funding the bank

1

Funding the Bank

2

The Relationship Between Liquidity Requirements, Cash, and Funding Sources

The amount of cash that a bank holds is influenced by the bank’s liquidity requirements

The size and volatility of cash requirements affect the liquidity position of the bank Deposits, withdrawals, loan

disbursements, and loan payments affect the bank’s cash balance and liquidity position

4


Recent Trends in Bank Funding Sources Bank customers have become more rate

conscious Many customers have demonstrated a a

strong preference for shorter-term deposits

Core deposits are viewed as increasingly valuable

Bank often issue hybrid CDs to appeal to rate sensitive depositors

5


Recent Trends in Bank Funding Sources Retail Funding

Deposit Accounts Transaction accounts Money market deposit accounts Savings accounts Small time deposits

6


Recent Trends in Bank Funding Sources Borrowed Funding

Federal Funds purchased Repurchase agreements Federal Home Loan Bank borrowings

7


Recent Trends in Bank Funding Sources Wholesale Funding

Includes borrowed funds plus large CDs

Equity Funding Common stock Preferred stock Retained earnings

8


Recent Trends in Bank Funding Sources Volatile (Managed) Liabilities

Funds purchased from rate-sensitive investors

Federal Funds purchased Repurchase agreements Jumbo CDs Eurodollar time deposits Foreign Deposits

Investors will move their funds if other institutions are paying higher rates

9


Recent Trends in Bank Funding Sources Core Deposits

Stable deposits that customers are less likely to withdraw when interest rates on competing investments rise

Includes: Transactions accounts MMDAs Savings accounts Small CDs

13

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

14

Characteristics of Retail-Type Deposits Transaction Accounts

Most banks offer three different transaction accounts

Demand Deposits DDAs

Negotiable Order of Withdrawal NOWs

Automatic Transfers from Savings ATS

15


Demand Deposits Checking accounts that do not pay

interest Held by individuals, business, and

governmental units Most are held by businesses since

Regulation Q prohibits banks from paying explicit interest on for-profit corporate checking accounts

16


NOW Accounts Checking accounts that pay interest

ATS Accounts Customer has both a DDA and savings

account The bank transfers enough from savings to

DDA each day to force a zero balance in the DDA account

For-profit corporations are prohibited from owning NOW and ATS accounts

17


Although the interest cost of transaction accounts is very low, the non-interest costs can be quite high

Generally, low balance checking accounts are not profitable for banks due to the high cost of processing checks

18

Characteristics of Retail-Type Deposits Nontransactional Accounts

Non-transaction accounts are interest-bearing with limited or no check-writing privileges

19


Money Market Deposit Accounts Pay interest but holders are limited to 6

transactions per month, of which only three can be checks

Attractive to banks because they are not required to hold reserves against MMDAs

20


Savings Accounts Have no fixed maturity

Small Time Deposits (Retail CDs) Have a specified maturity ranging from

7 days on up Large Time Deposits (Jumbo CDs)

Negotiable CDs of $100,000 or more Typically can be traded in the

secondary market

21

Characteristics of Retail-Type Deposits Estimating the Cost of Deposit

Accounts Interest Costs Legal Reserve Requirements Check Processing Costs Account Charges

NSF fees Monthly fees Per check fees

22

Characteristics of Retail-Type Deposits Estimating the Cost of Deposit

Accounts Transaction Account Cost Analysis

Classifies check-processing as: Deposits

Electronic Non-Electronic

Withdrawals Electronic Non-Electronic

23

Characteristics of Retail-Type Deposits Estimating the Cost of Deposit Accounts

Transaction Account Cost Analysis Classifies check-processing as:

Transit Checks Deposited Cashed

Account Opened or Closed On-Us checks cashed General account maintenance

Truncated Non-Truncated

24


Transaction Account Cost Analysis Electronic Transactions

Conducted through automatic deposits, Internet, and telephone bill payment

Non-Electronic Transactions Conducted in person or by mail

Transit Checks Checks drawn on any bank other than the

bank it was deposited into

25


Transaction Account Cost Analysis On-Us Checks Cashed

Checks drawn on the bank’s own customer’s accounts

Deposits Checks or currency directly deposited in the

customer's account Account Maintenance

General record maintenance and preparing & mailing a periodic statement

26


Transaction Account Cost Analysis Truncated Account

A checking account in which the physical check is ‘truncated’ at the bank and the checks are not returned to the customer

Official Check Issued A check for certified funds.

Net Indirect Costs Those costs not directly related to the product

such as management salaries or general overhead costs

28

Characteristics of Retail-Type Deposits 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

29


Deposit Accounts

12ratio)t requiremen Reserve - (1 float ofnet balance Average

incomet Noninteres-expenset Noninteres expenseInterest

sliabilitiebank ofcost net Average

30


Deposit Accounts Example:

If a demand deposit account does not pay interest, has $20.69 in transaction costs charges, $7.75 in fees, an average balance of $5,515, and 5% float, what is the net cost of the deposit?

3.29%12.10) - (1 .05) - (1 $5,515

$7.75 - $20.69 $0

Deposit Demand ofCost Net Average

32

Characteristics of Large Wholesale Deposits Wholesale Liabilities

Customers move these investments on the basis of small rate differentials, so these funds are labeled:

Hot Money Volatile Liabilities Short-Term Non-Core funding

33


Jumbo CDs $100,000 or more Negotiable

Can be traded on the secondary market Minimum maturity of 7 days Interest rates quoted on a 360-day year basis Insured up to $100,000 per investor per

institution Issued directly or indirectly through a dealer

or broker (Brokered Deposits)

34


Jumbo CDs Fixed-Rate Variable-Rate

Jump Rate (Bump-up) CD Depositor has a one-time option until

maturity to change the rate to the prevailing market rate

35


Jumbo CDs Callable Zero Coupon Stock Market Indexed

Rate tied to stock market index performance Rate Boards

Represent venues for selling non-brokered CDs via the Internet to institutional investors

Rate boards help raise funds quickly and represent a virtual branch for a bank

36

Characteristics of Large Wholesale Deposits Individual Retirement Accounts

Each year, a wage earner can make a tax-deferred investment up to $8,000 of earned income

Funds withdrawn before age 59 ½ are subject to a 10% IRS penalty

This makes IRAs an attractive source of long-term funding for banks

37

Characteristics of Large Wholesale Deposits Foreign Office Deposits

Eurocurrency Financial claim denominated in a currency

other than that of the country where the issuing bank is located

Eurodollar Dollar-denominated financial claim at a bank

outside the U.S. Eurodollar deposits

Dollar-denominated depots in banks outside the U.S.

39

Characteristics of Large Wholesale Deposits Borrowing Immediately Available Funds

Federal Funds Purchased The term Fed Funds is often used to refer to

excess reserve balances traded between banks This is grossly inaccurate, given reserves averaging

as a method of computing reserves, different non-bank 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

40


Security Repurchase Agreements (RPs or Repos)

Short-term loans secured by government securities that are settled in immediately available funds

Identical to Fed Funds except they are collateralized

Technically, the RPs entail the sale of securities with a simultaneous agreement to buy them back later at a fixed price plus accrued interest

41


Security Repurchase Agreements (RPs or Repos)

Most transactions are overnight In most cases, the market value of the

collateral is set above the loan amount when the contract is negotiated.

This difference is labeled the margin The lender’s transaction is referred to

as a Reverse Repo

42


Structured Repurchase 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

Flipper Repo Carries a floating rate that will convert, or

flip, to a fixed rate after some lock-out period

43

Characteristics of Large Wholesale Deposits Borrowing From the Federal Reserve

Discount Window Discount Rate

Policy is to set discount rate 1% (1.5%) over the Fed Funds target for primary (secondary) credit loans

To borrow from the Federal Reserve, banks must apply and provide acceptable collateral before the loan is granted

Eligible collateral includes U.S. government securities, bankers acceptances, and qualifying short-term commercial or government paper

44


Discount Rate

Current Interest Rates 9/09/2009

Primary Credit 0.50%Secondary Credit 1.00%Seasonal Credit 0.25%

Fed Funds Target 0 - 0.25%

45


Primary Credit Available to sound depository

institutions on a short-term basis to meet short-term funding needs

46


Secondary Credit Available to depository institutions that

are not eligible for primary credit Available to meet backup liquidity

needs when its use is consistent with a timely return to a reliance on market sources of funding or the orderly resolution of a troubled institution

47


Seasonal Credit Designed to assist small depository

institutions in managing significant seasonal swings in their loans and deposits

48


Emergency Credit May be authorized in unusual and

exigent circumstances by the Board of Governors to individuals, partnerships, and corporations that are not depository institutions

49

Characteristics of Large Wholesale Deposits Other Borrowing from the Federal

Reserve Term Auction Facility

Allows banks to bid for an advance that will generally have a 28-day maturity

Banks must post collateral against the borrowings and cannot prepay the loan

50

Characteristics of Large Wholesale Deposits Other Borrowing from the Federal

Reserve Term Securities Lending Facility

A facility in which the Open Market Trading Desk of the Federal Reserve Bank of New York makes loans to primary securities dealers

51

Characteristics of Large Wholesale Deposits Federal Home Loan Bank Advances

The FHLB system is a government-sponsored enterprise created to assist in home buying

The FHLB system is one of the largest U.S. financial institutions, rated AAA because of the government sponsorship

Any bank can become a member of the FHLB system by buying FHLB stock

If it has the available collateral, primarily real estate related loans, it can borrow from the FHLB

FHLB advances have maturities from 1 day to as long as 20 years

53

Electronic Money Intelligent Card

Contains a microchip with the ability to store and secure information

Memory Card Simply store information

54

Electronic Money Debit Card

Online PIN based Transaction goes through the ATM

system Offline

Signature based transactions Transaction goes through the credit

card system

55

Electronic Money Electronic Funds Transfer (EFT)

An electronic movement of financial data, designed to eliminate the paper instruments normally associated with such funds movement

Types of EFT ACH: Automated Clearing House POS: Point of Sale ATM Direct Deposit Telephone Bill Paying Automated Merchant Authorization Systems Preauthorized Payments

57

Check 21 Check Clearing for the 21st Century Act

Facilitates check truncation by reducing some of the legal impediments

Foster innovation in the payments and check collection system without mandating receipt of check in electronic form

Improve the overall efficiency of the nation’s payment system

58

Check 21 Check Truncation

Conversion of a paper check into an electronic debit or image of the check by a third party in the payment system other than the paying bank

Facilitates check truncation by creating a new negotiable instrument called a substitute check

59

Check 21 Substitute Check

The legal equivalent of the original check and includes all the information contained on the original

Check 21 does NOT require banks to accept checks in electronic form nor does it require banks to create substitute checks It does allow banks to handle checks

electronically instead of physically moving paper checks

61

Check 21 Check Clearing Process

Banks typically place a hold on a check until it verifies that the check is “good”

Expedited Funds Availability Act Under Reg CC, it states that:

Local check must clear in no more than two business days

Non-local checks must clear in no more than five business days

Government, certified, and cashiers checks must be available by 9 a.m. the next business day

63

Measuring the Cost of Funds Average Historical Cost of Funds

Many banks incorrectly use the average historical costs in their pricing decisions

The primary problem with historical costs is that they provide no information as to whether future interest costs will rise or fall.

Pricing decisions should be based on marginal costs compared with marginal revenues

64

Measuring the Cost of Funds 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

65


Costs of Independent Sources of Funds

It is difficult to measure marginal costs precisely

Management must include both the interest and noninterest costs it expects to pay and identify which portion of the acquired funds can be invested in earning assets

66



Marginal costs may be defined as :

jLiability of Balance InvestableNet Insurance Costs Acquistion Costs Servicing RateInterest

jLiability ofCost Marginal

67


Costs of Independent Sources of Funds Example:

Market interest rate is 2.5% Servicing costs are 4.1% of balances Acquisition costs are 1.0% of balances Deposit insurance costs are 0.25% of

balances Net investable balance is 85% of the balance

(10% required reserves and 5% float)

68



Example:

9.24% 0.09240.85

0.00250.010.0410.025Cost Marginal

69



Cost of Debt Equals the effective cost of borrowing from

each source, including interest expense and transactions costs

This cost 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

70


Costs of Independent Sources of Funds Cost of Debt

Example: Assume the bank will issue:

$10 million in par value subordinated notes paying $700,000 in annual interest and a 7-year maturity

It must pay $100,000 in flotation costs to an underwriter

The effective cost of borrowing (kd) is 7.19%

71



Cost of Debt Example:

7.19% k Thus)k(1

0$10,000,00)k(1

$700,000$9,900,000

d

7d

7

1tt

d

72



Cost of Equity The marginal cost of equity equals the

required return to shareholders It is not directly measurable because

dividend payments are not mandatory

73



Cost of Equity Several methods are commonly used to

approximate this required return: Dividend Valuation Model Capital Asset Pricing Model (CAPM) Targeted Return on Equity Model

Cost of Debt + Risk Premium

74


Costs of Independent Sources of Funds Cost of Preferred Stock

Preferred stock acts as a hybrid of debt and common equity

Claims are superior to those of common stockholders but subordinated to those of debt holders

Preferred stock pays dividends that may be deferred when management determines that earnings are too low.

The marginal cost of preferred stock can be approximated in the same manner as the Dividend Valuation Model however, dividend growth is zero

75



Trust Preferred Stock Trust preferred stock is attractive because

it effectively pays dividends that are tax deductible

This loan interest is tax deductible such that the bank effectively gets to deduct dividend payments as the preferred stock

76

Measuring the Cost of Funds Weighted Marginal Cost of Total Funds

This is the best cost measure for asset-pricing purposes

It recognizes both explicit and implicit costs associated with any single source of funds

77

Measuring the Cost of Funds Weighted Marginal Cost of Total Funds

It assumes that all assets are financed from a pool of funds and that specific sources of funds are not tied directly to specific uses of funds

m

1j

WMC jjkw

79

Funding Sources and Banking Risks Banks face two fundamental problems

in managing liabilities. Uncertainty over: What rates they must pay to retain and

attract funds The likelihood that customers will

withdraw their money regardless of rates

80

Funding Sources and Banking Risks Funding Sources: Liquidity Risk

The liquidity risk associated with a bank’s deposit base is a function of:

The competitive environment Number of depositors Average size of accounts Location of the depositor Specific maturity and rate

characteristics of each account

81

Funding Sources and Banking Risks Funding Sources: Liquidity Risk

Interest Elasticity How much can market interest rates change

before the bank experiences deposit outflows? If a bank raises its rates, how many new funds

will it attract? Depositors often compare rates and move

their funds between investment vehicles to earn the highest yields

It is important to note the liquidity advantage that stable core deposits provide a bank

82

Funding Sources and Banking Risks 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 a substantial premium to induce depositors to lengthen maturities

Those banks that choose not to pay this premium will typically have a negative one-year GAP

83

Funding Sources and Banking Risks Funding Sources: Interest Rate Risk

One strategy is to aggressively compete for retail core deposits

Individual are not as rate sensitive as corporate depositors and will often maintain their balances through rate cycles as long as the bank provides good service

84

Funding Sources and Banking Risks Funding Sources: Credit and Capital Risk

Changes in the composition and cost of bank funds can indirectly affect a bank’s credit risk by forcing it to reduce asset quality

For example, banks that substitute purchased funds for lost demand deposits will often see their cost of funds rise

Rather than let their interest margins deteriorate, many banks make riskier loans at higher promised yields

While they might maintain their margins in the near-term, later loan losses typically rise with the decline in asset quality

85

Managing Liquidity11

86

Meeting Liquidity Needs Bank Liquidity

A bank’s capacity to acquire immediately available funds at a reasonable price

Firms can acquire liquidity in three distinct ways:1. Selling assets2. New borrowings3. New stock issues

87

Meeting Liquidity Needs How effective each liquidity source is

at meeting the institution’s liquidity needs, depends on: Market conditions The market’s perception of risk at the

institution as well as in the marketplace

The market’s perception of bank management and its strategic direction

The current economic environment

88

Meeting Liquidity Needs Holding Liquid Assets

“Cash Assets” Do not earn any interest Represents a substantial opportunity cost

for banks Banks attempt to minimize the amount of cash

assets held and hold only those required by law or for operational needs

Liquid Assets Can be easily and quickly converted into

cash with minimum loss

89


“Cash Assets” do not generally satisfy a bank’s liquidity needs

If the bank holds the minimum amount of cash assets required, an unforeseen drain on vault cash (perhaps from an unexpected withdrawal) will cause the level of cash to fall below the minimum for legal and operational requirements

90


Banks hold cash assets to satisfy four objectives:

1. To meet customers’ regular transaction needs

2. To meet legal reserve requirements3. To assist in the check-payment

system4. To purchase correspondent banking

services

91


Banks own five types of liquid assets1. Cash and due from banks in excess of

requirements2. Federal funds sold and reverse repurchase

agreements3. Short-term Treasury and agency obligations4. High-quality short-term corporate and

municipal securities5. Government-guaranteed loans that can be

readily sold

92

Meeting Liquidity Needs Borrowing Liquid Assets

Banks can provided for their liquidity by borrowing

Banks historically have had an advantage over non-depository institutions in that they could fund their operations with relatively low-cost deposit accounts

93

Meeting Liquidity Needs Objectives of Cash Management

Banks must balance the desire to hold a minimum amount of cash assets while meeting the cash needs of its customers

The fundamental goal is to accurately forecast cash needs and arrange for readily available sources of cash at minimal cost

94

Reserve Balances at the Federal Reserve Bank Banks hold deposits at the Federal

Reserve because: The Federal Reserve imposes legal

reserve requirements and deposit balances qualify as legal reserves

To help process deposit inflows and outflows caused by check clearings, maturing time deposits and securities, wire transfers, and other transactions

95

Reserve Balances at the Federal Reserve Bank Required Reserves and Monetary

Policy The purpose of required reserves is to

enable the Federal Reserve to control the nation’s money supply

The Fed has three distinct monetary policy tools:

Open market operations Changes in the discount rate Changes in the required reserve ratio

96

Reserve Balances at the Federal Reserve Bank Required Reserves and Monetary Policy

Example A required reserve ratio of 10% means that a

bank with $100 in demand deposits outstanding must hold $10 in legal required reserves in support of the DDAs

The bank can thus lend out only 90% of its DDAs If the bank has exactly $10 in legal reserves, the

reserves do not provide the bank with liquidity If the bank has $12 in legal reserves, $2 is excess

reserves, providing the bank with $2 in immediately available funds

97

Reserve Balances at the Federal Reserve Bank Impact of Sweep Accounts on

Required Reserve Balances Under Reg. D, banks have reserve

requirements of 10% on demand deposits, ATS, NOW, and other checkable deposit (OCD) accounts

not reservable

98


Required Reserve Balances MMDAs are considered personal

saving deposits and have a zero required reserve requirement ratio

99


Required Reserve Balances Sweep accounts are accounts that

enable depository institutions to shift funds from OCDs, which are reservable, to MMDAs or other accounts, which are not reservable

100

Reserve Balances at the Federal Reserve Bank Impact of Sweep Accounts on Required

Reserve Balances Sweep Accounts

Two Types Weekend Program

Reclassifies transaction deposits as savings deposits at the close of business on Friday and back to transaction accounts at the open on Monday

On average, this means that for three days each week, the bank does not need to hold reserves against those balances

101

Reserve Balances at the Federal Reserve Bank Impact of Sweep Accounts on Required

Reserve Balances Sweep Accounts

Two Types Threshold Account

The bank’s computer moves the customer’s DDA balance into an MMDA when the dollar amount reaches some minimum and returns funds as needed

The number of transfers is limited to 6 per month, so the full amount of funds must be moved back into the DDA on the sixth transfer of the month

103

Meeting Legal Reserve Requirements Required reserves can be met over a

two-week period There are three elements of required

reserves: The dollar magnitude of base liabilities The required reserve fraction The dollar magnitude of qualifying

cash assets

104

Meeting Legal Reserve Requirements

105

Meeting Legal Reserve Requirements Historical Problems with Reserve

Requirements Reserve requirements varied by type of

bank charter and by state. Non-Fed member banks had lower

reserve requirements than Fed member banks

106

Meeting Legal Reserve Requirements Lagged Reserve Accounting

Computation Period Consists of two one-week reporting

periods beginning on a Tuesday and ending on the second Monday thereafter

Maintenance Period Consists of 14 consecutive days

beginning on a Thursday and ending on the second Wednesday thereafter

107


Reserve Balance Requirements The balance to be maintained in any

given maintenance period is measured by:

Reserve requirements on the reservable liabilities calculated as of the computation period that ended 17 days prior to the start of the maintenance period

Less vault cash as of the same computation period

108


Reserve Balance Requirements Both vault cash and Federal Reserve

Deposits qualify as reserves The portion that is not met by vault

cash is called the reserve balance requirement

111

Meeting Legal Reserve Requirements An Application: Reserve Calculation

Under LRA Four steps:

1. Calculate daily average balances outstanding during the lagged computation period.

2. Apply the reserve percentages.3. Subtract vault cash.4. Add or subtract the allowable reserve

carried forward from the prior period

113

Meeting Legal Reserve Requirements Correspondent Banking Services

System of interbank relationships in which the correspondent bank (upstream correspondent) sells services to the respondent bank (downstream correspondent)

114


Common Correspondent Banking Services Check collection, wire transfer, coin and currency

supply Loan participation assistance Data processing services Portfolio analysis and investment advice Federal funds trading Securities safekeeping Arrangement of purchase or sale of securities Investment banking services Loans to directors and officers International financial transactions

115


Banker’s Bank A firm, often a cooperative owned by

independent commercial banks, that provides correspondent banking services to commercial banks and not to commercial or retail deposit and loan customers

116

Liquidity Planning Short-Term Liquidity Planning

Objective is to manage a legal reserve position that meets the minimum requirement at the lowest cost

117

Liquidity Planning

118

Liquidity Planning Managing Float

During any single day, more than $100 million in checks drawn on U.S. commercial banks is waiting to be processed

Individuals, businesses, and governments deposit the checks but cannot use the proceeds until banks give their approval, typically in several days

Checks in process of collection, called float, are a source of both income and expense to banks

119

Liquidity Planning Liquidity versus Profitability

There is a short-run trade-off between liquidity and profitability

The more liquid a bank is, the lower are its return on equity and return on assets, all other things equal

In a bank’s loan portfolio, the highest yielding loans are typically the least liquid

The most liquid loans are typically government-guaranteed loans

120

Liquidity Planning The Relationship Between Liquidity, Credit

Risk, and Interest Rate Risk Liquidity risk for a poorly managed bank

closely follows credit and interest rate risk Banks that experience large deposit

outflows can often trace the source to either credit problems or earnings declines from interest rate gambles that backfired

Potential liquidity needs must reflect estimates of new loan demand and potential deposit losses

121

Liquidity Planning The Relationship Between Liquidity,

Credit Risk, and Interest Rate Risk

122

Traditional Aggregate Measures of Liquidity Risk Asset Liquidity Measures

The most liquid assets mature near term and are highly marketable

Any security or loan with a price above par, in which the bank could report a gain at sale, is viewed as highly liquid

Liquidity measures are normally expressed in percentage terms as a fraction of total assets

123


Highly Liquid Assets Cash and due from banks in excess of required

holdings Federal funds sold and reverse RPs. U.S. Treasury securities and agency obligations

maturing within one year Corporate obligations and municipal securities

maturing within one year and rated Baa and above

Loans that can be readily sold and/or securitized

124


Pledging Requirements Not all of a bank’s securities can be

easily sold Like their credit customers, banks are

required to pledge collateral against certain types of borrowings

U.S. Treasuries or municipals normally constitute the least-cost collateral and, if pledged against debt, cannot be sold until the bank removes the claim or substitutes other collateral

125


Pledging Requirements Collateral is required against four

different liabilities: Repurchase agreements Discount window borrowings Public deposits owned by the U.S.

Treasury or any state or municipal government unit

FLHB advances

126


Loans Many banks and bank analysts monitor

loan-to-deposit ratios as a general measure of liquidity

Loans are presumably the least liquid of assets, while deposits are the primary source of funds

A high ratio indicates illiquidity because a bank is fully loaned up relative to its stable funding

127

Traditional Aggregate Measures of Liquidity Risk Liability Liquidity Measures

Liability Liquidity: The ease with which a bank can issue

new debt to acquire clearing balances at reasonable costs

Measures typically reflect a bank’s asset quality, capital base, and composition of outstanding deposits and other liabilities

128


Commonly used measures: Total equity to total assets Risk assets to total assets Loan losses to net loans Reserve for loan losses to net loans The percentage composition of deposits Total deposits to total liabilities Core deposits to total assets Federal funds purchased and RPs to total liabilities Commercial paper and other short-term

borrowings to total liabilities

129


Core Deposits A base level of deposits a bank expects

to remain on deposit, regardless of the economic environment

Volatile Deposits The difference between actual current

deposits and the base estimate of core deposits

130

Longer-Term Liquidity Planning This stage of liquidity planning involves

projecting funds needs over the coming year and beyond if necessary Forecasts in deposit growth and loan demand

are required Projections are separated into three categories:

base trend, short-term seasonal, and cyclical values

The analysis assesses a bank’s liquidity gap, measured as the difference between potential uses of funds and anticipated sources of funds, over monthly intervals

132

Longer-Term Liquidity Planning The bank’s monthly liquidity needs are

estimated as the forecasted change in loans plus required reserves minus the forecast change in deposits:

Liquidity needs = Forecasted Δloans + ΔRequired reserves - Forecasted Δdeposits

133

Longer-Term Liquidity Planning

134


135


136

Longer-Term Liquidity Planning Considerations in the Selection of

Liquidity Sources The costs should be evaluated in

present value terms because interest income and expense may arise over time

The choice of one source over another often involves an implicit interest rate forecast

137

Contingency Funding Financial institutions must have

carefully designed contingency plans that address their strategies for handling unexpected liquidity crises and outline the appropriate procedures for dealing with liquidity shortfalls occurring under abnormal conditions

138

Contingency Funding Contingency Planning

A contingency plan should include: A narrative section that addresses the

senior officers who are responsible for dealing with external constituencies, internal and external reporting requirements, and the types of events that trigger specific funding needs

139


A contingency plan should include: A quantitative section that assesses the

impact of potential adverse events on the institution’s balance sheet (changes), incorporates the timing of such events by assigning deposit and wholesale funding run-off rates, identifies potential sources of new funds, and forecasts the associated cash flows across numerous short-term and long-term scenarios and time intervals

140


A contingency plan should include: A section that summarizes the key

risks and potential sources of funding, identifies how the modeling will monitored and tested, and establishes relevant policy limits

141


The institution’s liquidity contingency strategy should clearly outline the actions needed to provide the necessary liquidity

The institution’s plan must consider the cost of changing its asset or liability structure versus the cost of facing a liquidity deficit

142


The contingency plan should prioritize which assets would have to be sold in the event that a crisis intensifies

The institution’s relationship with its liability holders should also be factored into the contingency strategy

The institution’s plan should also provide for back-up liquidity

143

The Effective Use of Capital12

144

Why Worry About Bank Capital? Capital requirements reduce the risk of

failure by acting as a cushion against losses, providing access to financial markets to meet liquidity needs, and limiting growth

Bank capital-to-asset ratios have fallen from about 20% a hundred years ago to around 8% today

146

Risk-Based Capital Standards Historically, the minimum capital

requirements for banks were independent of the riskiness of the bank

Prior to 1990, banks were required to maintain: a primary capital-to-asset ratio of at

least 5% to 6%, and a minimum total capital-to-asset ratio

of 6%

147

Risk-Based Capital Standards Primary Capital

Common stock Perpetual preferred stock Surplus Undivided profits Contingency and other capital reserves Mandatory convertible debt Allowance for loan and lease losses

148

Risk-Based Capital Standards Secondary Capital

Long-term subordinated debt Limited-life preferred stock

Total Capital Primary Capital + Secondary Capital

Capital requirements were independent of a bank’s asset quality, liquidity risk, interest rate risk, operational risk, and other related risks

149

Risk-Based Capital Standards The 1986 Basel Agreement

In 1986, U.S. bank regulators proposed that U.S. banks be required to maintain capital that reflects the riskiness of bank assets

The Basel Agreement grew to include risk-based capital standards for banks in 12 industrialized nations

Regulations apply to both banks and thrifts and have been in place since the end of 1992

Today, countries that are members of the Organization for Economic Cooperation and Development (OECD) enforce similar risk-based requirements on their own financial institutions

150


A bank’s minimum capital requirement is linked to its credit risk

The greater the credit risk, the greater the required capital

Stockholders' equity is deemed to be the most valuable type of capital

151


Minimum capital requirement increased to 8% total capital to risk-adjusted assets

Capital requirements were approximately standardized between countries to ‘level the playing field'

152

Risk-Based Capital Standards Risk-Based Elements of Basel I

1. Classify assets into one of four risk categories

2. Classify off-balance sheet commitments into the appropriate risk categories

3. Multiply the dollar amount of assets in each risk category by the appropriate risk weight This equals risk-weighted assets

4. Multiply risk-weighted assets by the minimum capital percentages, currently 4% for Tier 1 capital and 8% for total capital

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Risk-Based Capital Standards

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Risk-Based Capital Standards

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What Constitutes Bank Capital? Capital (Net Worth)

The cumulative value of assets minus the cumulative value of liabilities

Represents ownership interest in a firm

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What Constitutes Bank Capital? Total Equity Capital

Equals the sum of: Common stock Surplus Undivided profits and capital reserves Net unrealized holding gains (losses)

on available-for-sale securities Preferred stock

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What Constitutes Bank Capital? Tier 1 (Core) Capital

Equals the sum of: Common equity Non-cumulative perpetual preferred

stock Minority interest in consolidated

subsidiaries, less intangible assets such as goodwill

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What Constitutes Bank Capital? Tier 2 (Supplementary) Capital

Equals the sum of: Cumulative perpetual preferred stock Long-term preferred stock Limited amounts of term-subordinated

debt Limited amount of the allowance for

loan loss reserves (up to 1.25 percent of risk-weighted assets)

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What Constitutes Bank Capital? Leverage Capital Ratio

Tier 1 capital divided by total assets net of goodwill and disallowed intangible assets and deferred tax assets

Regulators are concerned that a bank could acquire practically all low-risk assets such that risk-based capital requirements would be virtually zero

To prevent this, regulators have also imposed a 3 percent leverage capital ratio

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What Constitutes Bank Capital?

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What Constitutes Bank Capital?

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What Constitutes Bank Capital? Tier 3 Capital Requirements for Market

Risk Under Basel I Market Risk

The risk of loss to the bank from fluctuations in interest rates, equity prices, foreign exchange rates, commodity prices, and exposure to specific risk associated with debt and equity positions in the bank’s trading portfolio

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What Constitutes Bank Capital? Tier 3 Capital Requirements for Market

Risk Under Basel I Banks subject to the market risk

capital guidelines must maintain an overall minimum 8 percent ratio of total qualifying capital [the sum of Tier 1 capital, Tier 2 capital, and Tier 3 capital allocated for market risk, net of all deductions] to risk-weighted assets and market risk–equivalent assets

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What Constitutes Bank Capital? Basel II Capital Standards

Risk-based capital standards that encompass a three-pillar approach for determining the capital requirements for financial institutions

Basel II capital standards are designed to produce minimum capital requirements that incorporate more types of risk than the credit risk-based standards of Basel I

Basel II standards have not been finalized

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What Constitutes Bank Capital? Basel II Capital Standards

Pillar I Credit risk Market risk Operational risk

Pillar II Supervisory review of capital adequacy

Pillar III Market discipline through enhanced public

disclosure

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What Constitutes Bank Capital? Weaknesses of the Risk-Based Capital

Standards Standards only consider credit risk

Ignores interest rate risk and liquidity risk

Core banks subject to the advanced approaches of Basel II use internal models to assess credit risk

Results of their own models are reported to the regulators

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What Constitutes Bank Capital? Weaknesses of the Risk-Based Capital Standards

The new risk-based capital rules of Basel II are heavily dependent on credit ratings, which have been extremely inaccurate in the recent past

Book value of capital is often not meaningful since It ignores:

changes in the market value of assets unrealized gains (losses) on held-to-maturity

securities 97% of banks are considered “well capitalized” in

2007 Not a binding constraint for most banks

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What is the Function of Bank Capital For regulators, bank capital serves to

protect the deposit insurance fund in case of bank failures

Bank capital reduces bank risk by: Providing a cushion for firms to absorb

losses and remain solvent Providing ready access to financial

markets, which provides the bank with liquidity

Constraining growth and limits risk taking

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What is the Function of Bank Capital

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How Much Capital Is Adequate? Regulators prefer more capital

Reduces the likelihood of bank failures and increases bank liquidity

Bankers prefer less capital Lower capital increases ROE, all other

things the same Riskier banks should hold more capital

while lower-risk banks should be allowed to increase financial leverage

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The Effect of Capital Requirements on Bank Operating Policies Limiting Asset Growth

The change in total bank assets is restricted by the amount of bank equity

where TA = Total Assets EQ = Equity Capital ROA = Return on Assets DR = Dividend Payout Ratio EC = New External Capital

11

21 /TAEQ

ΔEC/TADR)ROA(1ΔTA/TA

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The Effect of Capital Requirements on Bank Operating Policies Changing the Capital Mix

Internal versus External capital Change Asset Composition

Hold fewer high-risk category assets Pricing Policies

Raise rates on higher-risk loans Shrinking the Bank

Fewer assets requires less capital

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Characteristics of External Capital Sources Subordinated Debt

Advantages Interest payments are tax-deductible No dilution of ownership interest Generates additional profits for

shareholders as long as earnings before interest and taxes exceed interest payments

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Characteristics of External Capital Sources Subordinated Debt

Disadvantages Does not qualify as Tier 1 capital Interest and principal payments are

mandatory Many issues require sinking funds

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Characteristics of External Capital Sources Common Stock

Advantages Qualifies as Tier 1 capital It has no fixed maturity and thus

represents a permanent source of funds

Dividend payments are discretionary Losses can be charged against equity,

not debt, so common stock better protects the FDIC

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Characteristics of External Capital Sources Common Stock

Disadvantages Dividends are not tax-deductible, Transactions costs on new issues

exceed comparable costs on debt Shareholders are sensitive to earnings

dilution and possible loss of control in ownership

Often not a viable alternative for smaller banks

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Characteristics of External Capital Sources Preferred Stock

A form of equity in which investors' claims are senior to those of common stockholders

Dividends are not tax-deductible Corporate investors in preferred stock

pay taxes on only 20 percent of dividends

Most issues take the form of adjustable-rate perpetual stock

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Characteristics of External Capital Sources Trust Preferred Stock

A hybrid form of equity capital at banks It effectively pays dividends that are tax deductible

To issue the security, a bank establishes a trust company

The trust company sells preferred stock to investors and loans the proceeds of the issue to the bank

Interest on the loan equals dividends paid on preferred stock

The interest on the loan is tax deductible such that the bank deducts dividend payments

Counts as Tier 1 capital

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Characteristics of External Capital Sources TARP Capital Purchase Program

The Troubled Asset Relief Program’s Capital Purchase Program (TARP-CPP), allows financial institutions to sell preferred stock that qualifies as Tier 1 capital to the Treasury

Qualified institutions may issue senior preferred stock equal to not less than 1% of risk-weighted assets and not more than the lesser of $25 billion, or 3%, of risk-weight assets

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Characteristics of External Capital Sources Leasing Arrangements

Many banks enter into sale and leaseback arrangements

Example: The bank sells its headquarters and

simultaneously leases it back from the buyer The bank receives a large amount of cash

and still maintains control of the property The net effect is that the bank takes a fully

depreciated asset and turns it into a tax deduction

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Capital Planning Process of Capital Planning

Generate pro formal balance sheet and income statements for the bank

Select a dividend payout Analyze the costs and benefits of

alternative sources of external capital

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Capital Planning Application

Consider a bank that has exhibited a deteriorating profit trend

Assume as well that federal regulators who recently examined the bank indicated that the bank should increase its primary capital-to-asset ratio to 8.5% within four years from its current 7%

The $80 million bank reported an ROA of just 0.45 percent

During each of the past five years, the bank paid $250,000 in common dividends

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Capital Planning Application

Consider a bank that has exhibited a deteriorating profit trend

The following slide extrapolates historical asset growth of 10%

Under this scenario, the bank will actually see its capital ratio fall

The following slide also identifies three different strategies for meting the required 8.5% capital ratio

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Depository Institutions Capital Standards The Federal Deposit Insurance

Improvement Act (FDICIA) focused on revising bank capital requirements to: Emphasize the importance of capital Authorize early regulatory intervention

in problem institutions Authorized regulators to measure

interest rate risk at banks and require additional capital when it is deemed excessive

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Depository Institutions Capital Standards The Act required a system for prompt

regulatory action It divides banks into categories

according to their capital positions and mandates action when capital minimums are not met

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Depository Institutions Capital Standards

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Federal Deposit Insurance Federal Deposit Insurance Corporation

Established in 1933 Coverage is currently $100,000 per

depositor per institution Original coverage was $2,500

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Initial Objective: Prevent liquidity crises caused by

large-scale deposit withdrawals Protect depositors of modes means

against a bank failure

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The Financial Institution Reform, Recovery and Enforcement Act of 1989 authorized the issuance of bonds to finance the bailout of the FSLIC

The act also created two new insurance funds, the Savings Association Insurance Fund (SAIF) and the Bank Insurance Fund (BIF); both were controlled by the FDIC

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The large number of failures in the late 1980s and early 1990s depleted the FDIC fund

During 1991 - 92, the FDIC ran a deficit and had to borrow from the Treasury

In 1991 FDIC began charging risk-based deposit insurance premiums ranging from $0.23 to $0.27 per $100, depending on a bank’s capital position.

By 1993, the reduction in bank failures and increased premiums allowed the FDIC to pay off the debt and put the fund back in the black

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Federal Deposit Insurance

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Federal Deposit Insurance FDIC Insurance Assessment Rates

FDIC insurance premiums are assessed using a risk-based deposit insurance system

Deposit insurance assessment rates are reviewed semiannually by the FDIC to ensure that premiums appropriately reflect the risks posed to the insurance funds and that fund reserve ratios are maintained at or above the target designated reserve ratio (DRR) of 1.25% of insured deposits

Deposit insurance premiums are assessed as basis points per $100 of insured deposits

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FDIC Improvement Act Merged the BIF and SAIF into the Deposit

Insurance Fund (DIF) Increasing coverage for retirement

accounts to $250,000 and indexing the coverage to inflation

Established a range of 1.15% to 1.50% within which the FDIC Board of Directors may set the Designated Reserve Ratio (DRR)

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Subgroup A Financially sound institutions with only

a few minor weaknesses This subgroup assignment generally

corresponds to the primary federal regulator’s composite rating of “1” or “2”

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Subgroup B Institutions that demonstrate

weaknesses that, if not corrected, could result in significant deterioration of the institution and increased risk of loss to the BIF or SAIF

This subgroup assignment generally corresponds to the primary federal regulator’s composite rating of “3”

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Subgroup C Institutions that pose a substantial

probability of loss to the BIF or the SAIF unless effective corrective action is taken

This subgroup assignment generally corresponds to the primary federal regulator’s composite rating of “4” or “5”

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Federal Deposit Insurance Problems With Deposit Insurance

Deposit insurance acts similarly to bank capital In banking, a large portion of borrowed funds

come from insured depositors who do not look to the bank’s capital position in the event of default

A large number of depositors, therefore, do not require a risk premium to be paid by the bank since their funds are insured

Normal market discipline in which higher risk requires the bank to pay a risk premium does not apply to insured funds

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Too-Big-To-Fail Many large banks are considered to be

“too-big-to-fail” As such, any creditor of a large bank

would receive de facto 100 percent insurance coverage regardless of the size or type of liability

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Deposit insurance has historically ignored the riskiness of a bank’s operations, which represents the critical factor that leads to failure

Two banks with equal amounts of domestic deposits paid the same insurance premium, even though one invested heavily in risky loans and had no uninsured deposits while the other owned only U.S. government securities and just 50 percent of its deposits were fully insured

The creates a moral hazard problem

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Moral Hazard A lack of incentives that would

encourage individuals to protect or mitigate against risk

In some cases of moral hazard, incentives are created that would actually increase risk-taking behavior

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Deposit insurance funds were always viewed as providing basic insurance coverage

Historically, there has been fundamental problem with the pricing of deposit insurance

Premium levels were not sufficient to cover potential payouts

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Historically, premiums were not assessed against all of a bank’s insured liabilities

Insured deposits consisted only of domestic deposits while foreign deposits were exempt

Too-big-to-fail doctrine toward large banks means that large banks would have coverage on 100 percent of their deposits but pay for the same coverage as if they only had the same $250,000 coverage as smaller banks do

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Federal Deposit Insurance Weakness of the Current Risk-Based Deposit

Insurance System Risk-based deposit system is based on capital

and risk Hence, banks that hold higher capital, everything

else being equal, pay lower premiums “Too Big to Fail”

The FDIC must follow the “least cost” alternative in the resolution of a failed bank. Consequently, the FDIC must consider all alternatives and choose the one that represents the lowest cost to the insurance fund

funding the bank

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