Liabilities Management
• Outline
– Structure of bank liabilities
Deposit sources of funds
Nondeposit sources of funds
– Balance sheet structure of bank liabilities
– Managing bank liabilities
Formulating pricing policy
Deposit pricing matrix
The pricing committee
Components of the pricing decision
Profitability and deposit pricing
Lending and deposit costs
Customer relationship pricing
Estimating the costs of bank funds
Structure of bank liabilities
• Deposit sources of funds
– Core deposits of regular bank customers.
– Purchased deposits are acquired on a nonpersonal basis from the
financial market at competitive interest rates.
– Categories of deposits accounts: demand deposits, small time and
savings deposits (or savings certificates or retail CDs), large time
deposits (negotiable certificates of deposit or NCDs).
– Deregulation: DIDMCA of 1980 (NOW accounts), Garn-St
Germain Act of 1982 (MMDAs) to compete with MMMFs, and
DIDC (Super NOW accounts in 1983).
– Liability management is based on purchased funds.
– Eurodollar deposits are dollar-denominated deposits in a bank
outside of the U.S. (not FDIC insured).
– Brokered deposits
Structure of bank liabilities
Depository Institutions Deregulation and Monetary
Control Act (DIDMCA of 1980)
Authorized all depository institutions to sell negotiable order of
withdrawal (NOW) accounts to individuals and nonprofit
organizations in December, 1980, as well as automatic transfer
service(ATS)accounts. These accounts had interest rate ceilings
initially imposed on them.
Garn-St Germain Depository Institutions Act of 1982
Authorized all depository institutions to issue money market deposit
accounts (MMDAs)in December,1982 with no interest rate
restrictions and limited check-writing privileges (unlike NOWs).
Depository Institutions Deregulation Committee (DIDC)
Established by DIDMCA of 1980, the DIDC authorized Super-NOW
accounts effective January, 1983. Eliminated all rate ceilings on
transactions accounts. Unlike NOWs, Super-NOWs offered market
rates of interest. Later deregulation of interest rates in 1986
eliminated the distinction between NOWs and Super-NOWS.
Structure of bank liabilities
• Deposit sources of funds
– Brokered deposits occur when large deposits are split into
$100,000 pieces and placed with different banks to obtain 100%
insurance. DIDMCA of 1980 raised deposit insurance limits from
$40,000 to $100,000 per account, which encompassed large NCDs.
FDIC Improvement Act of 1991 prohibits depository institutions from
using brokered deposits unless well or adequately capitalized.
Brokered deposits were used by failing savings and loan associations in
the 1980s to cover earnings losses.
– IRA and Keogh plans are personal pension plans that individuals
may use to defer federal income taxes on contributions and
subsequent investment earnings. Roth IRAs allowed under the
Taxpayer Relief Act of 1997. Banks act as custodians and gain a
stable, long-term source of deposit funds. Other financial service
firms are very competitive.
Structure of bank liabilities
• Nondeposit sources of funds
– Federal funds: Short-term, unsecured transfers of immediately
available funds between depository institutions for on business day
(i.e., overnight loans).
– Repurchase agreements: Secured, one-day loans in which claim to
the collateral is transferred. For example, a bank sells securities to
a corporate client and promises to repurchase the next day.
– Discount window advances: Banks can borrow from the 12
regional Federal Reserve banks by this means (subject to
Regulation A rules).
– Federal Home Loan Bank borrowings: Under FIRREA of 1989,
the FHLB can provide discount window services to not only
savings and loans (as in the past) but banking institutions.
Structure of bank liabilities
• Nondeposit sources of funds
– Bankers’ acceptances: time drafts drawn on a bank by either an
exporter or importer to finance international business transactions.
The bank may discount the acceptance in the money market to (in
effect) finance the transaction.
– Commercial paper: short-term, unsecured promissory note sold by
large companies with strong credit ratings. Banks can use their
holding companies to issue this short-term debt instrument.
– Capital notes and debentures: Senior debt capital that is not
federally insured and considered subordinate to bank deposits.
Recent changes to encourage bank issuance and improve market
discipline of banks.
Balance sheet structure
of bank liabilities
• As bank size decreases (increases), greater emphasis is
placed on retail deposits (managed liabilities).
• Sweep programs increased in popularity in the 1990s (i.e.,
funds are moved from transactions accounts with reserve
requirements to savings accounts with no such
requirements).
• Banks had difficulty retaining core deposits in the 1990s
due to the low interest rates in this period. Depositors
sought higher yields in money and capital markets.
• Banks increased mutual fund offerings to customers, which
was greatly enhanced by the Financial Services
Modernization Act of 1999.
Managing bank liabilities
• Formulating pricing policy
– Written document that contains the pricing details of deposit
services (e.g., service fees and minimum balance requirements,
deposits costs and volumes, credit availability and compensating
balance requirements, customer relationship pricing, promotional
pricing of new products, and other marketing elements such as
product differentiation.).
• Deposit pricing matrix
– Explicit (interest) and implicit (noninterest) pricing of deposits.
– Deregulation of interest rates on deposits in early 1980s shifted
banks to more explicit and less implicit pricing.
• The pricing committee
– Staffed by employees throughout the bank.
Managing bank liabilities
• Components of the pricing decision
– Factors affecting the pricing decisions on consumer deposits:
Wholesale cost of funds
Pricing strategy of competitors
Interest elasticity (or responsiveness) of consumer demand
Past deposit flows for various kinds of consumer accounts
Maturity structure of deposits
• Profitability and deposit pricing
– Cost/revenue analysis
Minimize total costs
Maximize total revenues
Set marginal costs equal to marginal revenues
Breakeven points define the range of profitable output levels
Managing bank liabilities
• Lending and deposit costs
– Compensating balances
– Tie-in arrangements between deposit and loan services
• Customer relationship pricing
– Relationship banking to meet total financial needs of customers
– Promotional pricing to introduce new products
– Other marketing elements related to pricing
Product differentiation
Distribution or physical delivery of deposit services to the public
Managing bank liabilities
• Estimating the cost of bank funds
– Average costs (dollar costs of funds/dollar amount of funds)
Weighted-average cost of funds
Average costs of alternative sources of funds should be the same in
theory (due to a bank using the cheapest source until its price rises to
other sources’ average costs)
Historical cost analyses to identify problems and opportunities
– Marginal costs (incremental costs of an additional dollar of funds)
Minimum yield on bank investments in loans and securities that must be
earned to avoid a loss in equity share values
Do not use the marginal cost of any particular source of funds as the
cutoff rate on investment decisions
Use the marginal cost of the entire mix of funds as a cutoff criterion in
investment decisions
Marginal cost of funds not best cutoff for long-run investment decisions.
In this case use the marginal cost of capital based on long-term debt
and equity costs.
Managing bank liabilities
Less costly sources of funds declines have higher risk, which
is consistent with higher bank profits as risk increases.
Cost
of
Funds
Risk of Funds