Chapter (13)

Managing Non-deposit Liabilities

I. Introduction:
The traditional source of funds for banks and their closest competitors, the thrift
institutions, is deposits. But what does management do when deposit volume and growth
are inadequate to support all the loans and investments the financial firm would like to
make? The largest banks learned that another source of funds was needed to supplement
deposit money. In this chapter we take a detailed look at such a funding source –the so-
called non-deposit liabilities that banks and other depository institutions, particularly the
largest institutions, draw upon every day.

II. Liability Management and the Customer Relationship Doctrine:

Managers of banks and other lending institutions learned over the years that turning down
a profitable loan request with the excuse, “we don’t have enough deposits to support the
loan”, is not well received by their customers. Denial of a credit request often means the
immediate loss of a deposit and perhaps the loss of any future business from the
disappointed customer. On the other hand, granting a loan request usually brings in both
new deposits and the demand for other financial services as well.

The banking community learned long ago the importance of the customer relationship
doctrine. This doctrine proclaims that the first priority of a lending institution is to make
loans to all those customers from whom the lender expects to receive positive net
earnings. If deposits are not immediately available to cover these loans and investments,
then management should seek out the lowest-cost source of borrowed funds available to
meet its customers’ credit needs.

III. Alternative Non-Deposit Sources of Funds:

In the sections that follow we examine the most popular non-deposit funds sources banks
use today.
A. Federal Funds Market:
The most popular domestic source of borrowed reserves among depository institutions is
the Federal Funds Market. Originally, Federal funds consisted exclusively of deposits US
banks hold at the Federal Reserve banks. These deposits are owned by banks and other
depository institutions and are held at the Fed primarily to satisfy legal reserve
requirements, clear checks, and pay for purchases of government securities. These
Federal Reserve balances can be transferred from one institution to another in seconds
through the Fed’s wire transfer network (Fed-wire).

Today, however, correspondent deposits that depository institutions hold with each other
also can be moved around the banking system the same day a request is made. The same
is true of large collected demand deposit balances that securities dealers and governments
own, which also can be transferred by wire. All three of these types of deposits make up
the raw material that is traded in the market for Federal funds. In technical terms, federal
funds are simply short-term borrowings of immediately available money.
Banks, thrifts, securities houses and other firms in need of immediate funds can negotiate
a loan with a holder of surplus inter-bank deposits or reserves at the Fed, promising to
return the borrowed funds the next day if need be.

The main use of the Federal funds market today is still the traditional one: a mechanism
that allows banks and other depository institutions short of reserves to meet their legal
reserve requirements or to satisfy customer loan demand by tapping immediately usable
funds from other institutions possessing temporarily idle funds.

To help suppliers and demanders of Federal funds find each other, funds brokers soon
appeared to trade Federal funds in return for commissions. Large correspondent banks,
known as accommodating banks, play a role similar to that of funds brokers for smaller
depository institutions in their region. An accommodating bank buys and sells Federal
funds simultaneously in order to make a market for the reserves of its customer
institutions, even though the accommodating bank itself may have no need for extra
funds.

Borrowing and lending institutions communicate either directly with each other or
indirectly through a correspondent bank or funds broker. Once borrowing and lending
institutions agree on the terms of a Federal funds loan –especially its interest rate and
maturity- the lending institution arranges to transfer reserves from a deposit it holds,
either at the Federal Reserve bank in its district or with a correspondent bank, into a
deposit controlled by the borrowing institution. This may be accomplished by wiring
Federal funds if the borrowing and lending institutions are in different regions of the
country. If both lender and borrower hold reserve deposits with the same Federal Reserve
bank to transfer funds from its reserve account to the borrower’s reserve account –a series
of bookkeeping entries accomplished in seconds via computer. When the loan comes due,
the funds are automatically transferred back to the lending institution’s reserve account.

The interest rate on a federal funds loan is subject to negotiation between borrowing and
lending institutions. While the interest rate attached to each Federal funds loan may differ
from the rate on any other loan, most of these loans use the effective interest rate
prevailing each day in the national market.

The Federal funds market uses three types of loan agreements:

Overnight loans: Overnight loans are unwritten agreements, negotiated via wire or
telephone, with the borrowed funds returned the next day. Normally, these loans are not
secured by specific collateral, though where borrower and lender do not know each other
well or there is doubt about the borrower’s credit standing, the borrower may be required
to place selected government securities in a custody account in the name of the lender
until the loan is repaid.

Term loans: are longer-term Federal funds contracts lasting several days, weeks, or
months, often accompanied by a written contract.
Continuing contracts: are automatically renewed each day unless either the borrower or
the lender decides to end this agreement.

B. Repurchase Agreements as a Source of Bank Funds:

Repurchase agreements (RP s) are very similar to federal funds transactions and are often
viewed as collateralized federal funds transactions. In a Federal funds transaction, the
seller (lender) is exposed to credit risk via the uncertainty that the borrowing institution
may not have the funds to repay. If the purchaser of federal funds were to provide
collateral in the form of marketable securities, it would reduce the credit risk. The
reduction in credit risk in exemplified in the lower cost of RP s when compared to
Federal funds rates. Most RP s are transacted across the Fed Wire system, just as are
Federal funds transactions. RP s may take a bit longer to transact because the seller of
funds (the lender) must be satisfied with the quality and quantity of securities provided as
collateral.
Repurchase agreements get their name from the process involved –the institution
purchasing funds (the borrower) is temporarily exchanging securities for cash. RP s
involve the temporary sale of high-quality, easily liquidated assets, such as Treasury bills,
accompanied by an agreement to buy back those assets on a specific future date at a
predetermined price. An RP transaction is often for overnight funds; however, it may be
extended for months.

The interest cost for both Federal funds transactions and repurchase agreements can be
calculated from the following formula:
Interest Cost of RP = Amount borrowed x Current RP rate x No of days in RP borrowing
360 days
For example, suppose the commercial bank borrows $50 million through an RP
transaction collateralized by government bonds for 3 days and the current RP rate in the
market is 6%. Then this bank’s total interest cost would be as follows:

Interest cost of RP = 50,000,000 x 0.06 x 3 = $24,995

360
Conventional (fixed-collateral) repurchase agreements designate specific securities to
serve as collateral for a loan, with the lender taking possession of those particular
instruments until the loan matures. In contrast, the general-collateral GCF RP permits
relatively easy and low-cost collateral substitution. Borrower and lender can agree upon a
variety of securities, any of which may serve as loan collateral. This agreed-upon array of
eligible collateral might include, for example, any Treasury securities maturing within 5
years or any obligation of the US Treasury or a federal agency. Thus, the same securities
pledged at the beginning do not have to be delivered at the end of a loan.

C. Borrowing from the Federal Reserve Bank in the District:

For a depository institution with immediate reserve needs, a viable alternative to the
Federal funds and RP markets in negotiating a loan from a Federal Reserve bank for a
short period of time (in most cases, no more than two weeks). The Fed will make the loan
through its discount window by crediting the borrowing institution’s reserve account held
at the Federal Reserve Bank in its district.
Each loan made by the Federal Reserve Bank must be backed by collateral acceptable to
the Fed. Most banks and other loan-eligible depository institutions keep government
securities in the vaults of the Federal Reserve banks for this purpose.

Three types of Federal Reserve loans are available from the discount window:
1. Primary credit: loans available for very short terms (usually overnight but
occasionally extending over a few weeks) to depository institutions in sound financial
condition. The primary credit loan rate is established at least every two weeks, subject to
review by the Board of Governors of the Federal Reserve System.
Users of primary credit do not have to show that they have exhausted other sources of
funds before asking the Fed for a loan. Moreover, the borrowing institution is no longer
prohibited from borrowing from the Fed and then loaning that money to other depository
institutions in the Federal funds market.

2. Secondary Credit: Loans available at a higher interest rate to depository institutions

not qualifying for primary credit. These loans are subject to monitoring by the Federal
Reserve banks to make sure the borrower is not taking on excessive risk. Such a loan can
be used to help resolve financial problems, to strengthen the borrowing institution’s
ability to find additional funds from private-market sources, and to reduce its debt to the
Fed. However, secondary credit cannot be used to fund the expansion of a bank’s assets.

3. Seasonal Credit: Loans covering longer time periods than primary credit for small and
medium-sized depository institutions experiencing seasonal swings in their deposits and
loans.

As noted above, each type of discount-window loan carries its own loan rate, with
secondary credit generally posting the highest interest rate and seasonal credit the lowest.

D. Development and Sale of Large Negotiable CDs:

The concept of liability management and short-term borrowing to supplement deposit
growth was given a significant boost early in the 1960s with the development of a new
kind of deposit, the negotiable CD. A CD is an interest-bearing receipt evidencing the
deposit of funds in the accepting bank for a specified period of time at a specified interest
rate.
There are four main types of negotiable CDs today. Domestic CDs are issued by US
banks inside the US. Euro-CDs are dollar-denominated CDs issued by banks outside the
United States. Yankee CDs are CDs sold through by large foreign banks active in the
United States through their US branches. Thrift CDs are CDs that are sold by large
savings and loan associations and other non-bank savings institutions.

During the 1960s, faced with slow or nonexistent growth in checkbook deposits.
Citigroup, one of the most innovative banks in the world, was the first to develop the
large ($100,000+) negotiable CD in 1961.
Negotiable CDs would be confined to short maturities, ranging from 7 days to 1-2 years
in most cases, but concentrated mainly in the 1-to-6 month maturity range for the
convenience of the majority of CD buyers. And the new instrument would be negotiable
–able to be sold in the secondary market any number of times before reaching maturity –
in order to provide corporate customers with liquidity in case their cash surpluses proved
to be smaller or less stable than originally forecast. To make the sale of negotiable CDs in
advance of their maturity easier, they were issued in bearer form.

Interest rates on fixed-rate CDs, which represent the majority of all large negotiable CDs
issued, are quoted on an interest-bearing basis, and the rate is computed assuming a 360-
day year. For example, suppose a bank promises an 8% annual rate to the buyer of a
$100,000 six-month (180 days) CD. The depositor will have the following at the end of
six months:

Amount due CD customer= Principal + Principal x Days to maturity x Annual rate of

interest
360 days
= 100,000 + 100,000 x 180 x 0.08 = $ 104,000
360

CDs that have maturities over one year normally pay interest to the depositor every six
months. Variable-rate CDs have their interest rates reset after a designated period of time
(called a leg or roll period). The new rate is based on a mutually accepted reference
interest rate, such as the London Inter-bank Offer Rate (LIBOR) attached to borrowings
of Eurodollar deposits or the average interest rate prevailing on prime-quality CDs traded
in the secondary market.
The net result of CD sales to customers is often a simple transfer of funds from one
deposit to another within the same depository institution, particularly from checkable
deposits in CDs. The selling institution gains loanable funds even from this simple
transfer because, in the US at least, legal reserve requirements are currently zero for CDs,
while checking accounts at the largest depository institutions carry a reserve requirement
of 10%. Also, deposit stability is likely to be greater for the receiving bank because the
CD has set maturity and normally will not be withdrawn until maturity. In contrast,
checkable (demand) deposits can be withdrawn at any time.

However, the cost of negotiable CDs, measured by their market interest rates, is sensitive
to competition among depository institutions, the credit rating of the offering institutions,
and economic conditions.

E. Eurocurrency Deposit Market:

Eurocurrency deposits were developed originally in Western Europe to provide liquid
funds that could be swapped among multinational banks or loaned to the banks’ largest
customers.
Eurodollars are dollar-denominated deposits placed in bank offices outside the US, they
are denominated on the receiving banks’ books in dollars rather than in the currency of
the home country and consist of bookkeeping entries in the form of time deposits.

The banks accepting these deposits may be foreign banks, branches of US banks
overseas, or international banking facilities (IBF s) set up on US soil. The heart of the
worldwide Eurodollar market is ion London, where British banks compete with scores of
American and other foreign banks for Eurodollar deposits. The Eurocurrency market is
the largest unregulated financial marketplace in the world, which is one reason it has
been one of the faster-growing financial markets.

A domestic bank can tap the Euro-market for funds by contacting one of the major
international banks that borrow and lend Eurocurrencies every day. The largest US banks
also use their own overseas branches to tap this market. When one of these branches
lends a Euro-deposit to its home office in the US, the home office records the deposit in
an account labeled liabilities to foreign branches. When a US bank borrows Euro-
deposits from a bank operating overseas, the transaction takes place through the
correspondent banking system. The lending bank will instruct a US correspondent bank
where it has a deposit to transfer funds in the amount of the Eurocurrency loan to the
correspondent account of the borrowing institution. These borrowed funds will be quickly
loaned to qualified borrowers or perhaps used to meet a reserve deficit.

Most Eurodollar deposits are fixed-rate time deposits.

Large-denomination Euro-CD s issued in the inter-bank market are called tap CDs, while
smaller denomination Euro CD s sold to a wide range of investors are called tranche
CDs.

F. Commercial Paper Market:

Late in the 1960s, large banks faced with intense demand for loans found a new source of
loanable funds –The commercial paper market-. Commercial paper consists of short-term
notes, with maturities from 3 or 4 days to 9 months, issued by well-known companies to
raise working capital. Most such paper is designed to finance the purchase of inventories
of goods or raw materials, cover taxes, or meet other immediate corporate cash needs.
The notes are sold at a discount from their face value through dealers or through direct
contact between the issuing company and interested investors.

G. Long-Term Non-deposit Funds Sources:

Banks and other financial firms also tap longer-term non-deposit funds stretching well
beyond one year. Examples include mortgages issued to fund the construction of
buildings and capital notes and debentures, which usually range from 7 to 12 years in
maturity and are used to supplement equity (owners’) capital.
Because of the long-term nature of these funding sources, they are sensitive to risk of
default.

IV. Choosing among Alternative Non-Deposit Sources:

With so many different non-deposit funds sources to draw on, managers of banks must
make choices among them. In using non-deposit funds, funds managers must answer the
following key questions:
1. How much in total must be borrowed from these sources to meet funding needs?
2. Which non-deposit sources are best, given the borrowing institution’s goals, at
any given moment in time?

A. Measuring a Financial Firm’s Total Need for Non-deposit Funds:

1. The Funds Gap:
Each depository institution’s demand for non-deposit funds is determined basically by the
size of the gap between its total credit demands and its deposits. Management must be
prepared to meet, not only today’s credit requests, but also all those it can reasonably
anticipate in the future. Such anticipations should be based on information gathered from
frequent contacts between the financial firm’s officers and both existing and potential
customers.

The second decision that must be made is how much in deposits is likely to be attracted
in order to finance the desired volume of loans and security investments. Again,
projections must be made of customer deposits and withdrawals, with special attention to
the largest depositors. Deposit projections must take into account current and future
economic conditions, interest rates, and the cash flow requirements of the largest
depositors.

The difference between current and projected credit and deposit flows yields an estimate
of each institution’s funds gap. Thus,

The funds Gap = Current & Projected loans and investments the lending institution
desires to make – Current & expected deposit inflows
For example, suppose a commercial bank has new loan requests that meet its quality
standards of $150 million; it wishes to purchase $75 million in new Treasury securities
being issued this week and expects drawings on credit lines from its best corporate
customers of $135 million. Deposits received today total &185 million, and those
expected in the coming week will bring in another $100 million. This bank’s estimated
funds gap (FG) for the coming week will be as follows (in millions of $):
FG = ($10 + $75 + $135) – ($185 +$100) = $75
Most institutions will add a small amount to this funds gap estimate to cover unexpected
credit demands or unanticipated shortfalls in deposit inflows.

B. Non-Deposit Funding Sources: Factors to Consider:

Which non-deposit sources will management use to cover a projected funds gap? The
answer to that question depends largely upon 5 factors:
1. The relative costs of raising funds from each non-deposit source.
Managers of financial institutions practicing liability management must constantly be
aware of the going market interest rates attached to different sources of borrowed funds.

2. The risk of each funding source.

The managers of financial institutions must consider at least two types of risk when
selecting among different non-deposit sources. The first is interest-rate risk –the
volatility of credit costs. The shorter the term of the loan, the more volatile the prevailing
market interest rate tends to be. Thus, most Federal funds loans are overnight and not,
surprisingly, this market interest rate tends to be the most volatile of all.
Management must also consider credit availability risk. There is no guarantee in any
credit market that lenders will be willing and able to accommodate every borrower. When
general credit conditions are tight, lenders may have limited funds to loan and may ration
credit, confining loans only to their soundest and most loyal customers.

3. The length of time (maturity or term) for each funding source.

Some funds sources cannot be relied on for immediate credit (such as commercial paper
and Euro-dollars). A manager in need of funds would be inclined to borrow in the Federal
funds market. However, if funds are not needed for a few days, selling CDs or
commercial paper becomes a more viable option.

4. The size of the institution that requires non-deposit funds.

The Federal Reserve’s discount window and the Federal funds market can make
relatively small denomination loans that are suitable for smaller banks and other
depository institutions as compared to large denomination loans given to larger banks.

5. Regulations limiting the use of alternative funds sources.

Government regulations may limit the amount, frequently, and use of borrowings by
banks. For example, CD s must be issued with maturities of at least 7 days. Another
example is the Federal Reserve banks limiting excessive borrowing from the discount
window, particularly by depository institutions that appear to display significant risk of
failure. All these regulations affect the choice of borrowing sources to banks.