Bank Management, 5th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2003 by South-Western, a division of Thomson Learning
MANAGING
LIABILITIES AND
THE COST OF FUNDS
Chapter 12
The composition of bank liabilities
 There are many different types of liabilities.
Some offer transaction capabilities with
relatively low or not interest.
 Others offer limited check writing
capabilities but pay higher interest rates.
 Liabilities with long-term fixed maturities
generally pay the highest rates.
 Customers who hold each instrument
respond differently to interest rate changes.

Banks with Assets
more than $10B
Liabilities and Stockholders' Equity
2001
Number of institutions reporting
80
Total liabilities
91.23%
Total deposits
63.10%
Deposits held in domestic offices
49.71%
Transaction accounts
9.49%
Demand deposits
8.24%
"NOW" accounts
1.25%
Nontransaction accounts
40.22%
Money market deposit accounts (MMDAs)
19.44%
Other savings deposits (excluding MMDAs)
6.58%
Total time deposits
41.47%
Time deposits of less than $100,000
7.38%
Memo: Core (Retail) deposits
42.88%
Time deposits of $100,000 or more
6.83%
Foreign Offices Deposits
13.39%
Noninterest-bearing deposits
0.68%
Interest-bearing deposits
12.70%
Interest-bearing deposits
49.37%
Deposits held in domestic offices
49.71%
Federal funds purchased & repurchase agreements 8.64%
Trading liabilities
3.97%
Other borrowed funds
9.24%
Memo: Volatile liabilities
35.75%
Subordinated debt
1.93%
All other liabilities
4.35%
Total liabilities in foreign offices
18.42%
Equity capital
8.77%
Perpetual preferred stock
0.08%
Common stock
0.32%
Surplus
4.76%
Undivided profits
3.61%
Cumulative foreign currency translation adjustment -0.03%
The
percentage
contribution
of various
sources of
bank funds: a
comparison of
large
versus small
banks:
1992 and 2001
(% of total
assets)
1992
51
93.38%
70.37%
52.65%
19.81%
14.42%
5.27%
32.84%
12.04%
6.21%
14.59%
9.69%
47.75%
4.90%
17.72%
0.88%
16.84%
54.27%
52.65%
8.94%
N/A
6.06%
38.54%
1.91%
5.11%
22.47%
6.62%
0.04%
0.72%
3.28%
2.65%
-0.06%
Banks with Assets
less than $100M
2001
4,486
89.10%
84.69%
84.69%
24.45%
12.81%
11.64%
60.25%
9.87%
7.64%
71.88%
29.62%
71.58%
13.11%
0.00%
0.00%
0.00%
71.69%
84.69%
0.91%
0.00%
2.69%
14.73%
0.01%
0.80%
0.00%
10.90%
0.02%
1.58%
4.38%
4.92%
0.00%
1992
8,292
90.62%
88.59%
88.56%
26.54%
12.82%
13.34%
62.02%
11.02%
10.59%
40.40%
32.67%
80.83%
7.73%
0.03%
0.00%
0.03%
75.72%
88.56%
0.78%
N/A
0.33%
8.94%
0.02%
0.81%
0.03%
9.38%
0.03%
1.60%
3.59%
4.16%
0.00%
The percentage contribution of various sources
of bank funds: a comparison of large versus
small banks (continued): 1992 and 2001
(% of total assets)
Banks with Assets
more than $10B
Liabilities and Stockholders' Equity
Number of institutions reporting
Memo: Domestic Offices
Deposit accounts of $100,000 or less
Total time and savings deposits
Noninterest-bearing deposits
Interest-bearing deposits
IRAs and Keogh plan accounts
Brokered deposits
2001
80
1992
24.96%
41.47%
13.05%
36.66%
1.97%
4.10%
30.77%
38.22%
15.23%
37.42%
3.20%
1.23%
51
Banks with Assets
less than $100M
2001
4,486
58.73%
71.88%
13.00%
71.69%
4.22%
0.84%
1992
8,292
71.31%
75.74%
12.87%
75.69%
5.06%
0.16%
General decline in core deposits
 Transaction accounts have decline in favor of interest bearing
MMDA on small time deposits (less than $100,000).
 Bank reliance on liabilities other than core deposits, including
federal funds purchased, securities sold under agreement to
repurchase, Federal Home Loan Bank (FHLB) advances,
borrowings from the Federal Reserve, and deposits in foreign
offices declined over the period 1992–2001 for large banks but
increased for smaller banks.
 Except for discount window borrowings, these funds all
have large denominations and pay market rates.
 They typically have relatively short-term maturities except
for some FHLB advances that can extend as long as 20
years.
 Banks use the term volatile liabilities to describe purchased
funds from rate-sensitive investors
 The types of instruments include federal funds purchased,
RPs, jumbo CDs, Eurodollar time deposits, foreign deposits,
and any other large-denomination purchased liability.
 Investors in these instruments will move their funds if other
institutions pay higher rates or if it is rumored that the
issuing bank has financial difficulties.
Average annual cost of liabilities: a comparison of
large versus small banks: 2001
Liabilities
Transaction accounts
MMDAS and other savings deposits
Large CDs
All other time deposits
Foreign office deposits
Total interest-bearing deposits
Federal funds & RPs
Other borrowed funds
Subordinated notes and bonds
All interest-bearing funds
Banks with
Assets from
$3 to $10
Billion
2001
1.71%
2.15
4.94
5.06
0.56
3.60%
3.57
5.16
1.93
3.86
SOURCE: Uniform Bank Performance Report.
Banks with
Assets from
$10 to $25
Million
2001
1.63%
2.79
5.40
5.53
NA
4.29%
1.27
1.37
NA
4.31
Increased competition for bank funds
 Perhaps the most difficult problem facing
bank management is how to develop
strategies to compete for funding sources.


First, bank customers have become much
more rate conscious.
Second, many customers have
demonstrated a strong preference for
shorter-term deposits.
Information
on the best
rates is much
easier to find
today.
Characteristics of
small denomination liabilities
 Instruments under $100,000 are normally
held by individual investors and are not
actively traded in the secondary market.
Accounts with transactions privileges
 Most banks offer three different accounts
with transactions privileges:
1.
2.
3.
demand deposits (DDAs),
negotiable orders of withdrawal (NOWs) and
automatic transfers from savings (ATS), and
money market deposit accounts (MMDAs).
Demand deposit accounts
…DDAs are non-interest-bearing checking
accounts held by individuals, businesses, and
governmental units
 NOW account’s are DDA’s that pay interest.

Only individuals and nonprofit organizations
can hold NOWs.

This is expected to change very soon.
Money market deposit accounts MMDAs
…similar to interest bearing checking accounts
but have limited transactions.
 Provide banks an instrument competitive with
money market mutual funds offered by large
brokerages.
 Limited to six transactions per month, of
which only three can be checks.
 Attractive to the bank because required
reserves are zero while required reserves on
DDAs and NOWs are 10 percent.

The bank can invest 100 percent of the funds
obtained from MMDA but only 90 percent from
checking and NOW.
Electronic money
 Consider carefully the impact of
technology in banking – almost all
products of the financial services
industry can be provided
electronically.
 You can pay for goods electronically,
apply and receive a loan
electronically, even invest and
transfer funds electronically.
It is estimated that cash accounted for 82.3% of
the total volume of payments in 2000
 Checks were the second largest in terms of volume
at 10.3%
 Electronic payments (ATM, credit cards and debit
cards) accounted for 7.4% of all payments.
 In terms of the value of transactions, however



cash accounted for only 0.3% of the total value of
transactions
checks were 10.9% and
electronic payments (AMT, credit cards and debit
cards) accounted for 2.9%.
 The vast majority of large transactions were
wholesale wire transfers such as CHIPS and Fed
Wire transactions.
 Although cash dominates the “small” payment end
of transactions, it represents a very small fraction of
the total value of payments.
E-cash and e-checks are not Federal
Reserve money but rather digital ‘tokens’
somewhat like bus tokens or casino chips,
only electronic versions.
 Lauren Bielski in an August, 2000 ABA
Banking Journal article argues that emoney “…is arguably more of an
electronic instruction to pay than true
‘electronic money.’”
Electronic money: smart cards
 There are basically two types of smart
cards:
1.
2.
an intelligent smart card and
a memory card.
 An intelligent smart card contains a
microchip with the ability to store and
secure information, and makes different
responses depending on the requirements
of the card issuers specific application
needs.
 Memory type cards simply store
information, similar to the stored
information on the back of a credit card.
Electronic funds transfer (EFT)
…an electronic movement of financial data,
designed to eliminate the paper instruments
normally associated with such fund movement.
 There are many types of EFTs including:







ACH,
POS,
ATM,
direct deposit,
telephone bill paying,
automated merchant authorization systems,
and
pre-authorized payments.
Electronic funds transfer systems
 Point of sale (POS) transaction
…a sale that is consummated by payment for
goods or services received at the point of the
sale or a direct debit of the purchase amount
to the customer’s checking account.
 Automated clearing house (ACH) transaction
…an electronically processed payment using
a standard data format.

ACH payments are electronic payments of
funds and government securities among
financial institutions and businesses
Internet bill payment, telephone bill payment,
automatic deposits, and bank drafts
 Although these types of payments seem to be
electronic, paper checks are still often
written on the customer’s behalf and mailed
to the business.
 These types of payments will most likely
become completely electronic in the near
future.
Functional cost analysis
 The Federal Reserve System conducts a
survey called the Functional Cost Analysis
Program to collect cost and income data on
commercial bank operations.
 According to functional cost analysis data,
demand deposits are the least expensive
source of funds.
Functional cost analysis classifies checkprocessing activities as either deposits (electronic
and non-electronic), withdrawals (electronic and
non-electronic), transit checks deposited, transit
checks cashed, account opened or closed, on-us
checks cashed or general account maintenance
(truncated and non-truncated)
 Electronic transactions
…those that occur through automatic
deposits, Internet and telephone bill payment,
ATM’s and ACH transactions.
 Non-electronic
…those transactions conducted in person or
by mail.
Functional cost analysis check-processing
 Transit checks deposited are defined as checks






drawn on any bank other than the subject bank.
On-us checks cashed are checks drawn on the
bank’s customer's account.
Deposits represent checks or currency directly
deposited in the customer's account.
Account maintenance refers to general record
maintenance and preparing and mailing a periodic
statement.
A truncated account is a checking account in which
the physical check is ‘truncated’ at the bank; i.e.,
checks are not returned to the customer.
Official check issued would be for certified funds.
Net indirect costs are those cost not directly related
to the product such as salaries to manage the bank
or general overhead cost applicable to all products at
the bank.
Cost and Revenue Analysis of Selected Transactions Accounts:
Banks With Deposits of $50 Million to $200 Million
Demand Accounts
Monthly
Income /
Unit Cost Expenses
Income
Interest Income (estimated 7.5% earnings credit)
Non-Interest Income
Service Charges
Penalty Fees
Other
Total Non-Interest Income
Expenses
Activity Charges
Deposit - Electronic
Deposit - Non Electronic
Withdrawal - Electronic
Withdrawal - Non Electronic
Transit Check Deposited
Transit Check Cashed
Account Opened
Account Closed
On-Us Checks Cashed
Account Maintenance (Truncated) monthly
Account Maintenance (Non truncated) monthly
Official check issued
Total Activity Expense
Net Indirect Expense
Total Non-Interest Expense
Interest Expense
Total Expense
Net Income (expense) Before Earnings Credit
Net Revenue Per Month
$
$
$
$
$
$
$
$
$
$
$
$
0.0089
0.2219
0.1073
0.2188
0.1600
0.2562
9.46
5.67
0.2412
2.42
8.60
1.02
Savings Accounts
Monthly
Income /
Unit Cost Expenses
Time Deposits
Monthly
Income /
Unit Cost Expenses
$
29.47
$
34.04
$
121.84
$
$
$
$
2.80
4.32
0.63
7.75
$
$
$
$
0.44
0.28
0.16
0.88
$
$
$
$
0.11
0.27
0.05
0.42
$
$
$
$
$
$
$
$
$
$
$
0.02
0.66
0.43
3.63
1.71
0.50
0.20
0.07
0.42
1.67
7.03
$ 16.34
$
4.35
$ 20.69
1.25% $
5.38
$ 26.07
$
$
(18.32)
11.15
$
$
$
$
$
0.0502
0.7777
0.4284
0.7777
0.5686
$
$
$
$
$
0.01
0.46
0.07
0.39
1.09
$
$
$
$
0.1650
3.1425
0.5400
1.4933
$
$
$
$
0.1296
2.2016
0.2840
0.5875
$
$
33.63
20.18
$
$
0.53
0.26
$
$
5.78
3.38
$
$
1.73
1.02
$
4.10
$
3.56
$
1.99
$
1.99
$
6.37
$
1.81
$
8.18
2.96% $ 13.45
$ 21.63
$ (20.75)
$ 13.29
Average Account Balance
$5,515.00
$5,557.00
a
Average Annual Net Cost
4.66%
4.57%
Average Interest Cost
1.37%
2.96%
Average Non-interest Cost
5.27%
1.80%
Average Non-interest Income
1.97%
0.19%
a
Required reserves are assumed to be 10 percent for demand accounts and zero for others. Float is assumed to be 5
percent for demand accounts, 2 percent for savings accounts and zero for time accounts.
Source: Functional Cost and Profit Analysis, Based on data furnished by participating banks in
twelve Federal Reserve Districts, 1999 National Average Report,
$
$
$
5.18% $
$
$
$
7.94
18.38
26.32
69.79
96.11
(95.69)
26.16
$19,495.00
5.89%
4.30%
1.62%
0.03%
Small time deposits
 Small time deposits have denominations
under $100,000, specified maturities ranging
from seven days to any longer negotiated
term.
 Banks can control the flow of deposits by
offering only products with specific
maturities and minimum balances and
varying the relative rates paid according to
these terms.
Service charges
 For many years, banks priced check handling
services below cost.
 While competition may have forced this
procedure, it was acceptable because banks
paid below-market rates on most deposits.
 Because banks now pay market rates on
deposits, they want all customers to pay at
least what the services cost.
 For most customers, service charges and
fees for banking services have increased
substantially in the 1990s.
Individual transaction account pricing
Interest cost and net cost of transaction
accounts
 The average historical cost of funds is a
measure of average unit borrowing costs for
existing funds.


Average interest cost for the total portfolio is
calculated by dividing total interest expense
by the average dollar amount of liabilities
outstanding.
Average historical interest costs for a single
source of funds can be calculated as the ratio
of interest expense by source to the average
outstanding debt for that source during the
period.
Interest costs alone, however, dramatically
understate the effective cost of transaction accounts.
1.
First, transaction accounts are subject to legal
reserve requirements of up to 10 percent of the
outstanding balances, invested in non-earning
assets (federal reserve deposits or vault cash).


This effectively increases the cost of transactional
accounts because a reduced portion of the balances
can be invested.
Non transactional accounts have no reserve
requirements and hence are cheaper, ceteris paribus,
because 100 percent of the funds can be invested.
Second, transaction accounts are subject to
processing costs.
3. Third, certain fees are charged on some accounts to
offset noninterest expenses and this reduces the
cost of these funds to the bank.
2.
Calculating the net cost of transaction accounts
 Annual historical net cost of bank liabilities is
historical interest expense plus noninterest expense
(net of noninterest income) divided by the investable
amount of funds:
Net Cost of Bank Liabilitie s
Interest Expense  Noninterest Expense - Noninterest Income

Average Balance net of float x (1 - required reserve ratio)
 A regular check account that does not pay interest,
has $20.69 in transaction costs charges $7.75 in fees,
an average balance of $5,515, 5% float would have a
net cost of:
$0  $20.69 - $7.75
% net cost of regular checking 
x12  4.66%
$5,515 x. 0.95 x 0.90
Required reserves on transactions account are 10%.
Characteristics of large denomination
liabilities
 In addition to small denomination deposits,
banks purchase funds in the money markets.
 Money center and large regional banks effect
most transactions over the telephone, either
directly with trading partners or through brokers.
 Smaller banks generally deal directly with
customers and have limited access to national
and international markets.
 Because customers move their investments on
the basis of small rate differentials, these funds
are labeled ‘hot money’ or volatile liabilities.
Jumbo CDs
…large, negotiable certificates of $100,000 or more
are referred to as jumbo CDs.
 Jumbo CDs are:
 issued primarily by the largest banks.
 purchased by businesses and governmental
units.
 CDs have grown to be the one of the most
popular hot-money, large-source financing
used by banks.



have a minimum maturity of 7 days.
interest rates are quoted on a 360-day year.
Insured up to $100,000 per investor per
institution.
 Banks issue jumbo CDs directly or indirectly
through dealers and brokers (brokered
deposits).
Immediately available funds
 Two types of balances are immediately
available:
1.
2.
deposit liabilities held at Federal Reserve
Banks and
certain ‘collected’ liabilities of commercial
banks that may be transferred or withdrawn
during a business day on order of the
account holder.
Federal Funds purchased
 The term federal funds is often used to refer
to excess reserve balances traded between
banks.
 This is grossly inaccurate, given reserves
averaging as a method of computing
reserves, different nonbank players in the
market, and the motivation behind many
trades.
 Most transactions are overnight loans,
although maturities are negotiated and can
extend up to several weeks.
 Interest rates are negotiated between trading
partners and are quoted on a 360-day basis.
Security repurchase agreements
…(RPs or Repos) are short-term loans secured by
government securities that are settled in
immediately available funds
 Technically, the loans embody a sale of
securities with a simultaneous agreement to
buy them back later at a fixed price plus
accrued interest.
 In most cases, the market value of the
collateral is set above the loan amount when
the contract is negotiated.

This difference is labeled the margin.
Foreign Office Deposits
…most large U.S. commercial banks compete
aggressively in international markets
 They borrow from and extend credit to foreign-based
individuals, corporations, and governments.

In recent years international financial markets and
multinational businesses have become increasingly
sophisticated to the point where bank customers go
overseas for cheaper financing and feel unfettered by
national boundaries.
 Transactions in short-term international markets
often take place in the Eurocurrency market.
 Eurocurrency
…financial claim denominated in a currency other
than that of the country where the issuing institution
is located.
 The most important Eurocurrency is the Eurodollar
Eurodollar liabilities
…transactions in short-term international markets
take place in the Eurocurrency market.
 The term Eurocurrency refers to a financial
claim denominated in a currency other than
that of the country where the issuing
institution is located.
 Eurodollar, a dollar-denominated financial
claim at a bank outside the United States.
The origin and expansion of Eurodollar
deposits
Individual retirement accounts
…savings plans for wage earners and their spouses
 The primary attraction of IRAs is their tax
benefits.
 Each wage earner can invest up to $2,000 of
earned income annually in an IRA.

Prior to 1987, the principal contribution was taxdeductible, and any accumulated earnings in the
account were tax-deferred until withdrawn.
 The Tax Reform Act of 1986 removed the tax-
deductibility of contributions for individuals
already covered by qualified pension plans if
they earned enough income.
Federal Home Loan Bank Advances
 The FHLB system is a government-sponsored enterprise
created to assist in home buying.
 The FHLB system is one of the largest U.S. financial
institutions, rated AAA (Aaa) because of the government
sponsorship.
 Any bank can become a member of the FHLB system by buying
FHLB stock.
 If it has the available collateral, primarily real estate related
loans, it can borrow from the FHLB.



The Gramm-Leach-Bliley (GLB) Act of 1999 made is much
easier for smaller banks to borrow and these borrows could be
used for non-real estate related loans.
GLB allows Banks with less than $500 million in assets to use
long-term advances for loans to small businesses, small farms
and small agri-businesses.
The act also established a new permanent capital structure for
the Federal Home Loan Banks with two classes of stock
authorized, redeemable on 6-months and 5-years notice.
 FHLB borrowings, or advances, have maturities as short as 1
day or as long as 10 years.
Greater competition for funds and the
authorization of new uses for FHLB advances
has resulted in rapid growth in the number of
banks with FHLB borrowing and the dollar
amount of these borrowings.
250
4500
$ Billions of FHLB Advances Outstanding
Number of Commercial Banks with FHLB Advances
200
3750
3000
150
2250
100
1500
50
750
0
0
Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec- Dec91
92
93
94
95
96
97
98
99
00
01
Number of CB with FHLB Advances
$ Billions of FHLB Advances Outstanding
Commercial Banks With FHLB Advances
A recent trend has seen banks use
longer-term FHLB advances as a
more permanent source of funding.
 The interest cost compares favorably with the
cost of jumbo CDs and other purchases
liabilities.


The range of potential maturities allows banks
to better manage their interest rate risk.
The interesting issue is whether these
advances are truly a permanent source of
funds and thus comparable to core deposits,
or whether they are hot money.
Measuring the cost of funds
 Average historical cost
 Versus the marginal cost of funds
Average historical net cost
…many banks incorrectly use the average historical
costs in their pricing decisions
 They simply add historical interest expense
with noninterest expense (net of noninterest
income) and divide by the investable amount
of funds to determine the minimum return
required on earning assets.

Any profit is represented as a markup
 The primary problem with historical costs is
that they provide no information as to
whether future interest costs will rise or fall.
 Pricing decisions should be based on
marginal costs compared with marginal
revenues.
Marginal cost of bank funds
 Marginal cost of debt
…a measure of the borrowing cost paid to
acquire one additional unit of investable
funds
 Marginal cost of equity capital
…a measure of the minimum acceptable rate
of return required by shareholders.
 Together, the marginal costs of debt and
equity constitute the marginal cost of funds,
which can be viewed as independent sources
or as a pool of funds.
Costs of independent sources of funds
 Unfortunately, it is difficult to measure
marginal costs precisely.
 Management must include both the interest
and noninterest costs it expects to pay and
identify which portion of the acquired funds
can be invested in earning assets.
 Conceptually, marginal costs may be defined
as :
Marginal Cost
Interst Rate + Servicing costs + Acquisiti on costs + Insurance

1 - % of funds in nonearning assets
Example:
Marginal costs of a hypothetical NOW account
 Assume:





market interest rate = 2.5%
servicing costs = 4.1%
acquisition costs = 1.0% of balances
deposit insurance costs = 0.25% of balances
percentage in nonearning assets = 15.0%
(10% required reserves and 5% float.)
 The estimated marginal cost is 9.24%:
0.025  0.041 0.01  0.0025
marginal cost 
 0.0924
0.85
Cost of debt
… the cost of long-term nondeposit debt equals
the effective cost of borrowing from each source,
including interest expense and transactions costs.
 Traditional analysis suggests that this cost is
the discount rate, which equates the present
value of expected interest and principal
payments with the net proceeds to the bank
from the issue.
Example:
Cost of subordinated notes
 Assume the bank will issue:
 $10 million in par value subordinated notes
 paying $700,000 in annual interest and
 carrying a 7-year maturity.
 It must pay $100,000 in flotation costs to an
underwriter.
 The effective cost of borrowing (kd), where t
equals the time period for each cash flow, is
7.19%:
7
$700,000 $10,000,000
$9,900,000 

t
7
(1

k
)
(1

k
)
t 1
d
d
or
k d  7.19%
Cost of equity
… conceptually, the marginal cost of equity
equals the required return to shareholders
 It is not directly measurable because
dividend payments are not mandatory.
 Still, several methods are commonly used to
approximate this required return:
1.
2.
3.
Dividend valuation model
Capital asset pricing model (CAPM)
Targeted return on equity model
Dividend valuation model
…this model discounts the expected cash flows
from owning stock in determining a reasonable
return to shareholders.
 The cost of equity equals the discount rate (required
return) used to convert future cash flows to their
present value equivalent:
where

Dt = the dollar value of the
Dt
expected dividend in period t
P
t
ke = cost of equity, and
(1

k
)
t 1
e
t = time period

 If dividends are expected to grow at a constant rate:
D0 (1  g)
ke 
g
P
Do = the expected % dividend yield
g = the expected growth in
earnings, dividend payments, and
stock price appreciation.
Example:
Cost of Bank Stock
 A bank’s stock currently trades at:



$24 per share and
pays a $1 annual dividend.
analysts’ forecasts the bank’s annual
dividends will increase by an average 10
percent annually.
 The estimated equity cost is 14.58%:
$1.10
ke 
 0.10
$24
 14.58%
Capital asset pricing model (CAPM)
… this model relates market risk, measured by
Beta (), to shareholders’ required returns.
 Formally, the required return to shareholders (ke')
equals the riskless rate of return (rf) plus a risk
premium (r) on common stock reflecting
nondiversifiable market risk:
ke  rf  ρ
 The risk premium equals the product of a security’s
Beta and the difference between the expected return
on the market portfolio (km) and the expected
riskless rate of return (rf).
 Beta measures a stock’s historical price volatility
relative to the price volatility of the market portfolio
as:
Covariance [individua l security(i ) return, market return]
βi 
Variance(m arket return)
Estimate the required return to
shareholders for individual securities
 Banks can use historical  estimates
and a projection of the market premium
(km' - rf) to estimate the required return
to shareholders for individual
securities:
ke, i  rf  βi (k m - rf )
Example:
…CAPM estimate for the bank’s cost of equity
 Assume:


a bank’s  estimate equals 1.42
assume the differential between the market
return (km) and risk-free return (rf) is expected
to average 5 percent, with the Treasury bill
rate expected to equal 6 percent
 The CAPM estimate for the bank’s cost of
equity is:
ke = 0.06 + 1.42 (0.05) = 13.1%
 This cost of equity should be converted to a
pretax equivalent, 19.85,% assuming a 34%
marginal tax rate.
Targeted return on equity model
…investors require higher pretax returns on
common stock than on debt issues because of the
greater assumed credit risk.
 Many banks use a targeted return on equity
guideline based on the cost of debt plus a
premium to evaluate the cost of equity.
Targeted net income
Targeted ROE 
Stockholde rs Equity
 This return is then converted to a pretax
equivalent yield.
Targeted income before taxes
Pretax required return 
Stockholde rs Equity
 It assumes that the market value of bank
equity equals the book value of equity.
Cost of preferred stock:
 Preferred stock has characteristics of debt and
common equity.
 It represents ownership with investors’ claims
superior to those of common stockholders but
subordinated to those of debtholders.
 Like common stock, preferred stock pays dividends
that may be deferred when management determines
that earnings are too low.
 The marginal cost of preferred stock (kp) can be
approximated in the same manner as the return on
common equity; however, dividend growth is zero:
kp 
Dp
Pp
where
Dp = contractual dividend payment,
Pp = net price of preferred stock,
Trust preferred stock
…a hybrid form of equity capital at banks
 Trust preferred stock is recent innovation in capital
financing.
 Attractive because it effectively pays dividends that
are tax deductible.
 To issue the securities, a bank or bank holding
company establishes a trust company.



The trust company sells preferred stock to investors
and loans the proceeds of the issue to the bank.
Interest on the loan equals dividends paid on the
preferred stock.
This loan interest is tax deductible such that the bank
effectively gets to deduct dividend payments as the
preferred stock.
 The after tax cost of trust preferred stock would be:
ktp =
D tp (1  t)
Ptp
where
Dtp = contractual dividend payment on
trust preferred,
Ptp = net price of trust preferred stock,
Weighted marginal cost of total funds:
…the best cost measure for asset-pricing
purposes is a weighted marginal cost of funds
(WMC)
 This measure recognizes both explicit and
implicit costs associated with any single
source of funds.
 It assumes that all assets are financed from a
pool of funds and that specific sources of
funds are not tied directly to specific uses of
funds.
WMC is computed in three stages.
1.
2.
3.

First, management must forecast the desired dollar
amount of financing to be obtained from each
individual debt source and equity.
Second, management must estimate the marginal
cost of each independent source of funds.
Finally, management should combine the individual
estimates to project the weighted cost, which
equals the sum of the weighted component costs
across all sources.
Each source’s weight (wj) equals the expected
dollar amount of financing from that source divided
by the dollar amount of total liabilities and equity
and kj equals the single-source j component cost of
m
financing:
WMC   w jk j
j1
Forecast of the weighted marginal cost of
funds
…projected figures for community state bank
Liabilities and Equity
(g)
Weighted
(d)
Processing
(f)
Marginal
Component Cost of
(a)
(b)
(c)
and
(e)
Average Percent Interest Acquisition Nonearning Marginal
Funds
Costs
(b) x (f)
Amount of Total Cost
Costs
Percentage
Demand deposits
Interest checking
Money market demand accounts
Other savings accounts
Time deposits < $100,000
Time deposits > $100,000
Total deposits
Federal funds purchased
Other liabilities
Total liabilities
$
$
$
$
$
$
$
$
$
$
28,210
5,551
13,832
3,640
18,382
9,055
78,670
182
4,550
83,402
Stockholders' equity
Total liabilities and equity
$ 7,599
$ 91,001
31.0%
6.1%
15.2%
4.0%
20.2%
10.0%
86.5%
0.2%
5.0%
91.7%
2.5%
3.5%
4.5%
4.9%
5.0%
5.0%
8.4% 18.9%*
100.0%
8.0%
6.5%
3.0%
1.2%
1.4%
0.3%
18.0%
15.0%
3.0%
1.5%
1.0%
0.5%
9.76%
10.59%
6.70%
5.79%
6.36%
5.34%
0.0302
0.0065
0.0102
0.0023
0.0129
0.0053
0.0%
0.0%
0.0%
40.0%
5.00%
0.00%
0.0001
4.0%
19.69%
0.0164
Weighted marginal cost of capital ———————————————————————————->
8.39%
Revised forecast of the weighted cost of
funds
Liabilities and Equity
Weighted
Component Marginal
Average Percent Interest Marginal
Cost of
Costs
Amount of Total Cost
Funds
Demand deposits
Interest checking
Money market demand accounts
Other savings accounts
Time deposits < $100,000
Time deposits > $100,000
Total deposits
Federal funds purchased
Other liabilities
Total liabilities
$
$
$
$
$
$
$
$
$
$
25,890
6,461
12,831
3,640
19,383
10,465
78,670
182
4,550
83,402
Stockholders' equity
Total liabilities and equity
$ 7,599
$ 91,001
28.5%
7.1%
14.1%
4.0%
21.3%
11.5%
86.5%
0.2%
5.0%
91.7%
4.0%
4.8%
5.8%
6.3%
6.5%
6.5%
8.4% 18.9%*
100.0%
9.8%
12.4%
8.0%
7.1%
7.8%
6.8%
0.0278
0.0088
0.0113
0.0028
0.0166
0.0079
6.5%
0.0%
0.0001
0.0000
19.7%
0.0164
Weighted marginal cost of capital ————————————————————->
9.16%
Banks face two fundamental
problems in managing liabilities:
1. Uncertainty over what rates they must pay
to retain and attract funds and
2. Uncertainty over the likelihood that
customers will withdraw their money
regardless of rates.
Funding sources and interest rate risk:
 During the 1980’s, most banks experienced
a shift in composition of liabilities away
from demand deposits into interest-bearing
time deposits and other borrowed funds.
 This shift reflects three phenomena
1.
2.
3.
the removal of Regulation Q interest rate
ceilings,
a volatile interest rate environment and
the development of new deposit and money
market products.
 The cumulative effect was to increase the
interest sensitivity of funding operations.
Reducing interest rate risk
… one widely recognized strategy to reduce
interest rate risk and the long-term cost of bank
funds is to aggressively compete for retail core
deposits.
 Individuals are generally not as rate sensitive
as corporate depositors.
 Once a bank attracts deposit business, many
individuals will maintain their balances
through rate cycles as long as the bank
provides good service and pays attention to
them.
 Such deposits are thus more stable than
money market liabilities.
Funding sources and liquidity risk
 The liquidity risk associated with all liabilities
has risen in recent years.
 Depositors often simply compare rates and
move their funds between investment
vehicles to earn the highest yields.
 The liquidity risk facing any one bank
depends on the competitive environment.
 Again, it is important to note the liquidity
advantage that stable core deposits provide
an acquiring bank.
Funding sources and credit risk
 Changes in the composition and cost of bank
funds can indirectly affect a bank’s credit risk
by forcing it to reduce asset quality.

Example, banks that have substituted
purchased funds for lost demand deposits
have seen their cost of funds rise.
 Rather than let their interest margins
deteriorate, many banks make riskier loans at
higher promised yields.

While they might maintain their margins in the
near-term, later loan losses typically rise with
the decline in asset quality.
Funding sources and bank safety
 Changes in the composition and cost of bank
funds have clearly lowered traditional
earnings.

This decrease slows capital growth and
increases leverage ratios.
 Borrowing costs will ultimately increase
unless noninterest income offsets this
decline or banks obtain new external capital.

Bank safety has thus declined in the
aggregate.
Risk characteristics
…when a bank is perceived to have asset quality
problems, uninsured customers move their
deposits.
Bank’s with asset quality problems must pay
substantial premiums to attract funds or rely on
regulatory agencies to extend emergency credit.
 Liquidity risk associated with a bank’s deposit base
is a function of many factors, including:
1. the number of depositors,
2. average size of accounts,
3. location of the depositor, and
4. specific maturity and rate characteristics of each
account.
 Equally important is the interest elasticity of
customer demand for each funding source.

Borrowing from the Federal Reserve.
 Federal Reserve Banks are authorized to
make loans to depository institutions to help
them meet reserve requirements.
 DIDMCA opened borrowing to any depository
institution that offers transactions accounts
subject to reserve requirements.
 The borrowing facility is called the discount
window.

Discount window loans directly increase a
member bank’s reserve assets.
Federal Reserve policies distinguish
among three types of loans.
1. Short-term adjustment loans
…made to banks experiencing unexpected deposit
outflow or overdrafts caused by computer problems
2. Seasonal borrowing privilege
…small banks are permitted to borrow if they can
demonstrate that they experience systematic and
predictable deposit withdrawals or new loan
demand
3. Extended credit
…loans granted to banks experiencing more
permanent deposit outflows, typically associated
with a run on the bank
Federal Deposit Insurance

The Banking Act of 1933 established the FDIC and
authorized federal insurance for bank deposits up
to $2,500, today the amount has been set at
$100,000.
 The Financial Institution Reform, Recovery, and
Enforcement Act of 1989 (FIRREA) authorized the
issuance of bonds to finance the bailout of the
FSLIC and resources to close problem thrifts.
 The Act also created two new insurance funds:
1.
Savings Association Insurance Fund (SAIF)
2.
Bank Insurance Fund (BIF).
 It further created the Resolution Trust
Corporation to handle failed thrifts.
Federal Deposit Insurance (continued)
 The Federal Deposit Insurance Corp.
Improvement Act (FDICIA) authorized:
 Risk-based deposit insurance premiums
ranging from $0.0 to $0.27 per $100,
depending on a bank’s capital position.
 At the end 2001, the FDIC insurance fund
exceeded the minimum 1.25% of insured
deposits, which meant that “well capitalized”
banks paid no insurance premium.
 At the end of 2001, over 92% of all banks were
considered well capitalized.
 Most expect that the economic problems of
the early 2000’s will mean that bank’s are
again assessed insurance premiums.
When an insured bank fails, the FDIC
has five basic options…
1. Purchase and Assumption
Bid’s are accepted by healthy banks for the
failed bank’s good loans and other assets
Open bank assistance
 An acquiring bank is provided financial
assistance by the FDIC in acquiring a failing
bank
Insured deposit assumption or transfer
 Insured deposits are transferred to a health
bank
Bridge Bank
 The FDIC will operate the bank for a short
period of time until it can find the appropriate
buyer
Payout option
 The FDIC immediately (one week) pays
depositors the full amount of their insured
funds

2.
3.
4.
5.
Bank Management, 5th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2003 by South-Western, a division of Thomson Learning
MANAGING
LIABILITIES AND
THE COST OF FUNDS
Chapter 12