Ch: 17 Commercial Bank Sources

and Uses of Funds

 Bank Sources of Funds:

Long-term Sources of Funds:

Deposit accounts:
• Bonds issued by the Bank
• Transaction Deposits • Bank Capital
• Savings Deposits
• Time Deposits
• Money Market Deposit Accounts

Borrowed Funds:

• Federal Funds purchased (borrowed)

• Borrowing from the Federal Reserve
Banks
• Repurchase agreements
• Eurodollar Borrowings
 Deposit Accounts
• Another type of Transaction
Transaction Deposits: account is Negotiable Order of
Withdrawal(NOW). It provides
checking services as well as
• The demand deposit account, or interest. It requires large
checking account, is offered to minimum balance.
customers who desire to write
checks against their account.
• Electronic Transactions:
Customers now use electronic
• From the bank’s perspective, banking to pay utility bills, check
demand deposit accounts are account balances, add deposits,
classified as transaction accounts Credit card payments, funds
that provide a source of funds transfer, cash withdrawals (ATM).
that can be used until withdrawn Debit cards allow customers to
by customers. make purchases and their
accounts are debited by the
amount.
 Savings Deposits

• The traditional savings account is the passbook savings

account, which does not permit check writing.

• The passbook savings account continues to attract

savers with a small amount of funds, as it often has no
required minimum balance.

• Another type of saving account is Automatic Transfer

Service (ATS). It allows customers to write checks and
the required amount is transferred to checking account
while on remaining balance, interest is earned.
 Time Deposits

Negotiable Certificate of
• Time deposits can not be Deposit:
withdrawn until a specified • Another type of time deposit
maturity. Two types of Time is a negotiable CD offered by
deposits are: some large banks to
corporations. They have a
1. Certificate of Deposit specific maturity and require
minimum balance.
2. Negotiable Certificate of
Deposit
• Their maturities are typically
short term, and their
minimum deposit requirement
is $100,000. A secondary
marked for NCDs does exist.
 Certificate of Deposit

• A common type of time deposit • Some CD rates are tied to the

known as retail certificate of deposit performance of a stock market index
requires a specified minimum but guarantee a minimum rate
amount of funds to be deposited for regardless of the stock markets
a specified period of time. performance.

• Banks are now able to offer a CD that • Callable CDs are also offered which
better meets an individual’s needs. can be called back before maturity.

• Most offer a wide variety, with • No organized secondary market exist

maturities as short as seven days and for CDs.
annualized interest rates that vary
among banks, and even among
maturity types within a single bank.
 Money Market Deposit Accounts

• These accounts do not have specific maturity

and are more liquid as compared to retail CDs.

• They provide limited check writing facility,

require large minimum balance and offer
higher return.
 Borrowed Funds

• Federal Funds Purchased:

• The interest rate charged in the
• The federal funds market allows federal funds market is called the
depository institutions to federal funds rate which changes
accommodate the short-term according to demand and supply
liquidity needs of other financial of funds.
institutions.
• If many banks have excess funds
• Federal funds purchased and few banks are short of funds,
represent a liability to the the federal funds rate would be
borrowing bank and an asset to low.
the lending bank that sells them.
• Federal funds rate is generally
• Loans are made from one day to between 0.25 % and 1 % higher
seven days. than T-Bill rate.
 Borrowing from the Federal Reserve
Bank
• Federal Reserve District banks
regulate certain activities of banks
and also provide short-term loans to
banks. This form of borrowing by
banks is often referred to as
borrowing at the Discount Window.
• The interest rate charged on these
loans is known as the discount rate.
• Loans from the discount windows are
short term, commonly from one day
to a few weeks.
• Like the federal funds market, the
discount window is mainly used to
resolve a temporary shortage of
funds.
• When a bank needs temporary funds,
it must decide whether borrowing
through the discount window is more
feasible than alternative non
depository sources of funds, such as
the federal funds market.
• The federal funds rate is more
volatile than the discount rate
because it is market determined, as it
adjusts to demand and supply
conditions on a daily basis.
• Conversely, the discount rate is set by
Federal Reserve and adjusted only
periodically to keep it inline with
other market rates.
 Repurchase Agreements

• A repurchase agreement represents the sale of securities by one

party to another with an agreement to repurchase the securities at
a specified date and price.

• The government securities involved in the repo transaction serve as

collateral for the corporation providing funds to the bank.

• Repurchase agreements transactions occur through a

telecommunications network connecting large banks, other
corporations, government securities dealers, and federal funds
brokers.

• The yield on repurchase agreements is slightly less than the federal

funds rate at any given point in time, since the funds loaned out are
backed by collateral and are therefore less risky.
Eurodollar Borrowings:
• If a U.S bank is in need of
short term funds, it may
borrow from those banks
outside the United States
that accept dollar
dominated deposits, or Euro
dollars.
Bonds Issued by the Bank:
• Like other corporations,
banks own some fixed
assets such as land,
buildings, and equipment.
• These assets often have an
expected life of 20 years or
more and are usually
financed with long term
sources of funds, such as
through the issuance of
bonds.
 Bank Capital

• It generally represents funds obtained through the issuance of stock

or through retaining earnings.

• Primary capital results from issuing common or preferred stock or

retaining earnings, while secondary capital results from issuing
subordinated notes and debentures.

• A bank’s capital provides a cushion to absorb losses, therefore, a

bank must maintain a specific minimum capital required by law.

• When banks issue new stock, they dilute the ownership of the
bank, since the proportion of the bank owned by existing
shareholders decreases.
 Uses of Funds by Banks
1. Cash:
1. Cash
2. Bank loans • Banks are required to hold
3. Investment securities some cash as reserves,
4. Federal Funds Sold since they must abide by
reserve requirements
5. Repurchase Agreements enforced by the Federal
6. Eurodollar loans Reserve.
7. Fixed Assets
• Banks also hold cash to
retain some liquidity and
accommodate any
withdrawal requests by
depositors.
 Bank Loans
Types of Business loans:

• A common type of business loan is the working capital loan

designed to support on going business operations.

• A working capital loan can support the business until sufficient cash
inflows are generated. These loans are typically short term, yet they
may be needed by businesses on a frequent basis.

• Banks also offer term loans, primarily to finance the purchase of

fixed assets such as machinery.

• A term loan involves a specified amount of funds to be loaned out,

for a specified period of time, and for a specified purpose.
• The bank can periodically request interest payments, with the loan
principal to be paid off in one lump sum at a specified date in the
future. This is called bullet loan.

• As an alternative to providing a term loan, the bank may consider

purchasing the assets and leasing them to the firm in need. This
method known as, direct lease loan.

• A more flexible financing arrangement is Informal Line of credit; it

allows the businesses to borrow up to some specified maximum
amount of fund over a specified period of time. Interest is charged
on borrowed amount in line with market rates. Banks are not legally
obligated to provide funds.
• Revolving credit loan obligates the bank to offer up to
some specified maximum amount of fund over a
specified period of time typically less than 5 years.

• Bank is committed to provide funds when requested; it

charges a commitment fee on unused funds.

• The interest rate charged by banks on loans to their

most creditworthy customers is known as the prime
rate.
Loan Participations:
• Several banks may be willing to
pool any available funds they
have to accommodate
corporation in what is referred to
as a loan participation.
• The main role of the other banks
is to supply funds to lead bank
which are channeled to the
borrower.
Types of Consumer Loans:
• Commercial banks provide
installment loans to individuals to
a finance purchases of cars and
household products. These loans
require the borrowers to make
periodic payments over time.
• Real Estate Loans:
• Banks also provide real estate
loans. They give residential and
commercial real estate loans.
 Loan Supporting Leverage Buyouts
• One of the latest trend in commercial
banking is financing leverage buyouts. The
loan amount provided by a single bank to
support an LBO is usually between $15
million and $40 million.
• Financing part of LBO is no different than
financing other privately held businesses.
• These businesses are highly leveraged and
experience cash flow pressure during periods
where sales are lower than normal.
• Many firms involved in LBOs represent
diversified conglomerates that will be split
into various divisions and sold.
• A commercial banks risk may rise as it
increases its financing of LBOs.
• Banks that reduce their most conservative
assets to finance LBOs will incur a higher
degree of risk. Many LBOs were financed
with junk bonds, which suggest a high degree
of risk.
• Some banks originate the loans designed for
LBOs and then sell them to other financial
institutions such as insurance companies,
pension funds and foreign banks. In this way,
they can generate fee income by servicing
the loans while avoiding the credit risk
associated with the loans.
• Bank regulators now monitor the amount of
bank financing provided to corporate
borrowers that will have a relatively high
degree of financial leverage. These loans,
known as highly leveraged transactions.
 Investment Securities

• Banks purchase treasury • Federal agency securities are

securities as well as securities commonly issued by federal
issued by the agencies of the agencies, such as the Federal
federal government. Home Loan Mortgage
Corporation and the Federal
• Government agency securities National Mortgage
can be sold in the secondary Association.
market, but the market is not
as active as it is for treasury • Banks purchase only
securities. investment grade securities
which have a low degree of
• Government agency securities default risk.
are not a direct obligation of
the federal government.
 Federal Funds Sold:
• Banks often lend funds in the
federal funds market. The funds
sold, or lend out, will be returned
at the time specified in the loan
agreement with interest.
Repurchase Agreements:
Fixed Assets:
• Banks must maintain some
amount of fixed Assets, such as
office buildings and land, so that
they can conduct their business
operations.

• Recall that from the borrower’s

perspective, the repurchase
agreement transaction involves
repurchasing the securities that it
had previously sold.
 Off-Balance Sheet Activities
1. Loan commitments
2. Standby letter of credit
3. Forward contracts
4. Swap contracts
1. Loan Commitments:
• A loan commitment is an
obligation by a bank to
provide a specified loan
amount to a particular firm
upon the firm’s request.
• The interest rate and
purpose of the loan may
also be specified. The bank
charges a fee for offering
the commitment.
 Off-Balance Sheet Activities
Standby Letter of Credit:
• A Standby letter of credit backs a customer’s
obligation to a third party.
• If the customer does not meet its obligation,
the bank will.
• The third party may require that the
customer obtain an SLC to complete a
business transaction.
Forward Contracts:
• Many banks engage in forward contracts in
which they agree to exchange one currency
for another on a particular future date at a
specified exchange rate.
Swap Contracts:
• Banks also serve as intermediaries for
interest rate swaps, whereby two parties
agree to periodically exchange interest
payments on a specified notional amount of
principal.
• Some banks facilitate currency swaps by
finding parties with optimistic future
currency needs and executing a swap
agreement.
• Currency swaps are somewhat similar to
forward contracts, except that they are
usually for more distant future dates.