Chapter 4:
Managing
Noninterest
Income and
Noninterest
Expense
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1
Issues in Interest Income and Interest
Expense
• Sharp increase in net interest margins (NIM) from
1945 to 1992 with a reversal of the trend since
then.
• NIMs increased sharply again from the beginning of
the financial crisis in 2008 until 2010 due primarily
to the Federal Reserve’s extraordinarily low interest
rate policy.
• Competition again heated up and the temporary
increase in NIM fell again.
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2
Issues in Interest Income and Interest
Expense
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3
Issues in Interest Income and Interest
Expense
• NIM have been decreasing since 1992 due to a
reversal of factors that led to the sharp increase.
• Where there are profits, competition follows.
• Popularity of mutual funds and stocks led to funds being
moved out of FDIC-insured deposits.
• Deregulation and innovation put pressure on loan rates
and deposit costs.
• Refinancing of loans at lower rates reduced yields.
• Increased number of competitors, financial sector
combinations and regulatory changes.
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4
Issues in Interest Income and Interest
Expense
• Larger institutions have de-emphasized lending in
favor of fees from loan securitization and offering a
variety of fee-based products and services.
• Smaller banks have continued to be much more
dependent on lending and their NIM.
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5
Issues in Interest Income and Interest
Expense
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6
Noninterest Income
• Sources of Noninterest Income
• Deposit service charges
• Fiduciary activities
• Trading, venture capital and securitization income
• Investment banking, advisory, brokerage and
underwriting fees and commissions
• Insurance commissions
• Net servicing fees
• Net gains/losses on loan sales
• Other net gains/losses and other noninterest income
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7
Noninterest Income
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8
Noninterest Income
• Biggest contributors are deposit service charges and
other noninterest income.
• Stable sources of revenue but difficult to increase over
time due to visibility and unpopularity with customers.
• Larger banks rely more on noninterest income than
their smaller counterparts.
• Large institutions have greater amounts and wider variety
of sources of noninterest income.
• Nondeposit fees and trading revenue are highly cyclical
because they depend on capital market activity.
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9
Noninterest Income
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10
Deposit Service Fees
• Deregulation encouraged “unbundling” of products
and charging for individual services rather than
offering them for free.
• Intense competition through the mid-2000’s led to
bundling, “free checking” and no-fee debit and
credit cards.
• Regulatory burden from Dodd-Frank Act has
reversed this trend and banks are again beginning
to charge for non-interest bearing checking
accounts.
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11
Deposit Service Fees
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12
Deposit Service Fees
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13
Deposit Service Fees
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14
Deposit Service Fees
• Critical decision is to determine the appropriate feebased business mix.
• Many institutions offer mortgage banking services.
• When rates are low firms earn substantial origination fees
from new loans and mortgage refinancing.
• When rates are high, origination fees decrease but
serving revenues increase.
• Many large banks prefer the huge potential fee
income from nonmortgage businesses which can
also be volatile due to economic changes.
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15
Noninterest Expense
• Five components:
• Personnel expense
• Occupancy expense
• Goodwill impairment
• Other intangible amortization
• Other operating expense
• The sum of these five components is called
overhead.
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16
Key Ratios
• Burden (Net Overhead Expense)
• Burden = Noninterest Expense – Noninterest Income
• Net noninterest margin = Burden/Average Total Assets
• The smaller these measures, the better the bank has performed.
• Efficiency ratio = Noninterest Expense/(Net Interest
Income + Noninterest Income)
• Larger banks tend to have lower (better) efficiency ratios because
they generate more noninterest income.
• Low efficiency ratios do not always lead to higher ROEs.
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17
Key Ratios
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18
Key Ratios
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19
Key Ratios
• Operating Risk Ratio = (Noninterest Expense Noninterest Income)/Net Interest Margin
• Lower is better because proportionally more income
comes from fees.
• Productivity Ratios:
• Asset per employee = Average Assets/Number of Fulltime Employees
• Average personnel expense = Personnel Expense/Number
of Full-time Employees
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20
Key Ratios
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21
Key Ratios
• For community banks, two related ratios provide
useful information about productivity.
• Dollar amount of loans per employee = Average Loans /
Number of Full-Time Employees
• Net income per employee = Net Income / Number of Fulltime Employees
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22
Key Ratios
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23
Which Lines of Business and Customers
are Profitable?
• Line-of-Business Profitability Analysis
• Risk-Adjusted Return on Capital (RAROC): Risk-adjusted
income / Capital
• Return on Risk Adjusted Capital (RORAC): Income /
Allocated-risk Capital
• Concept is to identify some measure of return
generated by a line of business and compare that
return with the allocated capital.
• Either the income may be adjusted for risk or the capital
measure may be adjusted for risk.
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24
Which Lines of Business and Customers
are Profitable?
• Customer Profitability Analysis
• Used to evaluate whether net revenue from an account
meets a bank’s profit objective.
• General rule is that 20% of a firm’s customers contribute
about 80% of profits.
• Objective is to identify the 20% (high value customers) and
determine their needs in order to protect and promote revenue.
• Next level (value and average customers) represent the second
biggest strategic opportunity for the firm.
• With low-value and high-maintenance customers the goal is to
increase profitability to encourage them to find services
elsewhere.
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25
Customer Profitability Analysis
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26
Customer Profitability Analysis
• Appropriate comparison is:
• If revenues exceeds expenses + target profit, account
generates a return in excess of minimum required return.
• If revenues equals expenses + target profit, account just
meets the minimum required return.
• If revenues exceed expenses but are less than expenses +
target profits, account is profitable but does not meet the
minimum required rate of return.
• If revenues are less than expenses, account is
unprofitable.
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27
Customer Profitability Analysis
• Expense Components:
• Noncredit services expense are obtained by multiplying
cost x activity.
• Credit services costs include interest cost of financing
loans and loan administration expenses.
• Business expense risk represents actual cash expenses
and noncash expenses and provisions for losses.
• Transaction risk is the risk inherent from fraud, theft, error,
computing system integrity, internal controls and delays in
processing, clearing and settling payment transactions.
• Default is the greatest risk with respect to credit services.
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28
Customer Profitability Analysis
• Revenue Components
• Investment Income from Deposit Balances
• Noninterest (Fee) Income
• Loan Interest
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29
Aggregate Profitability Results From
Customer Profitability Analysis
• Profitable customers maintain multiple
relationships with the bank such as substantial
loans and investment business.
• Unprofitable customers tend to “shop” for the
lowest price or do not use multiple products.
• Should encourage banks to offer product bundles based
on the size of the bank’s relationships.
• Banks who want to increase revenues should
identify perceived value of services by customers
and price them accordingly.
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30
What Is The Appropriate Business Mix?
• Some fee income comes from relatively stable
services and lines of business, while other fees are
highly volatile.
• Deposit service charges should be balanced with
fess from other lines of business or products with
higher growth potential.
• Potential fees is the motivation behind banks’
acquiring or merging with insurance companies.
• Community banks do not have the same opportunities to
enter investment banking and specialty intermediation.
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31
What Is The Appropriate Business Mix?
• Community banks do not have the same
opportunities to enter investment banking and
specialty intermediation.
• Many work with bankers’ banks in the same area to offer
services they could not offer independently.
• Many depository institutions offer mortgage
products.
• Many commercial banks are offering new services
such as remote deposit service and mobile banking.
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32
What Is The Appropriate Business Mix?
• Some managers view volatile fees as permanent
sources of income although they are not.
• Demonstrated by reduction in mortgage activity when
interest rates increased and the stock market crash.
• Some banks view fee business on a transaction
basis.
• They originate loans to distribute or sell which leads to
reduced interest rates and even reduced loan standards.
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33
What Is The Appropriate Business Mix?
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34
Strategies for Managing Noninterest
Expense
• Depository institutions are high-cost producers
relative to money market funds and commercial
paper and bond markets.
• Noninterest expense is too high and earnings are too low.
• Are there too many banks, credit unions and other
financial institutions in the U.S.?
• If banks combined operations, expense would decrease.
• This has motivated much of the bank merger activity.
• Manage costs in line with strategic objectives.
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35
Cost Management Strategies
• Expense Reduction
• Employee reduction, temporary workers and outsourcing
• Operating Efficiencies
• Reduce costs while maintaining the existing level of
products and services
• Increase output but maintain current expenses
• Improve workflow
• Economies of scale exist when average costs
decrease as output increases.
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36
Revenue Enhancement
• Involves changing the pricing of specific products
and services but maintaining a sufficiently high
volume of business so that total revenue increases.
• Closely linked to the concept of price elasticity.
• Identify products with price-inelastic demand.
• Price increase lowers demand but the decrease in
demand is less than the increase in price.
• Contribution growth allocates resources to best
improve overall long-term profitability.
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37
Chapter 5:
The
Performance of
Nontraditional
Banking
Companies
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whole or in part, except for use as permitted in a license distributed with a certain product
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38
The Performance of Nontraditional
Banking Companies
• Goldman Sachs:
• The world’s premier investment bank for many years.
• Converted to financial holding company in 2008 in
response to the global credit crisis.
• Mutual of Omaha Bank
• Subsidiary of Mutual of Omaha and run as in independent
company.
• BMW Bank of North America
• Industrial loan corporation (ILC) owned by BMW Financial
Services, a division of BMW North America.
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39
The Disappearance of Large Investments
Banks
• Financial Services Modernization Act (1999):
• Allowed commercial and investment banks to merge.
• Encouraged consolidation and new business expansion.
• Investment Banking Activities:
• Securities underwriting
• Advisory services
• Market making
• Propriety trading and investing
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40
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41
Securities Underwriting and Advisory
Services
• Securities Underwriting:
• Investment banks assist with stocks and bonds issues.
• First-time placement called an Initial Public Offering (IPO).
• Advisory Services:
• Numerous fee-based services that assist managing risks.
• Providing advice concerning mergers and acquisitions and spinoffs of lines of business.
• Managing investable assets, pension funds and investments.
• Making risk management decisions involving the uses of foreign
currencies, commodities, and derivatives.
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42
Market Making
• Investment bank may be willing to buy securities
from participants who want to sell and sell to
participants who want to buy.
• Profit from the bid-ask spread.
• Additional profit from the difference between the yield
on the securities owned and the interest paid on debt.
• Bank acts as a broker and does not take ownership of the
underlying security.
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43
Proprietary Trading and Principal
Investing
• Proprietary trading occurs when an investment
bank commits its own funds to take a risk position
in a security, commodity or asset.
• Hopes to profit later by reversing the trade.
• Principal investing occurs when the bank takes a
position in a security, derivative or stock with the
expectation to hold the position for some time,
perhaps even years, before trading out of it.
• In this context, investment banks have operated as hedge
funds or private equity funds.
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44
Proprietary Trading and Principal
Investing
• Hedge Fund:
• An investment fund that is limited to a small number of
sophisticated investors.
• The fund’s managers take positions that are of any type
and not subject to regulation.
• Managers generally charge a 2 percent fee applied to the
amount of assets under management plus a 20 percent
performance fee equal to 20 percent of the profit
generated during a year.
• This 2 + 20 fee structure generates an extraordinary profit for the
managers with limited downside risk.
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45
Proprietary Trading and Principal
Investing
• Private Equity Fund:
• Accept investments from institutional investors in the
form of limited partnership investments.
• The funds use the proceeds to buy companies and make
other investments, but usually have a longer investment
horizon than hedge funds when entering transactions.
• Fund managers earn a management fee plus a percentage
(usually 20 percent) of profits in excess of some minimum
rate of return.
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46
Goldman Sachs Group and Goldman Sacs
Bank USA
• Goldman Group was a $939 billion organization at
the end of 2012.
• Separates operations into four segments:
• Investment banking
• Institutional client services
• Investing and lending
• Investment management
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47
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48
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49
Goldman Group and Goldman Bank
Balance Sheets
• Financial instruments owned include cash and
derivative securities.
• Collateralized agreements:
• Borrowed securities and other financial instruments
purchased under an agreement to resell at a later date.
• Profit from earning interest on these securities net of interest
paid on their financing.
• Collateralized financings consist of securities loaned and
instruments sold under agreements to repurchase.
• These figures should be netted as they reflect transactions
designed to generate interest income net of financing costs.
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50
Goldman Group and Goldman Bank
Balance Sheets
• Receivables:
• Amounts owed to Goldman by brokers, firm customers,
and counterparties to derivative and other contracts.
• These amounts might be matched with the payables to
the same groups listed under liabilities.
• Unsecured borrowings:
• Represent “hot money” that can not be relied on to be
rolled over in a crisis situation.
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51
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52
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53
Key Performance Ratios
• Generating returns comparable to Goldman has
been difficult for most banks.
• Earnings were generally higher than almost all other large
financial institutions.
• Events in 2008 demonstrated that Goldman’s
business model was not sustainable.
• Severe liquidity crisis in 2008 due to housing market
collapse and declines in the values of assets owned.
• Stock price fell from $240 to under $70.
• Goldman reported its first quarterly loss in since it began
trading as a public company.
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54
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55
Risks Faced by Goldman Sachs
• Credit crisis of 2007–2009 caused money and
capital markets to stop functioning normally.
• Commercial paper market froze and large institutions
were hesitant to lend to each other.
• Goldman faced a potential run on the firm as lenders
were hesitant to roll over debts and Goldman was unable
to sell a sufficient volume of assets to readily access cash.
• Management decided to covert to a financial holding company
which allowed access to more stable core deposits for its funding.
• On the negative side, Goldman agreed to be regulated by the
Federal Reserve as a bank.
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56
Goldman Group’s Risk Profile
• Risks listed in Goldman’s 2007 annual report:
• Increasing and/or high rates and widening credit spreads.
• Market fluctuations that may adversely affect the value of
large trading and investment positions.
• Declines in the number and size of securities underwritings and mergers and acquisitions that may lower
revenues.
• Declines in equity values that may lower asset
management fees.
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57
Goldman Group’s Risk Profile
• Risks listed in Goldman’s 2007 annual report:
• Possible decline in the volume of transactions executed
by the firm as a specialist or market maker.
• An increase in market volatility that may cause the firm to
reduce its proprietary trading.
• Each of these risk factors appeared to be to the
detriment of Goldman Group in 2008.
• Goldman holds many different types of securities, some
of which are difficult to value. Under FASB 157, they are
required to classify assets as Level 1, Level 2, or Level 3.
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58
Accounting for Fair Market Value of
Securities Under FASB 157
• Level 1 Assets:
• Valuations based on observable market prices for the
identical asset or liability (marking to market).
• Publicly traded stock, government and agency bonds,
listed options and futures and mutual funds.
• Level 2 Assets:
• Valuations based on observable market data for similar
assets or liabilities (marking to matrix) with price quotes
typically obtained from dealer pricing services.
• Bonds that trade infrequently, mortgage-backed securities
and other asset-backed securities not publicly traded.
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59
Accounting for Fair Market Value of
Securities Under FASB 157
• Level 3 Assets:
• Valuations based on management’s best judgment of
what the underlying asset is worth (marketing to myth).
• Management may use any pricing model and make its
own assumptions regarding the parameters.
• Price quotes are the least reliable of all valuation
techniques.
• Some assets may be substantially overpriced or
underpriced depending on the model analytics.
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60
Goldman Group’s Risk Profile
• Subject to higher capital requirements as a financial
holding company.
• Reduced balance sheet and the amount of level 3 assets
and increased capital.
• Bank regulators have required Goldman Group to lower
its financial leverage.
• Dodd-Frank Volker Rule (2014) is expected to have
a significant impact on the company.
• Prohibits proprietary trading using FDIC funds and limits
hedge fund and private equity fund investing.
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61
The Financial Performance of Mutual of
Omaha Bank
• Mutual of Omaha (MO) is an insurance company
offering a wide range of insurance products along
with annuities and mutual funds.
• In 2007, opened Mutual of Omaha Bank (MO Bank) with
13 locations in Nebraska and Colorado through the
acquisition and merger of three existing banks
• MO Bank’s strategic objective is to “acquire community
banks in fast-growing cities with a high density of Mutual
of Omaha insurance customers.”
• Has a thrift charter granted by the Office of Thrift
Supervision.
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62
The Financial Performance of Mutual of
Omaha Bank
• In 2007, MO Bank had over $7 million in assets and
grew to $5.9 billion by the end of 2012.
• During 2008 acquired two failed banks and opened
new lending operations.
• Bank continues to acquire other locations in fastgrowing states.
• Second phase of MO Bank’s strategy is the creation
of a virtual online bank where customers can
transact business online from anywhere in the U.S.
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63
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64
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65
Mutual of Omaha Bank’s Risk Profile
• MO Bank faces the same types of risk that other
commercial banks face.
• Primary exposure is to credit risk.
• During 2012 charged off .53 percent of loans which is in
line with other banks of similar size.
• MO Bank benefits from the strong capital based and
low-risk profile of its parent.
• The principal benefit from operating as part of MO is the
diversification and access to capital.
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66
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67
The Financial Performance of BMW Financial
Services and BMW Bank of North America
• Many firms in financial services and the auto
industry own Industrial Loan Companies (ILCs).
• Originated in the early 1900s to make loans to borrowers
who could not get loans at commercial banks.
• Over time, ILCs were granted the right to issue deposits
insured by the FDIC.
• FDIC put a moratorium on extending FDIC insurance to
ILC’s in 2006, so no new ones have been chartered since.
• Historically, most ILCs operated to assist their parent
organization in some facet of the firm’s core business.
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68
The Financial Performance of BMW Financial
Services and BMW Bank of North America
• ILCs gained notoriety when Wal-Mart applied for an
ILC charter in 2005 and Home Depot followed.
• Community banks argued against granting Wal-Mart a
charter because they were concerned that traditional
banking services would be offered in all stores and
potentially drive them out of business.
• Criticisms against the charter included:
• There should be a separation between commerce and banking to
protect customers from potential conflicts of interest.
• Firms like Wal-Mart could dominant business in communities.
• ILCs are not subject to the same regulations as commercial banks
which may create safety and soundness problems.
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69
The Financial Performance of BMW Financial
Services and BMW Bank of North America
• BMW Bank of North America is an ILC owned by
BMW Financial Services.
• BMW Financial Services offers loans, leases, and credit
cards via BMW Bank and insurance services in
conjunction with Liberty Mutual Insurance Company.
• Operates from a single office in Utah, collects deposits
and uses borrowed funds to underwrite loans and leases
for the purchase of automobiles at BMW dealers.
• Due to its affluent customer base, operates somewhat like
a private bank within a large commercial banking
organization.
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70
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71
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72
BMW Bank’s Risk Profile
• Reported higher ROE and ROA than peer averages due
to much lower noninterest expenses to average assets.
• Invested proportionately more in loans and investment
securities than peers.
• Earns a higher yield on loans and securities but pays
much higher rates on its interest-bearing liabilities.
• Gets very little funding from demand deposits, raising
its overall cost of funds.
• Efficiency ratio is significantly lower than peers.
• Lower loan charge-offs and provisions for loan losses
than traditional commercial banks.
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73
Chapter 6:
Pricing FixedIncome
Securities
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74
Future Value and Present Value:
Single Payment
• Cash today is worth more than cash in the future.
• A security purchased for $1,000 for one year
promises to pay $1,080 exactly one year later.
• $1,000 is the present value (PV), $1,080 represents the
future value after one year (FV1) and $80 is interest (i).
I = $80/$1,000 = 0.08 or $1,000(1+ i) = $1,080
• With a single payment after one year that includes
interest and the initial investment:
PV(1 + i) = FV1
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75
Future Value and Present Value:
Single Payment
• Assume the second year 8% is paid on the entire
$1,080 interest.
• Effectively earning interest on the initial $1,000 plus
the first year interest of $80:
$1,080(1 + 0.08) = $1,166.40 = FV2 or
$1,000(1 + 0.08)(1+0.08) = $1,166.40 = FV2 or
PV(1 + i)2 = FV2
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76
Future Value and Present Value:
Single Payment
• If the FV and PV are known, the fixed annual
interest rate can be calculated as:
i = [FV2/PV]1/2 – 1
• Using the numbers from the previous example:
i = [$1,166.40/$1,000]1/2 – 1 = 0.08
• When an amount is invested for several periods
with compound interest:
PV(1 + i)n = FVn
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77
Future Value and Present Value:
Single Payment
• If everything is known except the interest rate:
i = [FVn/PV]1/n – 1
• The FV of $1,000 invested for 6 years at 8% interest
per year with annual compounding:
FV6 = $1,000(1.08)6 = $1,586.87
• If $1,000 is invested today for 6 years and the FV is
$1,700:
i = [$1,700/$1,000]1/6 – 1 = 0.0925
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78
Future Value and Present Value:
Single Payment
• Investors and borrowers may want to determine the
PV of some future cash payments or receipts. The
FV is discounted back to a PV equivalent:
PV = FVn/(1 + i)n
• Given the choice of $30,000 now or $37,500 in two
years with an opportunity cost of money of 8%, it is
better to take the $37,500 in two years:
PV = $37,500/(1.08)2 = $32,150
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79
Future Value and Present Value:
Multiple Payments
• FV or PV of each cash flow is computed separately
with the cumulative value determined as the sum of
the computation for each cash flow.
• Suppose $1,000 earning 8% is deposited at the
beginning of each of the next two years:
FV of deposit in first year = $1,000(1.08)2 = $1,166.40
FV of deposit in second year = $1,000(1.08) = $1,080.00
Cumulative future value = $2,246.40
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80
Future Value and Present Value:
Multiple Payments
• PV is often applied to a series of future cash flows.
or
• A security pays $90 a year at the end of each of the
next three years plus $1,000 at the end of year 3:
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81
Simple versus Compound Interest
• Simple Interest: Interest is paid only on the initial
principal invested – no interest on interest.
• Simple interest = PV – (i) – n
• If N = 1 year and I = 6%:
$1,000(0.06)1 = $60
• Compound Interest: Interest is paid on outstanding
principal plus any interest that has been earned but
not paid out – interest on interest.
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82
Compounding Frequency
• Interest may be compounded different intervals.
• Same formulas with an adjustment that converts
the annual interest rate to a periodic rate coinciding
with the compounding interval.
• Number of periods equal n times the number of
compounding periods in a year (m):
PV(1 + i/m)nm = FVn or PV = FVn /(1 + i/m)nm
• Future value is greatest when compounding period
is the highest and present value is lowest when
compounding frequency is highest.
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83
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84
The Relationship Between Interest Rates
and Option-Free Bond Prices
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85
Bonds with and without Options
• Bond are fixed-income securities with longer-term
maturities.
• Some carry options and some are option-free and
priced differently.
• Five common bond issues. A single bond may have
one or more embedded in its structure:
• Call option: Bond issuer can buy it (redeem) from bondholder for cash at a predetermined price at a set time.
• Put option: Bondholder can demand issuer redeem bond
for a predetermined cash price at a set time in the future.
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86
Bonds with and without Options
• Bond options (cont’d):
• Conversion option: Bondholder can demand issuer
convert bond into issuer’s common stock at a determined
price and time in the future. No cash changes hands.
• Extension option: Bondholder can extend bond maturity
by a set number of periods.
• Exchange: Bondholder can demand issuer convert bond
into common stock of a different company at a
predetermined price at a set time in the future.
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87
Bond Prices and Interest Rates Vary
Inversely
• Option-free fixed-rate coupon bond features:
• Par or face value representing the return of principal at
maturity, a final maturity in years, a fixed coupon
payment over the life of the bond, market price (PV) and
interest rate (i).
• Most fixed-coupon bonds are initially sold in the
primary market at prices close to the par value.
• Fixed coupon rate (coupon payment/face value)
determines the amount of coupon interest that is paid
periodically.
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88
Bond Prices and Interest Rates Vary
Inversely
• After issue, bonds trade in the secondary market
based on current market conditions.
• Current market prices reflect the coupon rate vs. the
coupon interest paid (based on market rate) on newly
issued bonds with similar features.
• Market rates and prices on fixed-income securities
vary coincidentally and are inversely related.
• Prices decline when interest rates rise and prices fall
when interest rates decline.
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89
Bond Prices and Interest Rates Vary
Inversely
• Bond with $10,000 face value and fixed interest
payments of $470 that matures in three years:
• Semiannual coupon rate is 4.7% ($470/$10,000) or
9.4% per annum.
• If the market rate of interest equals 4.7%
semiannually, the bond sells for face value:
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90
Bond Prices and Interest Rates Vary
Inversely
• If the market rate of interest rises to 5% semiannually, the price falls and bond sells at a discount:
• If the market rate of interest falls to 4.4% semiannually, the price rises and bond sells at a
premium:
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91
Bond Prices and Interest Rates Vary
Inversely
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92
Bond Prices Change Asymmetrically
to Rising and Falling Rates
• For a given absolute change in interest rates, the
percentage increase in an option-free bond’s price
will exceed the percentage decrease.
• For the same change in interest rates, bondholders will
receive a greater capital gain when rates fall than the
capital loss when rates rise for all option-free bonds.
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93
Bond Prices Change Asymmetrically
to Rising and Falling Rates
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94
Maturity Influences Bond Price
Sensitivity
• Short-term and long-term bonds exhibit different
price volatility.
• For bonds that pay the same coupon rate, long-term
bonds change proportionally more in price than do shortterm bonds for a given rate change.
• Longer term bondholders receive the periodic interest
payments longer than shorter term bondholders. This
longer term has a greater impact on price changes in
bonds due to interest rate changes.
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95
Maturity Influences Bond Price
Sensitivity
$
For a given coupon rate, long-term bonds
change proportionately more in price than
do short-term bonds for a given rate
change.
10,275.13
10,155.24
10,000.00
9,847.73
9,734.10
9.4%, 3-year bond
9.4%, 6-year bond
8.8
9.4
10.0
Interest Rate %
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96
The Size of the Coupon Influences
Bond Price Sensitivity
• High-coupon and low-coupon bonds exhibit
different price volatility.
• Given two bonds that are priced to yield the same yield to
maturity, the bond with the lower coupon will change in
price more than the bond with the higher coupon for a
given change in interest rate.
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97
The Size of the Coupon Influences
Bond Price Sensitivity
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98
Duration as an Elasticity Measure
• Duration is a measure of effective maturity that
incorporates timing and size of security cash flows.
• How price sensitive a security is to interest rate changes.
• The greater (shorter) the duration, the greater
(lesser) the price sensitivity.
• A security's duration can be interpreted as an
elasticity measure which provides information
about the change in market value as a result of
interest rate changes.
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99
Duration as an Elasticity Measure
• Letting P equal price, and I equal the prevailing
market interest rate, duration (DUR) can be
approximated as:
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100
Measuring Duration
• Duration is a weighted average of the time until the
expected cash flows from a security will be
received, relative to the security’s price.
• Macaulay’s Duration:
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101
Measuring Duration
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102
Duration of a Zero Coupon Bond
• No interim cash flows with a zero coupon security.
• The only payment for a three year $10,000 bond is
the face value at maturity. It’s estimated duration
(D) is:
• Macaulay’s duration of a zero coupon bond is equal
to its maturity.
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103
Comparative Price Sensitivity
• The greater the duration, the greater the price
sensitivity:
• Modified duration provides an estimate of price
volatility:
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104
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105
Recent Innovations in the Valuation of
Fixed-Income Securities
• Traditional valuation methods are too simplistic:
• Investors often do not hold securities until maturity.
• Present value calculations assume all coupon payments
are reinvested at the calculated yield to maturity.
• Many securities carry embedded options which
complicates valuation since it is unknown if options will
be exercised and impact cash flows actually received.
• Fixed-income securities should be priced as a
package of cash flows with each cash flow
discounted at the appropriate zero coupon rate.
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106
Total Return Analysis
• Allows investors to vary assumptions about holding
period, reinvestment rate and sale or maturity
value.
• Three sources of return from owning a bond:
• Coupon interest, reinvestment interest (interest-oninterest), and capital gain or loss at maturity or sale.
• Future value of coupon interest plus interest-oninterest with a constant reinvestment rate:
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107
Total Return Analysis
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108
Valuing Bonds as a Package of Cash Flows
• Consider a three year maturity, 9.4% coupon bond
with six remaining coupon payments of $470 and
one principal payment of $10,000 at maturity.
• Bond should be viewed as a package of seven
separate cash flows.
• Bond will be priced as a package of zero coupon
instruments which a different discount rate applied to
each payment.
• The first coupon will be discounted at the six-month rate,
the second at the one-year rate and so on.
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109
Valuing Bonds as a Package of Cash Flows
• Assuming the following zero-coupon rates:
• The value of the package of cash flows:
• Riskless profit if bond is sold for $10,000.
• Bond valuation is more complex than traditional analysis.
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110
Money Market Yields
• Practical applications are complicated by the fact
that interest rates on different securities are
measured and quoted in different terms.
• Particularly true of yield on money market instruments
with initial maturities under one year as some are
discounted and others bear interest.
• Some yields are based on a 360-day year and others
assume a 365-day year.
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111
Interest-Bearing Loans with Maturities of
One Year or Less
• The effective annual yield for a loan less than one
year is:
i 

i *  1 

365/h


(365/h)
1
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112
360-Day versus 365-Day Yields
• A security’s effective annual yield reflects the true
yield to an investor who holds the investment for a
full year (365 days).
• Some rates are reported based on an assumed 360day year but interest is actually earned all 365 days.
• Interest is actually earned for all 365 days, so investor
earns a higher effective rate of interest.
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113
Discount Yields
• Some money market instruments, such as Treasury
Bills, are discount instruments.
• Purchase price is always below the par value at maturity.
• Difference between the purchase price and par value at
maturity represents interest.
• Yields on discount instruments are calculated and
quoted on a discount basis assuming a 360-day
year.
• Not directly comparable to yields on interest-bearing
instruments.
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114
Discount Yields
• The pricing equation for a discount instrument is:
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115
Discount Yields
• Two problems with the discount rate:
• The return is based on the final price or maturity value,
rather than on the initial investment.
• It assumes a 360-day year which understates the effective
annual rate.
• Addressed by calculating the Bond Equivalent Rate
(ibe):
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116
Discount Yields
• To obtain an effective annual rate, incorporate
compounding, assuming a reinvestment of the
proceeds at the same periodic rate for the
remainder of the 365 days in the year.
 Pf - Po 
i *  1 
Po 

 365 
 h 


i be 

 1  1 

 365/h 
 365 
 h 


1
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117
Discount Yields
• Consider a $1 million T-bill with 182 days to
maturity and a price of $964,500.
• Discount rate
is 7.02%:
• Bond equivalent
rate is 7.38%:
• Effective interest
rate is 7.52%:
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Yields on Single-Payment, InterestBearing Securities
• Some money market instruments pay interest
calculated against the par value of the security.
• A single payment of interest and principal is made
at maturity.
• Nominal rate is quoted as a percent of par and
assumes a 360 day year.
• Understates the effective annual rate.
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Yields on Single-Payment, InterestBearing Securities
• Consider a 182-day CD with a $1 million par and
quoted yield of 7.02% (same quote as T-bill).
• Actual interest paid
after 182 days:
• The 365-day yield
is 7.12%:
• The effective
annual rate
is 7.24%:
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Yields on Single-Payment, InterestBearing Securities
• Both the 365-day yield and effective annual rate on
the CD are below the rates on the T-bill.
• Demonstrates the difference between discount and
interest-bearing instruments.
• Discount rate calculated as a return on par, not the initial
investment as with interest-bearing instruments.
• A discount rate understates both the 365-day rate and
effective rate by a greater percentage.
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121
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122
Chapter 10:
Funding the
Bank
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The Relationship Between Liquidity
Requirements, Cash, and Funding Sources
• Amount of cash a bank holds is influenced by bank’s
liquidity requirements.
• Size and volatility of cash requirements affects
liquidity position of bank.
• Transactions that reduce cash force bank to replenish
cash assets by issuing new debt or selling assets.
• Transactions that increase cash provide new investible
funds.
• Banks with ready access to borrowed funds can
enter into more transactions as they can borrow
quickly and at low cost to meet cash requirements.
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Recent Trends in Bank Funding Sources
• Retail funding is considered funding bank receives
from consumers and noninstitutional depositors.
• Transactions accounts, money-market demand accounts,
savings accounts and small time deposits.
• Borrowed or wholesale funding consists of federal
funds purchased, repurchase agreements, FHLB
borrowings and other borrowings such as
institutional CDs in amounts over $250,000
• Equity-related funding consists of subordinated
debt, common and preferred stock and retained
earnings.
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Recent Trends in Bank Funding Sources
• Following slides show:
• Between December 2007 and June 2013 deposit funds
increased from 65% to 75% of total assets and wholesale
funding fell from 24% to just 13% of assets.
• In 2013 small commercial banks (less than $100 million in
assets) relied much more on deposits and much less on
wholesale funds than larger banks. Banks with more than
$1 billion relied more on wholesale funds.
• In comparison with commercial banks, savings institutions
operate with proportionately fewer deposits and more
wholesale funds, reflecting heavier concentration in real
estate assets and greater use of FHLB financing.
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129
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Recent Trends in Bank Funding Sources
• Volatile (purchased) liabilities describe funds
obtained from interest-sensitive investors.
• Federal funds purchased, repurchase agreements, jumbo
CDs, Internet and brokered CD’s, Eurodollar time deposits.
foreign deposits and any other large purchased liability.
• Investors will move their funds if other institutions are
paying higher rates or hear rumors that the bank has
financial difficulties.
• FHLB increases collateral requirements for problem
institutions reducing the banks’ liquidity.
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Recent Trends in Bank Funding Sources
• Most banks prefer to obtain as much funding as
possible from core deposits:
• Stable deposits that customers are less likely to withdraw
when interest rates on competing investments rise.
• Includes: transactions accounts, MMDAs, savings
accounts and small CDs.
• Customers typically choose banks on basis of
convenience but electronic banking is changing this
model.
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Characteristics of Retail-Type Deposits
• Retail Deposits:
• Small denomination (under $100,000) liabilities.
• Normally held by individual investors.
• Not actively traded in the secondary market.
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Transaction Accounts
• Most banks offer three different accounts:
• Demand deposits accounts (DDA) are non-interest
bearing checking accounts held by individuals, businesses
and government units.
• Interest-bearing checking and automatic transfers from
savings (ATS) accounts are checking accounts that pay
interest.
• With ATS, customer has both a DDA and a savings account.
• Bank forces a zero balance in the DDA at the end of each day.
• Often labeled as sweep accounts.
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Transaction Accounts
• Money-market demand accounts not transaction
accounts because number of transactions is limited.
• Banks price interest-checking and savings accounts
on competitive conditions without restriction.
• Some limit number of checks that can be written without
fees and impose minimum balance requirements.
• The interest cost of transaction accounts is low, but
the non-interest costs can be quite high.
• Due to high cost of check processing, low balance
checking accounts are not profitable without fees.
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Nontransactional Accounts
• Interest-bearing accounts with limited or no checkwriting privileges.
• Money market deposit accounts (MMDA) are time
deposits that limit depositors to six transactions per
month (only three can be checks).
• Attractive to banks because no required reserves and
limited check processing reduce effective cost to bank.
• Savings accounts have no fixed maturity.
• Not as prevalent in banks today, as MMDAs and small
time deposits have replaced them.
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Nontransactional Accounts
• Small time deposits have balances under $250,000,
a specified maturity of 7 days or more and interest
penalties for early withdrawal.
• Economic difference between time deposits below
$50,000 and those between $50,000 and $250,000.
• Larger deposits act more like jumbo CDs and are very
rate-sensitive.
• Large time deposits (jumbo CDs) of $100,000 or
more whose value changes as CD rates changes.
• Negotiable and typically traded in the secondary market.
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Estimating the Cost of Deposit Accounts
• Cost includes:
• Interest which may be as low as zero or a fraction of 1%.
• Legal reserve requirements which can equal as much as
10% of the outstanding balance.
• Processing costs which are substantial when deposit
customers have a large number of transactions.
• Cost analysis data indicate demand deposits are the
least expensive source of funds.
• Profitability depends on average balance, number of
transactions and fees collected.
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Estimating the Cost of Deposit Accounts
• Additional fees include overdraft protection or NSF
fees (represent a risk charge).
• Overdrafts are an extension of credit.
• Cost analysis classifies check-processing activities as:
• Deposits or withdrawals:
• Electronic transactions occur through automatic deposits, Internet
and telephone payments, ATMs and ACH transactions.
• Nonelectronic transactions are handled in person or by mail.
• Transit checks deposited or cashed:
• Transit checks are checks from any other bank.
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Estimating the Cost of Deposit Accounts
• Cost analysis classifies check-processing activities as:
• Accounts opened or closed.
• “On-us” checks cashed:
• Checks drawn on the bank’s customers’ accounts.
• General account maintenance:
• General record maintenance and preparing statements.
• With a truncated account checks are not returned to the customer.
• An official check would be issued for certified funds.
• Net indirect costs are costs not directly related to the
product such as general overhead or manager salaries.
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140
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141
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Estimating the Cost of Deposit Accounts
• Banks pay market rates on deposits and want
customers to pay at least what the service costs.
• Has led to relationship pricing in which service charges
decline and interest rates increase with larger balances.
• Banks have unbundled services and price each separately.
• Some charge for services once considered courtesies such
as check cashing, balance inquiry and in person banking.
• Has led to a caste system of banking.
• Large depositors receive highest rates, pay the lowest fees and
receive personal attention from their banker.
• Small depositors earn lower rates, if any, pay higher fees and
receive less personal service.
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Calculating the Average Net Cost of
Deposit Accounts
• Average historical cost of funds:
• Measure of average unit borrowing costs for existing
funds.
• Average interest cost:
• Calculated by dividing total interest expense by the
average dollar amount of liabilities outstanding.
• Average net cost of bank liabilities:
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Calculating the Average Net Cost of
Deposit Accounts
• Example:
• If a demand deposit account does not pay interest, has
$18.69 in transaction costs charges, $10.15 in fees, an
average balance of $8,750, 5% float and 10% reserve
requirement, the average net cost would be:
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Characteristics of Large Wholesale
Deposits
• Banks must pay market rates and can attract funds
by paying a small premium over current market.
• Customers move these investments on the basis of
small rate differentials.
• These funds are labeled hot money, volatile liabilities or
short-term non-core funding.
• Include jumbo CDs, federal funds purchased, RPs,
Eurodollar time deposits, foreign deposits and any other
large-denomination purchased liability.
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Jumbo CDs (CDs)
• Large, negotiable certificates of $100,000 or more.
• Minimum maturity of 7 days.
• Interest rates quoted on a 360-day year basis.
• Insured up to $250,000 per investor per institution.
• Considered risky and traded accordingly.
• Can be issued directly or through dealers or brokers
(brokered deposits).
• Brokers provide small banks access to purchased funds.
• Packaged in $250,000 increments so deposits are fully
insured.
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Jumbo CDs (CDs)
• Bank regulators argue brokered CDs are often
abused.
• Based on link between brokered deposits and
problem/failed banks that use CD funds to speculate on
high-risk assets.
• If bank fails, FDIC must pay insured depositors.
• Community banks rely on CDARS as a form of
extended deposit insurance.
• Effectively allows a bank to offer full deposit insurance in
excess of $250,000 through transfers to other banks.
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Jumbo CDs (CDs)
• When managers expect rates to rise, try to lengthen
CD maturities prior to rate move.
• Opposite occurs when rates are expected to fall.
• Types of CDs:
• Fixed-rate: Typically 1, 3 or 6 month maturities. Today
maturities of up to 5 years are common.
• Variable-rate: Longer maturities with rates renegotiated
at specified intervals.
• Jump rate (bump-up) CD gives the depositor a one-time option
until maturity to change the rate to the prevailing market rate.
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Jumbo CDs (CDs)
• Types of CDs (cont’d):
• CD specials: Carry high initial rates for an odd number of
months in an attempt to attract new funds with a high,
but temporary, initial interest cost.
• Callable: Allow banks to repay the depositor principal if
rates fall after a specified deferment period (i.e. 2 years).
• Zero coupon: Sold at a steep discount from par and
appreciate to face value at maturity.
• Rate boards are venues for selling nonbrokered CDs
via the internet to institutional investors.
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Individual Retirement Accounts (IRAs)
• IRAs are savings plans for wage earners and their
spouses.
• Each year, a wage earner can make a tax-deferred
investment of earned income subject to IRS rules.
• Funds withdrawn before age 59 ½ are subject to a 10%
IRS penalty.
• Makes IRAs an attractive source of long-term funding that can be
used to balance the rate sensitivity of longer-term assets.
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Foreign Office Deposits
• Eurocurrency:
• Financial claim denominated in a currency other than that
of the country where the issuing bank is located.
• Eurodollar:
• Most important Eurocurreny. Dollar-denominated
financial claim at a bank outside the U.S.
• Eurodollar deposits:
• Dollar-denominated depots in banks outside the U.S.
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Borrowing Immediately Available Funds
• Federal Funds Purchased:
• The term federal funds is often used to refer to excess
reserve balances traded between banks.
• 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.
• Formal definition of federal funds is unsecured short-term
loans that are settled in immediately available funds.
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Borrowing Immediately Available Funds
• Security Repurchase Agreements (RPs or Repos):
• Short-term loans secured by government securities that
are settled in immediately available funds.
• Identical to federal funds except they are collateralized.
• Sale of securities with a simultaneous agreement to buy
them back later at a fixed price plus accrued interest.
• Market value of collateral is set above the loan amount.
• This difference is the margin.
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Structured Repurchase Agreements
• Normal repos are bullet repos with a fixed rate over
a set maturity with no options.
• Structured repo agreements:
• embeds an option (call, put, swap, cap, floor, etc.) in the
instrument to either lower its initial cost to the borrower
or better help the borrower match the risk and return
profile of an investment.
• A callable repo allows the deposit holder to
terminate (call) the CD prior to maturity.
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Borrowing from the Federal Reserve
• Borrowing facility is the discount window. Fixed,
discount rate set by district Federal Reserve Banks.
• Policy is to lend to most institutions at 1% and 1.5% over
the current federal funds target rate.
• Four distinct lending programs:
• Primary credit is available to sound depository institutions on a
short-term basis to meet short-term funding needs.
• Secondary credit is available to those not eligible for primary
credit. Generally overnight at a rate above the primary rate.
• Seasonal credit is designed to assist small depository institutions
significant seasonal swings in their loans and deposits.
• Emergency credit may be authorized in unusual circumstances to
non-depository individuals, partnerships and corporations.
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Other Borrowing from the Federal
Reserve
• Term Auction Facility:
• Allows banks to bid for an advance from the local Federal
Reserve Bank that will generally have a 28-day maturity.
• Banks must post collateral and cannot prepay the loan.
• Term Securities Lending Facility:
• Open Market Trading Desk of the Federal Reserve Bank of
New York makes loans to primary securities dealers.
• Allows dealers to trade relatively illiquid mortgage-backed
securities for Treasury securities they can readily pledge
as collateral against borrowings, creating liquidity.
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Federal Home Loan Bank Advances
• FHLB system is a government-sponsored enterprise
created to assist in home buying.
• FHLBs among the largest U.S. financial institutions.
• Borrowings rated AAA due to government
sponsorship.
• Bank can become a member by buying FHLB stock.
• Banks can borrow from the FHLB if it has available
collateral, primarily real estate-related loans.
• Advances have maturities from 1 day to 20 years.
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Electronic Money
• Intelligent Card:
• Contains microchip that can store and secure information.
• Makes different responses depending on requirements of
card issuer’s specific application needs.
• Memory Card:
• Simply stores information, similar to that on the back of a
credit card.
• Wireless transactions using computers and mobile
devices are increasingly used in the United States.
• Examples include PayPal and Square.
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Electronic Money
• Trillions of dollars of digital transactions each day.
• Wholesale electronic payments using wire transfers
account for over 3/4 of the value of transactions.
• Electronic Funds Transfer (EFT):
• Electronic movement of financial data, designed to
eliminate the paper instruments.
• Includes ACH, POS, AMT, direct deposit, telephone bill paying,
automated merchant authorization and preauthorized payments.
• Point of sale (POS) is a sale consummated by payment for goods
or services received or a direct debit of the purchase amount.
• Automated clearinghouse (ACH) transaction is an electronically
processed payment using a standard data format.
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Check 21
• Purposes of Check Clearing for the 21st Century
Act:
• To facilitate check truncation by reducing some of the
legal impediments.
• To foster innovation in the payments and check collection
system without mandating receipt of check in electronic
form.
• To improve the overall efficiency of the nation’s payment
system.
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Check 21
• Check truncation is the conversion of paper check
into electronic debit or image of check by a party in
the payment system other than the paying bank.
• Substitute check is the legal equivalent of original
check.
• Banks not required to accept checks in electronic
form or create substitute checks.
• Check 21 allows banks to handle checks electronically
instead of physically moving paper checks which should
make processing more efficient and less expensive.
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Check 21
• Check Clearing Process:
• Banks typically place a hold on a check until it verifies that
check writer has enough funds on deposit to cover it.
• Federal Reserve follows a timetable indicating how long a
bank must wait before it can receive credit on deposited
items.
• Most checks clear in one to three days.
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The Average Historical Cost of Funds
• Many banks incorrectly use the average historical
costs in their pricing decisions.
• Primary problem with historical costs is they provide no
information as to if future interest costs will rise or fall.
• When interest rates rise, average historical cost
understates the actual cost of issuing new debt. When
rates fall the opposite is true.
• Pricing decisions should be based on marginal costs
compared with marginal revenues.
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The Marginal Cost of Funds
• Marginal cost of debt:
• Measure of the borrowing cost paid to acquire one
additional unit of investable funds.
• Marginal cost of equity:
• Measure of the minimum acceptable rate of return
required by shareholders.
• Marginal cost of funds:
• The marginal costs of debt and equity.
• Especially useful in pricing decisions.
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Costs of Independent Sources of Funds
• Difficult to measure marginal costs precisely.
• Must include both interest and noninterest costs
expected to be paid and identify which portion of the
acquired funds can be invested in earning assets.
• Formula for measuring explicit marginal cost of a single
source of bank liability:
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Costs of Independent Sources of Funds
• Example:
• Market interest rate = 0.2%
• Servicing costs = 2.8% of balances
• Acquisition costs = 0.15% of balances
• Deposit insurance costs = 0.25% of balances
• Investable balance = 85% (10% required reserves, 5% float)
• Estimated marginal cost of obtaining additional
interest checking balances:
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Cost of Debt
• Marginal cost of different types of debt varies according
to the magnitude of each type of liability.
• High-volume transactions accounts have substantial servicing
costs and highest reserve requirements and float.
• Purchased funds pay higher rates but smaller transaction costs
and zero reserve requirements (greater investable balances).
• Cost of long-term non deposit debt equals effective cost
of borrowing from each source.
• This 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.
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Cost of Equity
• The marginal cost of equity equals the required
return to shareholders.
• Not directly measurable because dividend payments are
not mandatory but several methods are used:
• Dividend Valuation Model: The cost of equity equals the discount
rate (required return) used to convert future cash flows to their
present value equivalent.
• Capital Asset Pricing Model (CAPM): Required return to
shareholders equals the riskless rate of return plus a risk premium
on common stock reflecting nondiversifiable market risk.
• Targeted Return on Equity Model. Cost of debt plus a premium to
evaluate the cost of equity. Assumes book value = market value.
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Cost of Preferred Stock
• Preferred stock has characteristics of debt and
common equity.
• Claims are superior to those of common stockholders but
subordinated to those of debt holders.
• Dividends may be deferred when earnings are low.
• Marginal cost can be approximated using the dividend
valuation model except that dividend growth is zero.
• Trust preferred stock is a hybrid form of equity
capital.
• Effectively pays dividends that are tax deductible.
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Weighted Marginal Cost of Total Funds
• Best cost measure for asset-pricing purposes.
• Recognizes both explicit and implicit costs associated with
any single source of funds.
• Computed in three stages:
• Forecast desired dollar amount of financing to be
obtained from each individual debt and equity sources.
• Estimate marginal cost of each source of funds.
• Combine the estimates to project the weighted cost:
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Funding Sources and Banking Risks
• Banks face two fundamental problems in managing
liabilities. They are uncertainty over:
• what rates they must pay to retain and attract funds.
• likelihood customers will withdraw money regardless of
rates.
• Basic fear is vulnerability to a liquidity crisis from
unanticipated withdrawals and depositors and
lenders refusing to provide funds.
• Banks must have the capacity to borrow in financial
markets to replace deposits outflows and remain solvent.
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Funding Sources: Liquidity Risk
• Liquidity risk of deposit base is a function of:
• Number and location of depositors.
• Average size of accounts.
• Specific maturity and rate characteristics of each account.
• Competitive environment.
• Interest elasticity of customer demand for each
funding source is equally important.
• How much can interest rates change before bank
experiences deposit outflows?
• If a bank raises its rates, how many new funds will it
attract?
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Funding Sources: Interest Rate Risk
• Many depositors and investors prefer short-term
instruments that can be rolled over quickly as
interest rates change.
• Banks must offer premiums to lengthen maturities.
• Many banks have chosen not to pay premiums and
reprice liabilities more frequently than in the past.
• One strategy is to aggressively compete for retail
core deposits.
• Once a bank attracts deposit business, many will maintain
those balances as long as bank provides good service.
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Funding Sources: Credit Risk
• During financial crisis many failed banks relied on
FHLB advances and jumbo CDs to fund operations.
• Many banks financed loan growth with wholesale funds.
• Did funding sources or choice of loans cause the
failures?
• Inappropriate use of advances and CDs to fund overly
speculative loans caused the problems.
• Link between funding sources and credit risk tied to
reasonableness of business plans, credit analysis when
making loans, and monitoring of credit risk.
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