CHAPTER 9

BANK SOURCES
AND USES OF
FUNDS
1

MANAGING DEPOSIT SERVICES

Deposits
a unique item on a banks balance sheet
distinguishes it from other types of business firm.
a key element in defining the critical roles bank
plays in the economy.
the ability to attract deposits from businesses and
consumers imply the confidence level of the public
to that bank.
provide most of the raw material for bank loans
and, thus, represent the ultimate source of bank
profits and growth.

Two key issues that every bank must

deal with in managing the publics
deposit:
i)

ii)

Where can funds be raised at the lowest

possible cost?
How can management ensure that the
institution always has enough deposits to
support the volume of loans and other
investments and services the public
demands?
3

TYPES OF DEPOSITS OFFERED BY

BANKS
1.
2.
3.

Demand Deposits
Savings Deposits
Time Deposits

1) Demand Deposit

noninterest-bearing transaction
have no maturity and must be paid by banks when a
negotiable instrument, generally in the form of a
cheque or an electronic impulse is presented.
has no interest cost (so they are generally a banks
lowest-cost source of funding).
provides customers with payment services, such as
payment using cheques.
Example: the current account offered by commercial
banks in Malaysia .

2)Savings Deposit

These are interest-bearing deposits without specific

maturity.
Withdrawals can be made whenever the depositor
desires.
have no fixed maturity, and individuals keep track of
their balances through passbook or periodic bank
statement.

3)Time Deposit

a)

differ form savings deposits because they have a

predetermined maturity date, and withdrawals prior to
that date are often subject to interest penalties.
There are several categories of time deposit:
Large negotiable certificate of deposits
fixed rate, no rate limit, and fixed maturity date that
usually ranges between 14 and 270 days at the time of
issue.
- there is an active market for large negotiable CDs and
economically the are more like borrowings than
deposits.

b) Other time deposits of RM100,000 or more

- not subject to rate limits, nonnegotiable, can have
fixed or flexible maturities, and are deposited by
individuals, partnerships, corporations, and
municipalities.
c) Time deposits under RM100,000
- includes savings certificates with many varying
terms, individual retirement, and other time deposit.
- these deposits have no rate limit and no regulatory
size minimum.

Other Classifications of Deposit

a)

b)

Public deposits

demand, savings or time deposits of

governmental units.
Correspondent deposits

deposits of other banks.

Most correspondent deposits are demand deposits

because it offer services such as check clearance.

Interest Rates Offered on Different Types of

Deposits
-

Each type of deposits carries a different rate of

interest.
The longer the maturity of a deposit, the greater the
yield that must be offered to depositors.
For example, savings deposits are subject to immediate
withdrawal by the customer; hence, their offer rate to
customers is among the lowest of all deposits.
In contrast, negotiable CDs and deposits of a year or
longer to maturity often carry the highest deposit
interest rates that banks offer.

THE COMPOSITION OF BANK

DEPOSITS
-

In recent years, banks have been most able to sell time

and savings deposits to the public.
In contrast, demand deposits have declined
significantly due mainly to the rise of electronic
payments media, including credit and debit cards,
Web-based payments systems and electronic wire
transfers.
For bankers, the best mix of deposits would consist of
a high proportion of demand deposits and low-yielding
time and savings deposits.

These accounts are among the least expensive of all

sources of funds and often include a substantial
percentage of core deposits
- a stable base of deposited funds that is not highly
sensitive to movements in market interest rates ( a low
interest-rate elasticity) and tends to remain with the
bank.
Large block of core deposits increases the duration of a
banks liabilities and makes it less vulnerable to changes
in interest rates.
However, large deposits increase banks cost of borrowing

Faced with substantial interest cost pressures, many

bankers have pushed hard to reduce their noninterest
expenses (e.g., by automating their operations and
reducing the number of employees on the payroll) and
to increase operating efficiency.
The managers of banks would prefer to raise funds by
selling deposits that cost the least amount of money.
Demand deposit is typically among the cheapest
deposit that banks sell to the public.
The absence of interest payments on demand deposit
accounts usually help keep the cost of these deposits
down relative to the cost of time and savings deposit
and other sources of funds.

Savings deposits are relatively cheap because of the

low interest rate they carry.
Time deposits, CDs, and money market accounts
generally display low account activity in terms of
deposits and withdrawals compared to savings
accounts.
However, time deposits and money market accounts
incur higher cost to the bank compared to savings
account.
As a conclusion, bankers should manage properly the
funding mix of their deposit in order to raise funds and
at the same time lowering their operating cost.

Cost Plus Profit Deposit

Pricing

Cost-plus pricing formula:

Estimating
Unit Price
Operating
Planned
Overhead
Charged the
Expense
Profit from
Expense
Customer = Per Unit of +
+
Each
Allocated to
for Each
Deposit
Service Unit
the Deposit
Service
Service
Sold
Function

15

Estimating Deposit Service

Costs

Cost-plus pricing demands an accurate calculation of

the cost of each deposit service.
One popular approach called the pooled-funds cost
approach is to base deposit prices on the estimated
cost of raising funds, which requires management to:
1) calculate the cost rate of each source of funds;
2) multiply each cost rate by the relative proportion of
all funds coming from that particular source; and
3) sum all the resulting products to derive the
weighted average cost of all funds raised.
16

PRICING DEPOSITS USING

MARGINAL COST
-

How should banks price their deposit

services in order to attract new funds and
make a profit?
One of the method is by using marginal
cost the added cost of bringing in new
funds (not weighted average cost).
The reason for using marginal cost instead
of average cost is that frequent changes in
interest rates will make (historical) average
cost an unrealistic standard for pricing.

For example:
If interest rates are declining, the added
(marginal) cost of raising new money may fall
well below the average cost over all funds
raised by the bank. Some loans and
investments that looked unprofitable when
compared to average cost will now look quite
profitable when measured against the lower
marginal interest cost we must pay today to
make those new loans and investments.
Conversely, if interest rates are on the rise, the
marginal cost of todays new money may
substantially exceed the banks average cost of
funds. If management books new loans based
on average cost, they may turn out to be highly
unprofitable when measured against the
higher marginal cost of raising new funds in
todays market.

Measuring marginal cost

Marginal cost = change in total cost

= New interest rate Total funds
raised at new rate Old interest rate
Total funds raised at old rate

Marginal cost rate = Change in total

cost
Additional funds
raised

Example: Suppose a bank expects to raise RM25

million in new deposits by offering its depositors
an interest rate of 7%. Management estimates
that if the bank offers a 7.5% interest rate, it can
raise RM50 million in new deposit money.
Marginal cost = (RM50m X 7.5%) (RM25m x 7%)
= RM3.75m RM1.75m = RM2m

Marginal cost rate = RM2m

RM25m
= 0.08 (8%)

CONDITIONAL PRICING

Due to fierce competition for deposits among

banks in the US during 1970s, a new method
called conditional pricing was widely used.
A bank sets up a schedule of fees in which the
customer pays a low fee or no fee if the
deposit balance remains above some
minimum level, but faces a higher fee if the
average balance falls below the minimum.
The customer will then pay a price conditional
on how he or she uses the deposit.

21

Conditional pricing techniques vary deposit

prices based on one or more of these factors:
1) The number of transactions passing through
the
account (e.g. number of cheques
written, deposits made, wire transfers, stoppayment orders, or
notices of insufficient
funds issued).
2) The average balance held in the account
over a designated period (usually per month).
3) The maturity of the deposit in days, weeks,
or months.
22

Constance Dunham (1983), an economist,

classified current account conditional price
schedules into three broad categories:
1) flat-rate pricing the depositors cost is a fixed
charge per cheque, per time period, or both.
2) free pricing refers to the absence of a
monthly account maintenance fee or pertransaction
charge.
3) conditionally free pricing favours large
denomination deposits because services are free
if the account balance
stays above some
minimum figure. An advantage of this method is
that the customer chooses which deposit plan is
preferable.
23

MANAGING NONDEPOSIT LIABILITIES

AND OTHER SOURCES OF BORROWED
FUNDS

What does management do when deposit volume

and growth are inadequate to support all the
loans and investments the bank would like to
make?
They have to find other sources of funds that is
called nondeposit sources or liabilities .
For example, one of a banks customer has
requested a new loan for today amounting to
RM100m. However, the banks deposit division
reports that only RM50m in new deposits are
expected today. If management wishes to fully
meet the loan request, it must find another
RM50m, mainly from nondeposit sources.

TYPES OF NONDEPOSIT SOURCES OF

FUNDS
1.

2.
3.
4.
5.

Federal Funds Market (Short-term

borrowing)
Repurchase Agreements (Repos)
Borrowing from the Central Bank
Development and Sale of Large NCDs
Long-term Nondeposit Funds Sources

Federal Funds Market

The most popular domestic source of

borrowed reserves.
Federal funds consist exclusively of
deposits of commercial banks and other
depository institutions at the central bank.
These deposits are held at the central
bank primarily to satisfy legal reserve
requirements, clear cheques, and pay for
purchases of government securities.
In technical terms, Federal funds are
simply short-term borrowings of
immediately available money.

1.

2.

Banks and other financial institutions in need of

immediate funds can negotiate a loan with a
holder of surplus interbank market or reserves at
the central bank, promising to return the
borrowed funds the next day if need be.
The main use of the Federal funds market
includes:
A mechanism that allows banks that are short of
reserves to meet their legal reserve
requirements or to satisfy customer loan demand
by tapping immediately usable funds from other
institutions.
To supplement deposit growth and serves as a
channel for the policy initiatives of central bank
designed to control the growth of money and
credit in order to stabilize the economy.

Repurchase Agreements
(REPOs)

Repos are very similar to Federal funds

transactions and are often viewed as
collateralized Federal funds transactions.
Repos involve the temporary sale of highquality, easily liquidated assets, such as Tbills, accompanied by an agreement to buy
back those assets on a specific future date at
a predetermined price.
A repo transaction is often for overnight
funds; however, it may be extended for
months.

The interest cost for repurchase agreements

can be calculated from the following formula:

Interest cost = Amount borrowed Current

Repo rate
Number of days in Repo borrowing
360 days
Example: Suppose that a bank borrows RM50
million through a Repo transaction
collateralized by government bonds for 3 days
and the current Repo rate in the market is 6%.

So, the banks total interest cost:

Interest cost = RM50 million 0.06 3
360
= RM24,995

Borrowing from the Central Bank

A viable alternative to the Federal funds and Repo

market is negotiating a loan from the Central Bank
for a short period of time (not more than 2 weeks).
The Central Bank will make the loan through its
discount window by crediting the borrowing
institutions reserve account held at the Central
Bank.
Each loan made must be backed by collateral
acceptable to the Central Bank such as
government securities, agency securities, and
high-grade commercial papers.

Sale of Large Negotiable CDs

This funding source is a hybrid account:

legally, it is a deposit, but in practical terms
the NCD is another form of instrument
issued to tap temporary surplus funds held
by large corporations, wealthy individuals,
and governments.
A CD is an interest-bearing receipt for a
specified time period at a specified interest
rate.

Interest rates on fixed-rate CDs are quoted on an

interest-bearing basis, and the rate is computed
assuming a 360-day a year.
Example, Suppose a bank promises an 8%
annual interest rate to the buyer of a RM100,000
six-month CD. The depositor will have the
following at the end of 6 months:

Amount due = Principal + (Principal (Days to

Maturity/360) Annual Interest Rate)
= RM100,000 + (RM100,000 (180/360)
0.08)
= RM104,000

Long-term Nondeposit Funds Sources

The nondeposit sources of funds discussed

before are mainly short-term borrowings.
However, banks also tap longer-term
nondeposit funds that beyond one year.
Examples include morgtages issued to fund
the construction of buildings and capital
notes and debentures, which usually range
from 5 to 12 years in maturity and are used
to supplement equity capital.

MEASURING A BANKS TOTAL NEED

FOR NONDEPOSIT FUNDS:THE FUNDS
GAP

Each banks demand for nondeposit funds is

determined basically by the size of the gap
between its total credit demands and its deposits.
Managers responsible for the asset side of the
banks balance sheet must choose which of a wide
variety of customer credit requests they will meet.
Management must be prepared to meet, not only
todays credit request, but also the future credit
request.
Management also must determine how much in
deposits is likely to be attracted in order to
finance the desired volume of loans and security
investments.

Hence, projection must be made of

customer deposits and withdrawals, with
special attention to the largest depositors.
The difference between current and
projected credit and deposit flows is called
the funds gap.

Funds gap = current and projected loans and

investments the bank desires to make
current and expected deposit inflows.

Example: Suppose a commercial bank has new

loan requests that meet its quality standards
of RM150 million; it wishes to purchase RM75
million in new Treasury securities being
issued this week and expects drawings on
credit lines from its best corporate customers
of RM135 million. Deposits received today
total RM185 million, and those expected in the
coming week will bring in another RM100
million. The banks funds gap:

FG = (RM150 + RM75 + RM135) (RM185 +

RM100)
= RM360 RM285
=RM75