Funding the BankChapter 10

President and CEO, SW Graduate School of Banking FoundationDirector, Assemblies for Bank Directors

Adjunct Professor, Dept. of Finance, Cox School of BusinessSouthern Methodist University

scott@swgsb.org www.swgsb.org

S. Scott MacDonald, Ph.D.

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

2

Funding• Retail Funding, Deposit Accounts

• Transaction accounts• Money market deposit accounts• Savings accounts• Small time deposits

• Borrowed Funding• Federal Funds purchased• Repurchase agreements• Federal Home Loan Bank borrowings

• Wholesale Funding• Includes borrowed funds plus large CDs

• Equity Funding• Common stock• Preferred stock• Retained earnings

3

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

4

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

5

Much of the recent growth in the banking industry has come through borrowed funding, rather than core deposits.

Core deposits STILL create bank value!

Source: FDIC Quarterly Banking Profile

Notice an new trend?

Assets are our liabilities, while our liabilities are our assets!

0.0%

5.0%

10.0%

15.0%

20.0%

50%

60%

70%

80%

90%

100%

Borr

owed

Fund

s, S

ub. N

otes

and

Tot

al E

quity

Tota

l Dep

osits

Borrowed Funds

Total Deposits

Subordinated Notes

Total Equity

Percent of total funding Percent of total funding

Funding Sources

7

< $100 M $100M - $1B $1B - $10B > $10 B All CBsNumber of institutions reporting 1875 3523 450 89 5937

Total liabilities 88.62% 89.43% 88.33% 88.78% 88.83%Total deposits 85.44% 84.28% 78.76% 73.38% 75.49%

Deposits held in domestic offices 85.44% 84.22% 78.29% 61.04% 64.94%Transaction accounts 29.92% 21.56% 11.55% 9.87% 10.91%

Demand deposits 16.97% 12.83% 8.08% 8.57% 8.90%Nontransaction accounts 55.53% 62.66% 66.74% 51.17% 54.03%

Money market deposit accounts (MMDAs) 11.83% 18.49% 30.34% 31.78% 31.23%Other savings deposits (excluding MMDAs) 10.80% 15.03% 15.17% 11.65% 12.30%

Deposits held in foreign offices 0.00% 0.06% 0.48% 12.35% 10.55%Federal funds purchased & repurchase agreements 0.61% 1.41% 3.10% 3.39% 2.81%Trading liabilities 0.00% 0.00% 0.02% 2.45% 1.81%Other borrowed funds 1.98% 3.01% 5.28% 5.59% 5.45%

FHLB advances 1.88% 2.91% 4.15% 1.68% 2.23%Memo: Volatile liabilities 4.98% 6.94% 9.74% 21.93% 19.40%Subordinated debt 0.01% 0.02% 0.08% 1.05% 0.80%All other liabilities 0.57% 0.71% 1.08% 2.92% 2.47%Equity capital 11.38% 10.57% 11.67% 11.22% 11.17%

Deposits held in domestic offices 85.44% 84.22% 78.29% 61.04% 64.94%Noninterest-bearing deposits 17.24% 16.33% 17.27% 18.91% 18.38%Interest-bearing deposits 68.21% 67.89% 61.02% 42.13% 46.55%

Core (Retail) deposits 80.65% 76.99% 69.20% 54.78% 58.24%IRAs and Keogh plan accounts 4.54% 3.91% 2.54% 2.29% 2.47%Brokered deposits 1.26% 2.87% 5.47% 4.66% 4.82%

Fully insured 1.00% 2.64% 5.23% 3.58% 3.81%

Estimating the Cost of Deposit Accounts• Interest Costs• Legal Reserve Requirements• Check Processing Costs• Account Charges

• NSF fees• Monthly fees• Per check fees

8

• Classifies check-processing as:• Deposits

• Electronic• Non-Electronic

• Withdrawals• Electronic• Non-Electronic

Transit Checks Deposited Cashed

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

Truncated Non-Truncated 9

Transaction Account Cost Analysis

Definitions: 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• 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 • 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

10

11

Characteristics of Retail-Type Deposits• Calculating the Average Net Cost of Deposit

Accounts

12

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

incomet Noninteres-expenset Noninteres expenseInterest

sliabilitiebank ofcost net Average

Characteristics of Retail-Type Deposits

Calculating the Average Net Cost of Deposit AccountsExample:

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?

13

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

$7.75 - $20.69 $0

Deposit Demand ofCost Net Average

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

15

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

17

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

18

Borrowing From the Federal Reserve• Discount Window and the Discount Rate

• Policy is to set discount rate 25 b.p. over the Fed Funds target for primary 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

19

Types of Federal Reserve Credit• Primary Credit

• Available to sound depository institutions on a short-term basis to meet short-term funding needs

• 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

• Seasonal Credit• Designed to assist small depository institutions in

managing significant seasonal swings in their loans and deposits

• 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

20

Characteristics of Large Wholesale Deposits• Borrowing From the Federal Reserve

• Discount Rate

21

Effective Date: 2-19-2010, Current as of 4/6/13

Primary Credit 0.75%

Secondary Credit 1.25%

Seasonal Credit 0.20%

Fed Funds Target 0 - 0.25%

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• 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

• Commercial Paper Funding Facility (CPFF)• The CPFF effectively provided a framework for the

Fed to buy the commercial paper issued by large firms in need of financing. It served the same function as discount window lending. The program was terminated in 2010 when the markets improved

22

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

23

24

Check 21

Check Clearing for the 21st Century Act Facilitates check truncation by reducing

some of the legal impedimentsFoster 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

26

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

27

Check 21

Substitute CheckThe 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

28