The Future Monetary System
After completing this reading, you should be able to: Identify and describe the... Read More
After completing this reading, you should be able to:
The most considerable importance of a bank is to offer loans to all qualified customers. If it does not have sufficient funds, the bank should seek the cheapest cost of funding to meet its customers’ needs. However, this may lead to poor quality loans. Liability management involves buying funds, especially from other financial institutions, to cover good-quality credit requests and meet legal reserve requirements for deposits and other borrowings that may be required by the law.
The most common non-deposit sources that financial institutions use include:
Fed funds market is the most popular domestic source of borrowed reserves that allows depository institutions that are short of reserves to meet their legal reserve requirement as well as immediately usable funds from the other institutions who have idle funds temporarily.
Overnight loans are unwritten, often uncollateralized agreements usually negotiated over a telephone and are payable the next day.
Continuing contracts have daily renewals unless either the lender or borrower decides to end the contract. The agreements are commonly between smaller respondent institutions and their more significant correspondents, where the latter automatically invests the smaller institution’s deposits held with it in Fed funds loans until told to do otherwise.
Repurchase agreements are viewed as collateralized fed fund transactions. In such an agreement, one party agrees to sell high-quality assets such as T-bills to another party temporarily. At the same time, the selling party issues an agreement to buy back those securities on a specific future date at a predetermined price. These agreements are basically for overnight funds, though it can be extended for days, weeks, and even months.
The interest cost for repurchase agreements is equivalent to:
$$ \begin{align*} \text{Interest cost of RP} & = \text{Amount borrowed}×\text{Current RP rate} \\ & × \cfrac {\text{Number of days in RP borowing }}{360} \end{align*} $$
Suppose Pathway Bank borrows $4,300 million through a repurchase agreement with a government bond collateral for 16 days. The current repurchase agreement rate in the market is 8%. How much would be the bank’s total interest cost?
$$ \text{Interest cost of RP}=4,300×0.08×\cfrac {16 }{360} = 15.29 $$
Hence the cost of the RP will be approximately equal to $15.29 million.
Banks borrow from the federal reserve when they are unable to meet their reserve requirements due to low cash at hand at the close of the day. When banks borrow from the government’s central bank, they are making use of a discount window. There exist different types of loans depending on the needs with different rates of interest. However, there are limits/restrictions on the frequency of borrowing from the federal reserve.
Primary credit refers to loans available for the short-term and only to institutions in sound financial conditions. The interest rate is higher than the federal funds rate.
Secondary credit is available to institutions that do not qualify for primary credit but at a higher interest rate. Secondary credit is, however, tracked by the central bank to avoid excess risk.
Seasonal credit is loans that cover more extended periods relative to primary credit. They are mostly utilized by small and medium firms that experience seasonal fluctuations in deposits and loans.
In summary, secondary credit attracts the highest interest rates, followed by primary credit, and finally, seasonal credit with the lowest interest rates.
Federal Home Loan Bank lends substantial amounts of money, allowing institutions to use home mortgages as collateral for advances. These loans are utilized as a way of improving the liquidity of home mortgages at the same time motivating more lenders to provide credit. The maturity for federal home loan banks ranges from overnight to more than 20 years.
A negotiable CD is a source of short-term funds for commercial banks developed to tap temporary surplus funds held by large corporate and wealthy individual customers. It is an interest-bearing receipt evidencing the deposit of funds in the bank for a specified period for a specified interest rate. It is a hybrid account since it is legally a deposit.
Domestic CDs are issued by U.S institutions, which are inside the U.S territory.
Dollar-denominated CDs are issued by banks outside the U.S and are also known as EuroCDs.
A Yankee CD is a foreign certificate of deposit usually denominated in the U.S dollars.
Thrift CDs are certificate of deposits sold by non-bank institutions
The interest rates of fixed-rate CDs are quoted based on their interest-bearing, where the rate is computed based on a 360 days year. The advantage of negotiable CDs I that they offer a way to attract large amounts of funds quickly and for a known period. However, these funds are incredibly sensitive to interest and often are withdrawn as soon as the maturity date arrives unless management aggressively bids in terms of yield to keep the CD.
Assume a depository institution promises a 10% annual interest rate to a customer who buys a $950,000 120-day CD. How much will the customer have at the 120 days?
$$ \begin{align*} \text{Amount} = & \text{Principal}+\left(\text{Principal}× \cfrac {\text{Days to maturity}}{360 \text{days}} \right) \\ & × \text{Annual rate of interest} \\ & 950,000+\left( $950,000×\cfrac {120 \text{ days}}{360 \text{ days}}× 0.10 \right)=$981,667 \\ \end{align*} $$
Therefore, at the end of the 120 days, the depositor will have $981,667.
The Eurocurrency deposit market is the most significant unregulated financial market place in the world. It involves a group of banks that accept deposits and also make loans in foreign currencies outside their country of issue. They were initially developed in Western Europe to provide liquid funds to swap among institutions or act as loans to customers. The Eurodollar market is one of these markets. Eurodollars are dollar-denominated deposits placed in banks outside the United States.
Access to the Eurocurrency market is obtained by contacting correspondent banks by telephone, wire, or cable.
The commercial paper market involves short-term notes with a maturity period ranging from three or four days to nine months, issued by well-known companies to raise working capital. They are sold at a discounted price from their face value.
Industrial paper is used by non-financial institutions to finance purchases of inventories and to meet immediate financial needs. The inventories include goods or raw materials.
Finance paper is mostly issued by finance companies and the associates of a financial holding company. Issuing this paper provides the income useful for purchasing loans off the books of other financial firms within the same organization. This results in the firm creating additional funds for giving loans.
Note that banks do not issue commercial paper directly. However, its associates can issue them.
Long-term non-deposit funding sources involve loans that are extended for a period beyond one year. These loans include mortgages to fund the construction of new buildings, debentures, and capital notes. They range from a period of 5-12 years and supplements the owners’ capital or equity.
Note that, despite the mismatch created by long-term funding sources as most assets and liabilities held by depository institutions are short-term to medium-term, larger financial firms find long-term funding attractive due to the leverage effects of such debts.
Available funds gap is the distinction between current, and the projected credit and deposit flows that generate a need for increasing additional reserve when the gap is negative or profitably investing any excess reserve that may occur in case the gap is positive. In summary, this gap depends on:
The size of the available funds gap determines the need for non-deposit funds.
$$ \begin{align*} & \text{Available funds gap (AFG)} \\ & =\text{Current and projected loans and investments the lending institution desires to make} \\ & – \text{Current and expected deposit inflows and other available funds} \\ \end{align*} $$
Prime Bank expects new deposit inflows of $400million and deposit withdrawals of $600 million in the coming month. The bank has projected that new loan demand will reach $500 million, and customers with approved credit lines will need $200 million in cash. The bank will sell $520 million in securities but plans to add $100 million in new securities to its portfolio. What is Prime Bank’s projected available funds gap?
$$ \text{AFG} = ($500 + $200+ ($100 – $520) – ($400-600) = $480 \text{ million} $$
Once an institution identifies the available funding gap, it can then seek the available non-deposit funding sources to cover the gap. Many institutions will have a small available funding gap, which is easily funded by tapping the available non-deposit funding sources.
As we have mentioned in the previous section, the size of the available funding gap determines the need for non-deposit funds. Therefore, management should evaluate the best nondeposit source to use to cover the available funds gap. They should consider the following five factors:
Institution managers should compare the prevailing interest rate in the Fed Funds market, as it is the cheapest funding in terms of interest rates, with that of the negotiable CD market. Noninterest costs, deposit insurance costs, and the amount of money that will be available for new loans should be included.
Fed funds are advantageous as they are readily available, and their maturities are often flexible. However, their interest rates fluctuate, making it difficult to plan. The interest rates for the commercial paper and the CDs are somehow stable but range around and slightly above the rates for fed funds.
The actual cost of borrowing non-deposit funds consists of the interest cost and noninterest cost, such as time spent by the management staff in seeking new funding sources when necessary. A reliable formula for evaluating the cost of borrowing non-deposit funds is as follows:
$$ \begin{align*} & \text{Effective cost rate on deposit and nondeposit sources of funds} \\ & =\cfrac { \left(\text{Current interest cost on amounts borrowed} \\ + \text{Noninterest costs incurred to access these funds} \right)}{\text{Net investable funds raised from this source}} \\ \end{align*} $$
Where:
$$ \begin{align*} \text{Current interest cost on amounts borrowed} & = \text{Prevailing interest rate in the money market} \\ & ×\text{Amount of funds borrowed} \end{align*} $$
$$ \begin{align*} \text{Noninterest costs to access funds} = & (\text{Estimated cost rate representing staff time,facilities,} \\ & \text{and transaction costs} ×\text{Amount of funds borrowed}) \\ \end{align*} $$
$$ \begin{align*} \text{Net investable funds raised} = & \text{Total amount borrowed less legal reserve requirements deposit}, \\ & \text{insurance assessments and funds placed in nonearning assets} \end{align*} $$
Assume that a commercial paper is currently trading at an interest rate of 8.5%. It is estimated that the marginal noninterest cost, in the form of personnel expenses and transaction fees, from raising additional monies in the fed fund market is 0.3%. Assume that a depository institution needs $56 million to fund the loans it plans to make today, of which only $54 million is fully invested due to other immediate cash needs.
Evaluate the effective annualized cost rate for the commercial paper.
$$ \text{Current interest cost on fed funds} = 0.085 ×$56 \text{ million} = $4.76\text{ million} $$
$$ \begin{align*} \text{Noninterest cost in acquiring the commercial paper} & = 0.003 × $56 \text{ million} \\ & = $0.168 \text{ million} \\ \end{align*} $$
$$ \text{Net investable funds raised} =$56\text{ million}-2\text{ million} =$54\text{ million} $$
Hence the effective annual cost rate of the commercial paper earned is given as:
$$ \cfrac {$4.76+$0.168}{54}=0.091 $$
Therefore, the net annualized return on the loans and investments it purposes to undertake with the borrowed commercial paper is 9.1%.
There are two types of risk factors that management should take into consideration, interest rate risk and credit availability risk.
Interest rate risk is the volatility of credit costs. Interest rates fluctuate, especially in a perfect market where the rates are determined by the interaction between demand and supply forces. The level of interest fluctuation is correlated to their maturity periods. In other words, the shorter the period, the more the volatility. Considering the period of maturity, then we realize that most fed funds are more volatile as their period of credit extension ranges from one night to a few days.
Credit availability risk is the risk associated with the unavailability of credit. There are times when lenders have limited loans to offer due to strict credit conditions. In such cases, lenders prefer to offer loans to their favorable and loyal clients or even increase the interest rates for the loans. For example, the commercial paper markets, Eurodollar, and negotiable CDs have shown to be sensitive to credit availability risk. Therefore, financial institution managers should plan and make arrangements on how to source substitute sources of credit.
The required credit may not be immediately available at the time of need. Therefore, the institution managers should evaluate the urgency with which the credit is required and chose the appropriate credit source. For example, a manager may consider short-term funding, such as fed funds for urgent credit requirements.
Most money market loans have a standard trading unit of $1 million. This denomination exceeds the borrowing requirements for the smallest financial institutions. However, the central bank discount window and the fed funds market make smaller denominations appropriate for small institutions.
The federal and state regulations may limit factors such as amount, frequency, and use of borrowed funds. For example, the maturity of CDs in the United States should be at least seven days, while the depository institutions exhibiting substantial risk of failure may have its borrowing from the discount window been limited by the federal reserve bank.
The historical average cost approach, just as the name suggests, looks at the funds an institution has raised to date, and the costs related to raising such funds.
ABC Bank has the following breakdown of funding sources with the respective interest and non-interest rates. Given the bank’s total earning assests of $1,100 million, we demonstrate the historical cost approach as follows:
$$ \begin{array}{c|c|c|c|c|c|c} {} & \bf{\text{Amount} \\ {($\text{millions})} } & \bf{\text{Interest} \\ \text{Rate}} & \bf{\text{Interest} \\ \text{Cost}} & \bf{\text{Non-} \\ \text{interest} \\ \text{Rates}} & \bf{ \text{Noninterest} \\ \text{costs}} & \bf{\text{Total} \\ \text{Funding} \\ \text{Costs}} \\ \hline {\text{Checkable} \\ \text{deposit} \\ \text{accounts}} & {300} & {1.25\%} & {3.75} & {3\%} & {9} & {12.75} \\ \hline {\text{Time and} \\ \text{savings} \\ \text{deposits}} & { 600} & { 3.00\%} & { 18} & { 1.25\%} & { 7.5} & { 25.50} \\ \hline {\text{Money} \\ \text{market} \\ \text{borrowings}} & { 200} & { 3.25\%} & { 6.5} & { 1.00\%} & { 2} & { 8.50} \\ \hline {\text{Stockholders’} \\ \text{equity}} & { 200} & { 15\%} & { 30} & { 0} & { 0} & { 30.00} \\ \hline \bf{\text{Total} \\ \text{Funding}} & \bf{ 1,300} & {} & \bf{ 28.25} & {} & {} & \bf{46.75} \\ \end{array} $$
$$ \begin{align*} \text{Weighted average interest expense} & =\cfrac {\text{Total interest paid} }{\text{Total deposits and borrowings} } \\ & =\cfrac {$28.25}{1,100}=2.57\% \\ \end{align*} $$
$$ \begin{align*} & \text{Break-even cost rate on borrowed funds invested in earning assets} \\ &=\cfrac {\text{Total funding costs}}{\text{Total earning assets}} =\cfrac {46.75}{1,100}=4.25\% \end{align*} $$
Assuming the stockholder’s equity capital is estimated at 15% before taxes (the bank is currently in the 35-percent corporate tax bracket), we can calculate the historical weighted-average cost of capital (before-tax) as follows:
$$ \begin{align*} & \text{Weighted average overall cost of capital} = \text{Break-even cost} \\&+ \cfrac{\text{After-tax cost of stockholders’ investment}}{(1 – \text{Tax rate}) }× \cfrac {\text{Stockholders’ investment}}{\text{Earning assets}} \\ & =4.25\%× \left(\cfrac {1,100}{1,300} \right)+\left(15\%× \cfrac {200}{1,300} \right)=5.90\% \\ \end{align*} $$
This method of costing borrowed funds is future-oriented; that is, it focuses on future factors such as the level of minimum returns that should be earned on loans and investments in the future to cover the cost of all raised new funds. For illustration, assume that an institution’s estimate for the future funding sources and their cost are as shown in the following table:
Money Bank is considering funding a package of new loans for $500 million. Money Bank has projected that it must raise $550 million to have $500 million available to make the new loans (91% will actually be available to acquire earning assets).
What is the Bank’s projected pooled-funds marginal cost? What hurdle rate must it achieve on its earning assets?
$$ \begin{array}{c|c|c|c|c|c} {} & \bf{\text{Dollar} \\ \text{Amount} \\ ($ \text{ millions})} & \bf{\text{Interest} \\ \text{rate}} & \bf{\text{Non} \\ \text{interest} \\ \text{cost rate}} & \bf{\text{Total} \\ \text{interest} \\ \text{expenses}} & \bf{\text{Total} \\ \text{non-interest} \\ \text{expenses}} \\ \hline {\text{Time} \\ \text{deposits}} & 450 & 4.00\% & 1.00\% & 18 & 4.5 \\ \hline {\text{Transaction} \\ \text{deposits}} & 100 & 0\% & 2.00\% & 0 & 2 \\ \hline \textbf{Total} & \bf{550} & & & \bf{18} & \bf{6.5} \\ \end{array} $$
$$ \begin{align*} \text{ Projected pooled-funds marginal cost} & =\cfrac {\text{All expected operating expenses}}{\text{All new funds expected}} \\ & =\cfrac {(18+6.5)}{550}=4.45\% \end{align*} $$
A hurdle rate is defined as the minimum rate of return on an investment required by a manager. The hurdle rate of return is equivalent to:
$$ \text{Hurdle rate} = \cfrac {\text{All expected operating costs}}{\text{Dollars available to place in earning assets}} $$
Thus, in our example above, the hurdle rate of return is equivalent to:
$$ \text{Hurdle rate} = \frac {(18+6.5)}{500}=4.90\%$$
Thus, the firm, in this example, should earn 4.9% and above on average before taxation on all its new funds invested to meet the expected new funding cost.
Practice Question
The financial data in the following table belongs to Yankee Bank. Use the data to evaluate the weighted average overall cost of capital for the institution.
$$ \begin{array}{l|r} \text{Break-even cost} & 12.50\% \\ \hline \text{The after-tax cost of stock of stockholder’s investment} & 11\% \\ \hline \text{Tax rate} & 15\% \\ \hline \text{Stockholder’s investment} & $200,000 \\ \hline \text{Earning assets} & $300,000 \\ \end{array} $$
- 21.1%
- 18.7%
- 19.8%
- 31.9%
The correct answer is A.
$$ \begin{align*} & \text{Weighted average overall cost of capital} = \text{Break-even cost} \\&+ \cfrac{\text{After-tax cost of stockholders’ investment}}{(1 – \text{Tax rate}) }× \cfrac {\text{Stockholders’ investment}}{\text{Earning assets}} \\ \end{align*} $$
Which is equivalent to:
$$ \frac{\$100,000}{\$300,000}\times 12.5\%+ \cfrac {11\%}{(1 – 0.15)}×\cfrac {$200,000}{$300,000}=12.79\% $$
Thus, 21.1% is the lowest rate of return overall fund-raising costs Yankee Bank can afford to earn on its assets if its equity shareholders invest $200,000 in the institution.