Key Topics in This Chater

• Liability Management

• Customer Relationship Doctrine

• Alternative Non-deposit Funds Sources

• Measuring the Funds Gap

• Choosing among Different Funds Sources

• Determining the Overall Cost of Funds

Customer Relationship Doctrine

• The traditional source of funds for most depository institutions is the deposit account-both checking and savings deposits sold to individuals, businesses, and governments. The public’s demand for deposits supplies much of the raw material for lending and investing and, ultimately, for the profits these institutions earn.

• Sometimes deposit volume is inadequate to support all loans and investments these institutions would like to make. Managers of lending institutions learned over the years that turning down a profitable loan request with the usual excuse “We don’t have enough deposits or other funds sources to support the loan” – is not well received by their customers. Denial of a credit request often means the immediate loss of a customer account and perhaps the loss of any future business from the disappointed customer. On the other hand, granting a loan request – even when deposits and other cash flows are inadequate – usually brings in both new deposits and the demand for other services as well. And the benefits may reach far beyond the borrowing customer alone.

• Hence management has to find new money when deposit volume is inadequate to support all loans and investments these institutions would like to make.
• The financial community learned long ago the importance of the customer relationship doctrine, 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. 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.

• Of course, the customer relationship doctrine has its limitations. Sometimes it results in scores of poor-quality loans.

• During the 1960s and 1970s, the customer relationship doctrine spawned the liquidity management strategy known as liability management. Liability management consists of buying funds, mainly from other financial institutions, in order to cover good-quality credit requests and satisfy any legal reserve requirements on deposits and other borrowings that law or regulation may require.

• Non-deposit borrowings are most often short term rather than long term. Short-term debt, especially overnight loans have significant interest rate risk and the danger that the lender may be forced to borrow short term over and over again at higher and higher interest rates to fund a loan. But still, there are good reasons for “going short” in most non-deposit borrowings.
• Today there may not be enough time to find and negotiate long-term debt contracts; tomorrow may be another story and longer term deposits may soon roll in.
• Financial firms have gotten much better at managing interest rate risk than used to be the case, and they now have a lot of risk-management tools.
• Moreover, many assets institutions hold are also short term, including some overnight and intraday loans.
• In a falling interest rate environment, tomorrow’s borrowing costs should be lower than today’s costs.

• Clearly, liability management is an essential tool lenders need to sustain the growth of their lending programs. However, it also poses real challenges for financial-service managers, who must keep abreast of the market every day to make sure their institution is fully funded. Moreover, liability management is an interest-sensitive approach to raising funds. If interest rates rise and the lender is unwilling to pay those higher rates, funds borrowed from the money market will be gone in minutes. Money market suppliers of funds typically have a highly elastic response to changes in market interest rates.
• Yet, viewed from another perspective, funds raised by liability management techniques are flexible: the borrower can decide exactly how much he or she needs and for how long and usually find a source of funds that meets those requirements. In contrast, when deposits are sold to raise funds, it is the depositor who decides how much and how long funds will be left with each financial firm. With liability management institutions in need of more funds to cover expanding loan commitments or deficiencies in cash reserves can simply raise their offer rate in order to reduce their volume of money market borrowing.

Alternative Non-Deposit Sources of Funds

• As this table suggests, the usage of non-deposit sources of funds has fluctuated in recent years, but generally has risen to provide a bigger share of funds for depository institutions. Overall, non- deposit borrowings have often outstripped the growth of traditional deposits, in part because of the greater flexibility of non-deposit borrowings, which are less regulated, and the loss of some deposits in recent years to competing financial institutions, such as mutual funds, insurance companies, hedge funds, and pension funds, that are competing aggressively today to attract the public’s savings.

• While smaller banks and thrift institutions usually rely most heavily on deposits for their funding needs, leading depository institutions around the globe have come to regard the non- deposit funds market as a key source of short-term money to meet both loan demand and unexpected cash emergencies.

• This table shows the relationship between the size of banks and their affinity for non-deposit borrowing. Clearly, the smallest-size banks (each under $ 100 million in assets) support only a small share (about 4 percent) of their assets by non- deposit borrowings. Among the largest institutions (over $ 1 billion in assets), however, non-deposit borrowings covered about four times as much among large commercial bank assets (or 16 %).

Federal Funds Market

• The most popular domestic source of borrowed reserves among depository institutions is the Federal funds market. Originally, Fed funds consisted exclusively of deposits held at the Federal Reserve banks. These deposits are owned by depository institutions at the Fed primarily to satisfy legal reserve requirements, clear checks, and pay for purchases of government securities. These Federal Reserve balances can be transferred from one institution to another in seconds through the Fed’s wire transfer network (Fedwire), linking all Federal Reserve banks. Today, however, deposits that depository institutions hold with each other also can be moved around the banking system the same day a request is made.

• Financial institutions realized the potential source of profits inherent in these same-day monies. Since reserves deposited with the Federal Reserve banks and many demand deposits held by business firms pay little or no interest, bank and nonbank firms have a strong economic incentive to lend excess reserves. Moreover, there are no legal reserve requirements on Fed funds borrowings currently and few regulatory controls. These features have stimulated the growth of the market and helped keep the cost of borrowing down. Financial firms in need of immediate funds can negotiate a loan with a holder of surplus interbank deposits or reserves at the Fed.
• Uses –
  • The main use of the Fed funds market today is still the traditional one: a mechanism that allows depository institutions short of reserves to meet their legal reserve requirements
  • Another traditional use is to satisfy loan demand by tapping immediately usable funds from other institutions possessing temporarily idle funds.
  • Fed funds are also used to supplement deposit growth
  • Fed Funds give lenders a relatively safe outlet for temporary cash surpluses on which interest can be earned (even for a loan lasting only a few hours).
  • The Fed funds market serves as a conduit for the policy initiatives of the Federal Reserve System designed to control the growth of money and credit and stabilize the economy.

• By performing all of the above functions, the Fed funds market efficiently distributes reserves throughout the financial system to areas of greatest need. To help suppliers and demanders of Fed funds find each other, funds brokers soon appeared playing the role of market makers to trade Fed funds in return for commissions. Large, accommodating banks, play a role similar to that of funds brokers for smaller depository institutions in their region.

• This table gives a description of the accounting entries involved in the procedure for borrowing and lending Fed funds.

• The interest rate on a Fed funds loan is subject to negotiation between borrowing and lending institutions. While the interest rate attached to each Fed funds loan may differ from the rate on any other loan, most of these loans use the effective interest rate prevailing each day – a rate of interest posted by Fed funds brokers and major accommodating banks operating at the center of the funds marketplace. In recent years, tiered Fed funds rates (i.e., interest-rate schedules) have appeared at various times, with borrowing institutions in trouble paying higher interest rates or simply being shut out of this market completely.

• The Fed funds market typically uses one of three types of loan agreements –

• Overnight loans – These are unwritten agreements, negotiated via wire or telephone, with the borrowed funds returned the next day. Normally these loans are not secured by specific collateral, though where borrower and lender do not know each other well or there is doubt about the borrower’s credit standing, the borrower may be required to place selected government securities in a custody account in the name of the lender until the loan is repaid.
• Term loans – These are longer-term Fed funds contracts lasting several days, weeks, or months, often accompanied by a written contract.
• Continuing contracts – These are automatically renewed each day unless either borrower or lender decides to end this agreement. Most continuing contracts are made between smaller respondent institutions and their larger correspondents, with the correspondent automatically investing the smaller institution’s deposits held with it in Fed funds loans until told to do otherwise.

Repurchase Agreements

• Repurchase Agreements (RPs) are less popular and more complex than Fed funds. They are often viewed as collateralized Fed funds transactions. Unlike an ordinary Fed funds transaction, in RPs, the purchaser provides collateral in the form of marketable securities, and hence, credit risk is reduced. Most domestic RPs are transacted across the Fed Wire system, like Fed funds transactions. RPs may take a bit longer to transact then a Fed funds loan because the seller of funds (the lender) must be satisfied with the quality and quantity of collateral.

• RPs get their name from the process involved – the institution purchasing funds (the borrower) is temporarily exchanging securities for cash. In the “starting leg”, they involve the temporary sale of high-quality, easily liquidated assets, such as Treasury bills. There is an agreement to buy back those assets on a specific future date at a predetermined price in the “closing leg”. An RP transaction is often for overnight funds, but it may be extended for days, weeks, or even months.

• The interest cost for both Fed funds and repurchase agreements can be calculated from the following equation:

Interest cost of RP = Amount borrowed × Current RP rate × \(\frac{\text{Number of days in RP borrowing}}{360 \, \text{days}}\)

For example, suppose a bank borrows $50 million through an RP transaction collateralized by government bonds for three days and the current RP rate in the market is 6 percent. Then this bank’s total interest cost would be:

Interest cost of RP = $50,000,000 \times 0.06 \times \frac{3}{360} = $24,995

• This table shows both sides of a typical RP transaction.

• Overall, the RP market has contracted somewhat recently, especially during the 2007-2009 credit crisis, due to concern over the quality and market value of securities being pledged as collateral for these loans.

Bear Stearns and Lehman Brothers, were unable to find adequate support from the RP market.

General Collateral Finance RPs

• A major innovation occurred in the RP market with the invention of General Collateral Finance (GCF) RPs in 1998, under the leadership of the Bank of New York, JP Morgan Chase, and the Fixed Income Clearing Corporation (FICC).
  • Conventional (fixed-collateral) repurchase agreements designate specific securities to serve as collateral for a loan, with the lender taking possession of those particular instruments until the loan matures. In contrast, the general-collateral GCF RP has been used for low- cost collateral substitution. Borrower and lender can agree upon a variety of securities, any of which may serve as loan collateral. For example, a lender may accept any Treasury or federal agency security as a general collateral RP. The same securities pledged at the beginning do not have to be delivered at the end of a loan.
  • GCF RPs may be settled on the books of the FICC, which allows netting of obligations between lenders, borrowers, and brokers so that less money and securities must be transferred.
  • GCF RPs can be reversed early in the morning and settled late each day, giving borrowers greater flexibility during daylight hours in deciding what to do with collateral securities.
  • GCF RPs can make more efficient use of collateral, lower transactions cost, and help make the RP market somewhat more liquid.

Borrowing From Federal Reserve Bank

• For a depository institution with immediate reserve needs, a viable alternative to Fed funds and RPs is negotiating a loan from a central bank for a short period of time. For example, depository institutions operating in the United States may be eligible for loans granted by the Federal Reserve Bank in their particular region through the Fed’s discount windowby crediting the borrowing institution’s reserve account. This table gives an example of the typical accounting entries associated with a discount window loan.

• Each loan made by the Federal Reserve banks must be backed by collateral acceptable to the Fed. Most depository institutions keep U.S. government securities in the vaults of the Federal Reserve banks for this purpose. The Fed will also accept certain federal agency securities, high- grade commercial paper, and other assets judged satisfactory. Several types of loans are available from the Fed’s discount window:

• Primary credit – These are loans available for short terms (usually overnight but occasionally extending out to 90 days) to depository institutions in sound financial condition. Primary credit normally carries an interest rate slightly above the Federal Reserve’s target Fed funds interest rate. Users of primary credit do not have to show (as they did in the past) that they have exhausted other sources of funds before asking the Fed for a loan. Moreover, the borrowing institution is no longer prohibited from borrowing from the Fed and then loaning that money to other depository institutions in the Fed funds market.
• Secondary credit – These are loans available at a higher interest rate to depository institutions not qualifying for primary credit. These loans are subject to monitoring by the Federal Reserve banks to make sure the borrower is not taking on excessive risk. The interest rate on secondary credit may be about 50 basis points above the primary credit rate and 150 basis points above the Fed funds rate. Such a loan can be used to help resolve financial problems, to strengthen the borrowing institution’s ability to find additional funds from private-market sources, and to reduce its debt to the Fed. However, secondary credit is not supposed to be used to fund the expansion of a borrowing institution’s assets.
• Seasonal credit – These are loans covering longer periods than primary credit for small and medium-sized depository institutions experiencing seasonal (intra-year) swings in their deposits and loans (such as those swings experienced by farm banks during planting and harvesting time). The seasonal credit interest rate is set at the average level of the effective Fed funds rate and the secondary market rate on 90-day certificates of deposit.

Thus, each type of discount window loan carries its own loan rate, with secondary credit generally posting the highest interest rate and seasonal credit the lowest.

• In 1991 the U.S. Congress passed the FDIC Improvement Act, which places limits on how far the Federal Reserve banks can go in supporting a troubled depository institution with loans. Generally speaking, undercapitalized institutions cannot be granted discount window loans for more than 60 days in each 120-day period. Long-term Fed support is only permissible if the borrowing institution is a “viable entity”. If the Fed exceeds these limitations, it can be held liable to the FDIC for any losses incurred by the insurance fund should the troubled institution ultimately fail.
• Overall, the Fed’s discount window is not a particularly popular source of funding due to regulations, collateral requirements, and cost, though the credit crisis of 2007-2009 increased the popularity of the Fed’s “window” as a source of borrowed funds for a wide range of troubled firms.

Advances From Federal Home Loan Banks

• Recently another government agency-the Federal Home Loan Bank (FHLB) System-has been lending huge amounts of money to home mortgage lenders. The FHLB System, composed of 12 regional banks, was created by federal charter in 1932 to extend cash advances to depository institutions experiencing runs by anxious depositors. By allowing these troubled institutions to use the home mortgages they held in their portfolios as collateral for emergency loans, the FHLB improved the liquidity of home mortgages and encouraged more lenders to provide credit to the housing market.

• In recent years the number of financial institutions eligible to borrow from the FHLB has increased dramatically, especially among smaller community banks and thrift institutions. FHLB loans represent a stable source of funding at below-market interest rates. Fully collateralized by home mortgages the maturities of FHLB loans range from overnight to more than 20 years, bearing either fixed or variable interest rates. The system’s federal charter enables it to borrow money cheaply and pass those savings along to member institutions who also hold FHLB stock and receive dividends on that stock. Should a borrowing institution fail, the FHLB, legally, is first in line (even ahead of the FDIC) in recovering its funds. In general, this can be a popular funds source due to lower costs and flexibility in the maturity of loans permitted.

Large Negotiable CDs

• The concept of liability management and short-term borrowing to supplement deposit growth was given a significant boost early in the 1960s with the development of a new kind of deposit, the negotiable CD. A CD is an interest-bearing receipt which shows an evidence of the deposit of funds in the accepting depository institution for a specified time period at a specified interest rate or specified formula for calculating the interest rate. There are four main types of negotiable CDs today –
  • Domestic CDs are issued by U.S. institutions inside the territory of the United States.
  • Dollar-denominated CDs issued by banks outside the United States are known as Euro CDs.
  • The largest foreign banks active in the United States (such as Deutsche Bank and HSBC) sell CDs through their U.S. branches, called Yankee CDs.
  • Finally, nonbank savings institutions sell thrift CDs.

• Negotiable CDs would be confined to short maturities, ranging from seven days to one or two years in most cases, but concentrated mainly in the one- to six-month maturity range for the convenience of CD buyers. And the new instrument would be negotiable, i.e. they could be sold in the secondary market any number of times before reaching maturity to provide corporate customers with liquidity. To make the sale of negotiable CDs in advance of their maturity easier, they were issued in bearer form. Moreover, several dealers agreed to make a regular market in negotiable CDs carrying maturities of six months or less. The negotiable CD was an almost instant success. Large denomination CDs grew from almost zero in the early 1960s to nearly $2 trillion by 2011. As with all liability management instruments, management can control the quantity of CDs outstanding simply by varying the yield offered to CD customers.
• Interest rates on fixed-rate CDs, which represent the majority of all large negotiable CDs issued, are quoted on an interest-bearing basis, and the rate is computed assuming a 360-day year. The value of fixed-rate CDs can be calculated as

Amount Due CD customer = Principal + Principal × \(\frac{\text{Days to maturity}}{360 \, \text{days}}\) × Annual rate of interest

For 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:

= \$100,000 + \$100,000 × \(\frac{180}{360}\) × 0.08 = \$104,000

• CDs that have maturities over one year normally pay interest to the depositor every six months. Variable-rate CDs have their interest rates reset after a designated period of time (called a leg or roll period). The new rate is based on a mutually accepted reference interest rate, such as the London Interbank Offer Rate (LIBOR) attached to borrowings of Eurodollar deposits or the average interest rate prevailing on prime-quality CDs traded in the secondary market.

• The net result of CD sales to customers is often a simple transfer of funds from one deposit to another within the same depository institution, particularly from checkable deposits into CDs.
  • The selling institution gains loanable funds even from this simple transfer because, in the United States at least, legal reserve requirements are currently zero for CDs, while checking accounts at the largest depository institutions carry a reserve requirement of 10 percent.
  • Also, deposit stability is likely to be greater for the receiving depository institution because the CD normally will not be withdrawn until maturity. In contrast, checkable (demand) deposits can be withdrawn at any time.
• The Eurocurrency deposit market began in Europe during the 1950s. Eurodollars are dollar- denominated deposits placed in bank offices outside the United States. 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.

• The banks accepting these deposits may be foreign branches of U.S. banks overseas, or international banking facilities (IBFs) set up on U.S. soil but devoted to foreign transactions on behalf of a parent U.S. bank. The heart of the worldwide Eurodollar market is in London, where British banks compete with scores of American and other foreign banks for these deposits. The Eurocurrency market is the largest unregulated financial market-place in the world.

• Most Eurodollar deposits are fixed-rate time deposits. However, in 1970s, floating-rate CDs (FRCDs) and floating-rate notes (FRNs) were introduced to protect banks and their Eurodepositors from the risk of fluctuating interest rates. FRCDs and FRNs tend to be medium to long term, stretching from 1 year to 20 years. The offer rates on these longer-term negotiable deposits are adjusted, usually every three to six months, based upon interest rate movements in the interbank Euromarket.
• The majority of Eurodeposits mature within six months; however, some are as short as overnight. Most are interbank liabilities whose interest yield is tied closely to LIBOR. Large denomination Euro CDs issued in the interbank market are called tap CDs, while smaller- denomination Euro CDs sold to a wide range of investors are called tranche CDs. As with domestic CDs, there is an active resale market for these deposits.

• Major banks and their large corporate customers practice arbitrage between the Euro and American CD markets. For example, if domestic CD rates were to drop significantly below Euro interest rates on deposits of comparable maturity, a bank or its corporate customers could borrow in the domestic CD market and lend those funds offshore in the Euromarket. Similarly, an interest rate spread in the opposite direction might well lead to increased Euro borrowings with the proceeds flowing into CD markets inside the United States.

• This process of borrowing and lending Eurodollars for a bank headquartered in the US with a foreign bank is traced out in this table

Commercial Paper Market

• Commercial paper consists of short-term notes, with maturities normally ranging from three or four days to nine months, issued by well-known companies to raise working capital. The notes generally sold at a discount from face value through security are dealers or through direct contact with the issuing company.
  • A substantial portion of this paper-often called industrial paper – is designed to finance the purchase of inventories of goods or raw materials and to meet other immediate cash needs of nonfinancial companies.
  • Another form of commercial paper – usually called finance paper – is issued mainly by finance companies (such as GE Capital Corporation) and the affiliates of financial holding companies (such as HSBC Finance Corporation). The proceeds from issuing finance paper can be used to purchase loans off the books of other financial firms in the same organization, giving these institutions additional funds to make new loans.

• The table in the next page summarizes the process of indirect borrowing through commercial paper issued by affiliated firms. This funds source tends to be high in volume and moderate in cost but also volatile in available capacity and subject to credit risk. Recently foreign banks, such as Barclays Capital, have accelerated their mining of both European and American paper markets despite the pressures of the Great Recession.

Long Term Non-Deposit Sources

• 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 capital notes and debentures, which usually range from 5 to 12 years in maturity and are used to supplement equity (owners’) capital.

• 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. Nevertheless, the favorable leveraging effects of such debt have made it attractive to larger financial firms in recent years.

• Because of the long-term nature of these funding sources, they tend to be a sensitive barometer of the perceived risk exposure (particularly the risk of default) of their issuing institutions.

The Available Funds Gap

• With so many different non-deposit funds sources to draw upon, managers of financial firms must make choices among them. In using non-deposit funds, funds managers must answer the following key questions:

• How much in total must be borrowed from these sources to meet funding needs?
• Which non-deposit sources are best, given the borrowing institution’s goals ?

The demand for non-deposit funds is determined basically by the size of the gap between the institution’s total credit demands and its deposits and other available monies. Management must be prepared to meet, not only today’s credit requests, but all those it can reasonably anticipate in the future. .

• The difference between current and projected outflows and inflows of funds yields an estimate of each institution’s available funds gap.Thus,

𝐴𝐹𝐺

=

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑛𝑑 𝑝𝑟𝑜𝑗𝑒𝑐𝑡𝑒𝑑 𝑙𝑜𝑎𝑛𝑠 𝑎𝑛𝑑 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 𝑡ℎ𝑒 𝑙𝑒𝑛𝑑𝑖𝑛𝑔 𝑖𝑛𝑠𝑡𝑖𝑡𝑢𝑡𝑖𝑜𝑛 𝑑𝑒𝑠𝑖𝑟𝑒𝑠 𝑡𝑜 𝑚𝑎𝑘𝑒

—

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑛𝑑 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑑𝑒𝑝𝑜𝑠𝑖𝑡 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 𝑎𝑛𝑑 𝑜𝑡ℎ𝑒𝑟 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑢𝑛𝑑

For example, suppose a commercial bank

• has new loan requests that meet its quality standards of $150 million
• wishes to purchase $75 million in new Treasury securities being issued this week and
• expects drawings on credit lines from its best corporate customers of $135 million.
• Deposits and other customer funds received today total $185 million, and
• those expected in the coming week will bring in another $100 million.

This bank’s estimated available funds gap (𝐴𝐹𝐺) for the coming week will be as follows (in millions of dollars):

𝐴𝐹𝐺 = ($150 + $75 + $135) — ($185 + $100) = $306 — $285 = $75

Choice Among Non Deposit Sources

• The following factors influence the decision between various types of non-deposit funds –

1. The relative costs of raising funds from each source.
2. The risk (volatility and dependability) of each funding source.
3. The length of time (maturity or term) for which funds are needed.
4. The size of the institution that requires more funds.
5. Regulations limiting the use of alternative funds sources.

1. Relative Costs

Managers of financial institutions practicing liability management must constantly be aware of the going market interest rates attached to different sources of borrowed funds. Major lenders post daily interest rates at which they are willing to commit funds to other financial firms in need of additional reserves. In general, managers would prefer to borrow from the cheapest sources of funds, although other factors do play a role.

Among the cheapest short-term borrowed funds source is usually the prevailing effective interest rate on Federal funds loaned overnight to borrowing institutions. In most cases the interest rates attached to domestic CDs and Eurocurrency deposits are slightly higher than the Fed funds rate. Commercial paper (short-term unsecured notes) normally may be issued

Factor 1 Relative Costs

• Managers of financial institutions practicing liability management must constantly be aware of the going market interest rates attached to different sources of borrowed funds. Major lenders post daily interest rates at which they are willing to commit funds to other financial firms in need of additional reserves. In general, managers would prefer to borrow from the cheapest sources of funds, although other factors do play a role.

• Among the cheapest short-term borrowed funds source is usually the prevailing effective interest rate on Federal funds loaned overnight to borrowing institutions. In most cases the interest rates attached to domestic CDs and Eurocurrency deposits are slightly higher than the Fed funds rate. Commercial paper (short-term unsecured notes) normally may be issued at interest rates slightly above the Fed funds and CD rates, depending upon maturity and time of issue. Today the discount rate attached to loans from the Federal Reserve banks (known as the primary credit rate) is generally among the highest short-term borrowing rates because this form of Federal Reserve credit is generally priced above the central bank’s target for the Fed funds rate.
• A sample of interest rates on money market borrowings, averaged over selected years, is shown in this table.

• Although low compared to most other rates, the effective Fed funds rate prevailing in the marketplace is volatile, fluctuating around the central bank’s target (intended) Fed funds rate.
  • The key advantage of Fed funds is their ready availability through a simple phone call or online computer request. Moreover, their maturities often are flexible and may be as short as a few hours or last as long as several months.
  • The key disadvantage of Fed funds is their volatile market interest rate – its often wide fluctuations (especially during the settlement day) that make planning difficult.
• In contrast, market interest rates on CDs and commercial paper are usually more stable, but generally slightly above the Fed funds rate due to their longer average maturity and because of the marketing costs spent in finding buyers for these instruments. CDs and commercial paper usually are less popular in the short run than Fed funds and borrowings from the central bank’s discount window. CD and commercial paper borrowings are usually better for longer term funding needs that stretch over several days or weeks.

• The rate of interest is usually the main expense in borrowing non-deposit funds. However, noninterest costs cannot be ignored, including the time spent by management and staff to find the best funds sources each time new money is needed. A good formula for doing cost comparisons among alternative sources of funds is:

𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑐𝑜𝑠𝑡 𝑟𝑎𝑡𝑒 𝑜𝑛 𝐷𝑒𝑝𝑜𝑠𝑖𝑡 𝑎𝑛𝑑 𝑛𝑜𝑛𝑑𝑒𝑝𝑜𝑠𝑖𝑡 𝑠𝑜𝑢𝑟𝑐𝑒𝑠 𝑜𝑓 𝑓𝑢𝑛𝑑𝑠

=

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑠𝑡 𝑜𝑛 𝑎𝑚𝑜𝑢𝑛𝑡𝑠 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑 + 𝑁𝑜𝑛𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑠𝑡𝑠 𝐼𝑛𝑐𝑢𝑟𝑟𝑒𝑑 𝑡𝑜 𝑎𝑐𝑐𝑒𝑠𝑠 𝑡ℎ𝑒𝑠𝑒 𝑓𝑢𝑛𝑑𝑠

𝑁𝑒𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑎𝑏𝑙𝑒 𝑓𝑢𝑛𝑑𝑠 𝑟𝑎𝑖𝑠𝑒𝑑 𝑓𝑟𝑜𝑚 𝑡ℎ𝑖𝑠 𝑠𝑜𝑢𝑟𝑐𝑒

where

𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑠𝑡 𝑜𝑛 𝑎𝑚𝑜𝑢𝑛𝑡𝑠 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑 =

𝑃𝑟𝑒𝑣𝑎𝑖𝑙𝑖𝑛𝑔 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑚𝑜𝑛𝑒𝑦 𝑀𝑎𝑟𝑘𝑒𝑡

× 𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑓𝑢𝑛𝑑𝑠 𝐵𝑜𝑟𝑟𝑜𝑤𝑒𝑑

𝑁𝑜𝑛𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑐𝑜𝑠𝑡𝑠 𝑡𝑜 𝑎𝑐𝑐𝑒𝑠𝑠 𝑓𝑢𝑛𝑑𝑠 =

𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝑐𝑜𝑠𝑡 𝑟𝑎𝑡𝑒 𝑟𝑒𝑝𝑟𝑒𝑠𝑒𝑛𝑡𝑖𝑛𝑔 𝑠𝑡𝑎𝑓𝑓 𝑡𝑖𝑚𝑒, 𝑓𝑎𝑐𝑖𝑙𝑖𝑡𝑖𝑒𝑠, 𝑎𝑛𝑑 𝑡𝑟𝑎𝑛𝑠𝑎𝑐𝑡𝑖𝑜𝑛 𝑐𝑜𝑠𝑡𝑠

× 𝐴𝑚𝑜𝑢𝑛𝑡 𝑜𝑓 𝑓𝑢𝑛𝑑𝑠 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑

𝑁𝑒𝑡 𝑖𝑛𝑣𝑒𝑠𝑡𝑎𝑏𝑙𝑒 𝑓𝑢𝑛𝑑𝑠 𝑟𝑎𝑖𝑠𝑒𝑑 =

𝑇𝑜𝑡𝑎𝑙 𝑎𝑚𝑜𝑢𝑛𝑡 𝑏𝑜𝑟𝑟𝑜𝑤𝑒𝑑

— 𝑙𝑒𝑠𝑠 𝑙𝑒𝑔𝑎𝑙 𝑟𝑒𝑠𝑒𝑟𝑣𝑒 𝑟𝑒𝑞𝑢𝑖𝑟𝑒𝑚𝑒𝑛𝑡𝑠 𝑖𝑓 𝑎𝑛𝑦 ,

— 𝑑𝑒𝑝𝑜𝑠𝑖𝑡 𝑖𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒 𝑎𝑠𝑠𝑒𝑠𝑠𝑚𝑒𝑛𝑡𝑠 𝑖𝑓 𝑎𝑛𝑦 ,

— 𝑓𝑢𝑛𝑑𝑠 𝑝𝑙𝑎𝑐𝑒𝑑 𝑖𝑛 𝑛𝑜𝑛𝑒𝑎𝑟𝑛𝑖𝑛𝑔 𝑎𝑠𝑠𝑒𝑡𝑠

The cost associated with attracting each funds source is compared to the net amount of funds raised after deductions are made for reserve requirements (if any), insurance fees, and that portion of borrowed funds diverted into such nonearning assets as excess cash reserves or fixed assets.

Factor 1 – Relative Costs – Example 1

Suppose that

• Fed funds are currently trading at an interest rate of 6.0 percent.
• Management estimates that the marginal noninterest cost, in the form of personnel expenses and transactions fees, from raising additional monies in the Fed funds market is 0.25 percent.
• A depository institution will need $25 million to fund the loans it plans to make today, of which only $24 million can be fully invested due to other immediate cash demands.

Then the effective annualized cost rate for Fed funds would be calculated as follows:

Current interest cost on Federal funds= 0.06 × $25 million = $1.5 million Noninterest cost to access Federal funds= 0.0025 × $25 million= $0.0625 million

Net investable funds raised= $25 million-$1million= $24 million

$1.5 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 + $0.0625 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

Therefore, the effective annualized Fed funds cost rate is

\(\frac{\$1.5 \, \text{million} + \$0.0625 \, \text{million}}{\$24 \, \text{million}}\)

= 0.065104 or 6.51 percent. The depository institution would have to earn a net annualized return of at least 6.51 percent on the loans and investments it plans to make with these borrowed Fed funds just to break even.

Factor 1 – Relative Costs- Example 2

• Suppose management decides to consider borrowing funds by issuing negotiable CDs that carry a current interest rate of 7.00 percent. Moreover, raising CD money costs 0.75 percent in noninterest costs. Then the annualized effective CD cost rate =

\(\frac{0.07 × \$25 \, \text{million} + 0.0075 × \$25 \, \text{million}}{\$24 \, \text{million}} = \frac{\$1.75 \, \text{million} + \$0.1875 \, \text{million}}{\$24 \, \text{million}} = 0.0807 \, \text{or} \, 8.07\% \)

• An additional expense associated with selling CDs to raise money is the deposit insurance fee. In the US this fee varies with the risk and capitalization of each depository institution whose deposits are insured by the Federal Deposit Insurance Corporation (FDIC).

To illustrate how the FDIC insurance fee works, assume the current insurance rate is $0.0027 per dollar of deposits. The FDIC requires an insured depository institution to pay this insurance fee not just on the actual insured portion of a customer’s deposit account but on the full face amount.

Thus, the total insurance cost would be

𝑇𝑜𝑡𝑎𝑙 𝑑𝑒𝑝𝑜𝑠𝑖𝑡𝑠 𝑟𝑒𝑐𝑒𝑖𝑣𝑒𝑑 𝑓𝑟𝑜𝑚 𝑡ℎ𝑒 𝑝𝑢𝑏𝑙𝑖𝑐 𝐼𝑛𝑠𝑢𝑟𝑎𝑛𝑐𝑒 𝑓𝑒𝑒 𝑝𝑒𝑟 𝑑𝑜𝑙𝑙𝑎𝑟 $25 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 × 0.0027

= $67,500 or $0.0675 million

If this fee is deducted from the new amount of CDs actually available for use, then

Effective CD cost rate = \(\frac{\$1.9375 \, \text{million}}{\$24 \, \text{million} – \$0.0675 \, \text{million}}\) = 0.0810 \, \text{or} \, 8.1\%

Clearly, issuing CDs would be more expensive in the above example than borrowing Fed funds. However, CDs have the advantage of being available for several days, weeks, months, or years, whereas Fed funds loans must often be repaid in 24 hours.

• Non-deposit sources of funds generally are moderate in cost compared to other funding sources. Non-deposit funds tend to be more expensive than checkable deposits but less expensive than thrift (time and savings) deposits. However, the costs and the profits associated with non-deposit funds tend to be more volatile from year to year than the cost and profitability of deposits. Non-deposit funds do have the advantage of quick availability compared most types of deposits, but they are clearly not as stable a funding source for most institutions as time and savings deposits.

Factor 2 – Risk

• The managers of financial institutions must consider at least two types of risk when selecting among different non-deposit sources –

• Interest rate risk – the volatility of credit costs – All the interest rates, except most central banks’ discount rates, are determined by demand and supply forces in the open market and therefore are subject to erratic fluctuations. The shorter the term of the loan, the more volatile the prevailing market interest rate tends to be. Thus, most Fed funds loans are overnight and, not surprisingly, this market interest rate tends to be the most volatile of all.

• Credit availability risk – There is no guarantee in any credit market that lenders will be willing and able to accommodate every borrower. When general credit conditions are tight, lenders may have limited funds to loan and may ration credit, confining loans only to their soundest and most loyal customers. Sometimes a financial firm may appear so risky to money market lenders they will deny credit or make the price so high that its earnings will suffer. Experience has shown that the negotiable CD, Eurodollar, and commercial paper markets arc especially sensitive to credit availability risks. Funds managers must be prepared to switch to alternative sources of credit and, if necessary, pay more for funds they receive.

Factor 3 – Length of Time

• Some funds sources may be difficult to access immediately (such as commercial paper and long- term debt capital). A manager in need of loanable funds this afternoon would be inclined to borrow in the Fed funds market. However, if funds are not needed for a few days, selling longer-term debt becomes a more viable option. Thus, the term, or maturity, of the funds need plays a key role as well.

Factor 4 – Size of Financial Institution

• The standard trading unit for most money market loans is $ 1 million- a denomination that may exceed the borrowing requirements of the smallest financial institutions. For example, Eurodollar borrowings are in multiples of $1 million and usually are available only to money- center financial firms with the highest credit ratings. Large negotiable CDs from the largest depository institutions are preferred by most investors because there is an active secondary market for prime-rated CDs. Smaller depository institutions may not have the credit standing to be able to sell the largest negotiable CDs. The same is true of commercial paper. In contrast, the central bank’s discount window and the Fed funds market can make relatively small denomination loans that are suitable for smaller depository institutions.

Factor 5 – Regulations

• Federal and state regulations may limit the amount, frequency, and use of borrowed funds. For example, in the United States CDs must be issued with maturities of at least seven days. The Federal Reserve banks may limit borrowings from the discount window, particularly by depository institutions that appear to display significant risk of failure. Other forms of borrowing may be subjected to legal reserve requirements by action of the central bank. For example, during the late 1960s and early 1970s, when the Federal Reserve was attempting to fight inflation with tight-money policies, it imposed legal reserve requirements for a time on Fed funds borrowing, repurchase agreements, and commercial paper issued to purchase assets from affiliated lending institutions. While these particular requirements are not currently in force, it seems clear that in times of national emergency, government policymakers would move swiftly to impose new controls, affecting both the costs and risks associated with non-deposit borrowings.

Cost of Funds

• Borrowing institutions draw simultaneously on many different funds sources, including deposits, non-deposit borrowings, and owner’s equity capital. There are different methods for determining the cost of funding that brings together all the sources of funding normally in use. Two of the most popular overall funds cost methods are

• Historical average cost approach
• Pooled-funds approach

Historical Average Cost Approach

• This approach for looks at the past. It asks what funds the financial firm has raised to date and what they cost, including interest and noninterest costs.

• Weighted average interest expense is calculated before considering noninterest costs.
• Noninterest costs are incorporated to calculate a breakeven cost rate.
• Weighted average cost of capital is calculated, considering the expected return of shareholders.

Consider this example

Pooled Funds Approach

• This method of costing looks at the future. It asks what minimum rate of return must be earned on any future loans and investments just to cover the cost of all new funds raised.

• The pooled costs of deposit and non-deposit funds is calculated.
• The hurdle rate of return over all earning assets is calculated. It is the rate that earning assets should earn so that cost of new funds can be covered.

Consider the following estimate for future funding sources and costs –