CHAPTER 13 MANAGING NONDEPOSIT LIABILITIES

Chapter 13 - Managing Nondeposit Liabilities

CHAPTER 13

MANAGING NONDEPOSIT LIABILITIES

Goal of This Chapter: The purpose of this chapter is to learn about the principal nondeposit sources of funds that financial institutions can borrow to help finance their activities and to see how managers choose among the various nondeposit funds sources currently available to them.

Key Topics in this Chapter Liability Management Customer Relationship Doctrine Alternative Nondeposit Funds Sources Measuring the Funds Gap Choosing Among Different Funds Sources Determining the Overall Cost of Funds

Chapter Outline I. IntroductionII. Liability Management and the Customer Relationship Doctrine

A. Customer Relationship DoctrineB. Liability Management

Ill. Alternative Nondeposit Sources of FundsA. Federal Funds Market (“Fed Funds”)B. Repurchase Agreements as a Source of FundsC. Borrowing from Federal Reserve Banks

1. Primary Credit2. Secondary Credit3. Seasonal Credit

D. Advances from Federal Home Loan BanksE. Development and Sale of Large Negotiable CDsF. Eurocurrency Deposit MarketG. Commercial Paper MarketE. Long-Term Nondeposit Funds Sources

IV. Choosing Among Alternative Nondeposit SourcesA. Measuring a Financial Firm’s Total Need for Nondeposit Funds: The Available Funds

GapB. Nondeposit Funding Sources: Factors to Consider

1. Relative Costs2. The Risk Factor3. The Length of Time Funds Are Needed4. The Size of the Borrowing Institution5. Regulations

V. Summary of the Chapter

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Concept Checks

13-1. What is liability management?

Liability management involves the conscious control of the funding sources of a financial institution, using the interest rates (yields) offered on deposits and other borrowings to regulate the inflow of funds to match the bank's immediate funding needs.

13-2. What advantages and risks does the pursuit of liability management bring to a borrowing institution?

Improved control over funding sources enables a borrowing institution to plan its growth more completely, but liability management opens up certain risks, particularly of the interest-rate risk and solvency (default or failure) risk variety, because it tends to be more sensitive to changes in market interest rates.

13-3. What is the customer relationship doctrine, and what are its implications for fundraising by lending institutions?

The customer relationship doctrine places lending to customers at the top of the priority list, which proclaims that the first priority of a lending institution is to make loans to all those customers from whom the lender expects to receive positive net earnings. It argues that a lending institution should make all good loans that is, all loans that meet the institution's quality and profitability standards and then find the funds needed to fund those loans they decide to make. Funds uses thus become a higher immediate priority item than funds sources.

13-4. For what kinds of funding situations are Federal funds best suited?

Federal funds are best suited for institutions short of reserves to meet their legal reserve requirements or to satisfy customer loan demand. It satisfies this demand by tapping immediately usable funds.

13-5. Chequers State Bank loans $50 million from its reserve account at the Federal ReserveBank of Philadelphia to First National Bank of Smithville, located in the New York Federal Reserve Bank's district, for 24 hours with the funds returned the next day. Can you show the correct accounting entries for making this loan and for the return of the loaned funds?

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Step 1 - Lending the $50 million

Chequers State BankAssets Liabilities

Federal funds sold + $50 mill.Reserves at Fed - $50 mill.

Step 2 - Using the borrowed funds can also be shown, though it is not mentioned in the problem. You could show First National Bank of Smithville making a loan for $50 million under Assets, giving up $50 million from its reserve account.

First National Bank of Smithville

Assets Liabilities

Reserves Federal FundsAt Fed + $50 mill. Purchased +$50 mill.

Step 3 - Repaying the Loan of Federal Funds

Chequers State BankAssets Liabilities

Reserves at Fed + $50 mill.Federalfunds sold - $50 mill.

First National Bank of SmithvilleAssets Liabilities

Reservesat Fed - $50 mill.

Federal fundspurchased - $50 mill.

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13-6. Hillside Savings Association has an excess balance of $35 million in a deposit at its principal correspondent, Sterling City Bank, and instructs the latter institution to loan the funds today to another bank or thrift institution, returning them to its correspondent deposit the next business day. Sterling loans the $35 million to Imperial Security National Bank for 24 hours. Can you show the proper accounting entries for the extension of this loan and the recovery of the loaned funds by Hillside Savings?

Step 1 - Lending Federal Funds to a Correspondent

Hillside Security BankAssets Liabilities

Deposit withCorrespondent -$35 mill.Federal Funds loaned +$35 mill.

Sterling City BankAssets Liabilities

Federal fundspurchased +$35 mill.Respondent Bank's deposit -$35 mill.

Step 2 - The Correspondent Bank Loans Funds to another Bank


Reserves -$35 mill.Federal funds loaned +$35 mill.

Imperial Security National BankAssets Liabilities

Reserves + $35 mill. Federal fundspurchased $35 mill.

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Step 3 - Repaying the Loan to the Respondent Bank

Hillside Security BankAssets Liabilities

Deposit withCorrespondent +$35 mill.Federal funds loaned -$35 mill.


Federal funds purchased -$35 mill.Bank's deposit +$35 mill.

13-7. Compare and contrast Fed funds transactions with RPs?

Less popular than Fed funds and more complex are repurchase agreements (RPs). RPs are agreements to sell securities temporarily by a borrower of funds to a lender of funds with the borrower agreeing to buy back the securities at a guaranteed price at a set time in the future. Both are instruments available for short term borrowing. However, RP agreements are collateralized loans and thus, the lender is not exposed to credit risk as they are with Federal funds transactions. Most RPs are transacted across the Fed Wire system, just as are Fed funds transactions. RPs may take a bit longer to transact then a Fed funds loan because the seller of funds (the lender) must be satisfied with the quality and quantity of securities provided as collateral.

13-8. What are the principal advantages to the borrower of funds under an RP agreement?

RPs are a low-cost and low-risk way of borrowing loanable funds for short periods of time (usually 3 or 4 days). They are low risk because they are essentially a collateralized loan. The securities that are sold as part of the agreement act as collateral.

13-9. What are the advantages of borrowing from the Federal Reserve banks or other central bank? Are there any disadvantages? What is the difference between primary, secondary, and seasonal credit? What is the Lombard rate and why might such a rate be useful in achieving monetary policy goals?

13-5


Borrowing from the Federal Reserve banks is a viable alternative to the Federal funds market. These loans are made for a short term (usually two weeks). Primary credits are short term loans available to sound depositary institutions. Secondary credits are short term loans available to institutions that do not qualify for primary credit. Seasonal credit refers to loans given to small and medium sized institutions to cover seasonal swings in their deposits and loans. The Lombard rate is the Feds discount rate which is set above the Federal funds rate. If borrowing from the discount window is more expensive than the Fed funds market, banks will use the discount window less frequently and central banks do not have to restrict access to the discount window and do not have to worry about banks borrowing at the discount window and lending these funds at the Federal funds rate. Thus, the “Lombard” rate effectively acts as a ceiling on overnight borrowing rates.

13-10. How is a discount window loan from the Federal Reserve secured? Is collateral really necessary for these kinds of loans?

A discount window loan must be secured by collateral acceptable to a Federal Reserve bank (usually U.S. government securities). Most banks keep government securities in the vaults of the Federal Reserve for this purpose. The Federal Reserve bank will also accept some government agency securities and high-grade commercial paper as collateral.

Each type of discount window loan carries its own loan rate, with secondary credit generally posting the highest interest rate and seasonal credit the lowest. For example, in March 2008 the Federal Reserve’s discount window loan rates were 2.50 percent for primary credit, 3.00 percent for secondary credit, and 2.95 percent for seasonal credit.

13-11. Posner State Bank borrows $10 million in primary credit from the Federal Reserve Bank of Cleveland. Can you show the correct entries for granting and repaying this loan?

The proper entries are:

Step 1 - Securing a Loan from the Fed.

Posner State BankAssets Liabilities

Reserves on deposit at the Federal Reserve Bank + $10 mill

Notes payable +$10 mill.

Federal Reserve Bank of ClevelandAssets Liabilities

Loans and advances +$10 mill.

Bank reserve accounts $10 mill.

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Step 2 - Repaying the Loan to the Fed.

Posner State BankAssets Liabilities

Reserves on deposit at the Federal Reserve Bank -$10 mill

Notes Payable -$10 mill.

Federal Reserve Bank of ClevelandAssets Liabilities

Loans and advances -$10 mill.

Bank reserve accounts -$10 mill.

13-12. Which institutions are allowed to borrow from the Federal Home Loans Banks? Why is this source so popular for many institutions?

Federal Home Loan Banks lend to institutions that grant mortgage loans and uses those as collateral. These loans are very popular because they represent a stable source of funds at below market lending rates.

13-13. Why were negotiable CDs developed?

Negotiable CDs were developed to attract large corporate deposits and savings from wealthy individuals. Because these were not insured they paid a higher interest rate than traditional deposits. The concept of liability management and short-term borrowing to supplement depositgrowth was given a significant boost early in the 1960s with the development of negotiable CD.

13-14 What are the advantages and disadvantages of CDs as a funding source?

Negotiable CDs offer a way to attract large amounts of funds quickly and for a known time period. However, these funds are highly interest sensitive and often are withdrawn as soon as the maturity date arrives unless management aggressively bids in terms of yield to keep the CD.

13-15. Suppose a customer purchases a $1 million, 90-day CD, carrying a promised 6 percent annualized yield. How much in interest income will the customer earn when this 90-day instrument matures? What total volume of funds will be available to the depositor at the end of 90 days?

Interest Income = Principal * Days to Maturity * Annual RateTo Customer 360 days Of Interest

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= $15,000

Total amount = Principal + Interestdue Customer = $1,000,000 + $15,000

= $1,015,000

13-16. Where do Eurodollars come from?

Eurodollars arise from dollar deposits made in financial institutions and at branch offices outside U.S. territory. Many Eurodollar deposits arise from U.S. balance-of-payments deficits that give foreigners claims on U.S. assets and from the need to pay in dollars for some international commodities (such as oil) that are denominated principally in U.S. dollars.

13-17. How does a bank gain access to funds from the Eurocurrency markets?

Access to these funds is obtained by contacting correspondent banks by telephone, wire, or cable.

13-18. Suppose that JP Morgan Chase Bank in New York elects to borrow $250 million from Barclay’s Bank of London, loans the borrowed funds for a week to a security dealer, and then returns the borrowed funds. Can you trace through the resulting accounting entries?

If, Chase borrows from Barclay’s Bank of London, the entries would appear as follows:

JP Morgan-ChaseAssets Liabilities

Deposits held at other banks +$250 mill.

Deposits due to foreign banks +$250 mill.

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U.S. Bank Serving as Correspondent to Barclay’sAssets Liabilities

Deposits due foreign bank -$250 mill.Deposits ofJP Morgan-Chase +$250 mill.

Barclay’s Lending to JP Morgan-Chase BankAssets Liabilities

Deposit at U.S. Correspondent Bank +$250 mill.Eurodollar loan to JP-Morgan Chase Bank -$250 mill.

JP-Morgan Chase lending the funds to a security Dealer

JP Morgan ChaseLoan to Security Dealer +$250Deposit Held at Other Bank -$250

When JP Morgan-Chase repays its loans we have:

JP Morgan-Chase BankAssets Liabilities

Deposits held at other banks -$250 mill.

Deposits due to foreign banks -$250 mill.

U.S. Bank Serving as Correspondent to Foreign BankAssets Liabilities

Deposits due to foreign banks +$250 mill.Deposits of JP Morgan-Chase Bank -$250 mill.

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Foreign Bank Lending EurodollarsAssets Liabilities

Deposit at U.S. Correspondent Bank +$250 mill.Eurodollar loan to JP Morgan-Chase Bank -$250 mill.

13-19. What is commercial paper? What types of organizations issue such paper?

Commercial paper consists of short-term notes, with maturities ranging from three or four days to nine months, issued by well-known companies to raise working capital. The notes are generally sold at a discount from their face value through security dealers or through direct contact between the issuing company and interested investors.

Commercial paper is a high-quality, short-term debt obligation with an excellent credit rating to provide for short-term cash needs. There are two types of commercial paper. The first type is industrial paper generally issued by industrial companies to purchase inventories of goods or raw materials. The second type if finance paper is issued mainly by finance companies or financial holding companies to purchase loans of the books of other financial firms in the same organization so that more loans can be made.

13-20. Suppose that the finance company affiliate of Citigroup issues $325 million in 90 day commercial paper to interested investors and uses the proceeds to purchase loans from Citibank. What accounting entries should be made on the balance sheets of Citibank and Citigroup’s finance company affiliates?

The appropriate entries for the above transaction are:

Step 1 - Commercial Paper is Sold by the Affiliated Finance Company

CitibankAssets Liabilities

Finance AffiliateAssets Liabilities

Cash Account +$325 mill.

Commercial Paper +$325 mill.

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Step 2 - The Affiliated Finance Company Purchases Loans from Citibank

CitibankAssets Liabilities

Loans -$325 mill.Reserves +$325 mill.

Finance AffiliateAssets Liabilities

Cash Account -$325 mill.Loans Purchased from Citibank +$325 mill.

13-21. What long-term nondeposit funds sources do banks and some of their closest competitors draw upon today? How do these interest costs differ from those costs associated with most money market borrowings?

Long-term nondeposit funds include mortgages, capital notes, and debentures. Generally, the interest costs on these funds sources are substantially higher than money market loans but are more stable usually.

13-22. What is the available funds gap?

The funds gap is the difference between current and projected credit and deposit flows that creates a need for raising additional reserves or for profitably investing any excess reserves that may arise. The difference between current and projected outflows and inflows of funds yields anestimate of each institution’s available funds gap.

13-23. Suppose J.P. Morgan Chase Bank of New York discovers that projected new loan demand next week should total $325 million and customers holding confirmed credit lines plan to draw down $510 million in funds to cover their cash needs next week, while new deposits next week are projected to equal $680 million. The bank also plans to acquire $420 million in corporate and government bonds next week. What is the bank's projected available funds gap?

The expected funds gap (with all figures in millions of dollars) would be:

Projected = $325 + $510 + $420 - $680 = $575.Funds Gap

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13-24. What factors must the manager of a financial institution weigh in choosing among the various nondeposit sources of funding available today?

A manager must weigh factors such as relative costs, risk, length of time funds are needed, size of the institution and its funding need, and regulations in choosing what nondeposit funds sources to use. Other factors held constant, management will seek out the lowest cost nondeposit funding sources available subject to the risk of availability problems and the danger of interest-rate volatility. When funds are needed for longer periods, negotiable CDs and Eurodollars are usually the preferred sources whereas very short-term cash needs usually will be met by Federal funds and RPs or by borrowing from the Federal Reserve banks. However, regulations impose reserve requirements on some funding sources (e.g., CDs) which increases their cost and these rules limit access to some sources (e.g., borrowings from the Fed's Discount Window).

Problems

13-1. Robertson State Bank decides to loan a portion of its reserves in the amount of $70 million held at the Federal Reserve Bank to Tenison National Security Bank for 24 hours. For its part, Tenison plans to make a 24-hour loan to a security dealer before it must return the funds to Robertson State Bank. Please show the proper accounting entries for these transactions.

Step 1 - Lending the $70 million

Robertson State BankAssets Liabilities

Federal Funds Sold +$70 mill.Reserves at Fed. -$70 mill.

Tenison National Security BankAssets Liabilities

Reserves at Fed. +$70 mill.

Federal funds purchased +$70 mill.

Step 2 - Loaning the Borrowed Funds


Reserves at Fed. -$70 mill.Loans +$70 mill.

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Step 3 - Repaying the Loan of Federal Funds

Robertson State BankAssets Liabilities

Reserves at Fed. +$70 mill.Federal Funds Sold -$70 mill.


Reserves at +$70 mill.FedLoans - $70 mill

Reserves at Fed. -$70 mill.

Federal funds purchased -$70 mill.

13-2. Masoner Savings, headquartered in a small community, holds most of its correspondent deposits with Flagg Metrocenter Bank, a money center institution. When Masoner has a cash surplus in its correspondent deposit, Flagg automatically invests the surplus in Fed funds loans to other money center banks. A check of Masoner’s records this morning reveals a temporary surplus of $11 million for 48 hours. Flagg will loan this surplus for two business days to Secoro Central City Bank, which is in need of additional reserves. Please, show the correct balance sheet entries to carry out this loan and to pay off the loan when its term ends.

Step 1 - Lending Federal Funds to a Correspondent

Masoner SavingsAssets Liabilities

Deposit withCorrespondent -$11 mill.Federal funds loaned +11 mill.

Flagg Metrocenter BankAssets Liabilities

Federal funds purchased +$11 mill.Respondent Bank's deposit -$11 mill.

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Step 2 - The Correspondent Bank Loans Funds to Another Bank


Reserves -$11 mill.Federal funds loaned +$11 mill.

Secoro Central City BankAssets Liabilities

Reserves +$11 mill.

Federal funds purchased +$11 mill.

Step 3 - Repaying the Loan to the Respondent Bank

Masoner SavingsAssets Liabilities

Deposit withCorrespondent +$11 mill.Federal fundsloaned -$11 mill.


Federal funds purchased -$11 mill.Respondent Bank's deposit +$11 mill.

13-3. Relgade National Bank secures primary credit from the Federal Reserve Bank of San Francisco in the amount of $32 million for a term of seven days. Please show the proper entries for granting this loan and then paying off the loan.

The correct entries are:

13-14


Step 1 - Receiving a Loan from the Fed

Relgade National BankAssets Liabilities

Reserves on deposit at the Federal Reserve Bank +$32 mill.

Notes payable +$32 mill.

Federal Reserve Bank of San FranciscoAssets Liabilities

Loans and advances +$32 mill.

Bank reserve accounts +$32 mill.

Step 2 - Repaying the Loan to the Fed.

Relgade National BankAssets Liabilities

Reserves on Deposit at the Federal Reserve Bank. -$32 mill.

Notes payable -$32 mill.

Federal Reserve Bank of San FranciscoAssets Liabilities

Loans and advances -$32 mill.

Bank reserve accounts -$32 mill.

13-4. Rockfish Corporation purchases a 60-day negotiable CD with a $5 million denomination from Bait Bank and Trust, bearing a 3.75 percent annual yield. How much in interest will the bank have to pay when this CD matures? What amount in total will the bank have to pay back to Rockfish at the end of 60 days?

Interest Owed 60To Rockfish

Corp.= $5,000,000 * 360 * 0.0375

By Bank

= $31,250.00

Total amountowed Rockfish = $5,000,000 + $31,250.00

in 45 days in principle in interest

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= $5,031,250.00

13-5. Lost Valley Bank borrows $125 million overnight through a repurchase agreement (RP) collateralized by Treasury bills. The current RP rate is 2.75 percent. How much will the bank pay in interest cost due to this borrowing?

Interest cost of RP = $125,000,000 x 0.0275 x 1360

= $9,548.61

13-6. Rosemary Bank of New York expects new deposit inflows next month of $375million and deposit withdrawals of $500 million. The bank's economics department has projected that new loan demand will reach $460 million and customers with approved credit lines will need $175 million in cash. The bank will sell $480 million in securities, but plans to add $85 million in new securities to its portfolio. What is the projected available funds gap?

The estimated available funds gap (with all figures in millions of dollars) is:

Projected funds gap = $460 + $175 + [$85 - $480] - [$375 - $500]

= $365 million

13-7. Wells Fargo Bank borrowed $150 million in Fed funds from J.P. Morgan Chase Bank in New York City for 24 hours to fund a 30 day loan. The prevailing Fed funds rate on loans of this maturity stood at 2.25 percent when these two institutions agreed on the loan. The funds loaned by Morgan were in the reserve deposit that bank keeps at the Federal Reserve Bank of New York. When the loan to Wells Fargo Bank was repaid the next day, J.P. Morgan used $50 million of the returned funds to cover its own reserve needs and loaned $100 million in Fed funds to Bank of America, Charlotte, for a two day period at the prevailing funds rate of 2.40 percent. With respect to these transactions,

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(a) Construct T-account entries similar to those you encountered in this chapter, showing the original Fed funds loan and its repayment on the books of J.P. Morgan, Wells Fargo, and Bank of America Savings.

JP Morgan Chase Bank

Wells Fargo Bank Bank of America

Loan of Reservesis made to Wells Fargo Bank

Assets Reserves at Fed-150

Federal FundsLoaned +150

Assets Reserves at Fed.+150

Liabilities Fed Funds Purchased+150

Loan of reserves isrepaid to JP Morgan Chase Bank


Federal Funds Loaned-150

Assets Reserves at Fed.-150

Liabilities Fed. Funds Purchased-150

Loan of reserves byJP Morgan-Chase is extended to Bank of America Savings

Assets Reserves at Fed.-100

Federal Funds Loaned+100


Liabilities Fed. Funds Purchased+100

Loan is repaid by Bank of America Savings


Federal Funds Loaned-100

A ssets Reserves at Fed.-100

Liabilities Fed. Funds Purchases-100

(b) Calculate the total interest earned by Morgan on both Fed funds loans.

1. Wells Fargo Bank Loan: 0.0225 X $150 Million X 1/360 = $9,375 2. Bank of America Savings: 0.024 X $100 Million X 2/360 = $13,333

13-8. Clear Skies Bank of Florida issues a 3-month (90-day) negotiable CD in the amount of $25 million to ABC Insurance Company at a negotiated annual interest rate of 3.25 percent (360 day basis). Calculate the value of this CD account on the day it matures and the amount of interest income ABC will earn. What interest return will ABC Insurance earn in a 365 day year?

13-17


= Principal + (Principal * Days to Maturity / 360 * Annual Interest Rate) = $25 million + ($25 million * 90 / 360 * 0.0325) = $25,203,125

The amount of interest income Travelers will earn is:

$25 million *90 / 360 * 0.0325 = $203,125.

On the basis of a 365-day year Travelers' APY will be:

or 3.34%

13-9. Banks and other lending affiliates within the holding company of Goodtimes Financial are reporting heavy loan demand this week from companies in the southeastern United States that are planning a significant expansion of inventories and facilities before the beginning of the fall season. The holding company plans to raise $850 million in short-term funds this week, of which about $835 million will be used to meet these new loan requests. Fed funds are currently trading at 2.25 percent, negotiable CDs are trading in New York at 2.40 percent, and Eurodollar borrowings are available in London at all maturities under one year at 2.30 percent. One-month maturities of directly placed commercial paper carry market rates of 2.35 percent, while the primary credit discount rate of the Federal Reserve Bank of Richmond is currently set at 3.25 percent a source that Interstate has used in each of the past two weeks. Noninterest costs are estimated at 0.25 percent for Fed funds, discount window borrowings, and CDs; 0.35 percent for Eurodollar borrowings; and 0.50 percent for commercial paper. Calculate the effective cost rate of each of these sources of funds for Interstate and make a management decision on what sources to use. Be prepared to defend your decision.

Effective Federal Funds Cost Rate =

=

= 2.54%

Effective CD Cost Rate =

=

= 2.70%

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Effective Eurodollar Cost Rate =

=

= 2.70%

Effective Commercial Paper Cost Rate =

=

= 2.90%

Effective Cost of Borrowing from the Fed =

=

= 3.56%

The cheapest source of all would be borrowing from the Fed Funds Market.

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13-10. Surfs-Up Security Savings is considering the problem of trying to raise $80 million in money market funds to cover a loan request from one of its largest corporate customers, which needs a 6-week loan. However, current forecasts call for a rise in money market interest rates over the next six weeks. Current money market interest rates are currently at the levels indicated below:

Unfortunately, Surfs-Up’s economics department is forecasting a substantial rise in money market interest rates over the next six weeks. What would you recommend to its funds management department regarding how and where to raise the money needed? Be sure to consider such cost factors as legal reserve requirements, regulations, and what happens to the relative attractiveness of each funding source if interest rates rise continually over the period of the proposed loan.

Federal funds could be used to fund this loan, but not only do they happen to be the most expensive source in terms of interest cost right now, but also the Fed funds rate is very sensitive to market pressures and, therefore, will rise along with other market interest rates if the bank's forecast turns out to be correct. Either 3-month CDs or 3-month commercial paper appear to represent good alternatives because the bank, presumably, can lock in the interest cost to fund this loan for the entire life of the loan. Assuming that the money market shares the expectations of the bank that interest rates will rise over the next six weeks, the bank will very likely have to pay a premium over the current rates on either the CDs or commercial paper. However, locking in these rates would still represent the better alternative.

Alternative Scenario:

What if Surf’s-Up's economists are wrong and money market rates decline significantly over the next six weeks? How would your recommendations to funds management department change on how and where to raise the funds needed?

13-20


Significantly declining interest rates would make shorter-term sources much more attractive to the bank. Federal funds, for example, although currently the one of the most expensive sources may well be a good alternative, since the federal funds rate is very sensitive to interest rate changes. One-month CDs would also be a good alternative, as would one-month commercial paper. With the shorter maturities, the bank could readjust its costs downward as the interest rates continue to fall, maintaining the spread between the rate the bank is charging the borrower, which will be declining as rates fall, and the rate it is paying for its funds.

13-11. Firefly Bank and Trust has received $800 million in total funding, consisting of $200 million in checkable deposit accounts, $400 million in time and savings deposits, $100 million in money market borrowings, and $100 million in stockholders’ equity. Interest costs on time and savings deposits are 2.50 percent, on average, while noninterest costs of raising these particular deposits equal approximately 0.50 percent of their dollar volume. Interest costs on checkable deposits average only 0.75 percent because many of these deposits pay no interest, but noninterest costs of raising checkable accounts are about 2 percent of their dollar total. Money market borrowings cost Firefly an average of 3.25 percent in interest costs and 0.25 percent in noninterest costs. Management estimates the cost of stockholders’ equity capital at 13 percent before taxes. (The bank is currently in the 35-percent corporate tax bracket.) When reserve requirements are added in, along with uncollected dollar balances, these factors are estimated to contribute another 0.75 percent to the cost of securing checkable deposits and 0.50 percent to the cost of acquiring time and savings deposits. Reserve requirements (on Eurodeposits only) and collection delays add an estimated 0.25 percent to the cost of the money market borrowings.

(a) Calculate Firefly’s weighted average interest cost on total volume funds raised, figured on a before-tax basis?

(b) If the bank's earning assets total $700 million, what is its break-even cost rate?

(c) What is Firefly 's overall historical weighted average cost of capital?

a) Weighted Average Interest Cost = (Total dollar interest) / (Total deposits and borrowing) = $14.75 million / $700 million = 0.0211 or 2.11%

b) Break-even cost rate = (Total funding costs) / (earning assets) = $24.75/$700 = 0.0354 or 3.54%

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c) Firefly's historical weighted-average cost of capital (Before-tax)= (Breakeven cost rate * proportion of borrowed funds)+ (before-tax cost of stockholders' equity * proportion of stockholders' equity)= [(3.54%) * (700/800) + (13%) * (100/800)]= 3.10% + 1.63% = 4.72%

13-12. Aspiration Savings Association is considering funding a package of new loans in the amount of $400 million. Aspiration has projected that it must raise $450 million in order to have $400 million available to make the new loans. It expects to raise $325 million of the total by selling time deposits at an average interest rate of 2.25 percent. Noninterest costs from selling time deposits will add an estimated 0.45 percent in operating expenses. Aspiration expects another $125 million to come from noninterest-bearing transaction deposits, whose noninterest costs are expected to be 3.25 percent of the total amount of these deposits. What is the Association’s projected pooled-funds marginal cost? What hurdle rate must it achieve on its earning assets?

The bank's pooled marginal funds cost must be:

7.31 million + 5.5250 million = 2.85%$450 million

With only a net $400 million in funds the bank can invest, the bank's hurdle rate over total earning assets must be:

$12.8375 Million$400 Million= 3.21%

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Documents

CHAPTER 13 MANAGING NONDEPOSIT LIABILITIES