Solution manual bank management and financial services 9th edition by rose, peter chap013

Chequers State Bank loans $50 million from its reserve account at the Federal ReserveBank of Philadelphia to First National Bank of Smithville, located in the New York Federal Reserve Ba

CHAPTER 13 MANAGING NONDEPOSIT LIABILITIES

Goal of This Chapter: The purpose of this chapter is to learn about the principal nondeposit sources of funds that financial institutions can borrow from, to help finance their activities and tosee how managers choose among the various nondeposit funds sources currently available to them

Key Topics in this Chapter

• Liability Management

• Customer Relationship Doctrine

• Alternative Nondeposit Funds Sources

• Measuring the Funds Gap

• Choosing Among Different Funds Sources

• Determining the Overall Cost of Funds

Chapter Outline

I Introduction

II Liability Management and the Customer Relationship Doctrine

A Customer Relationship Doctrine

B Liability Management

III Alternative Nondeposit Sources of Funds

A Federal Funds Market (“Fed Funds”)

B Repurchase Agreements as a Source of Funds

C Borrowing from Federal Reserve Banks

1 Primary Credit

2 Secondary Credit

3 Seasonal Credit

D Advances from Federal Home Loan Banks

E Development and Sale of Large Negotiable CDs

F The Eurocurrency Deposit Market

G Commercial Paper Market

H Long-Term Nondeposit Funds Sources

IV Choosing Among Alternative Nondeposit Sources

A Measuring a Financial Firm’s Total Need for Nondeposit Funds: The Available Funds Gap

B Nondeposit Funding Sources: Factors to Consider

1 Relative Costs

2 The Risk Factor

3 The Length of Time Funds Are Needed

4 The Size of the Borrowing Institution

5 Regulations

V Summary of the Chapter

Concept Checks13-1 What is liability management?

Liability management involves conscious control of the funding sources of a financial institution,using the interest rates (yields) offered on deposits and other borrowings to regulate the inflow offunds to match the bank's immediate funding needs

13-2 What advantages and risks does the pursuit of liability management bring to a borrowing institution?

Improved control over funding sources enables a borrowing institution to plan its growth more accurately This is because funds raised by liability management techniques are flexible in terms

of the amounts raised and their maturity However, liability management opens up certain risks, particularly of the interest-rate risk variety, because it tends to be more sensitive to changes in market interest rates

13-3 What is the customer relationship doctrine, and what are its implications for fund-raising

13-4 For what kinds of funding situations are Federal funds best suited?

Federal funds are best suited for institutions short of reserves to meet their legal reserve

requirements or to satisfy customer loan demand It satisfies this demand by tapping immediatelyusable funds

13-5 Chequers State Bank loans $50 million from its reserve account at the Federal ReserveBank of Philadelphia to First National Bank of Smithville, located in the New York Federal Reserve Bank's district, for 24 hours, with the funds returned the next day Can you show the correct accounting entries for making this loan and for the return of the loaned funds?

Step 1 - Lending the $50 million

Chequers State Bank

Federal funds sold

+50 millionReserves at Fed

-50 million

Using the borrowed funds can also be shown, though it is not mentioned in the problem You could show First National Bank of Smithville making a loan for $50 million under Assets, giving

up $50 million from its reserve account

First National Bank of Smithville

Step 2 - Repaying the loan of Federal funds

Chequers State Bank

Reserves at Fed

+50 millionFederal funds sold

-50 million

First National Bank of Smithville

the proper accounting entries for the extension of this loan and for the recovery of the loaned funds by Hillside Savings?

Step 1 - Lending Federal funds to Sterling City Bank

Hillside Security Bank

Deposit with Sterling City Bank

-35 millionFederal funds sold

+35 million

Sterling City Bank

Federal funds purchased

+35 millionHillside Security Bank's deposit

-35 millionStep 2 - Sterling City Bank loans funds to Imperial Security National Bank

Sterling City Bank

Reserves

-35 millionFederal funds sold

+35 million

Imperial Security National Bank

Reserves

+$35 million Federal funds purchased+35 millionStep 3 -Sterling City Bank receives funds loaned to Imperial Security National Bank

Sterling City Bank

Reserves

+35 millionFederal funds sold

-35 million

Imperial Security National Bank

Reserves

-35 million

Federal funds purchased

-35 millionStep 4 - Repaying the loan to Hillside Security Bank

Hillside Security Bank

Deposit with Sterling City Bank

+35 millionFederal funds loaned

-35 million

Sterling City Bank

Federal funds purchased

-35 millionHillside Security Bank'sdeposit

+35 million13-7 Compare and contrast Fed funds transactions with RPs

Less popular than Fed funds and more complex are repurchase agreements (RPs) RPs are agreements to sell securities temporarily by a borrower of funds to the lender of funds with the borrower agreeing to buy back the securities at a guaranteed price at a set time in the future Both are instruments available for short term borrowing However, RP agreements are

collateralized loans and thus, the lender is not exposed to credit risk as they are with Federal funds transactions Most RPs are transacted across the Fedwire system, just as are Fed funds transactions RPs may take a bit longer to transact than a Fed funds loan because the seller of funds (the lender) must be satisfied with the quality and quantity of securities provided as collateral

13-8 What are the principal advantages to the borrower of funds under an RP agreement?RPs are a low-cost source of borrowing loanable funds for short periods of time (usually 3 or 4 days) Since the securities that are sold as part of the agreement act as collateral, the interest rate

is lower than Fed funds rate Also, borrowers with lower credit ratings who can provide

equivalent securities as collateral can borrow at these low rates

13-9 What are the advantages of borrowing from the Federal Reserve banks or other central banks? Are there any disadvantages? What is the difference between primary, secondary, and seasonal credit? What is a Lombard rate and why might such a rate be useful in achieving

monetary policy goals?

Borrowing from the Federal Reserve banks is a viable alternative to the Federal funds market These loans are made for a short term (usually two weeks) Advantages of borrowing from the Federal Reserve banks though depend on the category of loans a borrower is eligible for

Institutions accessing primary credit can loan the money to other depository institutions in the fed funds market Users of secondary credit can use the borrowings to strengthen their ability to borrow funds in the open market Users accessing seasonal credit can borrow funds for longer periods than primary credit Despite these advantages, stringent regulations regarding the

borrower’s credit quality, collateral requirements and cost of loans has made the Fed’s discount window unpopular

Primary credits are short term loans available to sound depositary institutions at rates slightly above the Federal Reserve’s target Fed funds interest rate Secondary credits are short term loans available to institutions that do not qualify for primary credit but need funds to strengthen their books Seasonal credit refers to loans given to small and medium sized institutions to cover seasonal swings in their deposits and loans

The Lombard rate is the Fed’s discount rate for primary credit which is set slightly higher than the Federal funds rate on overnight loans Since Lombard rate is the rate at which the banks will borrow money from the central bank, the Federal Reserve can effectively use this rate as a monetary policy tool It can increase the rate and desist the depository institutions to borrow in

an inflationary scenario to reduce the money supply in the economy To pursue an expansionary monetary policy, on the other hand, the Fed can reduce the rates and encourage the banks to borrow more, thereby ensuring larger money supply

13-10 How is a discount window loan from the Federal Reserve secured? Is collateral really necessary for these kinds of loans?

A discount window loan must be secured by collateral deposits acceptable to the Federal Reservebanks The Fed in turn makes the loan by crediting the borrower’s reserve account Collateral against each loan is mandatory Though usually the collateral is in the form of U.S government securities, the Federal Reserve also accepts some government agency securities and high-grade commercial paper as collateral

13-11 Posner State Bank borrows $10 million in primary credit from the Federal Reserve Bank

of Cleveland Can you show the correct entries for granting and repaying this loan?

The appropriate entries for this transaction are:

Step 1 - Securing a loan from the Fed.

Posner State Bank

Reserves on deposit at the Federal Reserve Bank

+10 million

Notes payable

+10 million

Federal Reserve Bank of Cleveland

Loans and advances

+10 million Bank reserve accounts+10 millionStep 2 - Repaying the loan to the Fed

Posner State Bank

Reserves on deposit at the Federal Reserve Bank

-10 million

Notes payable

-10 million

Federal Reserve Bank of Cleveland

Loans and advances

-10 million Bank reserve accounts-10 million

13-12 Which institutions are allowed to borrow from the Federal Home Loan Banks? Why is this source so popular for many institutions?

Institutions involved in mortgage lending can access credit from Federal Home Loan Banks by posting mortgages as collateral to the banks These loans are very popular because they represent

a stable source of funds for institutions at below market lending rates

13-13 Why were negotiable CDs developed?

Due to slow growth in checkbook savings in 1960s as a result of funds being diverted in other high yielding assets, banks developed negotiable CDs (which carried a higher rate of interest) to attract large corporate deposits and savings from wealthy individuals

13-14 What are the advantages and disadvantages of CDs as a funding source?

For borrowers, negotiable CDs offer a way to attract large amounts of funds quickly and for a known time period Also, deposit stability is likely to be greater because, unlike demand depositswhich can be withdrawn anytime, the CD will normally be held till maturity However, these funds are highly interest sensitive and depository institutions face the challenge of managing the yields through active rate-hedging techniques to retain the deposits.

13-15 Suppose a customer purchases a $1 million 90-day CD, carrying a promised 6 percent annualized yield How much in interest income will the customer earn when this 90-day

instrument matures? What total volume of funds will be available to the depositor at the end of

$1,000,000 + $15,000 = $1,015,000

13-16 Where do Eurodollars come from?

Eurodollars arise from dollar denominated deposits made in financial institutions outside U.S territory It can be a dollar deposit by a U.S based bank in its foreign branch or any other bank based outside of United States

13-17 How does a bank gain access to funds from the Eurocurrency markets?

A bank can borrow funds in a Eurocurrency market by either from one of its own subsidiaries in the international market or from another bank operating overseas through correspondent banking system If the funds are borrowed from one of its own branches or subsidiaries, it records it as a liability to foreign branch In a correspondent banking system, the lending bank instructs a domestic bank where it has a deposit to transfer funds in the account of Eurocurrency loan to the correspondent account of the borrowing institution

13-18 Suppose that JP Morgan Chase Bank in New York elects to borrow $250 million from Barclays Bank in London and loans the borrowed funds for a week to a security dealer, and then returns the borrowed funds Can you trace through the resulting accounting entries?

When, JP Morgan Chase Bank borrows from Barclays Bank in London, the entries would appear

as follows:

JP Morgan Chase Bank

Deposits held at other banks

+250 million Deposits due to foreign banks (Eurodollars borrowed)

+250 million

U.S Bank Serving as Correspondent to Barclays Bank

Deposits due to foreign bank

-250 millionDeposits of JP Morgan ChaseBank

+250 million

Barclays Bank in London

Deposit at U.S

correspondent bank

-250 millionEurodollar loan to JP Morgan Chase Bank

+250 millionEntries when JP Morgan Chase Bank lends the funds to a security dealer

JP Morgan Chase Bank

AssetsLoan to security

Liabilities and Net Worth

dealer

+250 millionDeposit held at other bank

-250 million

Entries when JP Morgan Chase Bank receives loaned funds from the security dealer

JP Morgan Chase Bank

Loan to security dealer

-250 millionDeposit held at other bank

+250 million

Entries when JP Morgan Chase Bank repays its loans:

JP Morgan Chase Bank

Deposits held at other banks

-250 million

Deposits due to Barclays Bank (Eurodollars borrowed)

-250 million

U.S Bank Serving as Correspondent to Barclays Bank

Deposits due to Barclays Bank

+250 millionDeposits of JP Morgan Chase Bank

-250 million

Barclays Bank in London

Deposits at U.S

correspondent bank

+250 millionEurodollar loan to JP Morgan Chase Bank

-250 million

13-19 What is commercial paper? What types of organizations issue such paper?

Commercial paper consists of short-term notes, with maturities ranging from three or four days

to nine months, issued by well-known companies to raise working capital The notes are

generally sold at a discount from their face value through security dealers or through direct contact with the issuing company

There are two types of commercial paper Industrial paper is issued by non-financial companies

to purchase inventories of goods or raw materials while finance paper is issued mainly by finance companies or financial holding companies Financial holding companies can use the proceeds from issuing finance paper to purchase loans off the books of other financial firms in the same organization to make more funds available for making loans

13-20 Suppose that the finance company affiliate of Citigroup issues $325 million in 90 day commercial paper to interested investors and uses the proceeds to purchase loans from Citibank What accounting entries should be made on the balance sheets of Citibank and Citigroup’s finance company affiliate?

The appropriate entries for the above transaction are:

Step 1 - Commercial Paper is sold by the Affiliated Finance Company

Loans

-325 millionReserves

+325 million

13-21 What long-term nondeposit funds sources do banks and some of their closest competitors draw upon today? How do these interest costs differ from those costs associated with most money market borrowings?

Long-term nondeposit funds include mortgages, capital notes, and debentures Generally, the interest costs on these funds sources are substantially higher than money market loans but are usually more stable

13-22 What is the available funds gap?

The available funds gap is the estimated difference between current and projected outflows and inflows of an institution

13-23 Suppose J.P Morgan Chase Bank of New York discovers that projected new loan demandnext week should total $325 million and customers holding confirmed credit lines plan to draw down $510 million in funds to cover their cash needs next week, while new deposits next