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BFW3651 Semester 2, 2015 Tutorial 3 Answer Guide
BFW3651 Semester 2, 2015 Tutorial 3 Answer Guide
The Scenic national Bank gets its funds from Demand Deposits, Time
Deposits, CDs, Subordinated Capital Notes and Common Stock. Scenic
National Banks balance sheet is presented below with the costs of each
source of funds (interest, acquisition and servicing costs) in parentheses.
Scenic National Banks tax rate is 50%.
Scenic National Banks Balance Sheet (000)
Cash
and
due Demand deposits
(0.04)
$100
$ 300
Investments
Time deposits
(0.06)
300
400
Loans
CDs
(0.06)
600
100
Capital notes
(0.08)
100
Common stock
(0.20)
100
Total
Total
1000
1000
(a) Scenic National bank would like to base its investment returns on the
historical average cost of funds. Based on the balance sheet of Scenic
National Bank compute what would be the hurdle rate for new
investment decisions.
Demand deposits
0.04 x $300 = $12.0
Time deposits
CDs
Capital notes
Common stock
0.06
0.06
0.08
0.20
x
x
x
x
$400 =
$100 =
$100 =
$100 =
1000
$24.0
$ 6.0
$ 8.0
$20.0
$70.0
3.
To price deposits successfully, service providers must know their costs. How these
costs are determined using the historical average cost approach? The marginal cost of
funds approach? What are the advantages and disadvantages of each approach?
The historical average cost approach looks at the past. It asks the following question:
What funds has the bank raised to date and what did they cost? The marginal cost
deposit-pricing method focuses upon the weighted average cost of new funds raised
from all of the different sources of funds the bank draws upon or plans to draw upon in
the current period. Under marginal cost pricing, the offering institution will set its
price at a level just sufficient to attract new funds and still earn a profit on the last
dollar of new funds raised.
The major advantage of marginal cost is that the marginal cost approach provides
valuable information to the managers of depository institutions, not only about setting
deposit interest rates, but also about deciding just how far the institution should go in
expanding its deposit base before the added cost of deposit growth catches up with
additional revenues, and total profits begin to decline. When profits start to fall,
management needs either to find new sources of funding with lower marginal costs, or
to identify new assets promising greater marginal revenues, or both.
The marginal cost is preferred over historical average cost as frequent changes in
interest rates will make historical average cost a treacherous standard for pricing and it
will have a spillover effect on other liabilities.
4.
A bank determines from an analysis of its cost-accounting figures that for each $500
minimum-balance checking account it sells, account processing and other operating
costs will average $4.87 per month and overhead expenses will run an average of
$1.21 per month. The bank hopes to achieve a profit margin over these particular costs
of 10 percent of total monthly costs. What monthly fee should it charge a customer
who opens one of these checking accounts?
The relevant formula is:
Unit price charged the customer for each deposit service =
Operating expense per unit of deposit service +
Estimated overhead expense allocated to the deposit-service function +
Planned profit margin from each service unit sold
In this case, the unit price charged per month should be $6.69 ($4.87 + $1.21 + [0.10
($4.87 + $1.21)]) for each $500 minimum-balance checking account it sells.
5.
Rhinestone National Bank reports the following figures in its current Report of
Condition:
Assets (millions)
Cash and interbank
deposits
Short-term security
investments
Total loans, gross
Long-term securities
Other assets
$50
150
65
45
195
65
Total assets
(a)
Equity capital
$625 Total liabilities and equity capital
55
$625
Evaluate the funding mix of deposits and non-deposit sources of funds employed by
Rhinestone. Given the mix of its assets, do you see any potential problems? What
changes would you like to see management of this bank make? Why?
Core deposits/Assets
Large Negotiable CDs/Assets
Deposits placed by Brokers/Assets
Other Deposits/Assets
Money Market Liabilities/Assets
Other Liabilities/Assets
Equity Capital/Assets
=
=
=
=
=
=
=
8.00 percent
24.00 percent
10.40 percent
7.20 percent
31.20 percent
10.40 percent
8.80 percent
The proportion of core deposits at Rhinestone is exceptionally low, while large CDs and other
money-market borrowings make up more than 55 percent of the banks total funding sources.
This funding mix tends to subject the bank to excessive vulnerability to quick withdrawal of
funds and high interest-rate risk exposure. Rhinestone also appears to be excessively
dependent on brokered deposits which are highly volatile and interest-sensitive. Adding in
these brokered deposits, more than half of Rhinestones assets are funded with highly interestsensitive deposits and money-market borrowings. Management needs to expand the banks
core deposits and other more stable funds sources having less sensitive interest rates.
(b)
Suppose market interest rates are projected to rise significantly. Does Rhinestone appear
to face significant losses due to liquidity risk? Due to interest rate risk? Please be as
specific as possible.
If interest rates rise, Rhinestone will experience higher interest costs immediately or
within hours or a few days on at least 50 percent of its funding sources. Unfortunately,
all but $65 million of its $625 million in total assets are longer-term, inflexible assets
whose interest yields cannot be adjusted as rapidly as the interest rates to be paid out on
the banks liabilities. Other factors held equal, the banks earnings will be squeezed.
Management need to do some serious restructuring work on both sides of the banks
balance sheet in moving toward more flexible-return assets and more flexible-cost
liabilities, and to move toward greater use of interest-rate hedging techniques
6.
Martian bank has organized its 100 branch network into loan branches and deposit
taking branches. However, there was much discontent by the branch staff when a
profitability performance based measurement linking to staff bonus was introduced in
the beginning of 2012. The dissatisfaction is centered on the failure by the Treasury
Department to compensate the deposit branches to reflect their effort, contribution and
cost in soliciting deposits, leading to losses for the branches.
The Asset and Liability Committee (ALCO) has directed the Treasury Department of
Martian Bank to come up with an appropriate mechanism to charge/compensate the
branches to reflect their true performance.
The loan and deposit data for Martian Bank as at 30/6/2012 are as follows
(i)
Value
$ 10.0 billion
$ 10.0 billion
Rates
Lending Rate 8.5 % p.a
Deposit Rate 3.5 % p.a
Define and explain the mechanism that would be employed by the Treasury
Department to overcome the dissatisfaction?
(ii) Construct a charge/compensation mechanism based on the data provided above with
a 2 % spread for the deposit branches, 1.0 % gain for the treasury department and 2.0
% spread for the loan branches.
(iii) Explain the outcome of this mechanism in relation to the initial dissatisfaction by the
deposit branches.
(Past Year Question 2012)
(i) In this case the treasury department functions to provide liquidity, allocate sufficient
funds to deficit branches, implement the price/cost decision and strategies taken by
the ALCO committee to improve the overall financial performance of the whole
bank.
The treasury department will utilize the transfer pricing mechanism to execute the
functions and to improve the satisfaction of the deposit branches. The treasury
department will act as an In House banker by purchasing all the deposits at a price
and providing funds to the loan branches at a cost.
(ii)
Table 1
Type
Deposits
Loan asset
Deposit Branches
($ billion)
10.0
Loan Branches
($ billion)
10.0
Rates
3.5 %
8.5 %
Treasury buys all deposits $10.0 billion from deposit branches at 5.5 % from
Buys deposits
Receives from selling to
branches
$
Billion
10.0
5.5
10.0
6.5
Branches
$ Billion
Receives
Pays Deposit
from Loan
Branches
Branches
0.55
0.65
Profit
0.10
Deposit Branches
$
Billion
10.0
5.5
10.0
3.5
Branches
$ Billion
Pays
Receives
0.55
(0.35)
0.20
Loan Branches
$0.10
Deposit Branches
$ 0.20
Loan Branches
$ 0.20
Total Profit
(iii)
$
Billion
10.0
10.0
6.5
8.5
Branches
$ Billion
Pays
Receives
(0.65)
0.85
0.20
$ 0.50 billion
The actions of treasury has provided a profit for all business units thus
increasing the satisfaction level. If treasury did not intervene, then the loan
branches would be making a profit and the deposit branches have to bear
the cost of deposits and incur loses.