Ch: 17 Commercial Bank Sources
and Uses of Funds
Bank Sources of Funds:
Long-term Sources of Funds:
Deposit accounts:
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Transaction Deposits
Savings Deposits
Time Deposits
Money Market Deposit Accounts
Borrowed Funds:
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Federal Funds purchased (borrowed)
Borrowing from the Federal Reserve
Banks
Repurchase agreements
Eurodollar Borrowings
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Bonds issued by the Bank
Bank Capital
Deposit Accounts
Transaction Deposits:
• The demand deposit account, or
checking account, is offered to
customers who desire to write
checks against their account.
• From the bank’s perspective,
demand deposit accounts are
classified as transaction accounts
that provide a source of funds
that can be used until withdrawn
by customers.
• Another type of Transaction
account is Negotiable Order of
Withdrawal(NOW). It provides
checking services as well as
interest. It requires
large
minimum balance.
• Electronic
Transactions:
Customers now use electronic
banking to pay utility bills, check
account balances, add deposits,
Credit card payments, funds
transfer, cash withdrawals (ATM).
Debit cards allow customers to
make purchases and their
accounts are debited by the
amount.
Savings Deposits
• The traditional savings account is the passbook savings
account, which does not permit check writing.
• The passbook savings account continues to attract
savers with a small amount of funds, as it often has no
required minimum balance.
• Another type of saving account is Automatic Transfer
Service (ATS). It allows customers to write checks and
the required amount is transferred to checking account
while on remaining balance, interest is earned.
Time Deposits
• Time deposits can not be
withdrawn until a specified
maturity. Two types of Time
deposits are:
1.
2.
Certificate of Deposit
Negotiable Certificate of
Deposit
Negotiable
Certificate
of
Deposit:
• Another type of time deposit
is a negotiable CD offered by
some
large
banks
to
corporations. They have a
specific maturity and require
minimum balance.
• Their maturities are typically
short
term,
and
their
minimum deposit requirement
is $100,000. A secondary
marked for NCDs does exist.
Certificate of Deposit
•
A common type of time deposit
known as retail certificate of deposit
requires a specified minimum
amount of funds to be deposited for
a specified period of time.
•
Some CD rates are tied to the
performance of a stock market index
but guarantee a minimum rate
regardless of the stock markets
performance.
•
Banks are now able to offer a CD that
better meets an individual’s needs.
•
Callable CDs are also offered which
can be called back before maturity.
•
Most offer a wide variety, with
maturities as short as seven days and
annualized interest rates that vary
among banks, and even among
maturity types within a single bank.
•
No organized secondary market exist
for CDs.
Money Market Deposit Accounts
• These accounts do not have specific maturity
and are more liquid as compared to retail CDs.
• They provide limited check writing facility,
require large minimum balance and offer
higher return.
Borrowed Funds
• Federal Funds Purchased:
• The federal funds market allows
depository
institutions
to
accommodate the short-term
liquidity needs of other financial
institutions.
• The interest rate charged in the
federal funds market is called the
federal funds rate which changes
according to demand and supply
of funds.
•
• Federal
funds
purchased
represent a liability to the
borrowing bank and an asset to
the lending bank that sells them.
• Loans are made from one day to
seven days.
If many banks have excess funds
and few banks are short of funds,
the federal funds rate would be
low.
• Federal funds rate is generally
between 0.25 % and 1 % higher
than T-Bill rate.
Borrowing from the Federal Reserve
Bank
•
Federal Reserve District banks
regulate certain activities of banks
and also provide short-term loans to
banks. This form of borrowing by
banks is often referred to as
borrowing at the Discount Window.
•
When a bank needs temporary funds,
it must decide whether borrowing
through the discount window is more
feasible than alternative non
depository sources of funds, such as
the federal funds market.
•
The interest rate charged on these
loans is known as the discount rate.
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Loans from the discount windows are
short term, commonly from one day
to a few weeks.
The federal funds rate is more
volatile than the discount rate
because it is market determined, as it
adjusts to demand and supply
conditions on a daily basis.
•
Conversely, the discount rate is set by
Federal Reserve and adjusted only
periodically to keep it inline with
other market rates.
•
Like the federal funds market, the
discount window is mainly used to
resolve a temporary shortage of
funds.
Repurchase Agreements
• A repurchase agreement represents the sale of securities by one
party to another with an agreement to repurchase the securities at
a specified date and price.
• The government securities involved in the repo transaction serve as
collateral for the corporation providing funds to the bank.
• Repurchase agreements transactions occur through a
telecommunications network connecting large banks, other
corporations, government securities dealers, and federal funds
brokers.
• The yield on repurchase agreements is slightly less than the federal
funds rate at any given point in time, since the funds loaned out are
backed by collateral and are therefore less risky.
Eurodollar Borrowings:
Bonds Issued by the Bank:
• If a U.S bank is in need of
short term funds, it may
borrow from those banks
outside the United States
that
accept
dollar
dominated deposits, or Euro
dollars.
• Like other corporations,
banks own some fixed
assets such as land,
buildings, and equipment.
• These assets often have an
expected life of 20 years or
more and are usually
financed with long term
sources of funds, such as
through the issuance of
bonds.
Bank Capital
• It generally represents funds obtained through the issuance of stock
or through retaining earnings.
• Primary capital results from issuing common or preferred stock or
retaining earnings, while secondary capital results from issuing
subordinated notes and debentures.
• A bank’s capital provides a cushion to absorb losses, therefore, a
bank must maintain a specific minimum capital required by law.
• When banks issue new stock, they dilute the ownership of the
bank, since the proportion of the bank owned by existing
shareholders decreases.
Uses of Funds by Banks
1. Cash:
1.
2.
3.
4.
5.
6.
7.
Cash
Bank loans
Investment securities
Federal Funds Sold
Repurchase Agreements
Eurodollar loans
Fixed Assets
• Banks are required to hold
some cash as reserves,
since they must abide by
reserve
requirements
enforced by the Federal
Reserve.
• Banks also hold cash to
retain some liquidity and
accommodate
any
withdrawal requests by
depositors.
Bank Loans
Types of Business loans:
• A common type of business loan is the working capital loan
designed to support on going business operations.
• A working capital loan can support the business until sufficient cash
inflows are generated. These loans are typically short term, yet they
may be needed by businesses on a frequent basis.
• Banks also offer term loans, primarily to finance the purchase of
fixed assets such as machinery.
• A term loan involves a specified amount of funds to be loaned out,
for a specified period of time, and for a specified purpose.
• The bank can periodically request interest payments, with the loan
principal to be paid off in one lump sum at a specified date in the
future. This is called bullet loan.
• As an alternative to providing a term loan, the bank may consider
purchasing the assets and leasing them to the firm in need. This
method known as, direct lease loan.
• A more flexible financing arrangement is Informal Line of credit; it
allows the businesses to borrow up to some specified maximum
amount of fund over a specified period of time. Interest is charged
on borrowed amount in line with market rates. Banks are not legally
obligated to provide funds.
• Revolving credit loan obligates the bank to offer up to
some specified maximum amount of fund over a
specified period of time typically less than 5 years.
• Bank is committed to provide funds when requested; it
charges a commitment fee on unused funds.
• The interest rate charged by banks on loans to their
most creditworthy customers is known as the prime
rate.
Loan Participations:
Types of Consumer Loans:
• Several banks may be willing to
pool any available funds they
have
to
accommodate
a
corporation in what is referred to
as a loan participation.
• Commercial
banks
provide
installment loans to individuals to
finance purchases of cars and
household products. These loans
require the borrowers to make
periodic payments over time.
• The main role of the other banks
is to supply funds to lead bank
which are channeled to the
borrower.
• Real Estate Loans:
• Banks also provide real estate
loans. They give residential and
commercial real estate loans.
Loan Supporting Leverage Buyouts
•
One of the latest trend in commercial
banking is financing leverage buyouts. The
loan amount provided by a single bank to
support an LBO is usually between $15
million and $40 million.
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Banks that reduce their most conservative
assets to finance LBOs will incur a higher
degree of risk. Many LBOs were financed
with junk bonds, which suggest a high degree
of risk.
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Financing part of LBO is no different than
financing other privately held businesses.
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These businesses are highly leveraged and
experience cash flow pressure during periods
where sales are lower than normal.
Some banks originate the loans designed for
LBOs and then sell them to other financial
institutions such as insurance companies,
pension funds and foreign banks. In this way,
they can generate fee income by servicing
the loans while avoiding the credit risk
associated with the loans.
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Many firms involved in LBOs represent
diversified conglomerates that will be split
into various divisions and sold.
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A commercial banks risk may rise as it
increases its financing of LBOs.
Bank regulators now monitor the amount of
bank financing provided to corporate
borrowers that will have a relatively high
degree of financial leverage. These loans,
known as highly leveraged transactions.
Investment Securities
• Banks
purchase
treasury
securities as well as securities
issued by the agencies of the
federal government.
• Government agency securities
can be sold in the secondary
market, but the market is not
as active as it is for treasury
securities.
• Government agency securities
are not a direct obligation of
the federal government.
• Federal agency securities are
commonly issued by federal
agencies, such as the Federal
Home
Loan
Mortgage
Corporation and the Federal
National
Mortgage
Association.
• Banks
purchase
only
investment grade securities
which have a low degree of
default risk.
Federal Funds Sold:
• Banks often lend funds in the
federal funds market. The funds
sold, or lend out, will be returned
at the time specified in the loan
agreement with interest.
Repurchase Agreements:
• Recall that from the borrower’s
perspective, the repurchase
agreement transaction involves
repurchasing the securities that it
had previously sold.
Fixed Assets:
• Banks must maintain some
amount of fixed Assets, such as
office buildings and land, so that
they can conduct their business
operations.
Off-Balance Sheet Activities
1. Loan Commitments:
1. Loan commitments
2. Standby letter of credit
3. Forward contracts
4. Swap contracts
• A loan commitment is an
obligation by a bank to
provide a specified loan
amount to a particular firm
upon the firm’s request.
• The interest rate and
purpose of the loan may
also be specified. The bank
charges a fee for offering
the commitment.
Off-Balance Sheet Activities
Standby Letter of Credit:
Swap Contracts:
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A Standby letter of credit backs a customer’s
obligation to a third party.
•
If the customer does not meet its obligation,
the bank will.
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The third party may require that the
customer obtain an SLC to complete a
business transaction.
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Banks also serve as intermediaries for
interest rate swaps, whereby two parties
agree to periodically exchange interest
payments on a specified notional amount of
principal.
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Some banks facilitate currency swaps by
finding parties with optimistic future
currency needs and executing a swap
agreement.
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Currency swaps are somewhat similar to
forward contracts, except that they are
usually for more distant future dates.
Forward Contracts:
•
Many banks engage in forward contracts in
which they agree to exchange one currency
for another on a particular future date at a
specified exchange rate.