Ch 17 Commercial Bank Sources and Uses of

Ch: 17 Commercial Bank Sources and Uses of Funds

Bank Sources of Funds: Deposit accounts: • Transaction Deposits • Savings Deposits • Time Deposits • Money Market Deposit Accounts Borrowed Funds: • • Federal Funds purchased (borrowed) Borrowing from the Federal Reserve Banks Repurchase agreements Eurodollar Borrowings Long-term Sources of Funds: • Bonds issued by the Bank • Bank Capital

Deposit Accounts Transaction Deposits: • The demand deposit account, or checking account, is offered to customers who desire to write checks against their account. • From the bank’s perspective, demand deposit accounts are classified as transaction accounts that provide a source of funds that can be used until withdrawn by customers. • Another type of Transaction account is Negotiable Order of Withdrawal(NOW). It provides checking services as well as interest. It requires large minimum balance. • Electronic Transactions: Customers now use electronic banking to pay utility bills, check account balances, add deposits, Credit card payments, funds transfer, cash withdrawals (ATM). Debit cards allow customers to 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Time Deposits • Time deposits can not be withdrawn until a specified maturity. Two types of Time deposits are: 1. 2. Certificate of Deposit Negotiable Certificate of Deposit: • Another type of time deposit is a negotiable CD offered by some large banks to corporations. They have a specific maturity and require minimum balance. • 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 known as retail certificate of deposit requires a specified minimum amount of funds to be deposited for a specified period of time. Banks are now able to offer a CD that better meets an individual’s needs. Most offer a wide variety, with maturities as short as seven days and annualized interest rates that vary among banks, and even among maturity types within a single bank. • • • Some CD rates are tied to the performance of a stock market index but guarantee a minimum rate regardless of the stock markets performance. Callable CDs are also offered which can be called back before maturity. No organized secondary market exist for CDs.

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 federal funds market allows depository institutions to accommodate the short-term liquidity needs of other financial institutions. • Federal funds purchased represent a liability to the borrowing bank and an asset to the lending bank that sells them. • Loans are made from one day to seven days. • The interest rate charged in the federal funds market is called the federal funds rate which changes according to demand supply of funds. • If many banks have excess funds and few banks are short of funds, the federal funds rate would be low. • Federal funds rate is generally between 0. 25 % and 1 % higher 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 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: Bonds Issued by the Bank: • 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. • 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. 2. 3. 4. 5. 6. 7. Cash Bank loans Investment securities Federal Funds Sold Repurchase Agreements Eurodollar loans Fixed Assets 1. Cash: • Banks are required to hold some cash as reserves, since they must abide by reserve requirements enforced by the Federal Reserve. • 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: Types of Consumer Loans: • Several banks may be willing to pool any available funds they have to accommodate a corporation in what is referred to as a loan participation. • Commercial banks provide installment loans to individuals to 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. • The main role of the other banks is to supply funds to lead bank which are channeled to the borrower.

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 securities as well as securities issued by the agencies of the federal government. • Government agency securities can be sold in the secondary market, but the market is not as active as it is for treasury securities. • Government agency securities are not a direct obligation of the federal government. • Federal agency securities are commonly issued by federal agencies, such as the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association. • Banks purchase only investment grade securities which have a low degree of default risk.

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: • Recall that from the borrower’s perspective, the repurchase agreement transaction involves repurchasing the securities that it had previously sold. Fixed Assets: • Banks must maintain some amount of fixed Assets, such as office buildings and land, so that they can conduct their business operations.

Off-Balance Sheet Activities 1. Loan Commitments: 1. Loan commitments 2. Standby letter of credit 3. Forward contracts 4. Swap contracts • 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.