Liabilities Management

1
Liabilities Management

• Outline
• Structure of bank liabilities
• Deposit sources of funds
• Nondeposit sources of funds
• Balance sheet structure of bank liabilities
• Managing bank liabilities
• Formulating pricing policy
• Deposit pricing matrix
• The pricing committee
• Components of the pricing decision
• Profitability and deposit pricing
• Lending and deposit costs
• Customer relationship pricing
• Estimating the costs of bank funds

2
Structure of bank liabilities

• Deposit sources of funds
• Core deposits of regular bank customers.
• Purchased deposits are acquired on a nonpersonal
  basis from the financial market at competitive
  interest rates.
• Categories of deposits accounts demand
  deposits, small time and savings deposits (or
  savings certificates or retail CDs), large time
  deposits (negotiable certificates of deposit or
  NCDs).
• Deregulation DIDMCA of 1980 (NOW accounts),
  Garn-St Germain Act of 1982 (MMDAs) to compete
  with MMMFs, and DIDC (Super NOW accounts in
  1983).
• Liability management is based on purchased funds.
• Eurodollar deposits are dollar-denominated
  deposits in a bank outside of the U.S. (not FDIC
  insured).
• Brokered deposits

3
Structure of bank liabilities
4
Structure of bank liabilities

• Deposit sources of funds
• Brokered deposits occur when large deposits are
  split into 100,000 pieces and placed with
  different banks to obtain 100 insurance. DIDMCA
  of 1980 raised deposit insurance limits from
  40,000 to 100,000 per account, which
  encompassed large NCDs.
• FDIC Improvement Act of 1991 prohibits depository
  institutions from using brokered deposits unless
  well or adequately capitalized.
• Brokered deposits were used by failing savings
  and loan associations in the 1980s to cover
  earnings losses.
• IRA and Keogh plans are personal pension plans
  that individuals may use to defer federal income
  taxes on contributions and subsequent investment
  earnings. Roth IRAs allowed under the Taxpayer
  Relief Act of 1997. Banks act as custodians and
  gain a stable, long-term source of deposit funds.
  Other financial service firms are very
  competitive.

5
Structure of bank liabilities

• Nondeposit sources of funds
• Federal funds Short-term, unsecured transfers of
  immediately available funds between depository
  institutions for on business day (i.e., overnight
  loans).
• Repurchase agreements Secured, one-day loans in
  which claim to the collateral is transferred.
  For example, a bank sells securities to a
  corporate client and promises to repurchase the
  next day.
• Discount window advances Banks can borrow from
  the 12 regional Federal Reserve banks by this
  means (subject to Regulation A rules).
• Federal Home Loan Bank borrowings Under FIRREA
  of 1989, the FHLB can provide discount window
  services to not only savings and loans (as in the
  past) but banking institutions.

6
Structure of bank liabilities

• Nondeposit sources of funds
• Bankers acceptances time drafts drawn on a
  bank by either an exporter or importer to finance
  international business transactions. The bank
  may discount the acceptance in the money market
  to (in effect) finance the transaction.
• Commercial paper short-term, unsecured
  promissory note sold by large companies with
  strong credit ratings. Banks can use their
  holding companies to issue this short-term debt
  instrument.
• Capital notes and debentures Senior debt
  capital that is not federally insured and
  considered subordinate to bank deposits. Recent
  changes to encourage bank issuance and improve
  market discipline of banks.

7
Balance sheet structure of bank liabilities

• As bank size decreases (increases), greater
  emphasis is placed on retail deposits (managed
  liabilities).
• Sweep programs increased in popularity in the
  1990s (i.e., funds are moved from transactions
  accounts with reserve requirements to savings
  accounts with no such requirements).
• Banks had difficulty retaining core deposits in
  the 1990s due to the low interest rates in this
  period. Depositors sought higher yields in money
  and capital markets.
• Banks increased mutual fund offerings to
  customers, which was greatly enhanced by the
  Financial Services Modernization Act of 1999.

8
Managing bank liabilities

• Formulating pricing policy
• Written document that contains the pricing
  details of deposit services (e.g., service fees
  and minimum balance requirements, deposits costs
  and volumes, credit availability and compensating
  balance requirements, customer relationship
  pricing, promotional pricing of new products, and
  other marketing elements such as product
  differentiation.).
• Deposit pricing matrix
• Explicit (interest) and implicit (noninterest)
  pricing of deposits.
• Deregulation of interest rates on deposits in
  early 1980s shifted banks to more explicit and
  less implicit pricing.
• The pricing committee
• Staffed by employees throughout the bank.

9
Managing bank liabilities

• Components of the pricing decision
• Factors affecting the pricing decisions on
  consumer deposits
• Wholesale cost of funds
• Pricing strategy of competitors
• Interest elasticity (or responsiveness) of
  consumer demand
• Past deposit flows for various kinds of consumer
  accounts
• Maturity structure of deposits
• Profitability and deposit pricing
• Cost/revenue analysis
• Minimize total costs
• Maximize total revenues
• Set marginal costs equal to marginal revenues
• Breakeven points define the range of profitable
  output levels

10
Managing bank liabilities

• Lending and deposit costs
• Compensating balances
• Tie-in arrangements between deposit and loan
  services
• Customer relationship pricing
• Relationship banking to meet total financial
  needs of customers
• Promotional pricing to introduce new products
• Other marketing elements related to pricing
• Product differentiation
• Distribution or physical delivery of deposit
  services to the public

11
Managing bank liabilities

• Estimating the cost of bank funds
• Average costs (dollar costs of funds/dollar
  amount of funds)
• Weighted-average cost of funds
• Average costs of alternative sources of funds
  should be the same in theory (due to a bank using
  the cheapest source until its price rises to
  other sources average costs)
• Historical cost analyses to identify problems and
  opportunities
• Marginal costs (incremental costs of an
  additional dollar of funds)
• Minimum yield on bank investments in loans and
  securities that must be earned to avoid a loss in
  equity share values
• Do not use the marginal cost of any particular
  source of funds as the cutoff rate on investment
  decisions
• Use the marginal cost of the entire mix of funds
  as a cutoff criterion in investment decisions
• Marginal cost of funds not best cutoff for
  long-run investment decisions. In this case use
  the marginal cost of capital based on long-term
  debt and equity costs.

12
Managing bank liabilities

• Less costly sources of funds declines have higher
  risk, which is consistent with higher bank
  profits as risk increases.

Cost of Funds
Risk of Funds