Funding the Bank
1
The Relationship Between Liquidity
Requirements, Cash, and Funding Sources
 The amount of cash that a bank holds
is influenced by the bank’s liquidity
requirements
 The size and volatility of cash
requirements affect the liquidity
position of the bank
 Deposits,
withdrawals, loan
disbursements, and loan payments
affect the bank’s cash balance and
liquidity position
2
3
The Relationship Between Liquidity
Requirements, Cash, and Funding Sources
 Recent Trends in Bank Funding Sources
Bank customers have become more rate
conscious
 Many customers have demonstrated a a
strong preference for shorter-term
deposits
 Core deposits are viewed as increasingly
valuable
 Bank often issue hybrid CDs to appeal to
rate sensitive depositors

4
The Relationship Between Liquidity
Requirements, Cash, and Funding Sources
 Recent Trends in Bank Funding
Sources
 Retail

Funding
Deposit Accounts
 Transaction accounts
 Money market deposit accounts
 Savings accounts
 Small time deposits
5
The Relationship Between Liquidity
Requirements, Cash, and Funding Sources
 Recent Trends in Bank Funding
Sources
 Borrowed
Funding
Federal Funds purchased
 Repurchase agreements
 Federal Home Loan Bank borrowings

6
The Relationship Between Liquidity
Requirements, Cash, and Funding Sources
 Recent Trends in Bank Funding
Sources
 Wholesale

Funding
Includes borrowed funds plus large
CDs
 Equity
Funding
Common stock
 Preferred stock
 Retained earnings

7
The Relationship Between Liquidity
Requirements, Cash, and Funding Sources
 Recent Trends in Bank Funding Sources

Volatile (Managed) Liabilities

Funds purchased from rate-sensitive
investors






Federal Funds purchased
Repurchase agreements
Jumbo CDs
Eurodollar time deposits
Foreign Deposits
Investors will move their funds if other
institutions are paying higher rates
8
The Relationship Between Liquidity
Requirements, Cash, and Funding Sources
 Recent Trends in Bank Funding
Sources
 Core
Deposits
Stable deposits that customers are less
likely to withdraw when interest rates
on competing investments rise
 Includes:

 Transactions accounts
 MMDAs
 Savings accounts
 Small CDs
9
10
11
12
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
13
Characteristics of Retail-Type
Deposits
 Transaction Accounts
 Most
banks offer three different
transaction accounts

Demand Deposits
 DDAs

Negotiable Order of Withdrawal
 NOWs

Automatic Transfers from Savings
 ATS
14
Characteristics of Retail-Type
Deposits
 Transaction Accounts
 Demand
Deposits
Checking accounts that do not pay
interest
 Held by individuals, business, and
governmental units

 Most are held by businesses since
Regulation Q prohibits banks from paying
explicit interest on for-profit corporate
checking accounts
15
Characteristics of Retail-Type
Deposits
 Transaction Accounts
 NOW Accounts
 Checking accounts that pay interest
 ATS Accounts
 Customer has both a DDA and savings
account
 The bank transfers enough from savings
to DDA each day to force a zero balance in
the DDA account
 For-profit corporations are prohibited
from owning NOW and ATS accounts
16
Characteristics of Retail-Type
Deposits
 Transaction Accounts
 Although
the interest cost of
transaction accounts is very low, the
non-interest costs can be quite high

Generally, low balance checking
accounts are not profitable for banks
due to the high cost of processing
checks
17
Characteristics of Retail-Type
Deposits
 Nontransactional Accounts
 Non-transaction
accounts are interestbearing with limited or no checkwriting privileges
18
Characteristics of Retail-Type
Deposits
 Nontransactional Accounts
 Money
Market Deposit Accounts
Pay interest but holders are limited to 6
transactions per month, of which only
three can be checks
 Attractive to banks because they are
not required to hold reserves against
MMDAs

19
Characteristics of Retail-Type
Deposits
 Nontransactional Accounts
 Savings

Have no fixed maturity
 Small

Accounts
Time Deposits (Retail CDs)
Have a specified maturity ranging from
7 days on up
 Large
Time Deposits (Jumbo CDs)
Negotiable CDs of $100,000 or more
 Typically can be traded in the
secondary market

20
Characteristics of Retail-Type
Deposits
 Estimating the Cost of Deposit
Accounts
 Interest
Costs
 Legal Reserve Requirements
 Check Processing Costs
 Account Charges
NSF fees
 Monthly fees
 Per check fees

21
Characteristics of Retail-Type
Deposits
 Estimating the Cost of Deposit
Accounts
 Transaction

Account Cost Analysis
Classifies check-processing as:
 Deposits
 Electronic
 Non-Electronic
 Withdrawals
 Electronic
 Non-Electronic
22
Characteristics of Retail-Type
Deposits
 Estimating the Cost of Deposit Accounts

Transaction Account Cost Analysis

Classifies check-processing as:
 Transit Checks
 Deposited
 Cashed
 Account Opened or Closed
 On-Us checks cashed
 General account maintenance
 Truncated
 Non-Truncated
23
Characteristics of Retail-Type
Deposits
 Estimating the Cost of Deposit
Accounts
 Transaction

Account Cost Analysis
Electronic Transactions
 Conducted through automatic deposits,
Internet, and telephone bill payment

Non-Electronic Transactions
 Conducted in person or by mail

Transit Checks
 Checks drawn on any bank other than the
bank it was deposited into
24
Characteristics of Retail-Type
Deposits
 Estimating the Cost of Deposit Accounts

Transaction Account Cost Analysis

On-Us Checks Cashed
 Checks drawn on the bank’s own customer’s
accounts

Deposits
 Checks or currency directly deposited in the
customer's account

Account Maintenance
 General record maintenance and preparing &
mailing a periodic statement
25
Characteristics of Retail-Type
Deposits
 Estimating the Cost of Deposit Accounts
 Transaction Account Cost Analysis
 Truncated Account
 A checking account in which the physical
check is ‘truncated’ at the bank and the checks
are not returned to the customer

Official Check Issued
 A check for certified funds.

Net Indirect Costs
 Those costs not directly related to the product
such as management salaries or general
overhead costs
26
27
Characteristics of Retail-Type
Deposits
 Calculating the Average Net Cost of
Deposit Accounts
 Average

Measure of average unit borrowing
costs for existing funds
 Average

Historical Cost of Funds
Interest Cost
Calculated by dividing total interest
expense by the average dollar amount
of liabilities outstanding
28
Characteristics of Retail-Type
Deposits
 Calculating the Average Net Cost of
Deposit Accounts
Average net cost of bank liabilitie s 
Interest expense  Noninteres t expense - Noninteres t income
12
Average balance net of float  (1 - Reserve requiremen t ratio)
29
Characteristics of Retail-Type
Deposits
 Calculating the Average Net Cost of
Deposit Accounts
 Example:

If a demand deposit account does not
pay interest, has $20.69 in transaction
costs charges, $7.75 in fees, an
average balance of $5,515, and 5%
float, what is the net cost of the
deposit?
Average Net Cost of Demand Deposit 
$0  $20.69 - $7.75
 12  3.29%
$5,515  (1 - .05)  (1 - .10)
30
31
Characteristics of Large
Wholesale Deposits
 Wholesale Liabilities
 Customers
move these investments on
the basis of small rate differentials, so
these funds are labeled:
Hot Money
 Volatile Liabilities
 Short-Term Non-Core funding

32
Characteristics of Large
Wholesale Deposits
 Wholesale Liabilities
 Jumbo CDs
 $100,000 or more
 Negotiable
 Can be traded on the secondary market
Minimum maturity of 7 days
 Interest rates quoted on a 360-day year
basis
 Insured up to $100,000 per investor per
institution
 Issued directly or indirectly through a
dealer or broker (Brokered Deposits)

33
Characteristics of Large
Wholesale Deposits
 Wholesale Liabilities
 Jumbo
CDs
Fixed-Rate
 Variable-Rate

 Jump Rate (Bump-up) CD
 Depositor has a one-time option until
maturity to change the rate to the
prevailing market rate
34
Characteristics of Large
Wholesale Deposits
 Wholesale Liabilities
 Jumbo CDs
 Callable
 Zero Coupon
 Stock Market Indexed
 Rate tied to stock market index performance

Rate Boards
 Represent venues for selling non-brokered
CDs via the Internet to institutional investors
 Rate boards help raise funds quickly and
represent a virtual branch for a bank
35
Characteristics of Large
Wholesale Deposits
 Individual Retirement Accounts
 Each
year, a wage earner can make a
tax-deferred investment up to $8,000 of
earned income
 Funds withdrawn before age 59 ½ are
subject to a 10% IRS penalty

This makes IRAs an attractive source of
long-term funding for banks
36
Characteristics of Large
Wholesale Deposits
 Foreign Office Deposits
 Eurocurrency
 Financial claim denominated in a currency
other than that of the country where the
issuing bank is located
 Eurodollar
 Dollar-denominated financial claim at a
bank outside the U.S.
 Eurodollar deposits
 Dollar-denominated depots in banks
outside the U.S.
37
38
Characteristics of Large
Wholesale Deposits
 Borrowing Immediately Available Funds

Federal Funds Purchased

The term Fed 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 non-bank 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
39
Characteristics of Large
Wholesale Deposits
 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 Fed Funds except they are
collateralized
 Technically, the RPs entail the sale of
securities with a simultaneous agreement
to buy them back later at a fixed price plus
accrued interest
40
Characteristics of Large
Wholesale Deposits
 Borrowing Immediately Available Funds

Security Repurchase Agreements (RPs or
Repos)
Most transactions are overnight
 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

The lender’s transaction is referred to as a
Reverse Repo
41
Characteristics of Large
Wholesale Deposits
 Borrowing Immediately Available Funds

Structured Repurchase 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
 Flipper Repo

 Carries a floating rate that will convert, or flip,
to a fixed rate after some lock-out period
42
Characteristics of Large
Wholesale Deposits
 Borrowing From the Federal Reserve
 Discount Window
 Discount Rate
 Policy is to set discount rate 1% (1.5%)
over the Fed Funds target for primary
(secondary) credit loans
 To borrow from the Federal Reserve,
banks must apply and provide acceptable
collateral before the loan is granted
 Eligible collateral includes U.S. government
securities, bankers acceptances, and
qualifying short-term commercial or
government paper
43
Characteristics of Large
Wholesale Deposits
 Borrowing From the Federal Reserve
 Discount
Rate
Current Interest Rates 9/09/2009
Primary Credit
0.50%
Secondary Credit
1.00%
Seasonal Credit
0.25%
Fed Funds Target
0 - 0.25%
44
Characteristics of Large
Wholesale Deposits
 Borrowing From the Federal Reserve
 Primary

Credit
Available to sound depository
institutions on a short-term basis to
meet short-term funding needs
45
Characteristics of Large
Wholesale Deposits
 Borrowing From the Federal Reserve
 Secondary
Credit
Available to depository institutions that
are not eligible for primary credit
 Available to meet backup liquidity
needs when its use is consistent with a
timely return to a reliance on market
sources of funding or the orderly
resolution of a troubled institution

46
Characteristics of Large
Wholesale Deposits
 Borrowing From the Federal Reserve
 Seasonal

Credit
Designed to assist small depository
institutions in managing significant
seasonal swings in their loans and
deposits
47
Characteristics of Large
Wholesale Deposits
 Borrowing From the Federal Reserve
 Emergency

Credit
May be authorized in unusual and
exigent circumstances by the Board of
Governors to individuals, partnerships,
and corporations that are not
depository institutions
48
Characteristics of Large
Wholesale Deposits
 Other Borrowing from the Federal
Reserve
 Term
Auction Facility
Allows banks to bid for an advance that
will generally have a 28-day maturity
 Banks must post collateral against the
borrowings and cannot prepay the loan

49
Characteristics of Large
Wholesale Deposits
 Other Borrowing from the Federal
Reserve
 Term

Securities Lending Facility
A facility in which the Open Market
Trading Desk of the Federal Reserve
Bank of New York makes loans to
primary securities dealers
50
Characteristics of Large
Wholesale Deposits
 Federal Home Loan Bank Advances





The FHLB system is a governmentsponsored enterprise created to assist in
home buying
The FHLB system is one of the largest U.S.
financial institutions, rated 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
FHLB advances have maturities from 1 day
to as long as 20 years
51
52
Electronic Money
 Intelligent Card
 Contains
a microchip with the ability to
store and secure information
 Memory Card
 Simply
store information
53
Electronic Money
 Debit Card
 Online
PIN based
 Transaction goes through the ATM
system

 Offline
Signature based transactions
 Transaction goes through the credit
card system

54
Electronic Money
 Electronic Funds Transfer (EFT)
 An electronic movement of financial data,
designed to eliminate the paper
instruments normally associated with
such funds movement
 Types of EFT







ACH: Automated Clearing House
POS: Point of Sale
ATM
Direct Deposit
Telephone Bill Paying
Automated Merchant Authorization Systems
Preauthorized Payments
55
56
Check 21
 Check Clearing for the 21st Century Act
Facilitates check truncation by reducing
some of the legal impediments
 Foster innovation in the payments and
check collection system without
mandating receipt of check in electronic
form
 Improve the overall efficiency of the
nation’s payment system

57
Check 21
 Check Truncation
 Conversion
of a paper check into an
electronic debit or image of the check
by a third party in the payment system
other than the paying bank
 Facilitates check truncation by
creating a new negotiable instrument
called a substitute check
58
Check 21
 Substitute Check
 The legal equivalent of the original check
and includes all the information contained
on the original
 Check 21 does NOT require banks to
accept checks in electronic form nor
does it require banks to create substitute
checks

It does allow banks to handle checks
electronically instead of physically
moving paper checks
59
60
Check 21
 Check Clearing Process
 Banks typically place a hold on a check
until it verifies that the check is “good”
 Expedited Funds Availability Act
 Under Reg CC, it states that:
 Local check must clear in no more than two
business days
 Non-local checks must clear in no more than
five business days
 Government, certified, and cashiers checks
must be available by 9 a.m. the next business
day
61
62
Measuring the Cost of Funds
 Average Historical Cost of Funds
 Many banks incorrectly use the
average historical costs in their pricing
decisions
 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
63
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Marginal

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 Debt
Cost of Funds
The marginal costs of debt and equity
64
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs
of Independent Sources of
Funds
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

65
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs
of Independent Sources of
Funds

Marginal costs may be defined as :
Marginal Cost of Liability j

Interest Rate  Servicing Costs  Acquistion Costs  Insurance
Net Investable Balance of Liability j
66
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs of Independent Sources of
Funds
 Example:
 Market interest rate is 2.5%
 Servicing costs are 4.1% of balances
 Acquisition costs are 1.0% of balances
 Deposit insurance costs are 0.25% of
balances
 Net investable balance is 85% of the
balance
(10% required reserves and 5% float)
67
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs
of Independent Sources of
Funds

Example:
0.025  0.041  0.01  0.0025
Marginal Cost 
 0.0924  9.24%
0.85
68
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs
of Independent Sources of
Funds

Cost of Debt
 Equals the effective cost of borrowing from
each source, including interest expense
and transactions costs
 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
69
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs of Independent Sources of Funds
 Cost of Debt
 Example:
 Assume the bank will issue:
 $10 million in par value subordinated
notes paying $700,000 in annual interest
and a 7-year maturity
 It must pay $100,000 in flotation costs
to an underwriter
 The effective cost of borrowing (kd) is
7.19%
70
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs
of Independent Sources of
Funds

Cost of Debt
 Example:
7
$700,000 $10,000,000
$9,900,000  

t
7
(1

k
)
(1

k
)
t 1
d
d
Thus k d  7.19%
71
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs
of Independent Sources of
Funds

Cost of Equity
 The marginal cost of equity equals the
required return to shareholders
 It is not directly measurable because
dividend payments are not mandatory
72
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs
of Independent Sources of
Funds

Cost of Equity
 Several methods are commonly used to
approximate this required return:
 Dividend Valuation Model
 Capital Asset Pricing Model (CAPM)
 Targeted Return on Equity Model
 Cost of Debt + Risk Premium
73
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs of Independent Sources of Funds
 Cost of Preferred Stock
 Preferred stock acts as a hybrid of debt and
common equity
 Claims are superior to those of common
stockholders but subordinated to those of
debt holders
 Preferred stock pays dividends that may be
deferred when management determines
that earnings are too low.
 The marginal cost of preferred stock can be
approximated in the same manner as the
Dividend Valuation Model however,
dividend growth is zero
74
Measuring the Cost of Funds
 The Marginal Cost of Funds
 Costs
of Independent Sources of
Funds

Trust Preferred Stock
 Trust preferred stock is attractive because
it effectively pays dividends that are tax
deductible
 This loan interest is tax deductible such
that the bank effectively gets to deduct
dividend payments as the preferred
stock
75
Measuring the Cost of Funds
 Weighted Marginal Cost of Total Funds
 This
is the best cost measure for
asset-pricing purposes
 It recognizes both explicit and implicit
costs associated with any single
source of funds
76
Measuring the Cost of Funds
 Weighted Marginal Cost of Total 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
m
WMC   w j k j
j1
77
78
Funding Sources and Banking
Risks
 Banks face two fundamental problems
in managing liabilities. Uncertainty
over:
 What
rates they must pay to retain and
attract funds
 The likelihood that customers will
withdraw their money regardless of
rates
79
Funding Sources and Banking
Risks
 Funding Sources: Liquidity Risk
 The
liquidity risk associated with a
bank’s deposit base is a function of:
The competitive environment
 Number of depositors
 Average size of accounts
 Location of the depositor
 Specific maturity and rate
characteristics of each account

80
Funding Sources and Banking
Risks
 Funding Sources: Liquidity Risk
 Interest Elasticity
 How much can market interest rates
change before the bank experiences
deposit outflows?
 If a bank raises its rates, how many new
funds will it attract?
 Depositors often compare rates and move
their funds between investment vehicles
to earn the highest yields
 It is important to note the liquidity
advantage that stable core deposits
provide a bank
81
Funding Sources and Banking
Risks
 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 a substantial premium
to induce depositors to lengthen
maturities
 Those banks that choose not to pay this
premium will typically have a negative
one-year GAP

82
Funding Sources and Banking
Risks
 Funding Sources: Interest Rate Risk
 One
strategy is to aggressively
compete for retail core deposits

Individual are not as rate sensitive as
corporate depositors and will often
maintain their balances through rate
cycles as long as the bank provides
good service
83
Funding Sources and Banking
Risks
 Funding Sources: Credit and Capital 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



For example, banks that substitute purchased
funds for lost demand deposits will often see
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
84
11
Managing Liquidity
85
Meeting Liquidity Needs
 Bank Liquidity
A
bank’s capacity to acquire
immediately available funds at a
reasonable price
 Firms can acquire liquidity in three
distinct ways:
1.
2.
3.
Selling assets
New borrowings
New stock issues
86
Meeting Liquidity Needs
 How effective each liquidity source is
at meeting the institution’s liquidity
needs, depends on:
 Market
conditions
 The market’s perception of risk at the
institution as well as in the
marketplace
 The market’s perception of bank
management and its strategic direction
 The current economic environment
87
Meeting Liquidity Needs
 Holding Liquid Assets
 “Cash Assets”
 Do not earn any interest
 Represents a substantial opportunity
cost for banks
 Banks attempt to minimize the amount of
cash assets held and hold only those
required by law or for operational needs
 Liquid

Assets
Can be easily and quickly converted
into cash with minimum loss
88
Meeting Liquidity Needs
 Holding Liquid Assets
 “Cash
Assets” do not generally satisfy
a bank’s liquidity needs

If the bank holds the minimum amount
of cash assets required, an unforeseen
drain on vault cash (perhaps from an
unexpected withdrawal) will cause the
level of cash to fall below the minimum
for legal and operational requirements
89
Meeting Liquidity Needs
 Holding Liquid Assets
 Banks hold cash assets to satisfy
four objectives:
1.
To meet customers’ regular
transaction needs
2.
To meet legal reserve requirements
3.
To assist in the check-payment
system
4.
To purchase correspondent banking
services
90
Meeting Liquidity Needs
 Holding Liquid Assets
 Banks own five types of liquid assets
1.
Cash and due from banks in excess of
requirements
2.
Federal funds sold and reverse
repurchase agreements
3.
Short-term Treasury and agency
obligations
4.
High-quality short-term corporate and
municipal securities
5.
Government-guaranteed loans that can
be readily sold
91
Meeting Liquidity Needs
 Borrowing Liquid Assets
 Banks
can provided for their liquidity
by borrowing
 Banks historically have had an
advantage over non-depository
institutions in that they could fund
their operations with relatively lowcost deposit accounts
92
Meeting Liquidity Needs
 Objectives of Cash Management
 Banks
must balance the desire to hold
a minimum amount of cash assets
while meeting the cash needs of its
customers
 The fundamental goal is to accurately
forecast cash needs and arrange for
readily available sources of cash at
minimal cost
93
Reserve Balances at the Federal
Reserve Bank
 Banks hold deposits at the Federal
Reserve because:
 The
Federal Reserve imposes legal
reserve requirements and deposit
balances qualify as legal reserves
 To help process deposit inflows and
outflows caused by check clearings,
maturing time deposits and securities,
wire transfers, and other transactions
94
Reserve Balances at the Federal
Reserve Bank
 Required Reserves and Monetary
Policy
 The
purpose of required reserves is to
enable the Federal Reserve to control
the nation’s money supply
 The Fed has three distinct monetary
policy tools:
Open market operations
 Changes in the discount rate
 Changes in the required reserve ratio

95
Reserve Balances at the Federal
Reserve Bank
 Required Reserves and Monetary Policy
 Example
 A required reserve ratio of 10% means that
a bank with $100 in demand deposits
outstanding must hold $10 in legal
required reserves in support of the DDAs
 The bank can thus lend out only 90% of its
DDAs

If the bank has exactly $10 in legal
reserves, the reserves do not provide the
bank with liquidity
 If the bank has $12 in legal reserves, $2 is
excess reserves, providing the bank with $2 in
immediately available funds
96
Reserve Balances at the Federal
Reserve Bank
 Impact of Sweep Accounts on
Required Reserve Balances
 Under
Reg. D, banks have reserve
requirements of 10% on demand
deposits, ATS, NOW, and other
checkable deposit (OCD) accounts
 not reservable
97
Reserve Balances at the Federal
Reserve Bank
 Impact of Sweep Accounts on
Required Reserve Balances
 MMDAs
are considered personal
saving deposits and have a zero
required reserve requirement ratio
98
Reserve Balances at the Federal
Reserve Bank
 Impact of Sweep Accounts on
Required Reserve Balances
 Sweep
accounts are accounts that
enable depository institutions to shift
funds from OCDs, which are
reservable, to MMDAs or other
accounts, which are not reservable
99
Reserve Balances at the Federal
Reserve Bank
 Impact of Sweep Accounts on Required
Reserve Balances

Sweep Accounts

Two Types
 Weekend Program
 Reclassifies transaction deposits as
savings deposits at the close of business
on Friday and back to transaction accounts
at the open on Monday
 On average, this means that for three days
each week, the bank does not need to hold
reserves against those balances
100
Reserve Balances at the Federal
Reserve Bank
 Impact of Sweep Accounts on Required
Reserve Balances

Sweep Accounts

Two Types
 Threshold Account
 The bank’s computer moves the
customer’s DDA balance into an MMDA
when the dollar amount reaches some
minimum and returns funds as needed
 The number of transfers is limited to 6 per
month, so the full amount of funds must be
moved back into the DDA on the sixth
transfer of the month
101
102
Meeting Legal Reserve
Requirements
 Required reserves can be met over a
two-week period
 There are three elements of required
reserves:
 The
dollar magnitude of base liabilities
 The required reserve fraction
 The dollar magnitude of qualifying
cash assets
103
Meeting Legal Reserve
Requirements
104
Meeting Legal Reserve
Requirements
 Historical Problems with Reserve
Requirements
 Reserve
requirements varied by type of
bank charter and by state.
 Non-Fed member banks had lower
reserve requirements than Fed member
banks
105
Meeting Legal Reserve
Requirements
 Lagged Reserve Accounting
 Computation

Consists of two one-week reporting
periods beginning on a Tuesday and
ending on the second Monday
thereafter
 Maintenance

Period
Period
Consists of 14 consecutive days
beginning on a Thursday and ending
on the second Wednesday thereafter
106
Meeting Legal Reserve
Requirements
 Lagged Reserve Accounting
 Reserve

Balance Requirements
The balance to be maintained in any
given maintenance period is measured
by:
 Reserve requirements on the reservable
liabilities calculated as of the computation
period that ended 17 days prior to the start
of the maintenance period
 Less vault cash as of the same
computation period
107
Meeting Legal Reserve
Requirements
 Lagged Reserve Accounting
 Reserve
Balance Requirements
Both vault cash and Federal Reserve
Deposits qualify as reserves
 The portion that is not met by vault
cash is called the reserve balance
requirement

108
109
110
Meeting Legal Reserve
Requirements
 An Application: Reserve Calculation
Under LRA
 Four
1.
2.
3.
4.
steps:
Calculate daily average balances
outstanding during the lagged
computation period.
Apply the reserve percentages.
Subtract vault cash.
Add or subtract the allowable reserve
carried forward from the prior period
111
112
Meeting Legal Reserve
Requirements
 Correspondent Banking Services
 System
of interbank relationships in
which the correspondent bank
(upstream correspondent) sells
services to the respondent bank
(downstream correspondent)
113
Meeting Legal Reserve
Requirements
 Correspondent Banking Services

Common Correspondent Banking Services










Check collection, wire transfer, coin and
currency supply
Loan participation assistance
Data processing services
Portfolio analysis and investment advice
Federal funds trading
Securities safekeeping
Arrangement of purchase or sale of securities
Investment banking services
Loans to directors and officers
International financial transactions
114
Meeting Legal Reserve
Requirements
 Correspondent Banking Services
 Banker’s

Bank
A firm, often a cooperative owned by
independent commercial banks, that
provides correspondent banking
services to commercial banks and not
to commercial or retail deposit and loan
customers
115
Liquidity Planning
 Short-Term Liquidity Planning
 Objective
is to manage a legal reserve
position that meets the minimum
requirement at the lowest cost
116
Liquidity Planning
117
Liquidity Planning
 Managing Float
 During any single day, more than $100
million in checks drawn on U.S.
commercial banks is waiting to be
processed
 Individuals, businesses, and governments
deposit the checks but cannot use the
proceeds until banks give their approval,
typically in several days
 Checks in process of collection, called
float, are a source of both income and
expense to banks
118
Liquidity Planning
 Liquidity versus Profitability
 There
is a short-run trade-off between
liquidity and profitability

The more liquid a bank is, the lower are
its return on equity and return on
assets, all other things equal
 In a bank’s loan portfolio, the highest
yielding loans are typically the least liquid
 The most liquid loans are typically
government-guaranteed loans
119
Liquidity Planning
 The Relationship Between Liquidity,
Credit Risk, and Interest Rate Risk

Liquidity risk for a poorly managed bank
closely follows credit and interest rate
risk


Banks that experience large deposit
outflows can often trace the source to
either credit problems or earnings
declines from interest rate gambles that
backfired
Potential liquidity needs must reflect
estimates of new loan demand and
potential deposit losses
120
Liquidity Planning
 The Relationship Between Liquidity,
Credit Risk, and Interest Rate Risk
121
Traditional Aggregate Measures
of Liquidity Risk
 Asset Liquidity Measures
 The
most liquid assets mature near
term and are highly marketable
 Any security or loan with a price above
par, in which the bank could report a
gain at sale, is viewed as highly liquid
 Liquidity measures are normally
expressed in percentage terms as a
fraction of total assets
122
Traditional Aggregate Measures
of Liquidity Risk
 Asset Liquidity Measures
 Highly Liquid Assets
 Cash and due from banks in excess of
required holdings
 Federal funds sold and reverse RPs.
 U.S. Treasury securities and agency
obligations maturing within one year
 Corporate obligations and municipal
securities maturing within one year and
rated Baa and above
 Loans that can be readily sold and/or
securitized
123
Traditional Aggregate Measures
of Liquidity Risk
 Asset Liquidity Measures
 Pledging

Requirements
Not all of a bank’s securities can be
easily sold
 Like their credit customers, banks are
required to pledge collateral against
certain types of borrowings
 U.S. Treasuries or municipals normally
constitute the least-cost collateral and, if
pledged against debt, cannot be sold until
the bank removes the claim or substitutes
other collateral
124
Traditional Aggregate Measures
of Liquidity Risk
 Asset Liquidity Measures
 Pledging

Requirements
Collateral is required against four
different liabilities:
 Repurchase agreements
 Discount window borrowings
 Public deposits owned by the U.S.
Treasury or any state or municipal
government unit
 FLHB advances
125
Traditional Aggregate Measures
of Liquidity Risk
 Asset Liquidity Measures
 Loans
 Many banks and bank analysts monitor
loan-to-deposit ratios as a general
measure of liquidity
 Loans are presumably the least liquid
of assets, while deposits are the
primary source of funds
 A high ratio indicates illiquidity
because a bank is fully loaned up
relative to its stable funding
126
Traditional Aggregate Measures
of Liquidity Risk
 Liability Liquidity Measures
 Liability
Liquidity:
The ease with which a bank can issue
new debt to acquire clearing balances
at reasonable costs
 Measures typically reflect a bank’s
asset quality, capital base, and
composition of outstanding deposits
and other liabilities

127
Traditional Aggregate Measures
of Liquidity Risk
 Liability Liquidity Measures

Commonly used measures:









Total equity to total assets
Risk assets to total assets
Loan losses to net loans
Reserve for loan losses to net loans
The percentage composition of deposits
Total deposits to total liabilities
Core deposits to total assets
Federal funds purchased and RPs to total
liabilities
Commercial paper and other short-term
borrowings to total liabilities
128
Traditional Aggregate Measures
of Liquidity Risk
 Liability Liquidity Measures
 Core

Deposits
A base level of deposits a bank expects
to remain on deposit, regardless of the
economic environment
 Volatile

Deposits
The difference between actual current
deposits and the base estimate of core
deposits
129
Longer-Term Liquidity Planning
 This stage of liquidity planning involves
projecting funds needs over the coming
year and beyond if necessary
Forecasts in deposit growth and loan
demand are required
 Projections are separated into three
categories: base trend, short-term
seasonal, and cyclical values
 The analysis assesses a bank’s liquidity
gap, measured as the difference between
potential uses of funds and anticipated
sources of funds, over monthly intervals

130
131
Longer-Term Liquidity Planning
 The bank’s monthly liquidity needs are
estimated as the forecasted change in
loans plus required reserves minus
the forecast change in deposits:
Liquidity needs = Forecasted Δloans +
ΔRequired reserves - Forecasted
Δdeposits
132
Longer-Term Liquidity Planning
133
Longer-Term Liquidity Planning
134
Longer-Term Liquidity Planning
135
Longer-Term Liquidity Planning
 Considerations in the Selection of
Liquidity Sources
The costs should be evaluated in present
value terms because interest income and
expense may arise over time
 The choice of one source over another
often involves an implicit interest rate
forecast

136
Contingency Funding
 Financial institutions must have
carefully designed contingency plans
that address their strategies for
handling unexpected liquidity crises
and outline the appropriate procedures
for dealing with liquidity shortfalls
occurring under abnormal conditions
137
Contingency Funding
 Contingency Planning
A

contingency plan should include:
A narrative section that addresses the
senior officers who are responsible for
dealing with external constituencies,
internal and external reporting
requirements, and the types of events
that trigger specific funding needs
138
Contingency Funding
 Contingency Planning
 A contingency plan should include:
 A quantitative section that assesses the
impact of potential adverse events on the
institution’s balance sheet (changes),
incorporates the timing of such events by
assigning deposit and wholesale funding
run-off rates, identifies potential sources
of new funds, and forecasts the
associated cash flows across numerous
short-term and long-term scenarios and
time intervals
139
Contingency Funding
 Contingency Planning
A

contingency plan should include:
A section that summarizes the key
risks and potential sources of funding,
identifies how the modeling will
monitored and tested, and establishes
relevant policy limits
140
Contingency Funding
 Contingency Planning
 The
institution’s liquidity contingency
strategy should clearly outline the
actions needed to provide the
necessary liquidity
 The institution’s plan must consider
the cost of changing its asset or
liability structure versus the cost of
facing a liquidity deficit
141
Contingency Funding
 Contingency Planning
 The
contingency plan should prioritize
which assets would have to be sold in
the event that a crisis intensifies
 The institution’s relationship with its
liability holders should also be
factored into the contingency strategy
 The institution’s plan should also
provide for back-up liquidity
142
12
The Effective Use of
Capital
143
Why Worry About Bank Capital?
 Capital requirements reduce the risk of
failure by acting as a cushion against
losses, providing access to financial
markets to meet liquidity needs, and
limiting growth
 Bank capital-to-asset ratios have fallen
from about 20% a hundred years ago
to around 8% today
144
145
Risk-Based Capital Standards
 Historically, the minimum capital
requirements for banks were
independent of the riskiness of the
bank
 Prior to 1990, banks were required to
maintain:
a
primary capital-to-asset ratio of at
least 5% to 6%, and
 a minimum total capital-to-asset ratio
of 6%
146
Risk-Based Capital Standards
 Primary Capital
 Common
stock
 Perpetual preferred stock
 Surplus
 Undivided profits
 Contingency and other capital reserves
 Mandatory convertible debt
 Allowance for loan and lease losses
147
Risk-Based Capital Standards
 Secondary Capital
Long-term subordinated debt
 Limited-life preferred stock

 Total Capital

Primary Capital + Secondary Capital
 Capital requirements were independent
of a bank’s asset quality, liquidity risk,
interest rate risk, operational risk, and
other related risks
148
Risk-Based Capital Standards
 The 1986 Basel Agreement

In 1986, U.S. bank regulators proposed that
U.S. banks be required to maintain capital
that reflects the riskiness of bank assets



The Basel Agreement grew to include riskbased capital standards for banks in 12
industrialized nations
Regulations apply to both banks and thrifts
and have been in place since the end of 1992
Today, countries that are members of the
Organization for Economic Cooperation and
Development (OECD) enforce similar riskbased requirements on their own financial
institutions
149
Risk-Based Capital Standards
 The 1986 Basel Agreement
A
bank’s minimum capital requirement
is linked to its credit risk

The greater the credit risk, the greater
the required capital
 Stockholders'
equity is deemed to be
the most valuable type of capital
150
Risk-Based Capital Standards
 The 1986 Basel Agreement
 Minimum
capital requirement
increased to 8% total capital to riskadjusted assets
 Capital requirements were
approximately standardized between
countries to ‘level the playing field'
151
Risk-Based Capital Standards
 Risk-Based Elements of Basel I
1.
2.
3.
Classify assets into one of four risk
categories
Classify off-balance sheet commitments
into the appropriate risk categories
Multiply the dollar amount of assets in each
risk category by the appropriate risk weight

4.
This equals risk-weighted assets
Multiply risk-weighted assets by the
minimum capital percentages, currently 4%
for Tier 1 capital and 8% for total capital
152
153
Risk-Based Capital Standards
154
Risk-Based Capital Standards
155
156
157
158
159
What Constitutes Bank Capital?
 Capital (Net Worth)
 The
cumulative value of assets minus
the cumulative value of liabilities
 Represents ownership interest in a
firm
160
What Constitutes Bank Capital?
 Total Equity Capital
 Equals
the sum of:
Common stock
 Surplus
 Undivided profits and capital reserves
 Net unrealized holding gains (losses)
on available-for-sale securities
 Preferred stock

161
What Constitutes Bank Capital?
 Tier 1 (Core) Capital
 Equals
the sum of:
Common equity
 Non-cumulative perpetual preferred
stock
 Minority interest in consolidated
subsidiaries, less intangible assets
such as goodwill

162
What Constitutes Bank Capital?
 Tier 2 (Supplementary) Capital
 Equals
the sum of:
Cumulative perpetual preferred stock
 Long-term preferred stock
 Limited amounts of term-subordinated
debt
 Limited amount of the allowance for
loan loss reserves (up to 1.25 percent
of risk-weighted assets)

163
What Constitutes Bank Capital?
 Leverage Capital Ratio
 Tier 1 capital divided by total assets
net of goodwill and disallowed
intangible assets and deferred tax
assets
 Regulators are concerned that a bank
could acquire practically all low-risk
assets such that risk-based capital
requirements would be virtually zero
 To prevent this, regulators have also
imposed a 3 percent leverage capital ratio
164
165
What Constitutes Bank Capital?
166
What Constitutes Bank Capital?
167
What Constitutes Bank Capital?
 Tier 3 Capital Requirements for Market
Risk Under Basel I
 Market

Risk
The risk of loss to the bank from
fluctuations in interest rates, equity
prices, foreign exchange rates,
commodity prices, and exposure to
specific risk associated with debt and
equity positions in the bank’s trading
portfolio
168
What Constitutes Bank Capital?
 Tier 3 Capital Requirements for Market
Risk Under Basel I
 Banks
subject to the market risk
capital guidelines must maintain an
overall minimum 8 percent ratio of total
qualifying capital [the sum of Tier 1
capital, Tier 2 capital, and Tier 3 capital
allocated for market risk, net of all
deductions] to risk-weighted assets
and market risk–equivalent assets
169
What Constitutes Bank Capital?
 Basel II Capital Standards
Risk-based capital standards that
encompass a three-pillar approach for
determining the capital requirements for
financial institutions
 Basel II capital standards are designed to
produce minimum capital requirements
that incorporate more types of risk than
the credit risk-based standards of Basel I


Basel II standards have not been finalized
170
What Constitutes Bank Capital?
 Basel II Capital Standards
 Pillar I
 Credit risk
 Market risk
 Operational risk
 Pillar II
 Supervisory review of capital adequacy
 Pillar III
 Market discipline through enhanced
public disclosure
171
What Constitutes Bank Capital?
 Weaknesses of the Risk-Based Capital
Standards
 Standards

only consider credit risk
Ignores interest rate risk and liquidity
risk
 Core
banks subject to the advanced
approaches of Basel II use internal
models to assess credit risk

Results of their own models are
reported to the regulators
172
What Constitutes Bank Capital?
 Weaknesses of the Risk-Based Capital
Standards
 The new risk-based capital rules of Basel II
are heavily dependent on credit ratings,
which have been extremely inaccurate in the
recent past
 Book value of capital is often not meaningful
since It ignores:



changes in the market value of assets
unrealized gains (losses) on held-to-maturity
securities
97% of banks are considered “well
capitalized” in 2007

Not a binding constraint for most banks
173
What is the Function of Bank
Capital
 For regulators, bank capital serves to
protect the deposit insurance fund in
case of bank failures
 Bank capital reduces bank risk by:
Providing a cushion for firms to absorb
losses and remain solvent
 Providing ready access to financial
markets, which provides the bank with
liquidity
 Constraining growth and limits risk taking

174
What is the Function of Bank
Capital
175
How Much Capital Is Adequate?
 Regulators prefer more capital
 Reduces the likelihood of bank failures
and increases bank liquidity
 Bankers prefer less capital
 Lower capital increases ROE, all other
things the same
 Riskier banks should hold more
capital while lower-risk banks should
be allowed to increase financial
leverage
176
The Effect of Capital Requirements
on Bank Operating Policies
 Limiting Asset Growth
 The change in total bank assets is
restricted by the amount of bank equity
ROA(1  DR)  ΔEC/TA 2
ΔTA/TA 1 
EQ1/TA 1
 where





TA = Total Assets
EQ = Equity Capital
ROA = Return on Assets
DR = Dividend Payout Ratio
EC = New External Capital
177
178
The Effect of Capital Requirements
on Bank Operating Policies
 Changing the Capital Mix
 Internal
versus External capital
 Change Asset Composition
 Hold
fewer high-risk category assets
 Pricing Policies
 Raise
rates on higher-risk loans
 Shrinking the Bank
 Fewer
assets requires less capital
179
Characteristics of External
Capital Sources
 Subordinated Debt
 Advantages
Interest payments are tax-deductible
 No dilution of ownership interest
 Generates additional profits for
shareholders as long as earnings
before interest and taxes exceed
interest payments

180
Characteristics of External
Capital Sources
 Subordinated Debt
 Disadvantages
Does not qualify as Tier 1 capital
 Interest and principal payments are
mandatory
 Many issues require sinking funds

181
Characteristics of External
Capital Sources
 Common Stock
 Advantages
Qualifies as Tier 1 capital
 It has no fixed maturity and thus
represents a permanent source of
funds
 Dividend payments are discretionary
 Losses can be charged against equity,
not debt, so common stock better
protects the FDIC

182
Characteristics of External
Capital Sources
 Common Stock
 Disadvantages
Dividends are not tax-deductible,
 Transactions costs on new issues
exceed comparable costs on debt
 Shareholders are sensitive to earnings
dilution and possible loss of control in
ownership
 Often not a viable alternative for
smaller banks

183
Characteristics of External
Capital Sources
 Preferred Stock
A
form of equity in which investors'
claims are senior to those of common
stockholders
 Dividends are not tax-deductible
 Corporate investors in preferred stock
pay taxes on only 20 percent of
dividends
 Most issues take the form of
adjustable-rate perpetual stock
184
Characteristics of External
Capital Sources
 Trust Preferred Stock


A hybrid form of equity capital at banks
It effectively pays dividends that are tax
deductible





To issue the security, a bank 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
preferred stock
The interest on the loan is tax deductible such
that the bank deducts dividend payments
Counts as Tier 1 capital
185
Characteristics of External
Capital Sources
 TARP Capital Purchase Program
 The
Troubled Asset Relief Program’s
Capital Purchase Program (TARPCPP), allows financial institutions to
sell preferred stock that qualifies as
Tier 1 capital to the Treasury

Qualified institutions may issue senior
preferred stock equal to not less than
1% of risk-weighted assets and not
more than the lesser of $25 billion, or
3%, of risk-weight assets
186
187
Characteristics of External
Capital Sources
 Leasing Arrangements
 Many banks enter into sale and
leaseback arrangements
 Example:
 The bank sells its headquarters and
simultaneously leases it back from the
buyer
 The bank receives a large amount of cash
and still maintains control of the property
 The net effect is that the bank takes a fully
depreciated asset and turns it into a tax
deduction
188
Capital Planning
 Process of Capital Planning
 Generate
pro formal balance sheet and
income statements for the bank
 Select a dividend payout
 Analyze the costs and benefits of
alternative sources of external capital
189
Capital Planning
 Application
 Consider a bank that has exhibited a
deteriorating profit trend
 Assume as well that federal regulators
who recently examined the bank indicated
that the bank should increase its primary
capital-to-asset ratio to 8.5% within four
years from its current 7%
 The $80 million bank reported an ROA of
just 0.45 percent
 During each of the past five years, the
bank paid $250,000 in common dividends
190
Capital Planning
 Application
 Consider
a bank that has exhibited a
deteriorating profit trend

The following slide extrapolates
historical asset growth of 10%
 Under this scenario, the bank will actually
see its capital ratio fall

The following slide also identifies three
different strategies for meting the
required 8.5% capital ratio
191
192
Depository Institutions Capital
Standards
 The Federal Deposit Insurance
Improvement Act (FDICIA) focused on
revising bank capital requirements to:
 Emphasize
the importance of capital
 Authorize early regulatory intervention
in problem institutions
 Authorized regulators to measure
interest rate risk at banks and require
additional capital when it is deemed
excessive
193
Depository Institutions Capital
Standards
 The Act required a system for prompt
regulatory action
 It
divides banks into categories
according to their capital positions and
mandates action when capital
minimums are not met
194
Depository Institutions Capital
Standards
195
196
Federal Deposit Insurance
 Federal Deposit Insurance Corporation
 Established
in 1933
 Coverage is currently $100,000 per
depositor per institution

Original coverage was $2,500
197
Federal Deposit Insurance
 Federal Deposit Insurance Corporation
 Initial
Objective:
Prevent liquidity crises caused by
large-scale deposit withdrawals
 Protect depositors of modes means
against a bank failure

198
Federal Deposit Insurance
 Federal Deposit Insurance Corporation
 The
Financial Institution Reform,
Recovery and Enforcement Act of 1989
authorized the issuance of bonds to
finance the bailout of the FSLIC

The act also created two new insurance
funds, the Savings Association
Insurance Fund (SAIF) and the Bank
Insurance Fund (BIF); both were
controlled by the FDIC
199
Federal Deposit Insurance
 Federal Deposit Insurance Corporation

The large number of failures in the late 1980s
and early 1990s depleted the FDIC fund



During 1991 - 92, the FDIC ran a deficit and
had to borrow from the Treasury
In 1991 FDIC began charging risk-based
deposit insurance premiums ranging from
$0.23 to $0.27 per $100, depending on a
bank’s capital position.
By 1993, the reduction in bank failures and
increased premiums allowed the FDIC to pay
off the debt and put the fund back in the black
200
Federal Deposit Insurance
201
Federal Deposit Insurance
 FDIC Insurance Assessment Rates



FDIC insurance premiums are assessed
using a risk-based deposit insurance system
Deposit insurance assessment rates are
reviewed semiannually by the FDIC to ensure
that premiums appropriately reflect the risks
posed to the insurance funds and that fund
reserve ratios are maintained at or above the
target designated reserve ratio (DRR) of
1.25% of insured deposits
Deposit insurance premiums are assessed
as basis points per $100 of insured deposits
202
Federal Deposit Insurance
 FDIC Insurance Assessment Rates
 FDIC Improvement Act
 Merged the BIF and SAIF into the
Deposit Insurance Fund (DIF)
 Increasing coverage for retirement
accounts to $250,000 and indexing the
coverage to inflation
 Established a range of 1.15% to 1.50%
within which the FDIC Board of
Directors may set the Designated
Reserve Ratio (DRR)
203
Federal Deposit Insurance
 FDIC Insurance Assessment Rates
204
Federal Deposit Insurance
 FDIC Insurance Assessment Rates
 Subgroup
A
Financially sound institutions with only
a few minor weaknesses
 This subgroup assignment generally
corresponds to the primary federal
regulator’s composite rating of “1” or
“2”

205
Federal Deposit Insurance
 FDIC Insurance Assessment Rates
 Subgroup
B
Institutions that demonstrate
weaknesses that, if not corrected,
could result in significant deterioration
of the institution and increased risk of
loss to the BIF or SAIF
 This subgroup assignment generally
corresponds to the primary federal
regulator’s composite rating of “3”

206
Federal Deposit Insurance
 FDIC Insurance Assessment Rates
 Subgroup
C
Institutions that pose a substantial
probability of loss to the BIF or the
SAIF unless effective corrective action
is taken
 This subgroup assignment generally
corresponds to the primary federal
regulator’s composite rating of “4” or
“5”

207
Federal Deposit Insurance
 FDIC Insurance Assessment Rates
208
Federal Deposit Insurance
 Problems With Deposit Insurance
 Deposit insurance acts similarly to bank
capital
 In banking, a large portion of borrowed
funds come from insured depositors who
do not look to the bank’s capital position
in the event of default
 A large number of depositors, therefore,
do not require a risk premium to be paid
by the bank since their funds are insured
 Normal market discipline in which higher
risk requires the bank to pay a risk
premium does not apply to insured funds
209
Federal Deposit Insurance
 Problems With Deposit Insurance
 Too-Big-To-Fail
Many large banks are considered to be
“too-big-to-fail”
 As such, any creditor of a large bank
would receive de facto 100 percent
insurance coverage regardless of the
size or type of liability

210
Federal Deposit Insurance
 Problems With Deposit Insurance

Deposit insurance has historically ignored
the riskiness of a bank’s operations, which
represents the critical factor that leads to
failure


Two banks with equal amounts of domestic
deposits paid the same insurance premium,
even though one invested heavily in risky
loans and had no uninsured deposits while
the other owned only U.S. government
securities and just 50 percent of its deposits
were fully insured
The creates a moral hazard problem
211
Federal Deposit Insurance
 Problems With Deposit Insurance
 Moral

Hazard
A lack of incentives that would
encourage individuals to protect or
mitigate against risk
 In some cases of moral hazard, incentives
are created that would actually increase
risk-taking behavior
212
Federal Deposit Insurance
 Problems With Deposit Insurance
 Deposit
insurance funds were always
viewed as providing basic insurance
coverage

Historically, there has been
fundamental problem with the pricing
of deposit insurance
 Premium levels were not sufficient to cover
potential payouts
213
Federal Deposit Insurance
 Problems With Deposit Insurance
 Historically, premiums were not assessed
against all of a bank’s insured liabilities
 Insured deposits consisted only of
domestic deposits while foreign deposits
were exempt
 Too-big-to-fail doctrine toward large banks
means that large banks would have
coverage on 100 percent of their deposits
but pay for the same coverage as if they
only had the same $250,000 coverage as
smaller banks do
214
Federal Deposit Insurance
 Weakness of the Current Risk-Based Deposit
Insurance System
 Risk-based deposit system is based on
capital and risk


Hence, banks that hold higher capital,
everything else being equal, pay lower
premiums
“Too Big to Fail”

The FDIC must follow the “least cost”
alternative in the resolution of a failed bank.
Consequently, the FDIC must consider all
alternatives and choose the one that
represents the lowest cost to the insurance
fund
215