Bank Sources And Uses Of Funds PDF

TOPIC 9 BANK SOURCES AND USES OF FUNDS MANAGING DEPOSIT SERVICES p.397 Deposits ◦a unique item on a bank’s balance sheet ◦distinguishes it from other types of business firm. ◦a key element in defining the critical roles bank plays in the economy. ◦the ability to attract deposits from bu...

TOPIC 9 BANK SOURCES AND USES OF FUNDS MANAGING DEPOSIT SERVICES p.397 Deposits ◦a unique item on a bank’s balance sheet ◦distinguishes it from other types of business firm. ◦a key element in defining the critical roles bank plays in the economy. ◦the ability to attract deposits from businesses and consumers imply the confidence level of the public to that bank. ◦provide most of the raw material for bank loans and, thus, represent the ultimate source of bank profits and growth. Two key issues that every bank must deal with in managing the public’s deposit: i) Where can funds be raised at the lowest possible cost? ii) How can management ensure that the institution always has enough deposits to support the volume of loans and other investments and services the public demands? 6 TYPES OF DEPOSITS OFFERED BY BANKS 1. Demand Deposits 2. Savings Deposits 3. Time Deposits 1) Demand Deposits Noninterest-bearing transaction Have no maturity and must be paid by banks when a negotiable instrument, generally in the form of a cheque or an electronic impulse is presented. Have no interest cost (so they are generally a bank’s lowest- cost source of funding). Provide customers with payment services, such as payment using cheques. Example: the current account offered by commercial banks in Malaysia. 2) Savings Deposits  These are interest-bearing deposits without specific maturity.  Withdrawals can be made whenever the depositor desires.  Have no fixed maturity, and individuals keep track of their balances through passbook or periodic bank statement. 3)Time Deposit  Differ from savings deposits because they have a predetermined maturity date, and withdrawals prior to that date are often subject to interest penalties.  There are several categories of time deposit: a) Large negotiable certificate of deposits  Fixed rate, no rate limit, and fixed maturity date that usually ranges between 14 and 270 days at the time of issue.  There is an active market for large negotiable CDs and economically the are more like borrowings than deposits. b) Other time deposits of RM100,000 or more  Not subject to rate limits, nonnegotiable, can have fixed or flexible maturities, and are deposited by individuals, partnerships, corporations, and municipalities. c) Time deposits under RM100,000  Include savings certificates with many varying terms, individual retirement, and other time deposit.  These deposits have no rate limit and no regulatory size minimum. Other Classifications of Deposit a) Public deposits  Demand, savings or time deposits of governmental units. b) Correspondent deposits  Deposits of other banks.  Most correspondent deposits are demand deposits because it offer services such as check clearance. Interest Rates Offered on Different Types of Deposits  Each type of deposits carries a different rate of interest.  The longer the maturity of a deposit, the greater the yield that must be offered to depositors.  For example, savings deposits are subject to immediate withdrawal by the customer; hence, their offer rate to customers is among the lowest of all deposits.  In contrast, negotiable CDs and deposits of a year or longer to maturity often carry the highest deposit interest rates that banks offer.  The Composition of Bank Deposits  In recent years, banks have been most able to sell time and savings deposits to the public.  In contrast, demand deposits have declined significantly due mainly to the rise of electronic payments media, including credit and debit cards, Web-based payments systems and electronic wire transfers.  For bankers, the best mix of deposits would consist of a high proportion of demand deposits and low-yielding time and savings deposits.  These accounts are among the least expensive of all sources of funds and often include a substantial percentage of core deposits  Core deposits are stable base of deposited funds that is not highly sensitive to movements in market interest rates ( a low interest-rate elasticity) and tends to remain with the bank.  Large block of core deposits increases the duration of a bank’s liabilities and makes it less vulnerable to changes in interest rates.  Faced with substantial interest cost pressures, many bankers have pushed hard to reduce their noninterest expenses (e.g., by automating their operations and reducing the number of employees on the payroll) and to increase operating efficiency.  The managers of banks would prefer to raise funds by selling deposits that cost the least amount of money.  Demand deposit is typically among the cheapest deposit that banks sell to the public.  The absence of interest payments on demand deposit accounts usually help keep the cost of these deposits down relative to the cost of time and savings deposit and other sources of funds.  Savings deposits are relatively cheap because of the low interest rate they carry.  Time deposits, CDs, and money market accounts generally display low account activity in terms of deposits and withdrawals compared to savings accounts.  However, time deposits and money market accounts incur higher cost to the bank compared to savings account.  As a conclusion, bankers should manage properly the funding mix of their deposit  Cost Plus Profit Deposit Pricing Cost-plus pricing formula: Estimating Unit Price Operating Overhead Planned Charged the Expense Per + Expense + Profit from Customer = Unit of Allocated to Each Service for Each Deposit the Deposit Unit Sold Service Service Function Estimating Deposit Service Costs  Cost-plus pricing demands an accurate calculation of the cost of each deposit service.  One popular approach called the pooled-funds cost approach is to base deposit prices on the estimated cost of raising funds, which requires management to: a. calculate the cost rate of each source of funds; b. multiply each cost rate by the relative proportion of all funds coming from that particular source; and c. sum all the resulting products to derive the weighted average cost of all funds raised. 19 Pricing Deposits Using Marginal Cost How should banks price their deposit services in order to attract new funds and make a profit?  One of the method is by using marginal cost – the added cost of bringing in new funds.  The reason for using marginal cost instead of average cost is that frequent changes in interest rates will make (historical) average cost an unrealistic standard for pricing. For example: If interest rates are declining, the added (marginal) cost of raising new money may fall well below the average cost over all funds raised by the bank. Some loans and investments that looked unprofitable when compared to average cost will now look quite profitable when measured against the lower marginal interest cost we must pay today to make those new loans and investments. Conversely, if interest rates are on the rise, the marginal cost of today’s new money may substantially exceed the bank’s average cost of funds. If management books new loans based on average cost, they may turn out to be highly unprofitable when measured against the higher marginal cost of raising new funds in today’s market.  Measuring marginal cost (p.409) Marginal cost = change in total cost = (New interest rate × Total funds raised at new rate) – (Old interest rate × Total funds raised at old rate) Marginal cost rate = Example (p 409) Suppose a bank expects to raise RM25 million in new deposits by offering its depositors an interest rate of 7 percent. Management estimates that if the bank offers a 7.50 percent interest rate, it can raise RM50 million in new deposit money. At 8 percent, RM75 million is expected to flow in, while a posted deposit rate of 8.5 percent will bring in a projected RM100 million. Finally, if the bank promises an estimated 9 percent yield, management projects that RM125 million in new funds will result from both new and existing deposits that customers will keep in the bank to take advantage of the higher rates offered. Let's assume as well that management believes it can invest the new deposit money at a yield of 10 percent. This investment yield represents marginal revenue, the added operating revenue the bank will generate by making new investments from new deposits. Marginal cost = (RM50m x 7.5%) – (RM25m x 7%) = RM3.75m – RM1.75m = RM2m Marginal cost rate = RM2m/Rm25m = 0.08 (8%) Difference between marginal revenue rate and marginal cost rate = 10% - 8% = 2%, bank makes 2% of profit. So, bank can offer 7.5% of rates for RM50m. See the next table for the other amount of new deposits. Exercise Red Brick Bank plans to launch a new deposit campaign next week in hopes of bringing in from $100 million to $600 million in new deposit money, which it expects to invest at a 5.5 percent yield. Management believes that an offer rate on new deposits of 2.75 percent would attract $100 million in new deposits and rollover funds. To attract $200 million, the bank would probably be forced to offer 3.25 percent. Red Brick’s forecast suggests that $300 million might be available at 3.75 percent, $400 million at 4.00 percent, $500 million at 4.25 percent, and $600 million at 4.5 percent. What volume of deposits should the institution try to attract to ensure that marginal cost does not exceed marginal revenue? The marginal revenue rate is greater than the marginal cost rate up to $500 million in new deposits. At $600 million, the marginal cost rate of 5.75% is greater than the marginal revenue rate of 5.50%. Therefore, Red Brick Bank should try and attract $500 million in new deposits. CONDITIONAL PRICING (p. 411)  Due to fierce competition for deposits among banks in the US during 1970s, a new method called conditional pricing was widely used.  A bank sets up a schedule of fees in which the customer pays a low fee or no fee if the deposit balance remains above some minimum level, but faces a higher fee if the average balance falls below the minimum.  The customer will then pay a price conditional on how he or she uses the deposit.  Conditional pricing techniques vary deposit prices based on one or more of these factors: a. The number of transactions passing through the account (e.g. number of cheques written, deposits made, wire transfers, stop-payment orders, or notices of insufficient funds issued). b. The average balance held in the account over a designated period (usually per month). c. The maturity of the deposit in days, weeks, or months. Constance Dunham (1983), an economist, classified current account conditional price schedules into three broad categories: 1. Flat-rate pricing – the depositor’s cost is a fixed charge per cheque, per time period, or both. 2. Free pricing – refers to the absence of a monthly account maintenance fee or per-transaction charge. 3. Conditionally free pricing – favors large denomination deposits because services are free if the account balance stays above some minimum figure. An advantage of this method is that the customer chooses which deposit plan is preferable. Managing Nondeposit Liabilities and Other Sources of Borrowed Funds (p. 427)  What does management do when deposit volume and growth are inadequate to support all the loans and investments the bank would like to make?  They have to find other sources of funds that is called nondeposit sources or liabilities.  For example, one of a bank’s customer has requested a new loan for today amounting to RM100m. However, the bank’s deposit division reports that only RM50m in new deposits are expected today. If management wishes to fully meet the loan request, it must find another RM50m, mainly from nondeposit sources.  TYPES OF NONDEPOSIT SOURCES OF FUNDS  Federal Funds Market (Short-term borrowing)  Repurchase Agreements (Repos)  Borrowing from the Central Bank  Development and Sale of Large NCDs  Long-term Nondeposit Funds Sources  Federal Funds Market  The most popular domestic source of borrowed reserves.  Federal funds consist exclusively of deposits of commercial banks and other depository institutions at the central bank.  These deposits are held at the central bank primarily to satisfy legal reserve requirements, clear cheques, and pay for purchases of government securities.  In technical terms, Federal funds are simply short-term borrowings of immediately available money.  Banks and other financial institutions in need of immediate funds can negotiate a loan with a holder of surplus interbank market or reserves at the central bank, promising to return the borrowed funds the next day if need be.  The main use of the Federal funds market includes: 1. A mechanism that allows banks that are short of reserves to meet their legal reserve requirements or to satisfy customer loan demand by tapping immediately usable funds from other institutions. 2. To supplement deposit growth and serves as a channel for the policy initiatives of central bank designed to control the growth of money and credit in order to stabilize the economy. Repurchase Agreements (REPOs)  Repos are very similar to Federal funds transactions and are often viewed as collateralized Federal funds transactions.  Repos involve the temporary sale of high-quality, easily liquidated assets, such as T-bills, accompanied by an agreement to buy back those assets on a specific future date at a predetermined price.  A repo transaction is often for overnight funds; however, it may be extended for months.  Borrowing from the Central Bank A viable alternative to the Federal funds and Repo market is negotiating a loan from the Central Bank for a short period of time (not more than 2 weeks). The Central Bank will make the loan through its discount window by crediting the borrowing institution’s reserve account held at the Central Bank. Each loan made must be backed by collateral acceptable to the Central Bank such as government securities, agency securities, and high-grade commercial papers. Sale of Large Negotiable CDs This funding source is a hybrid account: legally, it is a deposit, but in practical terms the NCD is another form of instrument issued to tap temporary surplus funds held by large corporations, wealthy individuals, and governments. A CD is an interest-bearing receipt for a specified time period at a specified interest rate. Interest rates on fixed-rate CDs are quoted on an interest-bearing basis, and the rate is computed assuming a 360-day a year. Example, Suppose a bank promises an 8% annual interest rate to the buyer of a RM100,000 six-month CD. The depositor will have the following at the end of 6 months: Amount due = Principal + (Principal × (Days to Maturity/360) × Annual Interest Rate) Long-term Non-deposit Funds Sources The non-deposit sources of funds discussed before are mainly short- term borrowings. However, banks also tap longer-term non-deposit funds that beyond one year. Examples include mortgages issued to fund the construction of buildings and capital notes and debentures, which usually range from 5 to 12 years in maturity and are used to supplement equity capital. MEASURING A BANK’S TOTAL NEED FOR NONDEPOSIT FUNDS: THE FUNDS GAP  Each bank’s demand for non-deposit funds is determined basically by the size of the gap between its total credit demands and its deposits.  Managers responsible for the asset side of the bank’s balance sheet must choose which of a wide variety of customer credit requests they will meet.  Management must be prepared to meet, not only today’s credit request, but also the future credit request.  Management also must determine how much in deposits is likely to be attracted in order to finance the desired volume of loans and security investments.  Hence, projection must be made of customer deposits and withdrawals, with special attention to the largest depositors.  The difference between current and projected credit and deposit flows is called available funds gap. Available funds gap (AFG) = current and projected loans and investments the bank desires to make – current and expected deposit inflows. Example: Suppose a commercial bank has new loan requests that meet its quality standards of RM150 million; it wishes to purchase RM75 million in new Treasury securities being issued this week and expects drawings on credit lines from its best corporate customers of RM135 million. Deposits received today total RM185 million, and those expected in the coming week will bring in another RM100 million. The bank’s funds gap: Available funds gap (AFG) = current and projected loans and investments the bank desires to make – current and expected deposit inflows. FG = (RM150 + RM75 + RM135) – (RM185 + RM100) = RM360 – RM285 =RM75