Module 5 Managing Liabilities

Hogan et al. divides liabilities into 2 broad categories: deposits and other liabilities.

Types of deposit

1. Current deposits: are transaction deposits that have no maturity, they may be interest and non- interest bearing
2. Fixed or term deposits: they differ from savings deposits because they have a predetermined maturity date and
withdrawals prior to that date are often subject to interest penalties.
3. Certificates of deposit (CDs): negotiable and non-negotiable
4. Other deposits:

 investment savings accounts: these have a minimum balance requirement.

 statement savings accounts: these have no minimum balance requirements.
 passbook accounts: these are low interest accounts with no minimum balance requirements.
 cash management accounts: These have a minimum daily balance requirement & typically pay high interest
rates.
 pensioner deeming accounts: These are savings accounts available to depositors of pensionable age.
 Vostro account: a foreign bank’s AUD deposit account held in an Australian bank.

Foreign Office Deposits:

Eurocurrency

 Financial claim denominated in a currency other than that of the country where the issuing bank is located.
 For example, an Australian bank receives a deposit denominated in USD. The accepting bank must be located
outside the country that issues the currency.

Eurodollar Deposits

 The Eurodollar deposits are the dominant Eurocurrency. These are US dollar liabilities of a bank located outside
of the United States. Eurodollar deposits are equivalent to US CDs.
 They are large denominations (multiple millions), have fixed maturities, and pay rates slightly above the
comparable CDs issues by US banks. They may be negotiable or non-negotiable.

At call deposits

 There are also at call deposits generally made by ADI’s wanting to earn interest on short term liquidity surpluses.
 However, some depositors leave funds for long periods, and hence they can be a source of cheap funding for ADI.

Other Liability Funding

Hogan et al. lists four general categories:

1. Other borrowings: senior debt, term subordinated debt, loan capital etc.
2. Bill acceptance facilities: bank bills accepted by the bank and sold on the market. The final holder will claim face value
from bank. The bank has an equal claim on the bill issuer. (30–180-day discount instruments)
3. Other Australian dollar liabilities: these include provision accounts, prepayments received, accounts payable and a
range of other liabilities
4. Foreign currency liabilities: including notes and bonds issued in foreign currencies overseas.

Term Funding Facility (TFF)

 Introduced by the government in March 2020 – initially available till September 30.
 It provides low-cost term funding to authorised deposit-taking institutions (ADIs) and an incentive for ADIs to
increase lending to businesses, particularly small- and medium-sized enterprises (SMEs).
 Under the TFF, ADIs had access to three-year funding at an interest rate of 0.25 per cent.
 Almost all of the funding available under the $84 billion TFF initial allowance was drawn down.
 Large Australian banks, regional banks and smaller ADIs drew down close to all of their initial allowances, while
foreign ADIs used nearly three-quarters of their allowances.
 The facility has been extended for the period 1 October 2020 to June 2021. Total funding available is $57 billion.
The interest rate has been reduced to 0.1%.
Australian Data
As at November 2020, statistics for Australian banks & Australian books of foreign banks are listed below.
Key bank liabilities, in order of size were:

1. Deposits: $2,384.27 billion AUD (Cheque accounts, savings accounts, term deposits etc.)
2. Bonds, notes and long-term borrowings: $ 540.093 billion AUD (These have a maturity > 1 year)
3. Short term borrowings: $266.32 billion AUD (securities sold under agreement to repurchase, promissory
notes/commercial paper, other short-term debt securities and short-term borrowings.)
4. Intra Group Deposits: $72.88 billion AUD
5. Bill Acceptances: $283 million AUD

Recent Trends in Bank Funding Sources (Koch and MacDonald)

 Bank customers have become more rate conscious.

 Many customers have demonstrated a strong preference for shorter-term deposits.
 Core deposits are viewed by banks as increasingly valuable: these are stable deposits.
 American Banks often issue hybrid CDs (eg. variable rate, equity indexed) to appeal to rate sensitive depositors.

5.2 Measuring the cost of funds

Reasons for measuring include:

1. Performance assessment – how well has the bank managed its costs overall.
2. Fund selection – there are a range of funding options and the cost is an important criteria for selection.
3. Acceptable returns - cost of funds is the basis for determining what level of returns a bank should be making on
its investments.
4. pricing new loans – the underlying cost of funds is a key consideration in determining the price of loans
extended.

Historical Average Cost

The cost of existing funds. Non-capital funds = liabilities

Historical cost of funds = Interest expense/Total non-capital funds

Alternatively, the calculation can be based on the value of interest-bearing funds only:

Interest expense/Interest bearing funds

In the following example (Hogan Table 5.5):

Interest bearing funds = Total liabilities – (non interest current accounts + bill acceptances + other liabilities)
Improper uses for historical cost measures
According to Koch and MacDonald: 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.

Valid uses for historical cost measures

Historical average cost can be used to assess past performance, and the calculation can be adjusted to account for
practical issues such as:

 Some funds must be invested in non-earning assets: required liquid reserves, premises etc.
 Expenses associated with attracting funds, such as advertising, should be included.
 What about the cost of shareholder’s equity (where equity supplies some of the funding)? Should it be included?

Addressing the practical issues

Various earning requirements of assets can be established based on the historical cost, as shown in part 2 of Table 5.5. See
Figure 5.2 for asset values.

Note:
a) Earning assets = Total assets – (notes and coin + cash at bankers + Fixed assets + Other assets)
note also : interest expense should be $9527
b) $3298 = net non-interest expense (non-interest expense – noninterest revenue) =$4845 - $1547
c) They are assuming a target after-tax return on equity of 8% and a 39% tax rate.

Marginal cost of funds

The Marginal Cost of Funds (MC) is the cost of new (additional 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.
 MC equals the effective cost of borrowing from each source, including interest expense and transactions costs.
 In theory, 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.
Measuring Marginal Cost (MC)

1. MC of funds from a specific source

This is the simplest measure: The bank can calculate the cost a specific type such as interest bearing current accounts,
investment savings accounts, long term debt etc.

Marginal cost specific fund type = interest cost of additional funds + Non-interest costs eg. costs of acquiring and servicing
new accounts, insurance (where relevant).

Example from Hogan text

See page 169 part 6. Funding cost projections for 2007 include the interest cost and net processing costs:

Calculating a few marginal costs:

Source of funds Projected Interest Net Processing Cost Marginal cost of
Cost (%) (%) source (%)
Interest bearing 5.88 3.0 8.88
current account
Statement savings 7.58 1.0 8.58
accounts
Fixed deposits 9.8 0.5 10.3

Examples from Koch and MacDonald

1. This example shows a base measure of required return on the earning (or investable) amount:

 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

0.025  0.041  0.01  0.0025

Marginal Cost   0.0924  9.24%
0.85
2. This example looks at the marginal cost of subordinated debt
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%
7
$700,000 $10,000,000
$9,900,000   
t 1 (1  k d ) t (1  k d ) 7
Thus k d  7.19%

SEE EXCEL CALUALTION SPREADSHEET

2. Pooled Marginal Cost of Funds
This looks at the additional amount of each type of liability a bank plans to acquire and the marginal cost of each type and
generates a total cost for each and also measures the investable portion.

 This is divided by the total amount of additional liability funds the bank plans to acquire to produce a pooled
marginal cost value. Required return on earning assets can also be calculated.
 Column 4 ‘interest and other costs’ are from page 169 and are the sum of interest costs and processing costs, i.e.,
they are the marginal costs from a specific source.
 We can vary the calculation by dividing the cost of new funds by the total amount of investable funds to work out
a required return from invested funds. (See the second calc. in Table 5.6.)
 The percentage of investable funds is taken from Table 5.4.
 A higher return is needed from invested funds to recover the costs as not all the funds are invested.

Valid Uses for Marginal Cost Measures

If the bank is looking at costs to decide:

 which is the best type of liability to acquire

 what is the best mix of liabilities
 how to price loans

then some form of marginal cost will be appropriate.

Sourcing Funds
The marginal cost from a specific source could be used as one of the determinants. For instance, it would enable the ADI
to select the cheapest source of funds. Recall that the marginal cost includes net non-interest costs (advertising and
operational costs net of noninterest revenue).

Loan Pricing
Loan pricing must take into account the cost of funding, the associated risks (credit, interest rate, liquidity, and capital),
and other costs such as overheads.

 Some measure of marginal cost will therefore be useful. We must remember that some of the liability funds will
be put into non-earning assets. This will increase the return that is required from the funds that do purchase
earning assets.
 Using MC for loan pricing when some of the liability funds are put into non-earning assets:
interest costs  other costs
1 - % in non - earning assets
 Note: technically, some non-earning assets may earn some interest. Cash is non-earning, but liquid assets such as
those held in Exchange Settlement Accounts (ESAs) do earn some interest.
 We can also make further adjustments if a proportion of funding is supplied by equity.
 How is non-capital funding calculated?

Non-cap + 0.08 = 1 + 0.1×Non-cap

NC - 0.1NC = 1 -0.08
NC[1-0.1] = 1 – 0.08
NC = (1-0.08)/(1-0.1) =1.0222

In part 2) of the calculation, why do we deduct

an amount for liquids?

Because: those liquid reserves will assume they

are going into an account e.g. exchange
settlement account which at this time is
earning 4% interest. Since we are looking at
cost of funds we want to net out that cost since
it is revenue.

Problems with this cost of funds measure include:

 Using one source may increase risk and this may increase the return required by shareholders. This extra cost
needs to be accounted for.
 ADIs will often use more than one source. One suggestion is that the source with the highest MC be used in the
calculation of loan price.

MC of pooled funding
Recall Hogan Table 5.6. When calculating MC for the purpose of pricing, we should adjust the calculation to account for
funds that are not invested in earning assets. Hence, the second calculation is appropriate:

Total $ cost
Investable funds

5.3 Risks associated with raising funds

This section looks at how different types of liability funding impact on the various categories of financial risk: liquidity risk,
interest rate risk, credit risk and capital risk.

Liquidity risk:

 Liquidity risk arises because depositors can withdraw their money with little or no warning, while banks tend to
invest these funds in longer term securities.
 Banks do of course hold cash for these purposes, and day to day withdrawals are fairly predictable and banks can
borrow funds to meet any shortfalls. However unseasonably large withdrawals may occur, and this can cause
problems if this trend occurs across the industry.

Interest rate risk:

 Interest rate risk arises when the interest sensitivity of borrowed funds is different to the sensitivity of the asset
bought with those funds.
 Mismatches can be diminished by targeted funding or via derivative instruments such as interest-rate futures or
swaps, or by changing the asset mix.

Note: 11am money: Funds which can be recalled, repaid or renegotiated as

to interest rate during a morning's money-market trading, up to 11am,
without the need for previous notice. These are different from 24 - hour
call money, on which notice must be given the previous day of any
intention to recall, repay or renegotiate on rate.
Credit risk:
Credit risk arises on the asset side of the ledger. However, liabilities may indirectly affect risk as noted below.

 The ADI may have a large exposure to a corporation that defaults. This could affect depositor’s confidence.
 If lenders/creditors or depositors are concerned about the ADI, they may require a higher rate of return.
 And, if the ADI pays a higher rate on borrowed funds, it may try to recoup this by making riskier investments, i.e.,
that entail more credit risk.

Capital risk:

 An ADI’s equity costs more than its deposits or other liabilities because equity holders have more risk.
 For this reason, an ADI may want to increase the proportion of liability funding i.e., increase leverage.
 This will increase capital risk: the risk that the bank will have insufficient capital to absorb losses.
 This risk is of course mitigated by capital adequacy (CAR) requirements.

Note: why do equity holders have more risk?

As noted in Reading 5.1, APRA’s priority for distributing assets in a windup is:

1. The ADI’s liabilities (if any) to APRA

2. The ADI’s debts (if any) to APRA
3. The ADI’s deposit liabilities in Australia
4. Senior debt
5. Subordinated debt
6. Hybridse
7. Preference Shares
8. Equity Holders

5.4 Funding strategies

ADIs vary in their liability funding mixes. See Table 5.10 from Hogan and Exhibit 10.4 from Koch and MacDonald.

- Small-Medium ADIs have on average, a higher percentage of retail deposit liabilities than large ADIs.

- Large banks have a higher proportion of wholesale deposits (large CDs) and other borrowing such as subordinated debt.

Strategies for deposit funding

1. Product development
Step 1: find out what customers want.
Step 2: develop products to fulfil these wants.
Products are developed for specific purposes but are also developed within a suite of products which must be managed as
a whole.
2. Market segmentation
Isolate certain sectors of the market and create products tailored specifically to that sector.
Care must be taken to accurately gauge demand for the new product.

3. Product differentiation and image

An ADI will need strategies to set their product apart from the competition. It may be difficult to achieve this via unique
features, and so emphasis may need to be placed on advertising and promotion.
Would the ADI want demand for its products to be elastic or inelastic? Part 2 @15:01

4. Deposit attraction

 Some factors affecting deposits are external to an ADI’s control: monetary and fiscal policy, economic growth etc.
 Factors over which the bank has discretion include: marketing effort, interest rates paid on deposits, number and
location of branches, number of branch personnel, services available to depositors eg. internet options etc.
 There is a link between lending and deposit attraction. If funds are in short supply, ADIs may give preference to
those customers who maintain deposit accounts with them.
 A line of credit, such as an overdraft, attached to an a/c may also encourage increased demand for deposit a/c.

5. Demand for specific deposit types

 Savings deposits: factors include advertising, rates and convenient access.

 Money market deposits: rates are primary, but transferability and general convenience + advertising play a part.
 Fixed deposits: factors include rates, features, penalties for early withdrawal.
 CDs: for CDs, ADIs must be well known and there must be a liquid secondary market for the CDs.

Strategies for non-deposit funding

 Rates are important for funds such as interbank borrowing or commercial paper.
 Repos require a pool of high-quality assets such as treasury securities.
 Eurocurrency and other foreign sources may be encouraged by the establishment of foreign offices and
connections with overseas banks and businesses.

Risk and the funding mix

The mix needs to balance cost and risk. An ADI needs to acquire an optimal liability mix that will maximise shareholder
value. Diversity of sources is important:

 Specific sources may become less available and more expensive.

 Retail deposits are interest inelastic: when rates are rising, this is a good source of funds.
 When rates are falling, money market funds are more attractive since they are more interest elastic.
 Another reason to have a diverse funding base is that it is difficult to change the funding mix quickly. It helps an
ADI to have a strong funding base and to be well known in money markets, so that funds can be attracted when
needed.
 Loan securitisation is an alternative means by which an ADI can gain access to funds – though currently the
market demand for securitised mortgages is depressed.

Revision Questions
1. Name one reason why a bank should measure the cost of funds.

One reason is in order to track its performance how well has the bank managed to keep its cost down. And how are those
phones tracking over time, compared to peer average etc.

2. Which cost measure is best for assessing past performances?

It won’t be a marginal cost because that is looking at the cost of future acquisitions of funding. It will be one of the
measures that look at historical data and weather its looking at measure of break even or a measure of historical average
cost. Its tracking back into the previous years and look at the cost trends, which enable the bank to make an assessment of
how its tracking and compare to its own objectives but also peer averages.

3. What does the following equation measure?

Interest plus all other net expenses/earning assets
This is the break even return required from assets that are earning a return to cover the cost of funds. Which is interest
and other net expenses associated whit attracting and generating funding for the bank.

4. Which are more interest elastic retail deposits or money market funds?

Money market funds are more elastic.

5. If rates are forecast to rise, which of these sources (retail deposits or money market funds) would a bank be wise
to use?

They may as well go with deposits funds because depositors are less responsive to a raising rate environment. They are not
necessarily going to withdraw their funds quickly and look for other ways to invest those funds because they have other
priorities. So, form the banks perspective this is good because in raising rate environment they are getting higher return on
their loans, if they can hold those deposits relatively unchanged then that increases the interest margin.

6. Calculate the percentage net cost of funds for a loan where:

 Internal transfer price of non-capital funds with the same maturity as the loan being financed is 6.5%
 the loan is being financed with 15% equity
 the target before tax return on equity is 16%
 the bank holds liquid assets equal to 10% of non-capital funds
 liquids earn on average 5%

Deposit funding + Equity Funding = Loan + Liquids

D + 0.15 = 1 + 0.1D
D – 0.1D = 1 1- 0.15
D[1-0.1] = 1 -0.15
D = (1 -0.15)/( 1-0.1) = 0.9444

This means that 94.44 cents of deposits plus 15 cents of equity will be required to fund a 1 dollar loan.

Deposits 0.9444 @6.5% = 0.061389

Equity 0.15 @ 16% = 0.024
Liquids 0.09444 @ 5% = -0.0472 (0.09444 = 10% of deposits)

= 8.067%