets: Valuations based on observable market prices for the identical asset or liability (marking to market). Publicly traded stock, government and agency bonds, listed options and futures and mutual funds. Level 2 Assets: Valuations based on observable market data for similar assets or liabilities (marking to matrix) with price quotes typically obtained from dealer pricing services. Bonds that trade infrequently, mortgage-backed securities and other asset-backed securities not publicly traded. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Accounting for Fair Market Value of Securities Under FASB 157
Level 3 Assets: Valuations based on management’s best judgment of what the underlying asset is worth (marketing to myth). Management may use any pricing model and make its own assumptions regarding the parameters. Price quotes are the least reliable of all valuation techniques. Some assets may be substantially overpriced or underpriced depending on the model analytics. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Subject to higher capital requirements as a financial holding company. Reduced balance sheet and the amount of level 3 assets and increased capital. Bank regulators have required Goldman Group to lower its financial leverage. Dodd-Frank Volker Rule (2014) is expected to have a significant impact on the company. Prohibits proprietary trading using FDIC funds and limits hedge fund and private equity fund investing. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Financial Performance of Mutual of Omaha Bank
Mutual of Omaha (MO) is an insurance company offering a wide range of insurance products along with annuities and mutual funds. In 2007, opened Mutual of Omaha Bank (MO Bank) with 13 locations in Nebraska and Colorado through the acquisition and merger of three existing banks MO Bank’s strategic objective is to “acquire community banks in fast-growing cities with a high density of Mutual of Omaha insurance customers.” Has a thrift charter granted by the Office of Thrift Supervision. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Financial Performance of Mutual of Omaha Bank
In 2007, MO Bank had over $7 million in assets and grew to $5.9 billion by the end of 2012. During 2008 acquired two failed banks and opened new lending operations. Bank continues to acquire other locations in fast- growing states. Second phase of MO Bank’s strategy is the creation of a virtual online bank where customers can transact business online from anywhere in the U.S. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Mutual of Omaha Bank’s Risk Profile
MO Bank faces the same types of risk that other commercial banks face. Primary exposure is to credit risk. During 2012 charged off .53 percent of loans which is in line with other banks of similar size. MO Bank benefits from the strong capital based and low-risk profile of its parent. The principal benefit from operating as part of MO is the diversification and access to capital. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Financial Performance of BMW Financial Services and BMW Bank of North America
Many firms in financial services and the auto industry own Industrial Loan Companies (ILCs). Originated in the early 1900s to make loans to borrowers who could not get loans at commercial banks. Over time, ILCs were granted the right to issue deposits insured by the FDIC. FDIC put a moratorium on extending FDIC insurance to ILC’s in 2006, so no new ones have been chartered since. Historically, most ILCs operated to assist their parent organization in some facet of the firm’s core business. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

ILCs gained notoriety when Wal-Mart applied for an ILC charter in 2005 and Home Depot followed. Community banks argued against granting Wal-Mart a charter because they were concerned that traditional banking services would be offered in all stores and potentially drive them out of business. Criticisms against the charter included: There should be a separation between commerce and banking to protect customers from potential conflicts of interest. Firms like Wal-Mart could dominant business in communities. ILCs are not subject to the same regulations as commercial banks which may create safety and soundness problems. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

BMW Bank of North America is an ILC owned by BMW Financial Services. BMW Financial Services offers loans, leases, and credit cards via BMW Bank and insurance services in conjunction with Liberty Mutual Insurance Company. Operates from a single office in Utah, collects deposits and uses borrowed funds to underwrite loans and leases for the purchase of automobiles at BMW dealers. Due to its affluent customer base, operates somewhat like a private bank within a large commercial banking organization. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

BMW Bank’s Risk Profile
Reported higher ROE and ROA than peer averages due to much lower noninterest expenses to average assets. Invested proportionately more in loans and investment securities than peers. Earns a higher yield on loans and securities but pays much higher rates on its interest-bearing liabilities. Gets very little funding from demand deposits, raising its overall cost of funds. Efficiency ratio is significantly lower than peers. Lower loan charge-offs and provisions for loan losses than traditional commercial banks. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 6: Pricing Fixed-Income Securities

Future Value and Present Value: Single Payment
Cash today is worth more than cash in the future. A security purchased for $1,000 for one year promises to pay $1,080 exactly one year later. $1,000 is the present value (PV), $1,080 represents the future value after one year (FV1) and $80 is interest (i). I = $80/$1,000 = 0.08 or $1,000(1+ i) = $1,080 With a single payment after one year that includes interest and the initial investment: PV(1 + i) = FV1 © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Assume the second year 8% is paid on the entire $1,080 interest. Effectively earning interest on the initial $1,000 plus the first year interest of $80: $1,080( ) = $1, = FV2 or $1,000( )(1+0.08) = $1, = FV2 or PV(1 + i)2 = FV2 © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

If the FV and PV are known, the fixed annual interest rate can be calculated as: i = [FV2/PV]1/2 – 1 Using the numbers from the previous example: i = [$1,166.40/$1,000]1/2 – 1 = 0.08 When an amount is invested for several periods with compound interest: PV(1 + i)n = FVn © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

If everything is known except the interest rate: i = [FVn/PV]1/n – 1 The FV of $1,000 invested for 6 years at 8% interest per year with annual compounding: FV6 = $1,000(1.08)6 = $1,586.87 If $1,000 is invested today for 6 years and the FV is $1,700: i = [$1,700/$1,000]1/6 – 1 = © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Investors and borrowers may want to determine the PV of some future cash payments or receipts. The FV is discounted back to a PV equivalent: PV = FVn/(1 + i)n Given the choice of $30,000 now or $37,500 in two years with an opportunity cost of money of 8%, it is better to take the $37,500 in two years: PV = $37,500/(1.08)2 = $32,150 © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Future Value and Present Value: Multiple Payments
FV or PV of each cash flow is computed separately with the cumulative value determined as the sum of the computation for each cash flow. Suppose $1,000 earning 8% is deposited at the beginning of each of the next two years: FV of deposit in first year = $1,000(1.08)2 = $1,166.40 FV of deposit in second year = $1,000(1.08) = $1,080.00 Cumulative future value = $2,246.40 © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Future Value and Present Value: Multiple Payments
PV is often applied to a series of future cash flows. A security pays $90 a year at the end of each of the next three years plus $1,000 at the end of year 3: or © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Simple versus Compound Interest
Simple Interest: Interest is paid only on the initial principal invested – no interest on interest. Simple interest = PV – (i) – n If N = 1 year and I = 6%: $1,000(0.06)1 = $60 Compound Interest: Interest is paid on outstanding principal plus any interest that has been earned but not paid out – interest on interest. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Compounding Frequency
Interest may be compounded different intervals. Same formulas with an adjustment that converts the annual interest rate to a periodic rate coinciding with the compounding interval. Number of periods equal n times the number of compounding periods in a year (m): PV(1 + i/m)nm = FVn or PV = FVn /(1 + i/m)nm Future value is greatest when compounding period is the highest and present value is lowest when compounding frequency is highest. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Relationship Between Interest Rates and Option-Free Bond Prices

Bonds with and without Options
Bond are fixed-income securities with longer-term maturities. Some carry options and some are option-free and priced differently. Five common bond issues. A single bond may have one or more embedded in its structure: Call option: Bond issuer can buy it (redeem) from bondholder for cash at a predetermined price at a set time. Put option: Bondholder can demand issuer redeem bond for a predetermined cash price at a set time in the future. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Bonds with and without Options
Bond options (cont’d): Conversion option: Bondholder can demand issuer convert bond into issuer’s common stock at a determined price and time in the future. No cash changes hands. Extension option: Bondholder can extend bond maturity by a set number of periods. Exchange: Bondholder can demand issuer convert bond into common stock of a different company at a predetermined price at a set time in the future. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Bond Prices and Interest Rates Vary Inversely
Option-free fixed-rate coupon bond features: Par or face value representing the return of principal at maturity, a final maturity in years, a fixed coupon payment over the life of the bond, market price (PV) and interest rate (i). Most fixed-coupon bonds are initially sold in the primary market at prices close to the par value. Fixed coupon rate (coupon payment/face value) determines the amount of coupon interest that is paid periodically. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

After issue, bonds trade in the secondary market based on current market conditions. Current market prices reflect the coupon rate vs. the coupon interest paid (based on market rate) on newly issued bonds with similar features. Market rates and prices on fixed-income securities vary coincidentally and are inversely related. Prices decline when interest rates rise and prices fall when interest rates decline. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Bond with $10,000 face value and fixed interest payments of $470 that matures in three years: Semiannual coupon rate is 4.7% ($470/$10,000) or 9.4% per annum. If the market rate of interest equals 4.7% semiannually, the bond sells for face value: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

If the market rate of interest rises to 5% semiannually, the price falls and bond sells at a discount: If the market rate of interest falls to 4.4% semiannually, the price rises and bond sells at a premium: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Point out that the APR is the same in either case, but your effective rate is different. Ask them which account they should use. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Bond Prices Change Asymmetrically to Rising and Falling Rates
For a given absolute change in interest rates, the percentage increase in an option-free bond’s price will exceed the percentage decrease. For the same change in interest rates, bondholders will receive a greater capital gain when rates fall than the capital loss when rates rise for all option-free bonds. Point out that the APR is the same in either case, but your effective rate is different. Ask them which account they should use. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Bond Prices Change Asymmetrically to Rising and Falling Rates

Maturity Influences Bond Price Sensitivity
Short-term and long-term bonds exhibit different price volatility. For bonds that pay the same coupon rate, long-term bonds change proportionally more in price than do short- term bonds for a given rate change. Longer term bondholders receive the periodic interest payments longer than shorter term bondholders. This longer term has a greater impact on price changes in bonds due to interest rate changes. Point out that the APR is the same in either case, but your effective rate is different. Ask them which account they should use. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Maturity Influences Bond Price Sensitivity
$ For a given coupon rate, long-term bonds change proportionately more in price than do short-term bonds for a given rate change. 10, , , ,847.73 9,734.10 Interest Rate % 9.4%, 3-year bond 9.4%, 6-year bond Point out that the APR is the same in either case, but your effective rate is different. Ask them which account they should use. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Size of the Coupon Influences Bond Price Sensitivity
High-coupon and low-coupon bonds exhibit different price volatility. Given two bonds that are priced to yield the same yield to maturity, the bond with the lower coupon will change in price more than the bond with the higher coupon for a given change in interest rate. Point out that the APR is the same in either case, but your effective rate is different. Ask them which account they should use. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Size of the Coupon Influences Bond Price Sensitivity

Duration as an Elasticity Measure
Duration is a measure of effective maturity that incorporates timing and size of security cash flows. How price sensitive a security is to interest rate changes. The greater (shorter) the duration, the greater (lesser) the price sensitivity. A security's duration can be interpreted as an elasticity measure which provides information about the change in market value as a result of interest rate changes. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Duration as an Elasticity Measure
Letting P equal price, and I equal the prevailing market interest rate, duration (DUR) can be approximated as: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Measuring Duration Duration is a weighted average of the time until the expected cash flows from a security will be received, relative to the security’s price. Macaulay’s Duration: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Measuring Duration © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Duration of a Zero Coupon Bond
No interim cash flows with a zero coupon security. The only payment for a three year $10,000 bond is the face value at maturity. It’s estimated duration (D) is: Macaulay’s duration of a zero coupon bond is equal to its maturity. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Comparative Price Sensitivity
The greater the duration, the greater the price sensitivity: Modified duration provides an estimate of price volatility: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Recent Innovations in the Valuation of Fixed-Income Securities
Traditional valuation methods are too simplistic: Investors often do not hold securities until maturity. Present value calculations assume all coupon payments are reinvested at the calculated yield to maturity. Many securities carry embedded options which complicates valuation since it is unknown if options will be exercised and impact cash flows actually received. Fixed-income securities should be priced as a package of cash flows with each cash flow discounted at the appropriate zero coupon rate. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Total Return Analysis Allows investors to vary assumptions about holding period, reinvestment rate and sale or maturity value. Three sources of return from owning a bond: Coupon interest, reinvestment interest (interest-on- interest), and capital gain or loss at maturity or sale. Future value of coupon interest plus interest-on- interest with a constant reinvestment rate: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Total Return Analysis © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Valuing Bonds as a Package of Cash Flows
Consider a three year maturity, 9.4% coupon bond with six remaining coupon payments of $470 and one principal payment of $10,000 at maturity. Bond should be viewed as a package of seven separate cash flows. Bond will be priced as a package of zero coupon instruments which a different discount rate applied to each payment. The first coupon will be discounted at the six-month rate, the second at the one-year rate and so on. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Valuing Bonds as a Package of Cash Flows
Assuming the following zero-coupon rates: The value of the package of cash flows: Riskless profit if bond is sold for $10,000. Bond valuation is more complex than traditional analysis. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Money Market Yields Practical applications are complicated by the fact that interest rates on different securities are measured and quoted in different terms. Particularly true of yield on money market instruments with initial maturities under one year as some are discounted and others bear interest. Some yields are based on a 360-day year and others assume a 365-day year. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Interest-Bearing Loans with Maturities of One Year or Less
The effective annual yield for a loan less than one year is: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

360-Day versus 365-Day Yields
A security’s effective annual yield reflects the true yield to an investor who holds the investment for a full year (365 days). Some rates are reported based on an assumed 360- day year but interest is actually earned all 365 days. Interest is actually earned for all 365 days, so investor earns a higher effective rate of interest. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Discount Yields Some money market instruments, such as Treasury Bills, are discount instruments. Purchase price is always below the par value at maturity. Difference between the purchase price and par value at maturity represents interest. Yields on discount instruments are calculated and quoted on a discount basis assuming a 360-day year. Not directly comparable to yields on interest-bearing instruments. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Discount Yields The pricing equation for a discount instrument is:

Discount Yields Two problems with the discount rate:
The return is based on the final price or maturity value, rather than on the initial investment. It assumes a 360-day year which understates the effective annual rate. Addressed by calculating the Bond Equivalent Rate (ibe): © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Discount Yields To obtain an effective annual rate, incorporate compounding, assuming a reinvestment of the proceeds at the same periodic rate for the remainder of the 365 days in the year. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Discount Yields Consider a $1 million T-bill with 182 days to maturity and a price of $964,500. Discount rate is 7.02%: Bond equivalent rate is 7.38%: Effective interest rate is 7.52%: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Yields on Single-Payment, Interest-Bearing Securities
Some money market instruments pay interest calculated against the par value of the security. A single payment of interest and principal is made at maturity. Nominal rate is quoted as a percent of par and assumes a 360 day year. Understates the effective annual rate. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Consider a 182-day CD with a $1 million par and quoted yield of 7.02% (same quote as T-bill). Actual interest paid after 182 days: The 365-day yield is 7.12%: The effective annual rate is 7.24%: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Both the 365-day yield and effective annual rate on the CD are below the rates on the T-bill. Demonstrates the difference between discount and interest-bearing instruments. Discount rate calculated as a return on par, not the initial investment as with interest-bearing instruments. A discount rate understates both the 365-day rate and effective rate by a greater percentage. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 10: Funding the Bank

The Relationship Between Liquidity Requirements, Cash, and Funding Sources
Amount of cash a bank holds is influenced by bank’s liquidity requirements. Size and volatility of cash requirements affects liquidity position of bank. Transactions that reduce cash force bank to replenish cash assets by issuing new debt or selling assets. Transactions that increase cash provide new investible funds. Banks with ready access to borrowed funds can enter into more transactions as they can borrow quickly and at low cost to meet cash requirements. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Recent Trends in Bank Funding Sources
Retail funding is considered funding bank receives from consumers and noninstitutional depositors. Transactions accounts, money-market demand accounts, savings accounts and small time deposits. Borrowed or wholesale funding consists of federal funds purchased, repurchase agreements, FHLB borrowings and other borrowings such as institutional CDs in amounts over $250,000 Equity-related funding consists of subordinated debt, common and preferred stock and retained earnings. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Following slides show: Between December 2007 and June 2013 deposit funds increased from 65% to 75% of total assets and wholesale funding fell from 24% to just 13% of assets. In 2013 small commercial banks (less than $100 million in assets) relied much more on deposits and much less on wholesale funds than larger banks. Banks with more than $1 billion relied more on wholesale funds. In comparison with commercial banks, savings institutions operate with proportionately fewer deposits and more wholesale funds, reflecting heavier concentration in real estate assets and greater use of FHLB financing. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Volatile (purchased) liabilities describe funds obtained from interest-sensitive investors. Federal funds purchased, repurchase agreements, jumbo CDs, Internet and brokered CD’s, Eurodollar time deposits. foreign deposits and any other large purchased liability. Investors will move their funds if other institutions are paying higher rates or hear rumors that the bank has financial difficulties. FHLB increases collateral requirements for problem institutions reducing the banks’ liquidity. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Most banks prefer to obtain as much funding as possible from core deposits: Stable deposits that customers are less likely to withdraw when interest rates on competing investments rise. Includes: transactions accounts, MMDAs, savings accounts and small CDs. Customers typically choose banks on basis of convenience but electronic banking is changing this model. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Characteristics of Retail-Type Deposits
Retail Deposits: Small denomination (under $100,000) liabilities. Normally held by individual investors. Not actively traded in the secondary market. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Transaction Accounts Most banks offer three different accounts:
Demand deposits accounts (DDA) are non-interest bearing checking accounts held by individuals, businesses and government units. Interest-bearing checking and automatic transfers from savings (ATS) accounts are checking accounts that pay interest. With ATS, customer has both a DDA and a savings account. Bank forces a zero balance in the DDA at the end of each day. Often labeled as sweep accounts. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Transaction Accounts Money-market demand accounts not transaction accounts because number of transactions is limited. Banks price interest-checking and savings accounts on competitive conditions without restriction. Some limit number of checks that can be written without fees and impose minimum balance requirements. The interest cost of transaction accounts is low, but the non-interest costs can be quite high. Due to high cost of check processing, low balance checking accounts are not profitable without fees. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Nontransactional Accounts
Interest-bearing accounts with limited or no check- writing privileges. Money market deposit accounts (MMDA) are time deposits that limit depositors to six transactions per month (only three can be checks). Attractive to banks because no required reserves and limited check processing reduce effective cost to bank. Savings accounts have no fixed maturity. Not as prevalent in banks today, as MMDAs and small time deposits have replaced them. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Nontransactional Accounts
Small time deposits have balances under $250,000, a specified maturity of 7 days or more and interest penalties for early withdrawal. Economic difference between time deposits below $50,000 and those between $50,000 and $250,000. Larger deposits act more like jumbo CDs and are very rate-sensitive. Large time deposits (jumbo CDs) of $100,000 or more whose value changes as CD rates changes. Negotiable and typically traded in the secondary market. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Estimating the Cost of Deposit Accounts
Cost includes: Interest which may be as low as zero or a fraction of 1%. Legal reserve requirements which can equal as much as 10% of the outstanding balance. Processing costs which are substantial when deposit customers have a large number of transactions. Cost analysis data indicate demand deposits are the least expensive source of funds. Profitability depends on average balance, number of transactions and fees collected. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Additional fees include overdraft protection or NSF fees (represent a risk charge). Overdrafts are an extension of credit. Cost analysis classifies check-processing activities as: Deposits or withdrawals: Electronic transactions occur through automatic deposits, Internet and telephone payments, ATMs and ACH transactions. Nonelectronic transactions are handled in person or by mail. Transit checks deposited or cashed: Transit checks are checks from any other bank. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost analysis classifies check-processing activities as: Accounts opened or closed. “On-us” checks cashed: Checks drawn on the bank’s customers’ accounts. General account maintenance: General record maintenance and preparing statements. With a truncated account checks are not returned to the customer. An official check would be issued for certified funds. Net indirect costs are costs not directly related to the product such as general overhead or manager salaries. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Banks pay market rates on deposits and want customers to pay at least what the service costs. Has led to relationship pricing in which service charges decline and interest rates increase with larger balances. Banks have unbundled services and price each separately. Some charge for services once considered courtesies such as check cashing, balance inquiry and in person banking. Has led to a caste system of banking. Large depositors receive highest rates, pay the lowest fees and receive personal attention from their banker. Small depositors earn lower rates, if any, pay higher fees and receive less personal service. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Calculating the Average Net Cost of Deposit Accounts
Average historical cost of funds: Measure of average unit borrowing costs for existing funds. Average interest cost: Calculated by dividing total interest expense by the average dollar amount of liabilities outstanding. Average net cost of bank liabilities: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Calculating the Average Net Cost of Deposit Accounts
Example: If a demand deposit account does not pay interest, has $18.69 in transaction costs charges, $10.15 in fees, an average balance of $8,750, 5% float and 10% reserve requirement, the average net cost would be: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Characteristics of Large Wholesale Deposits
Banks must pay market rates and can attract funds by paying a small premium over current market. Customers move these investments on the basis of small rate differentials. These funds are labeled hot money, volatile liabilities or short-term non-core funding. Include jumbo CDs, federal funds purchased, RPs, Eurodollar time deposits, foreign deposits and any other large-denomination purchased liability. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Jumbo CDs (CDs) Large, negotiable certificates of $100,000 or more.
Minimum maturity of 7 days. Interest rates quoted on a 360-day year basis. Insured up to $250,000 per investor per institution. Considered risky and traded accordingly. Can be issued directly or through dealers or brokers (brokered deposits). Brokers provide small banks access to purchased funds. Packaged in $250,000 increments so deposits are fully insured. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Jumbo CDs (CDs) Bank regulators argue brokered CDs are often abused.
Based on link between brokered deposits and problem/failed banks that use CD funds to speculate on high-risk assets. If bank fails, FDIC must pay insured depositors. Community banks rely on CDARS as a form of extended deposit insurance. Effectively allows a bank to offer full deposit insurance in excess of $250,000 through transfers to other banks. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Jumbo CDs (CDs) When managers expect rates to rise, try to lengthen CD maturities prior to rate move. Opposite occurs when rates are expected to fall. Types of CDs: Fixed-rate: Typically 1, 3 or 6 month maturities. Today maturities of up to 5 years are common. Variable-rate: Longer maturities with rates renegotiated at specified intervals. Jump rate (bump-up) CD gives the depositor a one-time option until maturity to change the rate to the prevailing market rate. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Jumbo CDs (CDs) Types of CDs (cont’d):
CD specials: Carry high initial rates for an odd number of months in an attempt to attract new funds with a high, but temporary, initial interest cost. Callable: Allow banks to repay the depositor principal if rates fall after a specified deferment period (i.e. 2 years). Zero coupon: Sold at a steep discount from par and appreciate to face value at maturity. Rate boards are venues for selling nonbrokered CDs via the internet to institutional investors. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Individual Retirement Accounts (IRAs)
IRAs are savings plans for wage earners and their spouses. Each year, a wage earner can make a tax-deferred investment of earned income subject to IRS rules. Funds withdrawn before age 59 ½ are subject to a 10% IRS penalty. Makes IRAs an attractive source of long-term funding that can be used to balance the rate sensitivity of longer-term assets. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Foreign Office Deposits
Eurocurrency: Financial claim denominated in a currency other than that of the country where the issuing bank is located. Eurodollar: Most important Eurocurreny. Dollar-denominated financial claim at a bank outside the U.S. Eurodollar deposits: Dollar-denominated depots in banks outside the U.S. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Borrowing Immediately Available Funds
Federal Funds Purchased: The term federal funds is often used to refer to excess reserve balances traded between banks. Grossly inaccurate, given reserves averaging as a method of computing reserves, different nonbank players in the market, and the motivation behind many trades. Most transactions are overnight loans, although maturities are negotiated and can extend up to several weeks. Interest rates are negotiated between trading partners and are quoted on a 360-day basis. Formal definition of federal funds is unsecured short-term loans that are settled in immediately available funds. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Borrowing Immediately Available Funds
Security Repurchase Agreements (RPs or Repos): Short-term loans secured by government securities that are settled in immediately available funds. Identical to federal funds except they are collateralized. Sale of securities with a simultaneous agreement to buy them back later at a fixed price plus accrued interest. Market value of collateral is set above the loan amount. This difference is the margin. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Structured Repurchase Agreements
Normal repos are bullet repos with a fixed rate over a set maturity with no options. Structured repo agreements: embeds an option (call, put, swap, cap, floor, etc.) in the instrument to either lower its initial cost to the borrower or better help the borrower match the risk and return profile of an investment. A callable repo allows the deposit holder to terminate (call) the CD prior to maturity. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Borrowing from the Federal Reserve
Borrowing facility is the discount window. Fixed, discount rate set by district Federal Reserve Banks. Policy is to lend to most institutions at 1% and 1.5% over the current federal funds target rate. Four distinct lending programs: Primary credit is available to sound depository institutions on a short-term basis to meet short-term funding needs. Secondary credit is available to those not eligible for primary credit. Generally overnight at a rate above the primary rate. Seasonal credit is designed to assist small depository institutions significant seasonal swings in their loans and deposits. Emergency credit may be authorized in unusual circumstances to non-depository individuals, partnerships and corporations. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Other Borrowing from the Federal Reserve
Term Auction Facility: Allows banks to bid for an advance from the local Federal Reserve Bank that will generally have a 28-day maturity. Banks must post collateral and cannot prepay the loan. Term Securities Lending Facility: Open Market Trading Desk of the Federal Reserve Bank of New York makes loans to primary securities dealers. Allows dealers to trade relatively illiquid mortgage-backed securities for Treasury securities they can readily pledge as collateral against borrowings, creating liquidity. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Federal Home Loan Bank Advances
FHLB system is a government-sponsored enterprise created to assist in home buying. FHLBs among the largest U.S. financial institutions. Borrowings rated AAA due to government sponsorship. Bank can become a member by buying FHLB stock. Banks can borrow from the FHLB if it has available collateral, primarily real estate-related loans. Advances have maturities from 1 day to 20 years. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Electronic Money Intelligent Card: Memory Card:
Contains microchip that can store and secure information. Makes different responses depending on requirements of card issuer’s specific application needs. Memory Card: Simply stores information, similar to that on the back of a credit card. Wireless transactions using computers and mobile devices are increasingly used in the United States. Examples include PayPal and Square. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Electronic Money Trillions of dollars of digital transactions each day. Wholesale electronic payments using wire transfers account for over 3/4 of the value of transactions. Electronic Funds Transfer (EFT): Electronic movement of financial data, designed to eliminate the paper instruments. Includes ACH, POS, AMT, direct deposit, telephone bill paying, automated merchant authorization and preauthorized payments. Point of sale (POS) is a sale consummated by payment for goods or services received or a direct debit of the purchase amount. Automated clearinghouse (ACH) transaction is an electronically processed payment using a standard data format. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Check 21 Purposes of Check Clearing for the 21st Century Act:
To facilitate check truncation by reducing some of the legal impediments. To foster innovation in the payments and check collection system without mandating receipt of check in electronic form. To improve the overall efficiency of the nation’s payment system. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Check 21 Check truncation is the conversion of paper check into electronic debit or image of check by a party in the payment system other than the paying bank. Substitute check is the legal equivalent of original check. Banks not required to accept checks in electronic form or create substitute checks. Check 21 allows banks to handle checks electronically instead of physically moving paper checks which should make processing more efficient and less expensive. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Check 21 Check Clearing Process:
Banks typically place a hold on a check until it verifies that check writer has enough funds on deposit to cover it. Federal Reserve follows a timetable indicating how long a bank must wait before it can receive credit on deposited items. Most checks clear in one to three days. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Average Historical Cost of Funds
Many banks incorrectly use the average historical costs in their pricing decisions. Primary problem with historical costs is they provide no information as to if future interest costs will rise or fall. When interest rates rise, average historical cost understates the actual cost of issuing new debt. When rates fall the opposite is true. Pricing decisions should be based on marginal costs compared with marginal revenues. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

The Marginal Cost of Funds
Marginal cost of debt: Measure of the borrowing cost paid to acquire one additional unit of investable funds. Marginal cost of equity: Measure of the minimum acceptable rate of return required by shareholders. Marginal cost of funds: The marginal costs of debt and equity. Especially useful in pricing decisions. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Costs of Independent Sources of Funds
Difficult to measure marginal costs precisely. Must include both interest and noninterest costs expected to be paid and identify which portion of the acquired funds can be invested in earning assets. Formula for measuring explicit marginal cost of a single source of bank liability: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Costs of Independent Sources of Funds
Example: Market interest rate = 0.2% Servicing costs = 2.8% of balances Acquisition costs = 0.15% of balances Deposit insurance costs = 0.25% of balances Investable balance = 85% (10% required reserves, 5% float) Estimated marginal cost of obtaining additional interest checking balances: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost of Debt Marginal cost of different types of debt varies according to the magnitude of each type of liability. High-volume transactions accounts have substantial servicing costs and highest reserve requirements and float. Purchased funds pay higher rates but smaller transaction costs and zero reserve requirements (greater investable balances). Cost of long-term non deposit debt equals effective cost of borrowing from each source. This is the discount rate, which equates the present value of expected interest and principal payments with the net proceeds to the bank from the issue. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost of Equity The marginal cost of equity equals the required return to shareholders. Not directly measurable because dividend payments are not mandatory but several methods are used: Dividend Valuation Model: The cost of equity equals the discount rate (required return) used to convert future cash flows to their present value equivalent. Capital Asset Pricing Model (CAPM): Required return to shareholders equals the riskless rate of return plus a risk premium on common stock reflecting nondiversifiable market risk. Targeted Return on Equity Model. Cost of debt plus a premium to evaluate the cost of equity. Assumes book value = market value. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost of Preferred Stock
Preferred stock has characteristics of debt and common equity. Claims are superior to those of common stockholders but subordinated to those of debt holders. Dividends may be deferred when earnings are low. Marginal cost can be approximated using the dividend valuation model except that dividend growth is zero. Trust preferred stock is a hybrid form of equity capital. Effectively pays dividends that are tax deductible. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Weighted Marginal Cost of Total Funds
Best cost measure for asset-pricing purposes. Recognizes both explicit and implicit costs associated with any single source of funds. Computed in three stages: Forecast desired dollar amount of financing to be obtained from each individual debt and equity sources. Estimate marginal cost of each source of funds. Combine the estimates to project the weighted cost: © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Funding Sources and Banking Risks
Banks face two fundamental problems in managing liabilities. They are uncertainty over: what rates they must pay to retain and attract funds. likelihood customers will withdraw money regardless of rates. Basic fear is vulnerability to a liquidity crisis from unanticipated withdrawals and depositors and lenders refusing to provide funds. Banks must have the capacity to borrow in financial markets to replace deposits outflows and remain solvent. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Funding Sources: Liquidity Risk
Liquidity risk of deposit base is a function of: Number and location of depositors. Average size of accounts. Specific maturity and rate characteristics of each account. Competitive environment. Interest elasticity of customer demand for each funding source is equally important. How much can interest rates change before bank experiences deposit outflows? If a bank raises its rates, how many new funds will it attract? © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Funding Sources: Interest Rate Risk
Many depositors and investors prefer short-term instruments that can be rolled over quickly as interest rates change. Banks must offer premiums to lengthen maturities. Many banks have chosen not to pay premiums and reprice liabilities more frequently than in the past. One strategy is to aggressively compete for retail core deposits. Once a bank attracts deposit business, many will maintain those balances as long as bank provides good service. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Funding Sources: Credit Risk
During financial crisis many failed banks relied on FHLB advances and jumbo CDs to fund operations. Many banks financed loan growth with wholesale funds. Did funding sources or choice of loans cause the failures? Inappropriate use of advances and CDs to fund overly speculative loans caused the problems. Link between funding sources and credit risk tied to reasonableness of business plans, credit analysis when making loans, and monitoring of credit risk. © 2015 Cengage Learning. All rights reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Chapter 4: Managing Noninterest Income and Noninterest Expense

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Chapter 4: Managing Noninterest Income and Noninterest Expense

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