COMMERCIAL BANK MANAGEMENT

Department of Banking

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 CHAPTER 3
MANAGING SOURCES OF FUNDS FOR COMMERCIAL BANKS

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Outline Chapter 3

3.1. Managing and pricing deposit services

3.1.1. Types of Deposits
3.1.2. Interest rates Offered on Different Types of Deposits
3.1.3. Pricing Deposit - Related Services
3.2. Managing Non-deposit liabilities
3.2.1. Liability Management and Customer Relationship Doctrine
3.2.2. Alternative Non-deposit Sources of Funds
3.2.3. Choosing among Alternative Non-deposit Sources

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Outline Chapter 3

3.3. The Management of Capital

3.3.1. The Many Tasks Capital Performs
3.3.2. Capital and Risk
3.3.3. Types of Capital in Use

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1. Managing and pricing deposit services

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Outline Managing and pricing deposit services

• Types of deposit accounts offered

• The changing mix of deposits and deposit costs
• Pricing deposit services and deposit interest rates
• Conditional deposit pricing
• Rules for deposit insurance coverage
• Disclosure of deposit terms
• Lifeline banking

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1. Managing and pricing deposit services

Key issues depository institutions are faced withs

1. Where can funds be raised at lowest possible cost?

2. How can management ensure that there are enough deposits to support lending and other

services the public demands?

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1.1. Types of Deposits

Types of deposits

Transaction Non-transaction
(payment or (savings or thrift) Hybrid deposits
demand) deposits deposits

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1.1. Types of Deposits Offered by Depository Institutions
1. Transaction (payment or demand) deposits
• Making payment on behalf of customers
• One of the oldest services
• Provider is required to honor any withdrawals immediately
2. Non-transaction deposits
• Longer-term
• Higher interest rates than transaction deposits
• Generally, less costly to process and manage
3. Hybrid deposits

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1.1. Types of Deposits Offered by Depository Institutions
1.1.1 Transaction (payment or demand) deposits
• Making payment on behalf of customers
• One of the oldest services
• Provider is required to honor any withdrawals immediately
• There are two types of transaction deposits
 Noninterest-Bearing Transaction Deposits
 Interest-Bearing Transaction Deposits

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1.1. Types of Deposits Offered by Depository Institutions
1.1.2 Non-transaction deposits
• An account whose primary purpose is to attract customer to save for future purposes

with higher interest rate and lower cost for managing

• Types of non-transaction deposits:
 Passbook Saving deposits
 Time deposits

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1.1. Types of Deposits Offered by Depository Institutions
1.1.2 Non-transaction deposits
 Passbook Saving deposits: Have no fixed maturity

• Withdrawal privileges are unlimited, without prior notice

• Stable fund to banks with little interest rate sensitivity
• Low interest rate
• For individuals, non-profit organization, businesses, governments
• In form of : Passbook savings account and Statement savings account

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1.1. Types of Deposits Offered by Depository Institutions
1.1.2 Non-transaction deposits
 Time deposits (CD is most popular type): Have a specified maturity ranging from 7

days on up

Large time deposits (Jumbo CDs) Small time deposits

• for corporation & wealthy individuals • Usually acquired by individuals
• in negotiable form CDs of $100,000-plus • nonnegotiable form CDs with smaller
• Typically can be traded in the secondary denomination
market many times before reaching • Cannot be traded before reaching
maturity maturity

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1.1. Types of Deposits Offered by Depository Institutions
1.1.2 Non-transaction deposits
 Time deposits

 Popular types of CDs

Bump-up CD – allows a depositor to switch to a higher interest rate if market rates rise
Step-up CD – permits periodic upward adjustments in the promised interest rate
Liquid CD – permits the depositor to withdraw some or all of their funds without a
withdrawal penalty

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1.1. Types of Deposits Offered by Depository Institutions
1.1.3 Retirement savings deposits
• Individual Retirement Account (IRA) - the Economic Recovery Tax Act of 1981
• Keogh Deposit – have tax benefits
• Roth IRA – The Tax Relief Act of 1997 allows non-tax-deductible contributions
• Default Option Retirement Plans – The Pension Protection Act of 2006

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1.2. Interest rates Offered on Different Types of Deposits

1.2.1 Interest rates on deposits

• Interest rates on deposits depend on:
 The maturity of the deposit

 The size of the offering institution

 The risk of the offering institution

 Marketing philosophy and goals of the offering institution

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1.2. Interest rates Offered on Different Types of Deposits

1.2.2 The changing composition of deposits in the US

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1.2. Interest rates Offered on Different Types of Deposits

1.2.3 Core deposits

• Definition: A stable base of funds that is not highly sensitive to movements in market
interest rates (low interest-rate elasticity) and which tend to remain with the bank

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1.2. Interest rates Offered on Different Types of Deposits

1.2.3 Core deposits

• Character:
o A large proportion includes transaction deposits and low-yielding time & savings deposits.
o Small time and savings deposits can be withdrawn immediately, their effective maturity
spans over years
o Increase bank’s liability duration and reduce interest rate vulnerability
o Share in total deposits in small banks (80%) higher than in large banks (70%) (FDIC: 2010)
o Declining trend due to inflation, deregulation, stiff competition and better educated-
customers

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1.2. Interest rates Offered on Different Types of Deposits

1.2.4 Ownership of Deposits

• Private sector: individuals, partnership and corporation (75%)

• State and local government (4%)

• Foreign governments, businesses, individuals, mostly in off-shore offices

• Other financial institutions (correspondent deposits)

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1.2. Interest rates Offered on Different Types of Deposits

1.2.5 Cost and revenue accounting

data for deposit accounts at First
Bank

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1.2. Interest rates Offered on Different Types of Deposits

1.2.6 Check 21 and substitute checks

• Check 21 Act, which is effective October 28/2004, permits
depository institutions to electronically transfer check
images instead of checks themselves, replacing originals
with substitute checks.

• The images are called substitute checks and is a legal copy

of the check

• Protects depositors against loss

• Benefits institutions by reducing the cost of check clearing

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1.2. Interest rates Offered on Different Types of Deposits

1.2.7 FDIC insurance coverage

• Banks insured through Bank Insurance Fund (BIF)
• Savings and loans insured through Savings Association Insurance Fund (SAIF)
• Covers only those deposits payable in the U.S.
• Many types of accounts are covered up to $100,000 (increased to $250,000 until year-
end 2009 by the Emergency Economic Stabilization Act of 2008) for each account holder
within the same bank (even if different branches)
• Deposits placed in separate institutions are insured separately

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1.2. Interest rates Offered on Different Types of Deposits

1.2.7 FDIC insurance coverage

• Consumers must be informed of the deposit terms before they open a new account

• Depository institutions must disclose:

 Minimum balance to open  Penalties for early withdrawal

 Minimum to avoid fees  Options at maturity
 How the balance is figured  The APY (average yields)
 When interest begins to accrue

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1.2. Interest rates Offered on Different Types of Deposits

1.2.5 DIV insurance coverage (IC)

• Insured deposit is a deposit in Vietnam dong of an individual deposited at a deposit
insurance participating organization in the form of term deposit, demand deposit, savings
deposit, certificate of deposit, promissory notes, bills and other forms of deposits as
prescribed by the Law on Credit Institution
(Article 18, The Law on Deposit Insurance, 2012)

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1.2. Interest rates Offered on Different Types of Deposits

1.2.5 DIV insurance coverage (IC)

• Unsured deposit:
o Deposits at credit institutions of individuals who own more than 5% of the charter
capital of such credit institutions.
o Money deposited at the credit organization of the individual who is a member of the
member Board, member of Board of Directors, member of control Board, General
Director (Director), Deputy General Director (Deputy Director) of that credit
o Money used to buy unknown valuable papers issued by the deposit insurance
participating organization.
(Article 19, The Law on Deposit Insurance, 2012)

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1.2. Interest rates Offered on Different Types of Deposits

1.2.5 DIV insurance coverage (IC)

• Role of IC: when a bank participating in deposit insurance falls into insolvency or goes
bankrupt, depositors will receive deposit insurance (Clause 1, Article 4 of the Law on
Deposit Insurance)
• The maximum amount of deposit insurance (including principal and interest) paid for all
insured deposits of a depositor at a credit institution is 125,000,000 VND (the Prime
Minister's Decision No. 32/2021/QD-TTg dated October 20, 2021)

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1.3 Pricing Deposit - Related Services

1.3.1 Reason for pricing Deposit

• Banks need to pay high enough to attract depositors
• Banks should avoid costly interest rate to protect potential profit margin
• Banks are price takers, not price maker
• Banks must decide to pay market-determined price to attract and hold depositors,
otherwise they may lose funds

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1.3 Pricing Deposit - Related Services

1.3.1 Factors affecting the price of deposit

• Interest expenses. This can be varied between transaction and non-transactional
accounts.
• Legal reserve requirements
• Number of customers’ transactions (i.e., processing costs)
• Size of deposits. Low-balance accounts tend to be more volatile and overdraw

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1.3 Pricing Deposit - Related Services

1.3.2. Different type of pricing Deposits

 Cost-plus pricing

 Historical average cost

 Marginal cost of deposits

 Conditional pricing

 Relationship pricing

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1.3 Pricing Deposit - Related Services
1.3.2. Different type of pricing Deposits
 Cost-plus pricing
• The Glass-Steagall Act of 1933 – Federal limits on interest rates paid on deposits – why?
• → protect banks from “excessive” interest rate competition for deposits
• → non-price competition as free-of-charge deposit-related services or below-cost pricing
• → implicit interest rate
• → fund allocation distortion
• The Depository Institutions Deregulation Act of 1980 gradually phases out federal limits on
deposit interest rate ([Link]
deregulation-monetary-control-act/[Link])
• → unbundle service pricing: deposits are priced separately

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1.3 Pricing Deposit - Related Services

1.3.2. Different type of pricing Deposits

 Cost-plus pricing
• Deposit services are priced high enough to cover all costs:

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1.3 Pricing Deposit - Related Services

1.3.2. Different type of pricing Deposits

 Cost-plus pricing
Example:
Bank A finds that its basic transaction account, which requires a $1,000 minimum balance,
costs this savings bank an average of $4.75 per month in servicing costs (including labor and
computer time) and $1.45 per month in overhead expenses. The savings bank also tries to
build in a $0.70 per month profit margin on these accounts. What monthly fee should the
bank charge each customer?

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1.3 Pricing Deposit - Related Services
1.3.2. Different type of pricing Deposits
 Historical average cost: determines the bank’s cost of funds by looking at the past. It looks
at what funds the bank has raised to date and what those funds have cost.

o Average historical cost of funds

Calculating the average
net cost of deposit accounts
o Average interest cost

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1.3 Pricing Deposit - Related Services
1.3.2. Different type of pricing Deposits
 Historical average cost
o Average historical cost of funds measure of average unit borrowing costs for existing funds

 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

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1.3 Pricing Deposit - Related Services
1.3.2. Different type of pricing Deposits
 Historical average cost
o Average interest cost is calculated by dividing total interest expense by the average dollar
amount of liabilities outstanding

Average Net Cost of Bank Liabilities 

Interest Expense  Noninteres t Expense - Noninteres t Income
Average Balance x [1 - (Required Reserve Ratio  Float ratio)]

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1.3 Pricing Deposit - Related Services
1.3.2. Different type of pricing Deposits
 Historical average cost
Example: Every month, 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 plus 10%
required reserve. Calculate average net cost of bank liabitlies?

Average Net Cost of Bank Liabilities 

Interest Expense  Noninteres t Expense - Noninteres t Income
Average Balance x [1 - (Required Reserve Ratio  Float ratio)]

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1.3 Pricing Deposit - Related Services
1.3.2. Different type of pricing Deposits

 Marginal cost of deposits

• Determine the bank’s cost of funds by looking at the future.

• Determine what minimum rate of return is the bank going to have to earn on any
future loans and securities to cover the cost of all new funds raised

• Many financial analysts would argue that the added cost (not weighted average
cost) of bringing new funds into the bank should be used to price deposits.

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1.3 Pricing Deposit - Related Services
1.3.2. Different type of pricing Deposits

 Marginal cost of deposits

Change in total cost

Marginal cost rate 
Additional fund raised

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1.3 Pricing Deposit - Related Services
1.3.2. Different type of pricing Deposits

 Marginal cost of deposits

Example: The bank raises its offer rate on new deposit from 7% to 7.5%. The total
funds raise at old rate are $25 million and total funds raise at new rate $50 million.

Calculate marginal cost rate?

Change in total cost

Marginal cost rate 
Additional fund raised

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1.3 Pricing Deposit - Related Services
1.3.2. Different type of pricing Deposits
 Marginal cost of deposits

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1.3 Pricing Deposit - Related Services
1.3.2. Different type of pricing Deposits
 Conditional pricing
• Schedule of fees were low if customer stayed above some minimum balance -
fees conditional on how the account was used
• Conditional pricing based on one or more of the following factors
o The number of transactions passing through the account
o The average balance held in the account during the period
o The maturity of the deposit

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1.3 Pricing Deposit - Related Services
1.3.2. Different type of pricing Deposits
 Conditional pricing
• Classified into 3 broad categories:
o Flat-rate pricing: the depositor’s cost is a fixed charge per check, per time period, or both
o Free pricing: the absence of a monthly account maintenance fee or per transaction charge
o Conditionally free pricing: favors large denomination deposits because services are free if
the account balance stays above some minimum figure. Conditionally free pricing also
allows the offering institution to divide its deposit market into high-balance, low-activity
accounts and low-balance, high-activity accounts.

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1.3 Pricing Deposit - Related Services
1.3.2. Different type of pricing Deposits
 Conditional pricing

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1.3 Pricing Deposit - Related Services
1.3.2. Different type of pricing Deposits
 Relationship pricing
• The bank prices deposits according to the number of services purchased or used.
The customer may be granted lower fees or have some fees waived if two or
more services are used.

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1.3 Pricing Deposit - Related Services

1.3.3. Basic or lifeline banking

• Some people feel that all individuals are entitled to a minimum level of financial
services no matter their income level

• Several depository institutions have responded to this problem with basic

deposit plans that allow users to cash some checks (such as Social Security
checks), make a limited number of personal withdrawals or write a small number
of checks (such as 10 free checks or charges per month), or earn interest on even
the smallest balances.

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2. Managing Nondeposit liabilities

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2. Managing Nondeposit liabilities

2.1. Liability Management and Customer Relationship Doctrine

2.2. Alternative Nondeposit Sources of Funds
2.3. Choosing among Alternative Nondeposit Sources

What does management do to find new money when deposit

volume is inadequate to support all loans and investments
these institutions would like to make?

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2.1. Liability Management and Customer Relationship Doctrine

 Customer relationship doctrine - The first priority of the bank is to make

loans to all qualified customers and if funds are not available the bank should
seek out the lowest cost source of funding to meet customers’ needs.

If enough 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.

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2.1. Liability Management and Customer Relationship Doctrine

 Liability management
• Liability management consists of buying funds, mainly from other financial institutions,
in order to cover good-quality credit requests and satisfy any legal reserve
requirements on deposits and other borrowings that law or regulation may require
• It is an interest-sensitive approach to raising bank funds
• It is flexible – the bank can decide exactly how much they need and for how long
• The control mechanism to regulate incoming funds is the price of funds

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2.2 Alternative Nondeposit Sources of Funds

• The usage of non-deposit sources of funds has risen

• Larger institutions rely on the non-deposit funds market as a key source of
short-term money to meet loan demand and unexpected cash emergencies

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2.2 Alternative Nondeposit Sources of Funds

• Federal Funds Market

• Repurchase Agreements
• Federal Reserve Bank
• Negotiable CDs
• Eurocurrency Deposit Market
• Commercial Paper
• Long Term Sources

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2.2 Alternative Nondeposit Sources of Funds

2.2.1 Federal Funds Market

• The main use of Fed fund market:
o The traditional purpose: a mechanism that allows banks short of reserves to meet
their legal reserve requirements or to satisfy loan demand by tapping immediately
usable funds from other institutions possessing temporarily idle funds.
o Provide supplement deposit growth and give lenders a relatively safe outlet for
temporary cash surpluses.
o Serve as a conduit for the policy initiatives of the Federal Reserve System designed
to control the growth of money and credit and stabilize the economy.

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2.2 Alternative Nondeposit Sources of Funds

2.2.1 Federal Funds Market

• Immediately available reserves are traded between financial institution and
usually returned within 24 hours, although maturities are negotiated and can
extend up to several weeks
• Interest rates are negotiated between trading partners and are quoted on a
360-day basis
• Borrowing and lending institutions communicate either directly with each
other or indirectly through a correspondent bank or funds broker.

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2.2 Alternative Nondeposit Sources of Funds

2.2.1 Federal Funds Market

The procedure for borrowing and lending Fed funds
First Way to Lend Fed Funds

Step 1: Lending reserves balances held at the Federal Reserve Banks to a

Borrowing Institution

Step 2: Repaying the Loan of Fed Funds through the Federal Reserve Banks

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2.2 Alternative Nondeposit Sources of Funds

2.2.1 Federal Funds Market

The procedure for borrowing and lending Fed funds
Second Way to Lend Fed Funds

Step 1. Lending Fed Funds by a Respondent Depository Institution to a

Correspondent Depository Institution

Step 2: Repaying the Loan of Fed Funds through the Federal Reserve Banks

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2.2 Alternative Nondeposit Sources of Funds

2.2.1 Federal Funds Market

 Types of Fed funds loan agreements
• Overnight loans
 Negotiated via wire or telephone, returned the next day

 Normally not secured by specific collateral, although might

 Maturities are negotiated and can extend up to several weeks
• Term loans
 Longer term Fed funds contracts (several days, weeks, or months)

• Continuing contracts
 Automatically renewed each day

 Normally between smaller respondent institutions and their larger

correspondents
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2.2 Alternative Nondeposit Sources of Funds

2.2.2 Repurchase Agreements

• Normally referred to as Repos or Short-term loans secured by government securities
• Equivalent to collateralized FED funds transactions; hence, less exposure to credit
risk
• Involves the temporary sale of high-quality assets (usually Government securities)
accompanied by an agreement to buy back those assets on a specific future date at a
predetermined price or yield

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2.2 Alternative Nondeposit Sources of Funds

Why is Repos
less risky than
Fed Funds?

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2.2 Alternative Nondeposit Sources of Funds

2.2.2 Repurchase Agreements

• The interest cost for both Fed funds and repurchase agreements can be
calculated from the following equation:

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2.2 Alternative Nondeposit Sources of Funds

2.2.2 Repurchase Agreements

For example, suppose a bank borrows $50 million through an RP transaction
collateralized by government bonds for three days and the current RP rate in the
market is 6%. Then this bank's total interest cost would be …?

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2.2 Alternative Nondeposit Sources of Funds

2.2.2 Structured Repurchase Agreements

Normal Repos vs. Structured Repos:
Normal repos: Fixed-rate agreements over a set maturity with no options.
Structured repos: Include options (call, put, swap, etc.) to adjust initial cost or risk-return profile.
Purpose of Structured Repos:
Provide flexibility: Options embedded in structured repos offer flexibility for borrowers.
Risk management: Structured repos help borrowers manage risk and returns more effectively.
Example: Callable Repos
Callable repos allow termination (call) of the agreement prior to maturity.
Used by issuers when interest rates rise, enabling reinvestment of funds at higher rates.

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2.2 Alternative Nondeposit Sources of Funds

2.2.3 Borrowing from Federal Reserve Banks

• The Fed will make the loan through its discount window by crediting the
borrowing institution's reserve account.
• Discount rate
o Policy is to set discount rate 1% (1.5%) over the Fed Funds target for
primary (secondary) credit loans
o To borrow from the Federal Reserve, banks must apply and provide
acceptable collateral before the loan is granted
o Eligible collateral includes U.S. government securities, bankers acceptances,
and qualifying short-term commercial or government paper
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2.2 Alternative Nondeposit Sources of Funds

2.2.3 Borrowing from Federal Reserve Banks

 Several types of loans are available from the Fed's discount window:
 Primary Credit
• Available to generally sound depository
institutions on a very short-term basis,
typically overnight
• It serves as a backup source of short-term
funds for sound depository institutions
 Secondary Credit
Available to depository institutions that are not
eligible for primary credit. Monitored by the
federal reserve to control excess risk

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2.2 Alternative Nondeposit Sources of Funds

2.2.3 Borrowing from Federal Reserve Banks

 Several types of loans are available from the Fed's discount window:

 Emergency Credit  Seasonal Credit

May be authorized in unusual and Cover longer periods than primary credit
exigent circumstances by the Board of to assist small depository institutions in
Governors to individuals, partnerships, managing significant seasonal swings in
and corporations that are not depository their loans and deposits
institutions The interest rate is a floating rate
Credit is only made if there is no
available other sources and failure to
provide credit would adversely affect the
economy

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2.2 Alternative Nondeposit Sources of Funds

2.2.4 Federal home loan bank advances (FHBL)

• The FHLB system is a government-sponsored enterprise created to assist in
home buying
• The FHLB system is one of the largest U.S. financial institutions, rated AAA
because of the government sponsorship
• FHLB has federal charter and can borrow cheaply and pass savings to
institutions
• FHLB Has 12 Regional Banks
• Any bank can become a member of the FHLB system by buying FHLB stock

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2.2 Alternative Nondeposit Sources of Funds

2.2.4 Federal home loan bank advances (FHBL)

• Advances from the Federal Home Loan Bank
 If it has the available collateral, primarily real estate related loans, it can
borrow from the FHLB, as a way to improve the liquidity of home
mortgages and encourage more lenders to provide credit
 FHLB advances have maturities from 1 day to as long as 20 years
 Number of loans has increased dramatically in recent years

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2.2 Alternative Nondeposit Sources of Funds

2.2.4 Negotiable CD
• An interest-bearing receipt evidencing the deposit of funds in the bank for a
specified period of time for a specified interest rate.
• It is considered a hybrid account since it is legally a deposit but in practical
terms, the it is just another form of IOU issued to tap temporary surplus funds
held by large corporations, wealthy individuals, and governments.

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2.2 Alternative Nondeposit Sources of Funds

2.2.5 Negotiable CD
• Four types of negotiable CDs
 Domestic CDs – issued by domestic banks in the U.S.
 Euro CDs – dollar denominated CDs issued outside the U.S.
 Yankee CDs – issued by foreign banks in the U.S.
 Thrift CDs – issued by large savings and loans and other nonbanks in the U.S.

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2.2 Alternative Nondeposit Sources of Funds

2.2.5 Eurocurrency deposit market

Savings transactions involve Eurocurrency and Eurodollar.
• Eurodollars are dollar-denominated deposits placed in banks outside the U.S.
• Eurocurrency deposits originally were developed in Western Europe to provide
liquid funds to swap among institutions or lend to customers
• Labeled ‘Liabilities to foreign branches’ when a foreign branch lends Euro-deposits
to its home office
• Maturities range from call to five years, typically traded in $1 million denominations.
• Most Eurodollar deposits are fixed-rate time deposits.
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2.2 Alternative Nondeposit Sources of Funds

2.2.6 Commercial paper (CP)

• Short-term notes with maturities from 3 or 4 days to 9 months issued by well-
known companies.
• Two types of CP
 Industrial paper - purchase inventories
 Finance paper – issued by finance companies and financial holding companies
• Banks cannot issue these directly but affiliated companies can issue them.

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2.2 Alternative Nondeposit Sources of Funds

2.2.7 Long-term non-deposit sources of funds

• Mortgages to fund the construction of new buildings.
• Capital notes and Debentures are examples of long term sources of funds

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2.2 Alternative Nondeposit Sources of Funds

How to choose among alternative nondeposit sourves

In using nondeposit 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 nondeposit sources are best, given the borrowing institution's goals, at any
moment in time?

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2.2 Alternative Nondeposit Sources of Funds
Measuring a Financial Firm's Total Need for Nondeposit Funds: The Available
Funds Gap
• Gap is based on:
 Current and projected demand and investments the bank desires to make
 Current and expected deposit inflows and other available funds
• Size of the gap determines need for non-deposit funds

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2.2 Alternative Nondeposit Sources of Funds
Measuring a Financial Firm's Total Need for Nondeposit Funds: The Available
Funds Gap

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 and other customer funds received today total $185
million, and those expected in the coming week will bring in another $100 million.
Calculate this bank's estimated available funds gap (AFG) for the coming week (in millions
of dollars)

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2.2 Alternative Nondeposit Sources of Funds
Non-deposit funding sources: factors to consider

 Relative costs of raising funds from each source

 Risk of each funding source

 Length of time for which funds are needed

 Size of the institution

 Regulations limiting the use of various funding sources

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2.2 Alternative Nondeposit Sources of Funds
Non-deposit funding sources: factors to consider
 Relative costs - Managers of financial institutions practicing liability management must
constantly be aware of the going market interest rates attached to different sources of
borrowed funds .
• Borrowed funds in increasing order of costs:
 Federal funds borrowings
 Domestic CDs and Eurocurrency deposits
 Commercial paper (short-term unsecured notes)
 Borrowings from the FED

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2.2 Alternative Nondeposit Sources of Funds
Non-deposit funding sources: factors to consider
 Relative costs
Advantages of Disadvantages of
Federal funds borrowings Federal funds borrowings

• Quick and simple availability • Rates are volatile with wide

(through phone call or online fluctuations, fluctuating around
computer) the central bank ’ s (intended)
• Maturities are flexible ranging Fed fund rate
from a few hours to several
months

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2.2 Alternative Nondeposit Sources of Funds
Non-deposit funding sources: factors to consider
 Relative costs
Advantages of Disadvantages of
CDs and commercial papers CDs and commercial papers

• Rates are more stable, though • Less popular in short run than
close to and slightly above Fed Fed funds and borrowing from
funds rate due to longer the discount window
maturities and marketing costs in
finding buyers
• Better for long-term needs over
several days or weeks

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2.2 Alternative Nondeposit Sources of Funds
Non-deposit funding sources: factors to consider
 Relative costs - Overall cost of funds

 The historical average cost approach - for determining how much funds cost looks at

the past, by asking what funds the financial firm has raised to date and what they cost.

 The pool-fund approach - looks at the future: What minimum rate of return must be

earned on any future loans and investments just to cover the cost of all new funds

raised?

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2.2 Alternative Nondeposit Sources of Funds
Non-deposit funding sources: factors to consider
 The Risk Factor

• Interest rate risk: the volatility of credit costs

• Credit availability risk: no guarantee that lender will be willing and able to

accommodate every borrower, due to

 Tight credit conditions

 High risk of borrowers

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2.2 Alternative Nondeposit Sources of Funds
Non-deposit funding sources: factors to consider
 Length of time for which funds are needed
• Some fund sources may be dif icult to access immediately → funds needed in the
short run should be borrowed from the Fed fund market
• If funds are not needed for a few days → selling longer-term debt might be a
more viable options.

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2.2 Alternative Nondeposit Sources of Funds
Non-deposit funding sources: factors to consider
 Size of the institution
• Standard trading unit for most money market loans is $1mil, often exceeding
borrowing requirements of smallest financial institutions
• Small depository institutions may not have credit standing to issue large
negotiable CDs
• Central bank’s window and Fed funds can make relatively small denomination
loans

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2.2 Alternative Nondeposit Sources of Funds
Non-deposit funding sources: factors to consider
 Regulations
• Federal and state regulations may limit the amount, frequency and the use of
borrowed funds
• In the US, CDs must be issued with maturities of at least 7 days
• FED may limit borrowings from the discount window, particularly by depository
institutions appearing to display significant risk of failure
• Some borrowing forms maybe subject to reserve requirements in case of tight-
money policies
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2.3. Borrowing sources for CIs - Vietnam

• SBV (subject to monetary policy and SBV assessment on CI’s liquidity need)
o Discounting operation (Chiết khấu/Tái CK GTCG)
Chiết khấu toàn bộ thời gian còn lại (Thời gian đáo hạn còn lại của GTCG < 91 ngày)
Chiết khấu có kỳ hạn (Thời gian đáo hạn còn lại của GTCG > 91 ngày) = Repurchase
Agreement (Repo)
o Refinancing operation (Tái cấp vốn)
Cầm cố Giấy tờ có giá
Cầm cố Hồ sơ tín dụng
• Inter-bank market (deposits at SBV and other CIs)
• Borrowing from SBV is usually cheaper than inter-bank loans, but subject to SBV conditions
and monetary policies
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3. Management of Capital

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3.1 The many tasks capital performs

• Provides a Cushion Against Risk of Failure

• Provides Funds to Help Institutions Get Started
• Promotes Public Confidence
• Provides Funds for Growth
• Regulator of Growth
• Role in Growth of Bank Mergers
• Regulatory Tool to Limit Risk Exposure
• Protects the Government’s Deposit Insurance System

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3.2 Capital and Risk

 Key Risks in Financial Institutions Management

• Credit Risk
• Liquidity Risk
• Interest Rate Risk
• Operational Risk
• Exchange Risk
• Crime Risk  Defenses Against Risk
 Quality Management
 Diversification
 Geographic
 Portfolio
 Deposit Insurance
 Owners’ Capital
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3.2 Capital and Risk

 Defenses Against Risk

 Quality Management: the ability of top-notch managers to move swiftly to deal
with problems before they overwhelm a financial firm

 Diversification:
o Geographic: spreading out credit accounts and deposits among a wide variety
of customers, including large and small business accounts, different
industries, and households with a variety of sources of income and collateral.

o Portfolio: refers to seeking out customers located in different communities or

countries, which presumably will experience somewhat different economic
conditions.

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3.2 Capital and Risk

 Defenses Against Risk

• Deposit Insurance: The Federal Deposit Insurance Corporation, established in

the United States in 1934 and today protecting regular depositors up to
$250,000 in any federally insured depository institution, was designed to
promote and preserve public confidence. While it has not stopped depository
institutions from failing, the FDIC appears to have stopped runs on neighboring
institutions when any one of them fails.

• Owners’ Capital: Owners' capital absorbs losses from bad loans, poor securities
investments, crime, and management misjudgment so that a financial firm can
keep operating until its problems are corrected and losses are recovered

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3.3 Types of Capital

• Common Stock • Subordinated Debentures

• Preferred Stock • Minority Interest in Consolidated
• Surplus Subsidiaries
• Undivided Profits • Equity Commitment Notes
• Equity Reserves

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3.3 Types of Capital

• Common Stock: measured by the par (face) value of common equity shares
outstanding, which pay a variable return depending on whether the issuing
institution's board of directors votes to pay a dividend.

• Preferred Stock : measured by the par value of any shares outstanding that promise
to pay a fixed rate of return (dividend rate); preferred stock may be perpetual,
nonvoting, have only limited life, or be issued as trust preferred stock (which has
features of both debt and equity securities).

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3.3 Types of Capital

• Surplus: the excess amount above each share of stock's par value paid in by the
institution's shareholders.

• Undivided Profits: the net earnings that have been retained in the busi- ness rather
than being paid out as dividends.

• Equity Reserves: funds set aside for contingencies, such as legal action against the
institution, as well as providing a reserve for dividends expected to be paid but not
yet declared and a sinking fund to retire stock or debt in the future.

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3.3 Types of Capital

• Subordinated debentures: representing long-term debt capital contributed by outside

investors, whose claims legally follow (i.e., are subordinated to) the claims of deposi-
tors; these debt instruments may carry a convertibility feature, permitting their
future exchange for shares of stock.

• Minority interest in consolidated subsidiaries: where the financial firm holds owner-
ship shares in other businesses.

• Equity commitment notes: debt securities repayable from the sale of stock.

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3.3 Types of Capital

 Reasong for Capital regulation?

• To Limit the Risk of Failures

• To Preserve Public Confidence
• To Limit Losses to the Federal Government Arising from Deposit Insurance Claims

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3.4 Capital regulation

3.4.1 The Basel I Agreement (1988)

Context:
• An International Treaty Involving the U.S., Canada, Japan and the Nations of
Western Europe to Impose Common Capital Requirements On All Banks Based in
Those Countries
• Emerged in response to weaknesses exposed by financial market turbulence in
the 1970s and 1980s; Responded to previous banking crises
Purposes:
• Established minimum capital requirements for banks to ensure they could
absorb losses adequately.
• Fostered international cooperation among regulators to promote stability and
consistency in banking regulation.

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3.4 Capital regulation

3.4.1 The Basel I Agreement

Tier 1 Capital Tier 2 Capital
• Common Stock and Surplus
• Undivided Profits • Allowance for Loan and Lease Losses
• Qualifying Noncumulative • Subordinated Debt Capital Instruments
• Mandatory Convertible Debt
Preferred Stock
• Cumulative Perpetual Preferred Stock
• Minority Interests in the Equity with Unpaid Dividends
Accounts of Consolidated • Equity Notes
Subsidiaries • Other Long Term Capital Instruments
• Selected Identifiable Intangible that Combine Debt and Equity Features
Assets Less Goodwill and Other
Intangible Assets

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3.4 Capital regulationg

3.4.1 The Basel Agreement

• Ratio of Core Capital (Tier 1) to Risk Weighted Assets Must Be At Least 4 Percent
• Ratio of Total Capital (Tier 1 and Tier 2) to Risk Weighted Assets Must Be At Least 8
Percent
• The Amount of Tier 2 Capital Limited to 100 Percent of Tier 1 Capital

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3.4 Capital regulation

3.4.1 The Basel Agreement

• Calculating Risk-Weighted Assets

• Compute Credit-Equivalent Amount of Each Off-Balance Sheet (OBS) Item
• Find the Appropriate Risk-Weight Category for Each Balance Sheet and OBS Item
• Multiply Each Balance Sheet and Credit-Equivalent OBS Item By the Correct Risk-
Weight
• Add to Find the Total Amount of Risk-Weighted Assets

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3.4 Capital regulation

3.4.2 Basel II
• Aims to correct the weaknesses of Basel I
• Three pillars of Basel II
• Capital requirements for each bank are based on their own estimated risk
exposure from credit, market and operational risks
• Supervisory review of each bank’s risk assessment procedures and the adequacy
of its capital
• Greater disclosure of each bank’s true financial condition, risk management
practices, and the reserve of risk capital
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 Q&A session
Thank you for listening!

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