MANAGING COST OF FUND
CHAPTER 3 ❤
1. Objectives
1.2 Different funding sources
1.1 How banks fund their operations
1.2.1 strengths and weaknesses
1.2.2 influences
bank’s liquidity risk and profitability
1.3 The nature of liquidity needs
1.4 The risk-return characteristics of alternative funding sources.
1.5 The costs of various sources of funds
1.6 The relationship between financing events and
1.6.2 bank's credit
1.6.3 bank's interest rate risk position.
1.6.1 bank’s liquidity
1.4.1 Characteristics of Retail-Type Deposits
1.4.2 Characteristics of Large Wholesale Liabilities.
2. The relationship between liquidity requirements, cash, and funding sources
2.2 Liquidity needs
2.3 Funding
2.1 Cash - Liquidity Requirements
Customers
more rate
shorter-term deposits
making core deposits
Hybrid CDs
Indexed CD
CD Special
Jump Rate (Bump up) CDs
2.4 Volatile Liabilities
2.3.1 Borrowed Funding
2.3.1 Wholesale Funding
2.3.1 Retail Funding (Deposit Accounts)
2.3.1 Equity Funding
4 types
3 types
1 type
3 types
Funds purchased from rate- senstive investors
rate- senstive investors
5 types
Jumbo CDs
Eurodollar time deposits
Repurchase agreements
Foreign Deposits
Federal Funds purchased
MMDAs
Saving accounts
Transaction accounts
Small time deposits
Repurchase agreements
Federal Home Loan Bank borrowings
Federal Funds purchased
Preferred stock
Retained earnings
Common stock
Includes borowed funds plus large CDs
3. Characteristics of Retail-Type Deposits
3.2 Non-transactional Accounts
3.1 Transactions Accounts
3.1.3 automatic transfers from saving ( ATS)
3.1.2 Negotiable order of withdrawal ( NOWs)
3.1.1Demand deposit accounts (DDAs)
3.2.2 Savings accounts
3.2.3 Large time deposits ( jumbo CDs )
3.3 Estimating the Cost of Deposit Accounts
3.3.1 Calculating the Average Net Cost of Deposit Accounts
3.3.1.1 Average Interest Cost
3.3.1.2 Average Historical Cost of Funds
not pay interest
primarily used for frequent transactions
pay interest
two accounts -- a DDA and a savings -- working in tandem
(Interest expense + noninterest expense – noninterest income )/(average balance x net of float x ( 1-Required Reserve ratio))x 12
measure of average unit borrowing cost for existing funds
have no fixed maturity
negotiable CDs of $100,000 of more
3.2.4 small time deposits ( retail CDs)
have a specified maturity ranging from 7 days on up
typically can be traded in the secondary market
certain restrictions regarding the number of withdrawals and the amount to be withdrawn in a particular time period
the customers can't withdraw their money with checks
The rate of interest paid on time deposits is usually higher than the other types of bank accounts
6. Funding sources and bankingt risk
Bank's problem
6.1 Liquidity Risk
6.3 credit and capital risk
6.2 Interest rate Risk
three kind of risk
Bank's deposit base
The competitive environment
number of depositors
Average size ofacounts
Location of depositor
specifiic maturity and rate characteristics of each account
the funtion
changes in the composition and cost of bank fund
offer a substantial premium
not to pay the premium
Prefer short- term instrument
the banks make riskier loan at higher promised yield
maintain margin in the near term
The banks substitute purchased funds
Three changes
Unncertainty over what rates they must pay to retain and attract funds
uncertainty over the likelyhood that customers will withdraw their money regardless of rates
5.The Average Historical Cost of Funds
5.1. The Marginal Cost of Funds
5.2. Costs of Independent Sources of Funds
5.3. Weighted Marginal Cost of Total Funds
Marginal cost of debt
Marginal cost of equity
Marginal cost of funds
Marginal cost of liability j=
(Interest Rate+Servicing Costs+ Acquisition Cost+ Insurance)/(Net Investable Balance of Liability j)
Cost of Debt
Cost of Equity
Dividend Valuation Model
Capital Asset Pricing Model (CAPM)
Targeted Return on Equity Model
Cost of Preferred Stock
Trust Preferred Stock
The best cost measure for asset-pricing purposes
Stages
- Forecast the desired dollar amount of financing to be obtained from each individual debt and equity source.
- Estimate the marginal cost of each independent source of funds
- Combine the individual estimates to project the weighted cost
4. Characteristics of Large Wholesale Liabilities
“hot money,” volatile liabilities, or short-term noncore funding
includes
Foreign Office Deposits
Jumbo CDs (CDs)
CD interest rates are quoted on the basis of a 360-day year
Maturity >= 7 days
Insured up to $250,000 per investor
Eurodollar
(Eurocurrency )
Federal Funds Purchased
Repurchase Agreements ( RPs or Repos )
Eurodollar Time Deposits
Overnight loans
Maturity up to several weeks
Interest rates is 360- days year basis
short- term loans secured by government securities
Same Fed funds, except they are collateralixed
Repurchase with a fixed pricemplus accrued interest
The margin
Borrowing from the Federal Reserve
Federal Home Loan Bank advances ( FHLB )
Discount Window
Discount Rate
Primary Credit
Secondary Credit ( are not eligible for primary credits )
Seasonal Credit
Emergency Credit
( are not depository institutions)
maturity from 1 day to as long as 20 years
3.2.1 Money market deposit accounts (MMDAs)
six transactions per month and only three can be ckeck
not required to hold reserves against