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Funding the Bank and Managing Liquidity,Chapter 8,Prof. Dr. Rainer StachuletzBanking Academy of Vietnam Based upon: Bank Management, 6th edition.Timothy W. Koch and S. Scott MacDonald,Prof. Dr. Rainer Stachuletz Banking Academy of Vietnam - Hanoi,The Relationship Between Liquidity Requirements, Cash, and Funding Sources,The amount of cash that a bank holds is influenced by the banks liquidity requirementsThe size and volatility of cash requirements affect the liquidity position of the bankDeposits, withdrawals, loan disbursements, and loan payments affect the banks cash balance and liquidity position,Effect of Maturing Certificates of Deposit and Loan Use on a Banks Deposit Balances at theFederal Reserve,Recent Trends in Bank Funding Sources,Bank customers have become more rate consciousMany customers have demonstrated a a strong preference for shorter-term depositsCore deposits are viewed as increasingly valuableBank often issue hybrid CDs to appeal to rate sensitive depositors,Types of Hybrid CDs,Jump Rate (Bump-up) CDsCustomers have the option (right) to request a change in rate one time prior to maturity.Indexed CDCD rates float with some base rate (index) such that the yield changes as the index changesCD SpecialCDs with unusual maturities (13 months or 23 months) in which the bank pays an above market rate. At maturity the CD converts to a traditional 12 month or 2-year CD.,Recent Trends in Bank Funding Sources,Retail FundingDeposit AccountsTransaction accountsMoney market deposit accountsSavings accountsSmall time depositsBorrowed FundingFederal Funds purchasedRepurchase agreementsFederal Home Loan Bank borrowings,Recent Trends in Bank Funding Sources,Wholesale FundingIncludes borrowed funds plus large CDsEquity FundingCommon stockPreferred stockRetained earnings,Recent Trends in Bank Funding Sources,Volatile LiabilitiesFunds purchased from rate-sensitive investorsFederal Funds purchasedRepurchase agreementsJumbo CDsEurodollar time depositsForeign DepositsInvestors will move their funds if other institutions are paying higher rates,Change in Total Deposits, Borrowed Funds, Subordinated Notes, and Total Equity Over Time, 19352004,Change in the Percentage Contribution of Various Bank Funding Components, 19922004,The Percentage Contribution of Various Sources of Bank Funds by Bank Size, 2004,Average Annual Interest Cost of Liabilities by Bank Size, 2004,Characteristics of Retail-Type Deposits,Retail DepositsSmall denomination (under $100,000) liabilitiesNormally held by individual investorsNot actively traded in the secondary market,Transaction Accounts,Most banks offer three different transaction accountsDemand DepositsDDAsNegotiable Order of Withdrawal NOWsAutomatic Transfers from SavingsATS,Transaction Accounts,Demand DepositsChecking accounts that do not pay interestHeld by individuals, business, and governmental unitsMost are held by businesses since Regulation Q prohibits banks from paying explicit interest on for-profit corporate checking accounts,Transaction Accounts,NOW AccountsChecking accounts that pay interestATS AccountsCustomer has both a DDA and savings accountThe bank transfers enough from savings to DDA each day to force a zero balance in the DDA accountFor-profit corporations are prohibited from owning NOW and ATS accounts,Transaction Accounts,Although the interest cost of transaction accounts is very low, the non-interest costs can be quite highGenerally, low balance checking accounts are not profitable for banks due to the high cost of processing checks,Non-Transaction Accounts,Non-transaction accounts are interest-bearing with limited or no check-writing privilegesMoney Market Deposit AccountsPay interest but holders are limited to 6 transactions per month, of which only three can be checksAttractive to banks because they are not required to hold reserves against MMDAs,Non-Transaction Accounts,Savings AccountsHave no fixed maturitySmall Time Deposits (Retail CDs)Have a specified maturity ranging from 7 days on upLarge Time Deposits (Jumbo CDs)Negotiable CDs of $100,000 or moreTypically can be traded in the secondary market,Estimating the Cost of Deposit Accounts,Interest CostsLegal Reserve RequirementsCheck Processing CostsAccount ChargesNSF feesMonthly feesPer check fees,Estimating the Cost of Deposit Accounts,Transaction Account Cost AnalysisClassifies check-processing as:DepositsElectronicNon-ElectronicWithdrawalsElectronicNon-Electronic,Estimating the Cost of Deposit Accounts,Transaction Account Cost AnalysisClassifies check-processing as:Transit ChecksDepositedCashedAccount Opened or ClosedOn-Us checks cashedGeneral account maintenanceTruncatedNon-Truncated,Estimating the Cost of Deposit Accounts,Transaction Account Cost AnalysisElectronic TransactionsConducted through automatic deposits, Internet, and telephone bill paymentNon-Electronic TransactionsConducted in person or by mailTransit ChecksChecks drawn on any bank other than the bank it was deposited into,Estimating the Cost of Deposit Accounts,Transaction Account Cost AnalysisOn-Us Checks CashedChecks drawn on the banks own customers accountsDepositsChecks or currency directly deposited in the customers account Account MaintenanceGeneral record maintenance and preparing & mailing a periodic statement,Estimating the Cost of Deposit Accounts,Transaction Account Cost AnalysisTruncated AccountA checking account in which the physical check is truncated at the bank and the checks are not returned to the customerOfficial Check IssuedA check for certified funds. Net Indirect CostsThose costs not directly related to the product such as management salaries or general overhead costs,Cost and Revenue Accounting Data for Deposit Accounts at FirstBank,Calculating the Average Net Cost of Deposit Accounts,Average Historical Cost of FundsMeasure of average unit borrowing costs for existing fundsAverage Interest CostCalculated by dividing total interest expense by the average dollar amount of liabilities outstanding,Calculating the Average Net Cost of Deposit Accounts,Example:A demand deposit account that does not pay interest has $20.69 in transaction costs charges, $7.75 in fees, an average balance of $5,515, and 5% float would have a net cost of 3.29%,Calculating the Average Net Cost of Deposit Accounts,Characteristics of Large Wholesale Liabilities,Wholesale LiabilitiesCustomers move these investments on the basis of small rate differentials, so these funds are labeled:Hot MoneyVolatile LiabilitiesShort-Term Non-Core funding,Characteristics of Large Wholesale Liabilities,Wholesale LiabilitiesIncludes:Jumbo CDsFederal Funds PurchasedRepurchase AgreementsEurodollar Time DepositsForeign Deposits,Characteristics of Large Wholesale Liabilities,Jumbo CDs$100,000 or moreNegotiableCan be traded on the secondary marketMinimum maturity of 7 daysInterest rates quoted on a 360-day year basisInsured up to $100,000 per investor per institutionIssued directly or indirectly through a dealer or broker (Brokered Deposits),Characteristics of Large Wholesale Liabilities,Jumbo CDsFixed-RateVariable-RateJump Rate (Bump-up) CDDepositor has a one-time option until maturity to change the rate to the prevailing market rateCallableZero CouponStock Market IndexedRate tied to stock market index performance,Characteristics of Large Wholesale Liabilities,Individual Retirement AccountsEach year, a wage earner can make a tax-deferred investment up to $3,000 of earned incomeFunds withdrawn before age 59 are subject to a 10% IRS penaltyThis makes IRAs an attractive source of long-term funding for banks,Characteristics of Large Wholesale Liabilities,Foreign Office DepositsEurocurrencyFinancial claim denominated in a currency other than that of the country where the issuing bank is locatedEurodollarDollar-denominated financial claim at a bank outside the U.S.,The Origin and Expansion of Eurodollar Deposits,Characteristics of Large Wholesale Liabilities,Federal Funds PurchasedThe term Fed Funds is often used to refer to excess reserve balances traded between banksThis is grossly inaccurate, given reserves averaging as a method of computing reserves, different non-bank players in the market, and the motivation behind many tradesMost transactions are overnight loans, although maturities are negotiated and can extend up to several weeksInterest rates are negotiated between trading partners and are quoted on a 360-day basis,Characteristics of Large Wholesale Liabilities,Repurchase Agreements (RPs or Repos)Short-term loans secured by government securities that are settled in immediately available fundsIdentical to Fed Funds except they are collateralizedTechnically, the RPs entail the sale of securities with a simultaneous agreement to buy them back later at a fixed price plus accrued interest,Characteristics of Large Wholesale Liabilities,Repurchase Agreements (RPs or Repos)Most transactions are overnightIn most cases, the market value of the collateral is set above the loan amount when the contract is negotiated. This difference is labeled the marginThe lenders transaction is referred to as a Reverse Repo,Characteristics of Large Wholesale Liabilities,Borrowing from the Federal ReserveDiscount WindowDiscount RatePolicy is to set discount rate 1% (1.5%) over the Fed Funds target for primary (secondary) credit loansTo borrow from the Federal Reserve, banks must apply and provide acceptable collateral before the loan is grantedEligible collateral includes U.S. government securities, bankers acceptances, and qualifying short-term commercial or government paper,Characteristics of Large Wholesale Liabilities,Borrowing from the Federal ReservePrimary CreditAvailable to generally sound depository institutions on a very short-term basis, typically overnightIt serves as a backup source of short-term funds for sound depository institutionsSecondary CreditAvailable to depository institutions that are not eligible for primary credit,Characteristics of Large Wholesale Liabilities,Borrowing from the Federal ReserveSeasonal CreditDesigned to assist small depository institutions in managing significant seasonal swings in their loans and depositsEmergency CreditMay be authorized in unusual and exigent circumstances by the Board of Governors to individuals, partnerships, and corporations that are not depository institutions,Characteristics of Large Wholesale Liabilities,Federal Home Loan Bank AdvancesThe FHLB system is a government-sponsored enterprise created to assist in home buyingThe FHLB system is one of the largest U.S. financial institutions, rated AAA because of the government sponsorshipAny bank can become a member of the FHLB system by buying FHLB stockIf it has the available collateral, primarily real estate related loans, it can borrow from the FHLBFHLB advances have maturities from 1 day to as long as 20 years,Commercial Banks with FHLB Advances, 19912004,Electronic Money,Intelligent CardContains a microchip with the ability to store and secure informationMemory CardSimply store informationDebit CardOnlinePIN basedTransaction goes through the ATM systemOfflineSignature based transactionsTransaction goes through the credit card system,Distribution of the Number of Noncash Payments in 2000 and 2003,2000,2003,Source: The 2004 Federal Reserve Payments Study, /Retail/pdf/2004PaymentResearchReport.pdf. Note: Online debit payments are PIN-based, which includes purchases at the point of sale with ATM cards, and offline debit payments, which are signature-based transactions. EBTs are electronic benefits transfers. Data does not include Fedwire or CHIPS wire transfers.,Check 21,Check Clearing for the 21st Century Act Facilitates check truncation by reducing some of the legal impedimentsFoster innovation in the payments and check collection system without mandating receipt of check in electronic formImprove the overall efficiency of the nations payment system,Check 21,Check TruncationConversion 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 bankFacilitates check truncation by creating a new negotiable instrument called a substitute check,Check 21,Substitute CheckThe legal equivalent of the original check and includes all the information contained on the originalCheck 21 does NOT require banks to accept checks in electronic form nor does it require banks to create substitute checksIt does allow banks to handle checks electronically instead of physically moving paper checks,Substitute Check Authorized by Check 21,The Check Clearing Process,Check Clearing Process,Banks typically place a hold on a check until it verifies that the check is “good”Expedited Funds Availability ActUnder Reg CC, it states that:Local check must clear in no more than two business daysNon-local checks must clear in no more than five business daysGovernment, certified, and cashiers checks must be available by 9 a.m. the next business day,Measuring the Cost of Funds,Average Historical Cost of FundsMany banks incorrectly use the average historical costs in their pricing decisionsThe 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,Measuring the Cost of Funds,Marginal Cost of FundsMarginal Cost of DebtMeasure of the borrowing cost paid to acquire one additional unit of investable fundsMarginal Cost of EquityMeasure of the minimum acceptable rate of return required by shareholdersMarginal Cost of FundsThe marginal costs of debt and equity,Measuring the Cost of Funds,Costs of Independent Sources of FundsIt is difficult to measure marginal costs preciselyManagement 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. Marginal costs may be defined as :,Measuring the Cost of Funds,Costs of Independent Sources of FundsAll elements in the numerator are expected costs,Measuring the Cost of Funds,Costs of Independent Sources of FundsExample:Market interest rate is 2.5%Servicing costs are 4.1% of balancesAcquisition costs are 1.0% of balancesDeposit insurance costs are 0.25% of balancesNet investable balance is 85% of the balance (10% required reserves and 5% float),Measuring the Cost of Funds,Cost of DebtEquals the effective cost of borrowing from each source, including interest expense and transactions costsThis 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 the Cost of Funds,Cost of DebtExample: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%:,Measuring the Cost of Funds,Cost of EquityThe marginal cost of equity equals the required return to shareholdersIt is not directly measurable because dividend payments are not mandatory. Several methods are commonly used to approximate this required return:Dividend Valuation ModelCapital Asset Pricing Model (CAPM)Target Return on Equity ModelCost of Debt + Risk Premium,Measuring the Cost of Funds,Preferred StockPreferred stock acts as a hybrid of debt and common equityClaims are superior to those of common stockholders but subordinated to those of debt holdersPreferred 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,Measuring the Cost of Funds,Trust Preferred StockTrust preferred stock is attractive because it effectively pays dividends that are tax deductibleTo issue the securities, a bank or bank holding company establishes a trust company.The trust company sells preferred stock to investors and loans the proceeds of the issue to the bankInterest on the loan equals dividends paid on the preferred stockThis loan interest is tax deductible such that the bank effectively gets to deduct dividend payments as the preferred stock,Measuring the Cost of Funds,Weighted Marginal Cost of Total FundsThis is the best cost measure for asset-pricing purposesIt recognizes both explicit and implicit costs associated with any single source of 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,Measuring the Cost of Funds,Weighted Marginal Cost of Total FundsSteps to compute WMCForecast the desired dollar amount of financing to be obtained from each individual debt and equity sourceEstimate the marginal cost of each independent source of fundsCombine the individual estimates to project the weighted costs, which equals the sum of the weighted component costs across all sources,Measuring the Cost of Funds,Weighted Marginal Cost of Total FundsSteps to compute WMCManagement should combine the individual estimates to project the weighted cost, where wj equals each sources weight and kj equals the single-source j component cost of financing such that:,Measuring the Cost of Funds,Example,Funding Sources and Banking Risks,Banks face two fundamental problems in managing liabilities. Uncertainty over:What rates they must pay to retain and attract fundsThe likelihood that customers will withdraw their money regardless of rates,Funding Sources: Liquidity Risk,The liquidity risk associated with a banks deposit base is a function of:The competitive environmentNumber of depositorsAverage size of accountsLocation of the depositorSpecific maturity and rate characteristics of

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