You are on page 1of 9

CHAPTER 15 MANAGING NONDEPOSIT LIABILITIES AND OTHER SOURCES OF BANK FUNDS Concept Checks 15-1 What is liability management?

Liability management involves the conscious control of the funding sources of a bank, 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. 15-2 What advantages and risks does the pursuit of liability management bring to a bank? Improved control over funding sources enables a bank 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. 15-3 What is the customer relationship doctrine and what are its implications for bank fund-raising? The customer relationship doctrine places lending to customers at the top of a bank's priority list; It argues that a bank should make all good loans - that is, all loans that meet the bank's quality and profitability standards - and then find the funds needed to fund those loans the bank decides to make. Funds uses thus become a higher immediate priority item than funds sources. 15-4 For what kinds of bank funding situations are federal funds best suited? Federal funds are best suited for banks short of reserves to meet their legal reserve requirements or to satisfy customer loan demand. It satisfies this demand by tapping immediately usable funds. 15-5 Chaucer State Bank loans $50 million from its reserve account at the Federal Reserve Bank of Philadelphia to First National Bank of Smithville, located in the New York Federal Reserve Bank's district, for 24 hours with the funds scheduled to be returned the next day. The proper accounting entries in this case would be Step 1 - Lending the $50 million Chaucers State Bank Assets 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. Step 3 - Repaying the Loan of Federal Funds Assets Reserves at Fed Federal funds sold Chaucers State Bank Liabilities

+ $50 mill. - $50 mill.

First National Bank of Smithville Assets Liabilities Reserves at Fed + $50 mill. Federal funds Purchased - $50 mill.

15-6. Hillside Security Bank 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, returning them to its correspondent deposit the next business day. Sterling loans the $35 million to Imperial Security National Bank for 24 hours. The proper accounting entries would be: Step 1 - Lending Federal Funds to a Correspondent Assets Deposit with Correspondent Federal Funds Loaned Hillside Security Bank Liabilities

-$35 m +$35m m

First National Bank of Sterling City Bank Smithville Assets Liabilities Assets Liabilitites Reserves At Fed + $50 mill. Federal funds Federal Funds purchased +$50 mill. +$35 mill. Purchased 2

Respondent Bank's deposit -$35 mill. Step 2 - The Correspondent Bank Loans Funds to another Bank Sterling City Bank Assets Liabilities Reserves Federal funds loaned -$35 mill. +$35 mill.

Imperial Security National Bank Assets Liabilities Reserves + $35 mill. Federal funds purchased $35 mill.

Step 3 - Repaying the Loan to the Respondent Bank Hillside Security Bank Assets Liabilities Deposit with Correspondent Federal funds loaned +$35 mill. -$35 mill. Sterling City Bank Assets Liabilities Federal funds purchased -$35 mill. Bank's deposit +$35 mill.

15-7

What are the advantages of borrowing from the Federal Reserve banks?

Borrowing from the Federal Reserve banks is usually the lowest interest-cost source of funds. However, there are strict rules for borrowing by banks and borrowing for rate arbitrage is prohibited, although there is some evidence it does occur. 15-8 How is a discount window loan from the Federal Reserve secured?

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. 15-9 Posner State Bank borrows $10 million in adjustment credit from the Federal Reserve Bank of Cleveland. Can you show the correct entries for the granting and repayment of this loan? The proper entries are: Step 1 - Securing a Loan from the Fed Posner State Bank Assets Reserves on deposit at the Federal Reserve Bank + $10 mill Liabilities Notes payable +$10 mill.

Federal Reserve Bank of Cleveland Assets Liabilities Loans and Advances +$10 m Bank reserve Accounts $10 m

Step 2 - Repaying the Loan to the Fed Posner State Bank Assets Reserves on deposit at the Federal Reserve Bank -$10 mill Liabilities Notes Payable -$10 mill.

Federal Reserve Bank of Cleveland Assets Liabilities Loans and advances -$10 mill. Bank reserve accounts -$10 mill.

15-10 Why were negotiable CDs developed? Negotiable CDs were developed by banks to attract large corporate deposits and savings from wealthy individuals. 15-11 What are the advantages and disadvantages of CDs as a bank 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 a banker aggressively bids in terms of yield to keep the CD. 15-12 Suppose a bank customer purchases a $1 million, 90-day CD, carrying a promised 6 percent annual 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 To Customer = Principal * Days to Maturity 360 days
1 360

Annual Rate Of Interest

= $1,000,000 x Total amount due Customer = = =

x 0.06 = $15,000 + + Interest $15,000

Principal $1,000,000 $1,015,000

15-13 Where do Eurodollars come from? Eurodollars arise from dollar deposits made in banks 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. 15-14 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. 15-15 Suppose that JP Morgan-Chase elects to borrow $250 million from one of its London branches, then loans the borrowed funds for a week to a security dealer, and then returns the borrowed funds to its branch office in London. Can you trace through what accounting entries must be made? What if JP Morgan-Chase had decided instead to borrow the $250 million from a foreign bank not related to JP Morgan-Chase? How do the accounting entries differ in these two cases?

If JP Morgan-Chase borrows from its own branch office the entries would appear as possible: Home Office of JP Morgan-Chase Bank Assets Liabilities Reserves +$250 mill. Liabilities to foreign branches +$ 250 mill.

Foreign Branch Office of JP Morgan-Chase Assets Liabilities Deposit at home office +$250 mill. Deposit from branch office +$250 mill.

When JP Morgan-Chase's home office makes a loan to a security dealer the entries are: Home Office of JP Morgan-Chase Bank Assets Liabilities Reserves Loans -$250 mill. +$250 mill.

When the Loan is repaid and funds are returned to JP Morgan-Chases foreign branch we have: Home Office of JP Morgan-Chase Bank Assets Liabilities Reserves -$250 mill. Liabilities to foreign branches -$ 250 mill.

Foreign Branch Office of JP Morgan-Chase Assets Liabilities Deposit at home office -$250 mill. Deposit from branch office customers -$250 mill.

If, instead, JP Morgan-Chase borrows from another bank abroad not affiliated with JP Morgan-Chase, the entries would appear as follows: JP Morgan-Chase Assets Deposits held at other banks +$250 mill. Liabilities Deposits due to foreign banks +$250 mill.

U.S. Bank Serving as Correspondent to Foreign Bank Assets Liabilities Deposits due foreign bank -$250 mill. Deposits of JP Morgan-Chase +$250 mill. Foreign Bank Lending to JP Morgan-Chase Bank Assets Liabilities Deposit at U.S. Correspondent Bank +$250 mill. Eurodollar loan to JP-Morgan Chase Bank -$250 mill. When JP Morgan-Chase repays its loans we have: JP Morgan-Chase Bank Assets Liabilities Deposits held at other banks -$250 mill. Deposits due to foreign banks -$250 mill.

U.S. Bank Serving as Correspondent to Foreign Bank Assets Liabilities Deposits due to foreign banks +$250 mill. Deposits of JP Morgan-Chase Bank -$250 mill. Foreign Bank Lending Eurodollars Assets Liabilities Deposit at U.S. Correspondent Bank +$250 mill. Eurodollar loan to JP Morgan-Chase Bank -$250 mill. 15.16 What is commercial paper? Commercial paper is a high-quality, short-term debt obligation issued by a large corporation with an excellent credit rating to provide for short-term cash needs.

15.17 Suppose that the finance company affiliate of Citicorp issues $325 million in 9 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 Citicorp's finance company affiliates? The appropriate entries for the above transaction are: Step 1 - Commercial Paper is Sold by the Affiliated Finance Company Citibank Assets Finance Affiliate Assets Cash Account +$325 mill. Liabilities Commercial Paper +$325 mill. Liabilities

Step 2 - The Affiliated Finance Company Purchases Loans from Citibank Citibank Assets Loans Reserves -$325 mill. +$325 mill. Finance Affiliate Assets Cash Account -$325 mill. Loans Purchased from Citibank +$325 mill. 15.18 How do RPs arise? 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. 15.19 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 Liabilities Liabilities

collateralized loan. The securities that are sold as part of the agreement act as collateral. 15.20 What long-term non-deposit funds sources do banks draw upon today? How do these interest costs differ from most money market borrowings? Long-term non-deposit 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. 15.21 What is the funds gap for a bank? The funds gap is the difference between current and projected credit and deposit flows that creates a need for raising additional bank reserves or for profitably investing any excess reserves that may arise. 15-22 Suppose that Bankers Trust Company of New York estimates next week's new loan demand at $325 million and customer drawings on confirmed credit lines of $510 million, while new deposits next week are projected to equal $680 million. If the bank also plans to acquire $420 million in corporate and government bonds next week, what is the bank's projected funds gap? The expected funds gap (with all figures in millions of dollars) would be: Projected Funds Gap = $325 + $510 + $420 - $680 = $575.

15.23 What factors must a bank manager weigh in choosing among the various nondeposit sources of bank funding available today? A bank manager must weigh factors such as relative costs, risk, length of time funds are needed, size of bank and its funding need, and regulations in choosing what nondeposit funds sources to use. Other factors held constant, bank management will seek out the lowest cost non-deposit 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).

You might also like