Solution manual bank management and financial services 9th edition by rose, peter chap013

Chapter 13 - Managing Nondeposit Liabilities CHAPTER 13 MANAGING NONDEPOSIT LIABILITIES Goal of This Chapter: The purpose of this chapter is to learn about the principal nondeposit sources of funds that financial institutions can borrow from, to help finance their activities and to see how managers choose among the various nondeposit funds sources currently available to them • • • • • • Key Topics in this Chapter Liability Management Customer Relationship Doctrine Alternative Nondeposit Funds Sources Measuring the Funds Gap Choosing Among Different Funds Sources Determining the Overall Cost of Funds Chapter Outline I Introduction II Liability Management and the Customer Relationship Doctrine A Customer Relationship Doctrine B Liability Management III Alternative Nondeposit Sources of Funds A Federal Funds Market (“Fed Funds”) B Repurchase Agreements as a Source of Funds C Borrowing from Federal Reserve Banks Primary Credit Secondary Credit Seasonal Credit D Advances from Federal Home Loan Banks E Development and Sale of Large Negotiable CDs F The Eurocurrency Deposit Market G Commercial Paper Market H Long-Term Nondeposit Funds Sources IV Choosing Among Alternative Nondeposit Sources A Measuring a Financial Firm’s Total Need for Nondeposit Funds: The Available Funds Gap B Nondeposit Funding Sources: Factors to Consider Relative Costs The Risk Factor The Length of Time Funds Are Needed The Size of the Borrowing Institution Regulations V Summary of the Chapter 13-1 Chapter 13 - Managing Nondeposit Liabilities Concept Checks 13-1 What is liability management? Liability management involves conscious control of the funding sources of a financial institution, 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 13-2 What advantages and risks does the pursuit of liability management bring to a borrowing institution? Improved control over funding sources enables a borrowing institution to plan its growth more accurately This is because funds raised by liability management techniques are flexible in terms of the amounts raised and their maturity However, liability management opens up certain risks, particularly of the interest-rate risk variety, because it tends to be more sensitive to changes in market interest rates 13-3 What is the customer relationship doctrine, and what are its implications for fund-raising by lending institutions? The customer relationship doctrine places lending to customers at the top of the priority list, which proclaims that 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 It argues that a lending institution should make all good loans—all loans that meet the institution's quality and profitability standards It must then find the funds needed to fund those loans How the funds are used takes a higher priority than how the funds are raised 13-4 For what kinds of funding situations are Federal funds best suited? Federal funds are best suited for institutions short of reserves to meet their legal reserve requirements or to satisfy customer loan demand It satisfies this demand by tapping immediately usable funds 13-5 Chequers 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 returned the next day Can you show the correct accounting entries for making this loan and for the return of the loaned funds? 13-2 Chapter 13 - Managing Nondeposit Liabilities Step - Lending the $50 million Chequers State Bank Assets Liabilities and Net Worth Federal funds sold +50 million Reserves at Fed -50 million 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 First National Bank of Smithville Assets Liabilities and Net Worth Reserves at Fed Federal funds purchased +50 million +50 million Step - Repaying the loan of Federal funds Chequers State Bank Assets Liabilities and Net Worth Reserves at Fed +50 million Federal funds sold -50 million First National Bank of Smithville Assets Liabilities and Net Worth Reserves at Fed -50 million Federal funds purchased -50 million 13-6 Hillside Savings Association 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 institution, returning them to its correspondent deposit the next business day Sterling loans the $35 million to Imperial Security National Bank for 24 hours Can you show 13-3 Chapter 13 - Managing Nondeposit Liabilities the proper accounting entries for the extension of this loan and for the recovery of the loaned funds by Hillside Savings? Step - Lending Federal funds to Sterling City Bank Hillside Security Bank Assets Liabilities and Net Worth Deposit with Sterling City Bank -35 million Federal funds sold +35 million Sterling City Bank Assets Liabilities and Net Worth Federal funds purchased +35 million Hillside Security Bank's deposit -35 million Step - Sterling City Bank loans funds to Imperial Security National Bank Sterling City Bank Assets Liabilities and Net Worth Reserves -35 million Federal funds sold +35 million Imperial Security National Bank Assets Liabilities and Net Worth Reserves Federal funds purchased +$35 million +35 million Step -Sterling City Bank receives funds loaned to Imperial Security National Bank Assets Sterling City Bank Liabilities and Net Worth Reserves 13-4 Chapter 13 - Managing Nondeposit Liabilities +35 million Federal funds sold -35 million Imperial Security National Bank Assets Liabilities and Net Worth Reserves -35 million Federal funds purchased -35 million Step - Repaying the loan to Hillside Security Bank Hillside Security Bank Assets Liabilities and Net Worth Deposit with Sterling City Bank +35 million Federal funds loaned -35 million Assets Sterling City Bank Liabilities and Net Worth Federal funds purchased -35 million Hillside Security Bank's deposit +35 million 13-7 Compare and contrast Fed funds transactions with RPs Less popular than Fed funds and more complex are repurchase agreements (RPs) RPs are agreements to sell securities temporarily by a borrower of funds to the lender of funds with the borrower agreeing to buy back the securities at a guaranteed price at a set time in the future Both are instruments available for short term borrowing However, RP agreements are collateralized loans and thus, the lender is not exposed to credit risk as they are with Federal funds transactions Most RPs are transacted across the Fedwire system, just as are Fed funds transactions RPs may take a bit longer to transact than a Fed funds loan because the seller of funds (the lender) must be satisfied with the quality and quantity of securities provided as collateral 13-8 What are the principal advantages to the borrower of funds under an RP agreement? RPs are a low-cost source of borrowing loanable funds for short periods of time (usually or days) Since the securities that are sold as part of the agreement act as collateral, the interest rate 13-5 Chapter 13 - Managing Nondeposit Liabilities is lower than Fed funds rate Also, borrowers with lower credit ratings who can provide equivalent securities as collateral can borrow at these low rates 13-9 What are the advantages of borrowing from the Federal Reserve banks or other central banks? Are there any disadvantages? What is the difference between primary, secondary, and seasonal credit? What is a Lombard rate and why might such a rate be useful in achieving monetary policy goals? Borrowing from the Federal Reserve banks is a viable alternative to the Federal funds market These loans are made for a short term (usually two weeks) Advantages of borrowing from the Federal Reserve banks though depend on the category of loans a borrower is eligible for Institutions accessing primary credit can loan the money to other depository institutions in the fed funds market Users of secondary credit can use the borrowings to strengthen their ability to borrow funds in the open market Users accessing seasonal credit can borrow funds for longer periods than primary credit Despite these advantages, stringent regulations regarding the borrower’s credit quality, collateral requirements and cost of loans has made the Fed’s discount window unpopular Primary credits are short term loans available to sound depositary institutions at rates slightly above the Federal Reserve’s target Fed funds interest rate Secondary credits are short term loans available to institutions that not qualify for primary credit but need funds to strengthen their books Seasonal credit refers to loans given to small and medium sized institutions to cover seasonal swings in their deposits and loans The Lombard rate is the Fed’s discount rate for primary credit which is set slightly higher than the Federal funds rate on overnight loans Since Lombard rate is the rate at which the banks will borrow money from the central bank, the Federal Reserve can effectively use this rate as a monetary policy tool It can increase the rate and desist the depository institutions to borrow in an inflationary scenario to reduce the money supply in the economy To pursue an expansionary monetary policy, on the other hand, the Fed can reduce the rates and encourage the banks to borrow more, thereby ensuring larger money supply 13-10 How is a discount window loan from the Federal Reserve secured? Is collateral really necessary for these kinds of loans? A discount window loan must be secured by collateral deposits acceptable to the Federal Reserve banks The Fed in turn makes the loan by crediting the borrower’s reserve account Collateral against each loan is mandatory Though usually the collateral is in the form of U.S government securities, the Federal Reserve also accepts some government agency securities and high-grade commercial paper as collateral 13-11 Posner State Bank borrows $10 million in primary credit from the Federal Reserve Bank of Cleveland Can you show the correct entries for granting and repaying this loan? The appropriate entries for this transaction are: 13-6 Chapter 13 - Managing Nondeposit Liabilities Step - Securing a loan from the Fed Posner State Bank Assets Liabilities and Net Worth Reserves on deposit at the Notes payable Federal Reserve Bank +10 million +10 million Federal Reserve Bank of Cleveland Assets Liabilities and Net Worth Loans and advances Bank reserve accounts +10 million +10 million Step - Repaying the loan to the Fed Posner State Bank Assets Liabilities and Net Worth Reserves on deposit at the Notes payable Federal Reserve Bank -10 million -10 million Federal Reserve Bank of Cleveland Assets Liabilities and Net Worth Loans and advances Bank reserve accounts -10 million -10 million 13-12 Which institutions are allowed to borrow from the Federal Home Loan Banks? Why is this source so popular for many institutions? Institutions involved in mortgage lending can access credit from Federal Home Loan Banks by posting mortgages as collateral to the banks These loans are very popular because they represent a stable source of funds for institutions at below market lending rates 13-13 Why were negotiable CDs developed? Due to slow growth in checkbook savings in 1960s as a result of funds being diverted in other high yielding assets, banks developed negotiable CDs (which carried a higher rate of interest) to attract large corporate deposits and savings from wealthy individuals 13-14 What are the advantages and disadvantages of CDs as a funding source? 13-7 Chapter 13 - Managing Nondeposit Liabilities For borrowers, negotiable CDs offer a way to attract large amounts of funds quickly and for a known time period Also, deposit stability is likely to be greater because, unlike demand deposits which can be withdrawn anytime, the CD will normally be held till maturity However, these funds are highly interest sensitive and depository institutions face the challenge of managing the yields through active rate-hedging techniques to retain the deposits 13-15 Suppose a customer purchases a $1 million 90-day CD, carrying a promised percent annualized 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 for the customer: 90 = $1,000,000 × × 06  = $15,000 360 Volume of funds available to the investor at the end of 90 days is principal amount plus interest; $1,000,000 + $15,000 = $1,015,000 13-16 Where Eurodollars come from? Eurodollars arise from dollar denominated deposits made in financial institutions outside U.S territory It can be a dollar deposit by a U.S based bank in its foreign branch or any other bank based outside of United States 13-17 How does a bank gain access to funds from the Eurocurrency markets? A bank can borrow funds in a Eurocurrency market by either from one of its own subsidiaries in the international market or from another bank operating overseas through correspondent banking system If the funds are borrowed from one of its own branches or subsidiaries, it records it as a liability to foreign branch In a correspondent banking system, the lending bank instructs a domestic bank where it has a deposit to transfer funds in the account of Eurocurrency loan to the correspondent account of the borrowing institution 13-18 Suppose that JP Morgan Chase Bank in New York elects to borrow $250 million from Barclays Bank in London and loans the borrowed funds for a week to a security dealer, and then returns the borrowed funds Can you trace through the resulting accounting entries? When, JP Morgan Chase Bank borrows from Barclays Bank in London, the entries would appear as follows: JP Morgan Chase Bank Assets Liabilities and Net Worth Deposits held at other banks Deposits due to foreign banks +250 million (Eurodollars borrowed) +250 million 13-8 Chapter 13 - Managing Nondeposit Liabilities U.S Bank Serving as Correspondent to Barclays Bank Assets Liabilities and Net Worth Deposits due to foreign bank -250 million Deposits of JP Morgan Chase Bank +250 million Barclays Bank in London Assets Liabilities and Net Worth Deposit at U.S correspondent bank -250 million Eurodollar loan to JP Morgan Chase Bank +250 million Entries when JP Morgan Chase Bank lends the funds to a security dealer JP Morgan Chase Bank Liabilities and Net Worth Assets Loan to security dealer +250 million Deposit held at other bank -250 million Entries when JP Morgan Chase Bank receives loaned funds from the security dealer JP Morgan Chase Bank Assets Liabilities and Net Worth Loan to security dealer -250 million Deposit held at other bank +250 million Entries when JP Morgan Chase Bank repays its loans: Assets JP Morgan Chase Bank Liabilities and Net Worth 13-9 Chapter 13 - Managing Nondeposit Liabilities Deposits held at other Deposits due to Barclays Bank banks (Eurodollars borrowed) -250 million -250 million U.S Bank Serving as Correspondent to Barclays Bank Assets Liabilities and Net Worth Deposits due to Barclays Bank +250 million Deposits of JP Morgan Chase Bank -250 million Barclays Bank in London Assets Liabilities and Net Worth Deposits at U.S correspondent bank +250 million Eurodollar loan to JP Morgan Chase Bank -250 million 13-19 What is commercial paper? What types of organizations issue such paper? Commercial paper consists of short-term notes, with maturities ranging from three or four days to nine months, issued by well-known companies to raise working capital The notes are generally sold at a discount from their face value through security dealers or through direct contact with the issuing company There are two types of commercial paper Industrial paper is issued by non-financial companies to purchase inventories of goods or raw materials while finance paper is issued mainly by finance companies or financial holding companies Financial holding companies can use the proceeds from issuing finance paper to purchase loans off the books of other financial firms in the same organization to make more funds available for making loans 13-20 Suppose that the finance company affiliate of Citigroup issues $325 million in 90 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 Citigroup’s finance company affiliate? The appropriate entries for the above transaction are: Step - Commercial Paper is sold by the Affiliated Finance Company 13-10 Chapter 13 - Managing Nondeposit Liabilities Assets Citibank Liabilities and Net Worth Assets Affiliated Company Liabilities and Net Worth Cash account Commercial paper +325 million +325 million Step - The Affiliated Finance Company purchases loans from Citibank Assets Citibank Liabilities and Net Worth Loans -325 million Reserves +325 million Affiliated Company Assets Liabilities and Net Worth Cash account -325 million Loans purchased from Citibank +325 million 13-21 What long-term nondeposit funds sources banks and some of their closest competitors draw upon today? How these interest costs differ from those costs associated with most money market borrowings? Long-term nondeposit funds include mortgages, capital notes, and debentures Generally, the interest costs on these funds sources are substantially higher than money market loans but are usually more stable 13-22 What is the available funds gap? The available funds gap is the estimated difference between current and projected outflows and inflows of an institution 13-23 Suppose J.P Morgan Chase Bank of New York discovers that projected new loan demand next week should total $325 million and customers holding confirmed credit lines plan to draw down $510 million in funds to cover their cash needs next week, while new deposits next 13-11 Chapter 13 - Managing Nondeposit Liabilities week are projected to equal $680 million The bank also plans to acquire $420 million in corporate and government bonds next week What is the bank's projected available funds gap? The projected available funds gap will be: ( $325 + $510 + $420 ) - $680  = $575 million 13-24 What factors must the manager of a financial institution weigh in choosing among the various nondeposit sources of funding available today? A manager must weigh factors such as relative costs and risks of each funding source, length of time for which the funds are needed, size of the borrowing institution, and regulations in choosing what nondeposit funds sources to use Other factors held constant, management will seek out the lowest cost nondeposit funding sources available subject to credit availability and the interest-rate volatility risks 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) Problems and Projects 13-1 Robertson State Bank decides to loan a portion of its reserves in the amount of $70 million held at the Federal Reserve Bank to Tenison National Security Bank for 24 hours For its part, Tenison plans to make a 24-hour loan to a security dealer before it must return the funds to Robertson State Bank Please show the proper accounting entries for these transactions Step - Lending the $70 million Robertson State Bank Assets Liabilities and Net Worth Federal Funds sold +70 million Reserves at Fed -70 million Tenison National Security Bank Assets Liabilities and Net Worth Reserves at Fed Federal funds purchased +70 million +70 million Step - Loaning the borrowed funds 13-12 Chapter 13 - Managing Nondeposit Liabilities Tenison National Security Bank Assets Liabilities and Net Worth Reserves at Fed -70 million Loans made +70 million Step - Received funds loaned Tenison National Security Bank Assets Liabilities and Net Worth Reserves at Fed +70 million Loans made -70 million Step - Repaying the loan of Federal funds Assets Robertson State Bank Liabilities and Net Worth Reserves on deposits at Fed +70 million Federal funds sold -70 million Tenison National Security Bank Assets Liabilities and Net Worth Reserves on deposits at Federal funds purchased Fed -70 million -70 million 13-2 Masoner Savings, headquartered in a small community, holds most of its correspondent deposits with Flagg Metrocenter Bank, a money center institution When Masoner has a cash surplus in its correspondent deposit, Flagg automatically invests the surplus in Fed funds loans to other money center banks A check of Masoner’s records this morning reveals a temporary surplus of $11 million for 48 hours Flagg will loan this surplus for two business days to Secoro Central City Bank, which is in need of additional reserves Please show the correct balance sheet entries to carry out this loan and to pay off the loan when its term ends Step - Lending Federal Funds to Flagg Metrocenter Bank 13-13 Chapter 13 - Managing Nondeposit Liabilities Assets Masoner Savings Liabilities and Net Worth Deposits with Flagg Metrocenter Bank -11 million Federal funds loaned +11 million Flagg Metrocenter Bank Assets Liabilities and Net Worth Federal funds purchased +11 million Masoner Savings’ Bank deposit -11 million Step - Flagg Metrocenter Bank loans funds to Secoro Central City Bank Flagg Metrocenter Bank Assets Liabilities and Net Worth Reserves -11 million Federal funds loaned +11 million Secoro Central City Bank Assets Liabilities and Net Worth Reserves +11 million Federal funds purchased +11 million Step - Flagg Metrocenter Bank receives loaned funds from Secoro Central City Bank Flagg Metrocenter Bank Assets Liabilities and Net Worth Reserves +11 million Federal funds loaned -11 million Secoro Central City Bank Assets Liabilities and Net Worth 13-14 Chapter 13 - Managing Nondeposit Liabilities Reserves -11 million Federal funds purchased -11 million Step - Repaying the loan to the Masoner Savings Masoner Savings Liabilities and Net Worth Assets Deposit with Flagg Metrocenter Bank +11 million Federal funds loaned -11 million Flagg Metrocenter Bank Assets Liabilities and Net Worth Federal funds purchased -11 million Masoner Savings’ Bank deposit +11 million 13-3 Relgade National Bank secures primary credit from the Federal Reserve Bank of San Francisco in the amount of $32 million for a term of seven days Please show the proper entries for granting this loan and then paying off the loan The correct entries are: Step - On receiving loan from the Fed Assets Relgade National Bank Liabilities and Net Worth Reserves on deposit at Notes payable the Federal Reserve Bank +32 million +32 million Federal Reserve Bank of San Francisco Assets Liabilities and Net Worth Loans and advances Bank reserve accounts +32 million +32 million 13-15 Chapter 13 - Managing Nondeposit Liabilities Step - Repaying the loan to the Fed Relgade National Bank Assets Liabilities and Net Worth Reserves on deposit at Notes payable the Federal Reserve Bank -32 million -32 million Federal Reserve Bank of San Francisco Assets Liabilities and Net Worth Loans and advances Bank reserve accounts -32 million -32 million 13-4 Shad Corporation purchases a 60-day negotiable CD with a $5 million denomination from Bait Bank and Trust, bearing a 2.95 percent annual yield How much in interest will the bank have to pay when this CD matures? What amount in total will the bank have to pay back to Shad at the end of 60 days? Amount of interest for the bank on CD:  60  $5,000,000 × 0.0295 ×  ÷ = $24,583.33  360  Amount to be repaid by the bank to Rockfish: $5,000,000 + $24,583.33 = $5,024,583.33 13-5 Deep Valley Bank borrows $125 million overnight through a repurchase agreement (RP) collateralized by Treasury bills The current RP rate is 2.50 percent How much will the bank pay in interest cost due to this borrowing? Interest cost for Lost Valley Bank will be:   $125,000,000 ì 0.025 ì ữ = $8,680.56 360  13-6 Thyme Bank of New York expects new deposit inflows next month of $265 million and deposit withdrawals of $425 million The bank's economics department has projected that new loan demand will reach $400 million and customers with approved credit lines will need $175 million in cash The bank will sell $450 million in securities, but plans to add $60 million in new securities to its portfolio What is its projected available funds gap? The estimated available funds gap is the difference between estimated cash outflows and inflows for an institution It can be calculated as: Current and projected loans and investments - Current and expected inflows 13-16 Chapter 13 - Managing Nondeposit Liabilities Therefore, the available funds gap for Thyme Bank will be ( $425 + $400 + $175 + $60 ) - ( $265 + $450 ) = $345 million 13-7 Wells Fargo Bank borrowed $150 million in Fed funds from JP Morgan Chase Bank in New York City for 24 hours to fund a 30 day loan The prevailing Fed funds rate on loans of this maturity stood at 2.25 percent when these two institutions agreed on the loan The funds loaned by Morgan were in the reserve deposit that the bank keeps at the Federal Reserve Bank of New York When the loan to Wells Fargo was repaid the next day, JP Morgan used $50 million of the returned funds to cover its own reserve needs and loaned $100 million in Fed funds to Bank of America, Charlotte, for a two day period at the prevailing Fed funds rate of 2.40 percent With respect to these transactions, (a) Construct T-account entries similar to those you encountered in this chapter, showing the original Fed funds loan and its repayment on the books of JP Morgan, Wells Fargo, and Bank of America and (b) calculate the total interest income earned by JP Morgan on both Fed funds loans Entries in the books of JP Morgan Chase Bank: JP Morgan Chase Bank Assets Liabilities and Net Worth Fed funds sold to Wells Fargo Bank Day +150 million Reserves at Fed -150 million Reserves at Fed Day +150 million Fed funds sold to Wells Fargo Bank -150 million Fed funds sold to Bank of America +100 million Reserves at Fed -100 million Reserves at Fed Day +100 million Fed funds sold to Bank of America -100 million 13-17 Chapter 13 - Managing Nondeposit Liabilities Entries in the books of Wells Fargo Bank: Wells Fargo Bank Assets Liabilities and Net Worth Day Reserves on deposit at Fed Fed funds purchased +150 million +150 million Reserves on deposit at Fed Fed funds purchased Day -150 million -150 million Entries in the books of Bank of America: Bank of America Assets Liabilities and Net Worth Reserves on deposit at Fed Fed funds purchased Day +100 million +100 million Day Reserves on deposit at Fed Fed funds purchased -100 million -100 million (b) Interest earned by JP Morgan Chase Bank on1 Wells Fargo Bank loan: $150,000,000 ì 0.0225 ì ữ = $9,375 360   Bank of America loan:  $100,000,000 ì 0.024 ì ữ = $13,333.33 360   13-8 Blue Skies Bank of Florida issues a three-month (90-day) negotiable CD in the amount of $20 million to ABC Insurance Company at a negotiated annual interest rate of 2.75 percent (360 day basis) Calculate the value of this CD account on the day it matures and the amount of interest income ABC will earn What interest return will ABC Insurance earn in a 365 day year? Interest amount on the CD: 90 20,000,000ì0.0275ì ữ = $137,500 360   Therefore, value of the CD account on maturity will be: $20,000,000 + $137,500  = $20,137,500 Given 365 days per year, interest amount on CD will be: 90 20,000,000 ì 0.0275 ì ữ = $165, 616.44 365   and, value of the CD account on maturity will be: $20,000,000 + $165, 616.44  = $20,165, 616.44 13-18 Chapter 13 - Managing Nondeposit Liabilities 13-9 Banks and other lending affiliates within the holding company of Best-of-Times Financial are reporting heavy loan demand this week from companies in the southeastern United States that are planning a significant expansion of inventories and facilities before the beginning of the fall season The holding company plans to raise $775 million in short-term funds this week, of which about $700 million will be used to meet these new loan requests Fed funds are currently trading at 2.25 percent, negotiable CDs are trading in New York at 2.40 percent, and Eurodollar borrowings are available in London at all maturities under one year at 2.30 percent One-month maturities of directly placed commercial paper carry market rates of 2.35 percent, while the primary credit discount rate of the Federal Reserve Bank of Richmond is currently set at 2.75 percent — a source that Best-of-Times has used in each of the past two weeks Noninterest costs are estimated at 0.25 percent for Fed funds, discount window borrowings, and CDs; 0.35 percent for Eurodollar borrowings; and 0.50 percent for commercial paper Calculate the effective cost rate of each of these sources of funds for Best-of-Times and make a management decision on what sources to use Be prepared to defend your decision  $775 × 0.0225 + $775 ì 0.0025 ì 100 ữ = 2.768% Effective Federal Funds cost rate:  $700    $775 × 0.024 + $775 × 0.0025  × 100 ÷ = 2.934% Effective CD cost rate:  $700    $775 × 0.023 + $775 × 0.0035 ì 100 ữ = 2.934% Effective Eurodollar cost rate:  $700    $775 × 0.0235 + 775 × 0.005  × 100 ÷ = 3.155% Effective Commercial Paper cost rate:  $700    $775 × 0.0275 + 775 ì 0.0025 ì 100 ữ = 3.321% Effective cost of borrowing from the Fed:  $700   The cheapest source of all would be borrowing from the Fed Funds Market However, since the inventory expansion for the companies is not a loan which is going to be repaid in a day or two, the bank can also consider funding through CD or Eurodollar, both of which cost the same 13-10.Surfs-Up Security Savings is considering the problem of trying to raise $80 million in money market funds to cover a loan request from one of its largest corporate customers, which needs a six-week loan Assume that market interest rates are at the levels indicated below: Federal funds, average for week just concluded Discount window of the Federal Reserve bank CDs (prime rated, secondary market): One month 13-19 1.98% 2.25% 2.52% Chapter 13 - Managing Nondeposit Liabilities 2.80% 3.18% 3.00% Three months Six months Eurodollar deposits (three months) Commercial paper (directly placed): One month Three months 2.33% 2.70% Unfortunately, Surfs-Up’s economics department is forecasting a substantial rise in money market interest rates over the next six weeks What would you recommend to its funds management department regarding how and where to raise the money needed? Be sure to consider such cost factors as legal reserve requirements, regulations, and what happens to the relative attractiveness of each funding source if interest rates rise continually over the period of the proposed loan Federal funds could be used to fund this loan They happen to be the least expensive source in terms of interest cost right now, However, Fed funds rate is very sensitive to market pressures and, therefore, will rise along with other market interest rates if the bank's forecast turns out to be correct Discount window loans have very high regulations and are mostly used in case all the other sources of funding are exhausted Assuming that the expectations of the bank that interest rates will rise over the next six weeks actualize, the bank will very likely have to pay a premium over the current rates on either the one-month CDs or commercial paper Either a 3-month CD or 3-month commercial paper appear to represent good alternatives because the bank, presumably, can lock in the interest cost to fund this loan for the entire life of the loan Alternative scenario: What if Surfs-Up's economists are wrong and money market rates decline significantly over the next six weeks? How would your recommendation to the funds management department change on how and where to raise the funds needed? Significantly declining interest rates would make short-term sources of funding much more attractive to the bank Federal funds, for example, may well be a good alternative as it is highly sensitive to interest rate changes One-month CDs would also be a good alternative, as would one-month commercial paper With the shorter maturities, the bank could readjust its costs downward as the interest rates continue to fall 13-11 June Bug Bank and Trust has received $750 million in total funding, consisting of $200 million in checkable deposit accounts, $400 million in time and savings deposits, $100 million in money market borrowings, and $50 million in stockholders’ equity Interest costs on time and savings deposits are 2.50 percent, on average, while noninterest costs of raising these particular deposits equal approximately 0.50 percent of their dollar volume Interest costs on checkable deposits average only 0.75 percent because many of these deposits pay no interest, but noninterest costs of raising checkable accounts are about percent of their dollar total Money market borrowings cost June Bug an average of 2.75 percent in interest costs and 0.25 percent in 13-20 Chapter 13 - Managing Nondeposit Liabilities noninterest costs Management estimates the cost of stockholders’ equity capital at 12 percent before taxes (The bank is currently in the 35-percent corporate tax bracket.) When reserve requirements are added in, along with uncollected dollar balances, these factors are estimated to contribute another 0.75 percent to the cost of securing checkable deposits and 0.50 percent to the cost of acquiring time and savings deposits Reserve requirements (on Eurodeposits only) and collection delays add an estimated 0.25 percent to the cost of the money market borrowings (a) Calculate June Bug’s weighted average interest cost on total funds raised, figured on a beforetax basis (b) If the bank's earning assets total $700 million, what is its break-even cost rate? (c) What is June Bug's overall historical weighted average cost of capital? Sources of funds Funds Checkable deposits 200 Time and Savings deposits 400 Money market borrowings 100 Total 700 Interest costs (%) 0.75% 2.50% 2.75% Interest costs ($) 1.5 10 2.75 14.25 Noninterest Operating costs Other costs costs 2.00% 0.75% 5.5 0.50% 0.50% 4.0 0.25% 0.25% 0.5 10.0 a) Weighted average interest cost: All interest paid 14.25 ì100 ữ = 2.0357% ×100 Or  Total funds raised  700  b) Break-even cost rate on borrowed funds invested in earning assets: Interest costs + other expenses  14.25 + 10.00 ì100 Or ì 100 ữ = 3.464% Earning assets 700   c) June Bug's historical weighted-average cost of capital (Before-tax) Stockholder's investment Breakeven cost + Before-tax cost of stockholder's investment × Or Total earnings asset 50  3.46 + 12ì ữ = 4.32% 700 13-12 Inspiration Savings Association is considering funding a package of new loans in the amount of $400 million Inspiration has projected that it must raise $450 million in order to have $400 million available to make new loans It expects to raise $325 million of the total by selling time deposits at an average interest rate of 1.75 percent Noninterest costs from selling time deposits will add an estimated 0.45 percent in operating expenses Inspiration expects another $125 million to come from noninterest-bearing transaction deposits, whose noninterest costs are expected to be 2.00 percent of the total amount of these deposits What is the Association’s projected pooled-funds marginal cost? What hurdle rate must it achieve on its earning assets? 13-21 Chapter 13 - Managing Nondeposit Liabilities Source of Funds Total Total Amount Interest Noninterest Interest Noninterest ($millions) Rate Cost Rate Expenses Expenses Time deposits $325 Noninterest-bearing transaction deposits 125 Total $450 1.75% 0.45% 2.00% $5.69 0.00 $5.69 $1.4625 2.5000 $3.9625 Projected pooled-funds marginal costs:  ( 3.9625 + 5.69 )  All expected operating expenses ×100 Or  × 100 ÷ = 2.144% All new funds expected 450   Hurdle rate for the association can be calculated using: All expected operating expenses 3.9625 + 5.69 ) ×100 or ( × 100 = 2.4125% Amount available to place in earning assets 400 13-22 ... Liabilities and Net Worth Reserves on deposit at the Notes payable Federal Reserve Bank +10 million +10 million Federal Reserve Bank of Cleveland Assets Liabilities and Net Worth Loans and advances Bank. .. Security Bank Hillside Security Bank Assets Liabilities and Net Worth Deposit with Sterling City Bank +35 million Federal funds loaned -35 million Assets Sterling City Bank Liabilities and Net... Sterling City Bank Hillside Security Bank Assets Liabilities and Net Worth Deposit with Sterling City Bank -35 million Federal funds sold +35 million Sterling City Bank Assets Liabilities and Net Worth