Lesson 8

Lesson 8:
Managing Non-Deposit Liabilities
1
Outline
• Rationale for non-deposit liabilities.
• The Funding Gap.
• Sources of non-deposit liabilities.
• Factors involved in choosing among funding sources.
2
Recap
• The balance sheet is a statement of assets and liabilities.
• It presents to potential investors an indication of the financial
health of the firm.
• In the last lesson we started to look at the management of a
bank’s liabilities. We focused on deposit liabilities.
• In this lesson we will focus on another component of the bank’s
liabilities – non-deposit liabilities.
• Remember that the balance sheet usually has a third component
– Equity.
3
Recap
• Example of a bank’s balance sheet.
Deposits
Non-Deposit
liabilities
4
Introduction
• Recall that banks are intermediaries that borrow funds in order to
lend to those who wish to borrow.
• Banks must therefore raise funds in order to lend to borrowers.
• Where domestic savers exist, the main source of funds available
to banks is the pool of savings by households (and other sectors
such as corporations and government). In the previous lesson we
referred to these savings as “deposits” and further described
deposits as liabilities to banks, because these deposits must be
given back to the savers at some point.
• Retail deposits tend to grow in line with the size of the economy
and with the wealth levels of households.
5
Introduction
• When the demand for credit (/loans) is growing faster than the
pool of available deposits, banks will tend to look for other
sources of funds to meet increased demand for credit.
• These other sources of funds for a bank we will refer to as “non-
deposit liabilities”. Sometimes literature may use the term “non-
core liabilities” (and will refer to deposits as “core liabilities”).
You may ask why would a bank bother to acquire additional sources
of funds beyond the available pool of deposits ...
6
Rationale for banks’ non-deposit liabilities
• Recall that according to regulations as laid out by the central bank,
banks will hold a portion of all deposits as reserves with the central
bank. Beyond that, banks will tend not to lend all its deposits since it
will have customers with chequing accounts and will have to release
those funds back to their customers on demand.
• Inflation (or rising prices) may mean that a given stock of deposits
can provide fewer loans over time.
• Recall that banks are generally for-profit entities. The opportunity to
earn profit margins through an ability to gain interest income on
loans in an amount above the interest they pay out for deposits.
Therefore, banks targeting profit growth will find responding to
demand for loans as attractive.
7
Rationale for banks’ non-deposit liabilities
• The Customer Relationship Doctrine. 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. Thus, lending
decisions often precede funding decisions. All loans and
investments whose returns exceed their cost and whose quality
meets the lending institution’s credit standards should be made.
• Banks may tend to want to invest in good projects from customers
assessed as “creditworthy”.
8
Non-deposit Liabilities
• The ratio of non-deposit liabilities to deposit liabilities will tend to
reflect the underlying pace of credit growth.
• When deposit liabilities are “sticky” and do not grow in line with
the credit supply, the record of liabilities in a banks’ balance sheet
will be filled with non-deposit liabilities obtained from either the
money market or the capital market.
• Banks have increasingly been turning to non-deposit funding
sources. This appears in the literature also as “wholesale funding”
sources.
9
Non-Deposit Liabilities
• The demand for non-deposit funds is determined by the size of
the gap between the institution’s total credit demands and its
deposits and other available monies.
• Gap is based on:
• Current and projected demand and investments the bank
desires to make; and
• Current and expected deposit inflows and other available
funds.
• The size of this gap determines the need for non-deposit funds.
10
The Funding Gap
• The funding gap is calculated as the difference between current
and projected credit and deposit flows.
• If the difference shows the projected need for credit exceeding
the expected deposit flows, the bank has to raise additional
resources either by attracting more deposits or by using non-
deposit sources.
• If the difference shows the projected credit requirements as
below available resources, then the bank will have to find
profitable investment avenues for the surplus resources.
11
The Funding Gap
• Assume the bank makes the following projections for the next week of its
operations:
New credit demand: G$100million
Drawdowns of loans already approved: G$300million
New deposits inflows: G$300million
Planned investments in government/corporate securities: G$200million
• The projected funding gap for the bank would be:
• Need for funds = 100 + 300 + 200 = G$600million
less
• Deposit funds expected = G$300 million
• The funding gap for the bank for the following week is expected to be
G$300 million.
12
Liability Management
• If enough deposits are not immediately available to cover these
loans and investments, then management should seek out the
lowest-cost source of borrowed funds available to meet its
customers’ credit needs.
• During the collapse of the subprime mortgage market in the
2007-2009 business recession, regulators found that many
mortgage lenders went overboard in approving loans, falling well
below normal industry standards with little or no documentation.
13
Liability Management
• During the 1960s and 1970s, the customer relationship doctrine
spawned the liquidity management strategy known as liability
management.
• The bank buys funds in order to satisfy loan requests and reserve
requirements.
• It is flexible – The bank can decide exactly how much it needs and
for how long.
• The control mechanism to regulate incoming funds is the price of
funds.
14
Non-Deposit Sources of Funds
There are several non-deposit sources of liabilities in use by banks:
• Borrowing from the central bank.
• Inter-bank borrowing.
• Repurchase Agreements.
• Advances from the Federal Home Loan Bank.
• Negotiable CDs.
• Eurocurrency Market.
• Commercial Paper.
• Long-Term Non-deposit Funds Sources.
• Others?
15
Alternative Non-Deposit Sources of Funds
• The usage of non-deposit sources of funds has risen.
• Larger institutions rely on the non-deposit funds market as a key
source of short-term money to meet loan demand and
unexpected cash emergencies.
16
Borrowing from the Central Bank
• The central bank is considered the lender of “last resort”.
• Commercial banks will tend to borrow from the central bank
because:
• They do not have sufficient assets (at current market prices) to
dispose of in order to generate the funds they have assessed
to be in need of.
• May not be successful in borrowing from other commercial
banks.
• Of the simplicity of the process.
• The process of borrowing from the central bank is shrouded in
stigma.
17
Borrowing from the Central Bank
• Banks primarily borrow from the central bank to make up the
reserve requirement.
• However, banks can also borrow from the central bank to satisfy
loan requests assessed to be profitable. This may become
necessary when market conditions do not allow for borrowing
from other sources.
18
Borrowing from the central bank
• Banks can access the ‘discount window’ of the central bank,
which serves to prevent depository institutions (particularly
banks) from failing due to liquidity constraints.
• But borrowing banks are expected to be solvent (able to pay
debts).
• Deposits with correspondent banks and demand deposit balances
of security dealers and governments can be used for loans to
institutions.
• The interest rate on the loan, the discount rate, tends to be a bit
higher than the rate banks charge each other.
19
• Types of Loan Agreements:
• Overnight Loans:
• Negotiated via wire or telephone. Returned the next day.
• Normally not secured by specific collateral.
• Term Loans:
• Longer term contracts (several days, weeks, or months).
• Continuing Contracts.
• Automatically renewed each day.
20
• Several types of loans are available from the central bank’s
discount window:
• Primary Credit:
• This loan is available for short terms and to institutions in
sound financial condition.
• Rate is slightly higher than the federal funds rate.
• Secondary Credit:
• These loans are available at a higher interest rate to
institutions not qualifying for primary credit.
21
• Several types of loans are available from the central bank’s
discount window:
• Seasonal Credit:
• These loans cover longer periods than primary credit for small
and medium institutions experiencing seasonal swings in
deposits and loans.
• The central bank will make the loan through its discount window
by crediting the borrowing institution’s reserve account.
22
Borrowing from other banks
• Banks borrow from each other. Those with enough cash see an
opportunity to improve their interest income by lending, and those
without enough cash see an opportunity to borrow to meet
immediate demand and until enough loan funds are received.
• This market in the U.S. is referred to as the federal funds market.
• The interest rate is referred to as the federal funds rate.
• Most loans are overnight loans.
• Some loans can have maturities as long as one week.
23
Borrowing from other banks
• Banks tend to popularly use this option of funding for meeting
shortfalls in the reserve requirement.
24
Repurchase Agreements (RP)
• This source of funds is less popular than inter-bank borrowing.
• Used most for overnight funds.
• Though the agreement may be extended for days, weeks, or even
months.
• The lender provides cash to a borrower against collateral provided
by the borrower. Collateral can be of greater value than the cash
provided.
• The collateral provided tends to be securities e.g. government or
corporate bonds, treasury bills.
• While any type of security can be used, more liquid securities are
preferred.
25
• If the borrower defaults (fails to honor the agreement), the lender
takes control of the collateral.
• The agreement involves an interest rate called the “repo rate”.
• Higher perceived risk tends to attract a higher repo rate.
• The interest cost is calculated according to the following formula:
Interest cost of RP = Amount borrowed x Current Repo rate x
(Number of days in RP borrowing/360 days).
• Under this agreement, the seller legally repurchases the securities
from the buyer at loan maturity. This occurs in a single transaction.
26
• There are risks with repurchase agreements:
• The seller may fail to purchase the security at the maturity
date. In that case, the buyer will have to keep the security and
liquidate it to recover the cash lent.
• The security may have, however, lost value. This is mitigated
by the over-collaterization of the repurchase agreement.
• If the value of the security rises there is a credit risk for the
borrower in that the creditor may not sell them back. If this is
anticipated, the repurchase agreement can be under-
collateralized.
27
Advances from Federal Home Loan Banks
• Allows institutions (home mortgage lenders) to use home
mortgages as collateral for advances.
• A way to improve the liquidity of home mortgages and encourage
more lenders to provide credit.
• Number of loans has increased dramatically in recent years.
• Maturities range from overnight to more than 20 years.
• Has federal charter and can borrow cheaply and pass savings on
to institutions.
28
Negotiable Certificates of Deposits
• Banks may develop and sell large negotiable certificates of
deposits (CDs) to raise cash.
• These are time-deposit financial products.
• They take the form of an interest-bearing receipt evidencing the
deposit of funds in the bank for a specified period of time for a
specified interest rate.
• CDs are considered a hybrid product since they are legally
deposits.
29
• Interest rates are negotiable.
• This instrument can be sold at a discount to its face value, or
interest is paid.
• Participants in the market for negotiable CDs are usually wealthy
individuals and institutions with excess cash and looking for
investment opportunities e.g. corporations, insurance companies,
pension funds, etc.
• The tend to be low-risk investments – They are insured by the
FDIC for up to $250,000 per depositor per bank.
30
• These instruments are not callable, i.e. banks cannot redeem
them prior to the maturity date.
• Examples include –
• Zero-coupon certificate of deposit: purchased at a discounted
rate and does not pay our interest periodically but as a lump
sum at maturity.
• Yankee certificate of deposit: issued in the U.S. by the branch
of a foreign bank. They usually cannot be cashed in before
maturity.
31
• Types of Negotiable CDs:
• Variable-rate CDs.
• Fixed-rate CDs:
• Represents the majority of CDs.
• Interest rates on fixed-rate CDs are quoted on an interest-
bearing basis and the rate is computed assuming a 360-day
year.
32
Negotiable Certificates of Deposit
• Example:
• Suppose a depository institution promises an 8 percent annual
interest rate to the buyer of a $100,000 six-month (180-day) CD.
• The depositor will have the following at the end of six months:
Amount due CD customer = Principal + Principal x

(Days to maturity/360 days) x annual rate of interest.
= $100,000 + $100,000 x (180/360) x 0.08 = $ 104, 000.
33
Negotiable Certificates of Deposit
• The holder of the CD agrees to keep money in the account for a
set period of time.
• When the CD reaches its maturity date, it can be redeemed for
the initial principal investment plus any interest earned.
• If the holder of the CD attempts to withdraw money before the
CD’s maturity date, they will face a penalty that can prevent the
payment of interest.
• The term of CDs can range from one month to five years.
• The longer the term, the higher the interest rate.
• They tend to earn higher rates than on savings accounts, and
therefore may not be the first-choice option for banks.
34
The Eurocurrency Market
• The money market for borrowing and lending currencies that are
held in the form of deposits in banks located outside the
countries in which those currencies are issued as legal tender.
• The Eurocurrency market is simply a market for bank time
deposits and loans denominated in a currency other than that of
the country in which the bank is located.
• International banking facilities in the U.S. are allowed and have
the following major features: no reserve requirements, no
interest ceilings on deposits; minimum maturity of two business
days for nonbank deposits; nonbank transactions can be in
minimum amounts of $100,000; foreign residency required for
loans and deposits.
35
• Eurocurrency deposits were developed originally in Western
Europe to provide liquid funds that could be swapped among
multinational banks or loaned to the banks’ largest customers.
• Because they are denominated on the receiving banks’ books in
dollars rather than in the currency of the home country and
consist of accounting entries in the form of time deposits, they
are not spendable on the street like currency.
• Most Eurodollar deposits are fixed-rate time deposits.
Eurodollars are dollar-denominated deposits placed in bank offices
outside the United States.
36
• Most Eurodollar deposits are fixed-rate time deposits.
• Floating-rate CDs and floating-rate notes were introduced in an
effort to protect banks and their Euro depositors from the risk of
fluctuating interest rates.
• The Eurocurrency market is the largest unregulated financial
marketplace in the world.
• They tend to have smaller eurocurrency spreads, due to:
• It is a wholesale market; It typically operates in units of
$1million; It services large and well-known clients. It therefore
has low overhead cost.
• No deposit insurance.
37
• Clients are known with high-quality credits and therefore they
tend to experience smaller default risk.
• The market generally uses floating interest rates and therefore
experiences lower interest rate risk.
38
Commercial Paper Market
• Commercial paper is issued by banks (and large corporations) with
the intention of raising cash (and working capital).
• It is a money market instrument that has maturities normally ranging
from three or four days to nine months.
• Usually issued at a discount from face value and reflects prevailing
market interest rates.
• They can be sold through security dealers or through direct contact
with buyers.
• Types: (1) Industrial Paper – purchase inventories by corporations; (2)
Finance Paper – Issued by finance companies and financial holding
companies.
39
• It is an unsecured form of promissory note that pays a fixed rate of
interest.
• It meets short-term funding needs of the bank.
• It is attractive as it helps the bank avoid the hurdles and expense of
applying for loans.
• The rates offered tend to rise along with economic growth.
• They tend not to be insured. They are backed by the financial
strength of the issuer. Many issuers of commercial paper tend to
purchase insurance as a form of backup against loss.
40
• This funds source tends to be high in volume and moderate in
cost but also volatile in available capacity and subject to credit
risk.
41
Long-term Non-Deposit Sources of Funds
• The non-deposit sources of funds discussed to this point are
mainly short-term borrowings.
• However, many financial firms also tap longer-term non-deposit
funds stretching well beyond one year.
• Examples include mortgages issued to fund the construction of
buildings and debentures.
Debentures are fixed-interest loan certificates.
42
Long-term Non-Deposit Sources of Funds
• These longer-term non-deposit funds sources have remained
relatively modest over the years due to regulatory restrictions and
the augmented risks associated with long-term borrowing.
• Also, because most assets and liabilities held by depository
institutions are short- to medium-term, issuing long-term
indebtedness creates a significant maturity mismatch.
43
Other Sources of Funds
• Banks can also pursue less popular and non-traditional funding
sources:
• They may decide to issue shares.
• They may tap non-traditional sources such as the International
Finance Corporation.
44
Choosing Non-Deposit Sources of Funds
• If the bank decides that it will use non-deposit sources of funding
to fill the funding gap, it will have to consider the following factors
when choosing among alternative funding sources:
• The relative costs of raising funds from each source.
• The risk (volatility and dependability) of each funding source.
• The length of time (maturity or term) for which funds are
needed.
• The size of the institution that requires more funds.
• Regulations limiting the use of alternative funds sources.
45
• The relative costs of raising funds from each source:
• Managers should compare the prevailing interest rate among
the various options. The inter-bank rate is likely to be the
cheapest rate and should therefore be included in the list of
source prices to be compared.
• The actual cost for raising funds extends however beyond the
interest rate.
• The cost includes such things as time spent seeking new
funding sources when necessary, and the cost of using any
brokers.
46
• The relative costs of raising funds from each source:
• A useful formula is:
(current interest cost on amounts to be borrowed + noninterest costs
incurred to access those funds) / net investable funds raised from this
source.
Where
(1) Current interest cost on amounts to be borrowed = Prevailing
interest rate x Amount of funds borrowed.
(2) Noninterest cost to access funds = (estimated cost representing
staff time, facilities, transaction costs) x Amount of funds borrowed.
(3) Net investable funds raised = Total amount borrowed less legal
reserve requirement deposit, insurance assessments and funds placed
in nonearning assets.
47
• The risk of each funding source:
• Management should consider 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 shorter the maturity period, the more the volatility.
• 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.
48
• The length of time funds are needed:
• 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
source.
49
• The size of the borrowing institution:
• Most money market loans have a standard trading unit of
$1million. 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.
50
• Regulations:
• 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.
51
• Other factors held constant, management will seek out the lowest
cost of non-deposit funding sources available.
• Assume the following scenario:
Funding source Market interest rate Cost of access (per
(per cent) cent)
Central bank 6.0 0.10
CDs 8.0 0.20
Foreign funds 10.0 0.30
Other money market funds 6.5 0.25
52
• Assume that the bank wants to raise G$400million, of which
G$300million will meet the loans and investment commitments
expected.
• The effective cost of funds will be = [(market rate x 400) + (cost of
access x 400)/300].
53
• What will be the effective annual cost of each funding source be
in our example?
Hint: make the calculation row by row
54
• Banks will tend to compare the effective cost of each possible
type of funds.
• Banks will have to compare the effective cost of each type of
funds with the cost of getting fresh deposits in the market and
the yield it expects to earn on deployment of the funds into loans
and investments.
• Banks can also consider a mix of various sources of funds, subject
to availability and other factors previously stated.
Remember: Banks will tend to use the lowest-cost source of funds
or the lowest cost source combination.
55
• The hurdle rate of return is the minimum rate of return on an
investment required by a manager. The hurdle rate of return is
equivalent to:
All expected operating costs/Funds available to place in

earning assets.
• It tells the minimum earning rate (%) the bank must earn (before
taxation) on all its funds invested in meeting the expected new
funding cost.
• What is the hurdle rate in our example?
56
Are non-deposits sources more costly and risky?
• Borrowings from the market are generally perceived to be more
costly than deposit funds.
• Where borrowings are undertaken, banks tend to be exposed to
market risk i.e. the cost of borrowing and their availability may
fluctuate.
• Lenders who do not have insurance protection are likely to seek
interest rates that are commensurate with the risk profile of the
borrowing bank and would generally expect the bank to match
market interest rates.
57
• Apart from the consideration of cost, wholesale funding is not
without risk.
• Non-deposit sources lack the stability of deposit sources.
• Therefore, banks must develop the capability to access the
appropriate type of funds at short notice and to repay on time.
• This implies that these banks would have to ensure back up
measures, such as short-term investment in government
securities, which can be sold at short notice. Such measures may
affect the banks’ profitability since liquid securities yield lower
returns.
58
• Banks may also have to invest in personnel with the requisite
expertise in managing sourcing and repayment of such funds in
the market.
• On the other hand, such wholesale borrowings may be cheaper at
the margin than deposits, even if the rates paid on non-deposit
funds are actually higher. One reason would be the lower
transaction costs for raising bulk wholesale funds, which banks
often raise with a mere phone call. In doing so, banks save on
branch, personnel and system costs.
59
Exercise
1. Examine the balance sheet of any two commercial banks in
Guyana. What pattern in non-deposit liabilities do you see?
What is the ratio of deposit to non-deposit liabilities?
60

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Lesson 8:

Managing Non-Deposit Liabilities

Amount due CD customer = Principal + Principal x

Debentures are fixed-interest loan certificates.

All expected operating costs/Funds available to place in

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