Book 4. Liquidity and Treasury Risk

FRM Part 2

LTR 13. Managing Non-Deposit Liabilities

Presented by: Sudhanshu

Module 1. Non-Deposit Liabilities and Available Funds Gap

Module 2. Choice and Cost of Non-Deposit Sources of Funds

Module 1. Non-Deposit Liabilities and Available Funds Gap

Topic 1. Sources of Nondeposit Liabilities

Topic 2. Available Funds Gap (AFG)

Topic 1. Sources of Nondeposit Liabilities

  • Financial institutions use nondeposit liabilities to cover funding gaps when their primary funding sources (deposits and owners' equity) are not enough to fund assets like loans and securities. This approach is known as liability management, and the cost of these funds is highly sensitive to changes in interest rates, which increases a bank's interest rate risk.
  • A variety of nondeposit funding sources are available to banks, with maturities ranging from overnight to several years.

    • Federal Funds (Fed Funds):

      • Short-term, often overnight, borrowings between depository institutions to meet reserve requirements and loan demand.

      • The funds are on deposit at the Federal Reserve (the Fed).

      • Types include overnight loans, term loans (with written contracts), and continuing contracts that automatically renew daily.

  • Repurchase Agreements (Repos):

    • Collateralized short-term borrowings. A borrower sells high-quality securities (e.g., Treasury bills, notes, or bonds) and agrees to repurchase them at a predetermined price at maturity. The collateral reduces credit risk for the lender.

    • The repo interest cost is calculated as:

​​

  • Discount Window Borrowing:

    • Short-term loans from the Federal Reserve, credited to the bank's reserve account. Loans must be backed by acceptable collateral.

    • Primary credit: Usually overnight loans at a rate slightly higher than the target fed funds rate.

    • Secondary credit: Loans for institutions that do not qualify for primary credit, at a higher rate.

    • Seasonal credit: Longer-maturity loans for institutions with seasonal needs.

  • ​Federal Home Loan Bank (FHLB) Borrowing:

    • Provides stable, below-market rate funding to mortgage lenders and other institutions.

    • Home mortgages are typically used as collateral.

\text { Interest Cost }=\text { Borrowed Amount } \times \text { Current Repo Interest Rate } \times\left(\frac{\text { Number of Days Borrowing }}{360}\right)

  • Negotiable Certificates of Deposit (CDs):

    • While legally deposits, they function as a short-term money market funding source, typically in multiples of $1 million.

    • For fixed-rate CDs, the interest is calculated based on a 360-day year:

 

  • Four major types are Domestic CDs, Dollar-denominated CDs (Euro CDs), Yankee CDs, and Thrift CDs.​​

  • Eurocurrency Deposits:

    • Deposits in banks outside their home country.

    • Eurodollar deposits are dollar-denominated deposits in banks outside the U.S. and are mostly fixed-rate.

  • Commercial Paper: Short-term borrowings used by large companies, usually for a few days to a maximum of 270 days

\text { Interest Cost }=\text { Principal Amount } \times CD \text { Interest Rate } \times\left(\frac{\text { Days to Maturity }}{360}\right)

Practice Questions: Q1

Q1. Which of the following nondeposit funding sources requires collateral?
A. Fed funds and commercial paper.
B. Commercial paper and discount window borrowing.
C. Fed funds and repurchase agreements.
D. Discount window borrowing and repurchase agreements.

Practice Questions: Q1 Answer

Explanation: D is correct.

Repurchase agreements involve selling securities to a lender and buying them back at a later date for a previously agreed upon price, thus they are collateralized. The Federal Reserve also demands collateral in order to borrow at the discount window.

Topic 2. Available Funds Gap (AFG)

  • The available funds gap (AFG) is a critical tool for a bank's liquidity management. It represents the difference between a bank's projected needs for funds (outflows) and its projected available funds (inflows).
  • When this gap is positive, it indicates a funding shortfall that must be covered by borrowing from non-deposit sources. The bank's management uses this calculation to determine exactly how much funding they need to raise.
  • A safety margin is a key part of this calculation and is often added to the final AFG to ensure the bank has a buffer for unexpected loan demand or a shortfall in deposits.
  • This forward-looking approach helps banks to plan and secure funding proactively.
  • The formula for the AFG is:
    • ​AFG = current and projected loans and other investments - current and expected deposit inflows and other available funds
  • Example: Ravens Bank expects $100 million in new loans, $15 million in security investments, and $30 million in credit line drawdowns. They anticipate $75 million in new deposits. With a 10% safety margin, the planned borrowing would be: AFG=($100+$15+$30)−$75=$70 million
    • ​Planned borrowing=$70 million×1.10=$77 million

Practice Questions: Q2

Q2. Which of the following types of non deposit funding was created to provide liquidity to mortgage lenders?
A. Fed funds.

B. Repurchase agreements.
C. Federal Home Loan Bank (FHLB) borrowing.
D. Discount window borrowing.

Practice Questions: Q2 Answer

Explanation: C is correct.

The FHLB system was created in 1932 to make loans to mortgage lenders, at a time when banks were experiencing runs on deposits. The FHLB stabilized the system, allowing banks to continue to make mortgage loans.

Practice Questions: Q3

Q3. Barbara Friedman, a bank manager on the asset-liability committee, must estimate the amount of money market funding she expects the bank to need in the coming week. Friedman estimates that the bank will make $60 million of new loans in the coming week. The bank does not plan to make any security investments but does expect additional drawdowns on credit lines to equal $10 million.
The bank is in a highly competitive deposit market and only expects $15 million in new deposits in the coming week. However, based on previous years’ experience, she expects that two of the bank’s largest customers will withdraw $1 million each in the coming week. Friedman should estimate the available funds gap for the coming week to be:
A. $43 million.
B. $45 million.
C. $53 million.
D. $57 million.

Practice Questions: Q3 Answer

Explanation: D is correct.

available funds gap = current and projected loans and other investments − current and expected deposit inflows and other available funds
AFG = ($60 + $10) − ($15 − $2) = $57million
In this case, the bank’s expected outflows are twofold: the new loans and the expected drawdowns on credit lines. While the bank expects $15million of new deposits, Friedman cannot ignore the forecast $2million being withdrawn by two deposit customers, leaving a net $13million of deposits. Thus, she expects the bank to need $57million in non deposit sources of funding in the coming week.

Module 2. Choice and Cost of Non-Deposit Sources of Funds

Topic 1. Choice of Funds

Topic 2. Cost of Funds

Topic 1. Choice of Funds

  • The choice of a nondeposit funding source depends on several key factors:
    • Relative Costs: Banks constantly monitor interest rates in different markets and generally choose the least expensive source of funds. This decision is not based solely on the interest rate, but on the effective cost, which includes non-interest expenses like reserve requirements, deposit insurance fees, and administrative costs. The effective cost is calculated as:

 

 

  • Risks: This involves considering both interest rate risk and credit availability risk.

    • Interest rate risk arises because the interest rates on nondeposit funds are market-driven and can be volatile. Shorter-term loans, such as fed funds, tend to have the most volatile rates.

    • Credit availability risk is the concern that funding may not be reliable or available when a bank needs it. Markets for large-denomination instruments like CDs, Eurodollars, and commercial paper can be more susceptible to this risk, especially during periods of financial stress.​

\text { Effective cost }=\frac{\text { current interest cost on funds borrowed }+ \text { noninterest costs incurred to access funds }}{\text { net investable funds raised }}
  • Maturity: The maturity of the funding must be aligned with the maturity of the need. For example, a bank might use overnight fed funds to meet daily reserve requirements, but it would use a longer-term funding source, such as FHLB borrowing, to fund fixed-rate mortgages. Fed funds are immediately available, whereas long-term debt and commercial paper are not.
  • Size of the Financial Institution: A bank's size directly impacts its access to certain funding markets. Smaller institutions may not have access to large-unit markets like negotiable CDs and Eurodollar deposits, which are often traded in multiples of $1 million. These banks may have to rely more on discount window borrowing or fed funds.

  • Regulatory Requirements: Regulations can impose limits or constraints on a bank's choice of funding. For instance, some regulations may require a minimum maturity of seven days for certain types of CDs, or they may limit the amount or frequency of borrowing from certain sources.

Topic 2. Cost of Funds

  • Banks use two primary methods to calculate the overall cost of funds: the historical average cost approach and the pooled funds approach.

    • Historical Average Cost Approach: This method uses the historical costs of all funding sources, including interest and noninterest expenses, as well as the required rate of return for shareholders. This approach is backward-looking and reflects the costs the bank has already incurred.

      • Weighted average interest expense: This measures the average interest paid on all funds raised.

      •  

    • ​​Breakeven cost rate on borrowed funds: This is the rate a bank must earn on its earning assets to cover both its borrowing costs and other operating expenses, but before considering the required return for equity holders.
      • ​
    • Weighted average overall cost of capital: This is the total cost of all capital, including the before-tax cost of stockholders' investment.

​

 

\frac{\text { total interest paid }}{\text { total funds raised }}
\frac{\text { total interest paid }+ \text { other operating expenses }}{\text { earning assets }}
\text { breakeven cost }+\left(\frac{\text { after-tax cost of stockholders' investment }}{1-\text { tax rate }} \times \frac{\text { stockholders' investment }}{\text { earning assets }}\right)

  • Pooled Funds Approach: This is a forward-looking approach used to determine the minimum rate of return, or hurdle rate, that a bank must earn on future loans and securities to cover the costs of new funds it will raise. This method is crucial for pricing new loans and investments.

    • Pooled deposit and nondeposit funds expense: This represents the average cost of all new funds that are expected to be raised. It is a benchmark for the cost of future funding.

      • ​

​

  • Hurdle rate over all earning assets: This is the minimum before-tax return the bank must earn on every dollar of new funds invested in earning assets to cover the cost of raising those funds.
    • ​

 

\frac{\text { all expected operating expenses }}{\text { all new funds expected }}
\frac{\text { expected operating expenses }}{\text { dollars invested in earning assets }}

Practice Questions: Q1

Q1. Kris Gaines, Treasurer at Palm Air Bank and Trust, is considering ways to meet a funding gap created by greater than expected loan demand. Palm Air is a medium sized bank located in Florida. The funding gap is approximately $850,000. Gaines is choosing between several non depository funding types. The funds are needed immediately. Which type of funding is most appropriate in this
situation?
A. Commercial paper.
B. Negotiable certificates of deposit (CDs).
C. Federal funds borrowing.
D. Eurodollar deposits.

Practice Questions: Q1 Answer

Explanation: C is correct.

Federal (fed) funds are likely the best funding choice for three reasons. First, because Palm Air Bank and Trust is a medium-sized bank, it may not have access to commercial paper, negotiable CDs, and Eurodollar deposits. Second, these funding sources come in units of $1million or more. Because the bank needs less than $1million, commercial paper, negotiable CDs, and Eurodollar deposits are not necessarily appropriate. Third, the funds are needed immediately. Fed funds are available in smaller denominations and are usually immediately available.

Practice Questions: Q2

Q2. Blue Star Bank expects to raise $300 million, $250 million of which will be invested in earning assets. The total expected interest and overhead costs on the newly raised funds is forecasted to be $22 million. The pooled deposit and non deposit funds expense and hurdle rate over all earning
assets are, respectively:
A. 7.33%; 7.33%.
B. 7.33%; 8.80%.
C. 8.80%; 7.33%.
D. 8.80%; 8.80%.

Practice Questions: Q2 Answer

Explanation: B is correct.

pooled deposit and non deposit funds expenses = all expected operating expenses / all new funds expected = $22 / $300 = 7.33%
hurdle rate over all earning assets = expected operation expenses / dollars invested in earning assets = $22 / $250 = 8.80%