Book 4. Liquidity and Treasury Risk

FRM Part 2

LTR 12. Managing Non-Deposit Liabilities

Presented by: Sudhanshu

Module 1. Non-Deposit Liabilities and Available Funds Gap

Module 2. Choice and Cost of Non-Deposit Sources of Funds

Module 1. Non-Deposit Liabilities and Available Funds Gap

Topic 1. Overview of Nondeposit Liabilities

Topic 2. Sources of Nondeposit Liabilities

Topic 2. Federal Funds (Fed Funds)

Topic 3. Repurchase Agreements (Repos)

Topic 4. Discount Window Borrowing

Topic 5. FHLB

Topic 6. Negotiable CDs

Topic 7. Eurocurrency Deposit Market

Topic 8. Commercial Paper Market

Topic 9. Long-Term Nondeposit Funds

Topic 10. Available Funds Gap (AFG)

Topic 1. Overview of Nondeposit Liabilities

• Deposits as primary funding: Deposits are the main funding source for depository institutions, but deposits and owner's equity may be insufficient to fully fund loans and securities.

• Customer relationship doctrine: Banks should approve loans that generate positive long-term earnings, rather than rejecting customers due to temporary deposit shortfalls.

• Role of nondeposit funding: Funding gaps are filled using nondeposit liabilities from money and capital markets, with maturities ranging from overnight to long term.

• Key funding decisions: Banks must determine how much nondeposit funding is required and which sources best match their needs.

• Liability management: Actively managing nondeposit funding to meet loan demand and regulatory requirements is a daily, interest-sensitive process that increases interest rate risk.

• Flexibility and scale: Nondeposit funding offers flexibility to raise funds as needed in normal markets, and large banks rely on it far more heavily than small banks.

Topic 2. Sources of Nondeposit Liabilities

• Sources of nondeposit liabilities include:

  • Federal funds (fed funds)

  • Repurchase agreements (repos)

  • Discount window borrowing

  • FHLB

  • Negotiable CDs

  • Eurocurrency deposit market

  • Commercial paper market

  • Long-term nondeposit funds

Topic 3. Federal Funds (Fed Funds)

• Nature of Fed funds: Federal funds are short-term interbank borrowings of reserve balances held at the Federal Reserve.

• Primary uses: They are used to meet reserve requirements, clear payments, fund Treasury purchases, and satisfy short-term loan demand not covered by deposits.

• Tenor and policy role: Fed funds are typically overnight and serve as a key instrument for the Federal Reserve’s monetary policy implementation.

• Settlement and intermediation: Transactions are settled via wire or transfer depending on region, often facilitated by correspondent banks or funds brokers.

• ​Types of Fed funds loans: Fed funds loans generally fall into three main categories.

  • Overnight loans: Borrowed funds are repaid the next business day.

  • Term loans: Loans have fixed maturities ranging from days to months and are typically governed by written contracts.

  • Continuing contracts: Loans automatically roll over daily until terminated by either party, commonly used between smaller institutions and correspondent banks.

• Definition: Repos are collateralized short-term borrowing.

• Repo Mechanics: In a repo, the borrower sells high-quality liquid securities for cash and agrees to repurchase them at maturity at a predetermined price, reversing the initial transaction.

• ​​​Repos vs Fed Funds: Repos are less common and more complex than fed funds.

• Collateral Role: Collateral typically consists of marketable securities such as Treasury bills, notes, or bonds, reducing credit risk for the lender.

• GCF Repos: General Collateral Finance (GCF) repos were introduced in 1998 by the Bank of New York, JPMorgan Chase, and the Fixed Income Clearing Corporation (FICC), allowing parties to agree on eligible collateral rather than specific securities.

• Settlement and Netting: GCF repos permit delivery of any acceptable collateral at maturity and allow netting of obligations through FICC, lowering transaction and settlement costs. Both fed funds and most domestic repos settle via the Fedwire system.

• Crisis Impact: Repo market activity declined sharply during the 2007–2009 crisis due to concerns over collateral quality and valuation.

• Repo Interest: Repo Interest is calculated as:

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Topic 4. Repurchase Agreements (Repos)

• ​​Discount Window Borrowing: Although the Fed is not primarily a lender, banks can obtain short-term loans at the discount window, with funds credited to their reserve accounts and secured by eligible collateral (e.g., Treasuries, agency securities).

• Type of Discount Window Borrowing: Discount window borrowing may be classified into three categories:

  • Primary Credit: Typically overnight loans priced slightly above the target federal funds rate, available to financially sound institutions.

  • Secondary Credit: Higher-cost loans for institutions that do not qualify for primary credit, priced up to about 150 bps above the federal funds rate.

  • Seasonal Credit: Longer-term loans for banks with predictable seasonal funding needs, priced at the average of the federal funds rate and the 90-day CD rate.

• Seasonal credit carries the lowest rate, followed by primary credit, and secondary credit the highest.

Topic 5. Discount Window Borrowing

• Purpose and Origin: The Federal Home Loan Bank (FHLB) system was created in 1932 during widespread bank runs to provide funding to mortgage lenders.

• Collateral and Borrowers: Loans are secured by home mortgages and extended to community banks, thrifts, and mortgage lenders.

• Funding Characteristics: FHLB funding is typically longer term (though it can be overnight), stable, and offered at below-market fixed or floating rates.

• Creditor Priority: In the event of an institutional failure, the FHLB has first claim on recovery, ranking ahead of the FDIC

Topic 6. Federal Home Loan Bank (FHLB)

Practice Questions: Q1

Q1. Which of the following types of non deposit funding was created to provide liquidity to mortgage lenders?
A. Fed funds.

B. Repurchase agreements.

C. Federal Home Loan Bank (FHLB) borrowing.

D. Discount window borrowing.

Practice Questions: Q1 Answer

Explanation: C is correct.

The FHLB system was created in 1932 to make loans to mortgage lenders, at a time when banks were experiencing runs on deposits. The FHLB stabilized the system, allowing banks to continue to make mortgage loans.

• Function: Negotiable (jumbo) CDs are legally classified as deposits but they  function like fed funds and repos, providing short-term money market funding.

• Size and market role: Issued in denominations of $100,000 or more, typically in $1 million multiples, negotiable CDs were designed to compete with instruments such as commercial paper.

• Rate structure: Negotiable CDs can be fixed or floating rate, with the majority issued at fixed rates.

• Interest calculation: Fixed-rate negotiable CDs accrue interest on a 360-day basis, similar to repos.

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• Types of Negotiable CDs: There are four major types of negotiable CDs:

  • Domestic CDs: U.S. institutions issuing CDs inside the U.S.

  • Dollar-denominated CDs (Euro CDs): Dollar-denominated CDs issued by banks outside the U.S.

  • Yankee CDs: Foreign bank issued CDs to sell through U.S. branches.

  • Thrift CDs: Issued by nonbanks such as thrift institutions.

Topic 7. Negotiable (Jumbo) CDs

• Definition: Eurodollar deposits are USD-denominated deposits held at banks outside the United States.

• Origin and Purpose: Developed in Western Europe in the 1950s, eurocurrency deposits created a market for lending funds to large customers and for interbank trading among multinational banks.

• Accounting Treatment: When a non-U.S. branch lends to its U.S. home office, the position is recorded as liabilities to foreign branches.

• Interest Structure: Most eurodollar deposits, like negotiable CDs, are fixed-rate instruments.

Topic 8. Eurocurrency Deposit Market

• Definition and Tenor: Commercial paper is a short-term borrowing instrument (typically a few days up to 270 days) issued by large companies at a discount to face value.

• Issuance and Purpose: It is issued via private placement or dealers and is commonly used to finance working capital needs such as inventory.

• Types of Issuers: Industrial paper is issued by corporates, while finance paper is issued by finance companies such as GE Capital.

Topic 9. Commercial Paper Market

Practice Questions: Q2

Q2. Which of the following nondeposit funding sources requires collateral?
A. Fed funds and commercial paper.
B. Commercial paper and discount window borrowing.
C. Fed funds and repurchase agreements.
D. Discount window borrowing and repurchase agreements.

Practice Questions: Q2 Answer

Explanation: D is correct.

Repurchase agreements involve selling securities to a lender and buying them back at a later date for a previously agreed upon price, thus they are collateralized. The Federal Reserve also demands collateral in order to borrow at the discount window.

• Long-Term Debt Role: Banks can borrow in long-term debt markets, though this funding is typically viewed as secondary capital rather than a primary funding source.

• Secured Financing: Mortgages are issued as secured instruments to finance construction activities.

• Unsecured Financing: Banks may also issue capital notes and unsecured debentures, usually with maturities ranging from 5 to 12 years.

Topic 10. Long-Term Nondeposit Funds

Topic 11. Available Funds Gap (AFG)

• Available Funds Gap (AFG): Difference between the current and projected inflows and outflows of bank's funds.
• When deposits do not fully cover lending, investments, or withdrawals, institutions borrow the gap using non-deposit funding sources. 

• Banks often add a small amount to their AFG to cover unexpected loan demand, a shortfall in deposits, or above-average withdrawals.

• AFG is estimated as:
  • ​AFG = (current and projected loans and other investments) - (current and expected deposit inflows and other available funds)
• Example: Ravens Bank expects $100 million in new loans, $15 million in security investments, and $30 million in credit line drawdowns. They anticipate $75 million in new deposits. With a 10% safety margin, the planned borrowing would be:
  • ​$AFG=(\$100+\$15+\$30)-\$75=\$70\; M$
  • ​$Planned\; Borrowing=\$70\; M\times 1.10=\$77\; M$

Practice Questions: Q3

Q3. Barbara Friedman, a bank manager on the asset-liability committee, must estimate the amount of money market funding she expects the bank to need in the coming week. Friedman estimates that the bank will make $60 M of new loans in the coming week. The bank does not plan to make any security investments but does expect additional drawdowns on credit lines to equal $10 M.
The bank is in a highly competitive deposit market and only expects $15 M in new deposits in the coming week. However, based on previous years’ experience, she expects that two of the bank’s largest customers will withdraw $1 M each in the coming week. Friedman should estimate the available funds gap for the coming week to be:
A. $43 M.
B. $45 M.
C. $53 M.
D. $57 M.

Practice Questions: Q3 Answer

Explanation: D is correct.

Available funds gap (AFG) = (current and projected loans and other investments)− (current and expected deposit inflows and other available funds)
AFG = ($60 + $10) − ($15 − $2) = $57 M

In this case, the bank’s expected outflows are twofold: the new loans and the expected drawdowns on credit lines.

While the bank expects $15 M of new deposits, Friedman cannot ignore the forecast $2 M being withdrawn by two deposit customers, leaving a net $13 M of deposits.

Thus, she expects the bank to need $57 M in non deposit sources of funding in the coming week.

Module 2. Choice and Cost of Non-Deposit Sources of Funds

Topic 1. Choice of Funds

Topic 2. Relative Cost of Funding Source

Topic 3. Risks of Funding Source

Topic 4. Maturity of Funding Source

Topic 5. Size of the Financial Institution

Topic 6. Regulatory Requirements

Topic 7. Cost of Funds: Historical Average Cost Approach

Topic 8. Cost of Funds: Pooled Funds Approach

Topic 1. Choice of Funds

• Role of Nondeposit Funding: Nondeposit sources bridge the gap between security purchases and credit demand when deposits are insufficient.

• Forward-Looking Planning: Banks must forecast current and future loan demand to determine funding needs accurately.

• Funding Choice Drivers: The selection of nondeposit funds depends on:

  • Relative cost of funding source,

  • Risk of funding source,

  • Maturity of funding source,

  • Size of the financial institution, and

  • Regulatory requirements

Topic 1. Choice of Funds

• Role of Nondeposit Funding: Nondeposit sources bridge the gap between security purchases and credit demand when deposits are insufficient.

• Forward-Looking Planning: Banks must forecast current and future loan demand to determine funding needs accurately.

• Funding Choice Drivers: The selection of nondeposit funds depends on:

  • Relative cost of funding source,

  • Risk of funding source,

  • Maturity of funding source,

  • Size of the financial institution, and

  • Regulatory requirements

Topic 2. Relative Cost of Funding Source

• Funding Source Selection: Institutions continuously compare funding sources and typically choose the lowest-cost option, with fed funds usually cheapest, CDs and Eurocurrency deposits slightly higher, and commercial paper generally the most expensive depending on maturity.

• Availability vs Volatility: Fed funds are available across very short maturities but can be volatile, especially on settlement days when reserve requirements must be met.

• Stability Vs Tenor Matching: CDs and commercial paper provide greater rate stability at higher cost, while fed funds are preferred for very short-term needs and CDs/CP are better suited for funding over several days to weeks.

• Noninterest Costs and Net Funds: Funding decisions must account for noninterest costs (reserves, insurance, administrative and transaction costs), with net investable funds defined as the portion ultimately deployed into earning assets.

• The effective cost of deposit and nondeposit funding is calculated as:
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• Funding source risk: Risks arise from the availability, reliability, and volatility of funding sources, with most interest rates (except discount window borrowing) determined by market supply and demand.
  • Interest Rate Risk: Interest rate risk rises with rate volatility, which is highest for short-term borrowings, making fed funds the most volatile among non-deposit funding sources.

  • Credit Availability Risk: Institutions must assess the reliability of funding sources, with fed funds typically more dependable than CDs, Eurodollars, and commercial paper, which may become unavailable and require switching to higher-cost alternatives.

Topic 3. Risks of Each Funding Source

• Maturity Alignment: Banks must match the maturity of borrowed funds to the underlying need (e.g., long-term funding for fixed-rate mortgages versus overnight funding for reserve requirements).

• Availability of Funding Sources: Some instruments, such as long-term debt and commercial paper, may not be immediately accessible, while Fed funds are available on demand.

• Timing and Maturity Considerations: Managers must account for both the maturity and availability of funding needs when selecting among alternative funding sources.

Topic 4. Maturity of Each Funding Source

• Limited Market Access: Smaller institutions often lack access to negotiable CDs and Eurodollar markets due to large minimum trading sizes (e.g., $1 million).

• Secondary Market Availability: Investors favor instruments like negotiable CDs from money-center banks because of active secondary markets, which smaller institutions cannot easily offer.

• Alternative Funding Sources: As a result, smaller institutions rely more on discount window borrowing or federal funds, which are available in smaller denominations.

Topic 5. Size of the Financial Institution

• Limits on funding instruments: Regulations can restrict specific funding sources, such as imposing minimum maturities (e.g., CDs requiring at least seven days).

• Borrowing constraints: Regulators may cap how much an institution can borrow, how often it can borrow, or how the borrowed funds may be used.

• Stress-period restrictions: During periods of financial stress, authorities like the Fed may impose additional constraints, such as reserve requirements on instruments like fed funds, repos, and commercial paper.

• Impact on cost and risk: Regulatory changes can alter both the cost and risk profile of funding sources, affecting their attractiveness and usability.

Topic 6. Regulatory Requirements

Topic 7. Cost of Funds: Historical Average Cost Approach

• Historical Average Cost Approach: This method uses the historical costs of all funding sources, including interest and noninterest expenses, as well as the required rate of return for shareholders. This approach is backward-looking and reflects the costs the bank has already incurred.

  • Step 1: Weighted average interest expense: Average interest paid on all funds raised

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  • ​​Step 2: Breakeven cost rate on borrowed funds: The rate a bank must earn on its assets to cover funding and operating costs, excluding the required return to equity holders.
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  • Step 3: Weighted average overall cost of capital: Total cost of all capital, including the before-tax cost of stockholders' investment.
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Topic 7. Cost of Funds: Historical Average Cost Approach

• Example: Orange Tree Bank estimates its cost of funds using the historical average cost approach, given noninterest expenses of $11 million, total assets of $1 billion, earning assets of $800 million, equity of $100 million, a 12% after-tax required equity return, and a 20% tax rate, based on the bank’s historical funding costs table given below.
  • Funding Sources

Topic 7. Cost of Funds: Historical Average Cost Approach

• Step 1: Weighted average interest expense ​
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• ​​Step 2: Breakeven cost rate on borrowed funds invested in earning assets 
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• Step 3: Weighted average overall cost of capital
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• This means that Orange Tree Bank’s weighted average cost of funds is 6.35%. Therefore, the bank must earn a minimum of 6.35% on earning assets to cover the cost of capital, assume a $100 million investment from shareholders. 

• Pooled Funds Approach: This is a forward-looking approach.

  • This method is used to determine the minimum rate of return, or hurdle rate, that a bank must earn on future loans and securities to cover the costs of new funds it will raise.

  • This method is crucial for pricing new loans and investments.

• Pooled deposit and nondeposit funds expense: This represents the average cost of all new funds that are expected to be raised. It is a benchmark for the cost of future funding.

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• Hurdle rate over all earning assets: This is the minimum before-tax return which the bank must earn on every dollar of new funds invested in earning assets to cover the cost of raising those funds.
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Topic 8. Cost of Funds: Pooled Funds Approach

• Example: Orange Tree Bank estimates the following in terms of raising additional funds and investing those funds. Given the forecast data, calculate the pooled deposit and nondeposit funds expense and the hurdle rate required on all newly raised funds.

• ​​Forecast of New Deposit and Nondeposit Fundingc

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Topic 8. Cost of Funds: Pooled Funds Approach

• Pooled deposit and nondeposit funds expense

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• However, only $221 million of the $270 million raised will be invested in earning assets. As such,

• Hurdle rate over all earning assets
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• This means that Orange Tree Bank must earn at least 10.23% before tax on all new deposit and nondeposit funds, to meet the expected costs of raising new funds.

Topic 8. Cost of Funds: Pooled Funds Approach

Practice Questions: Q1

Q1. Kris Gaines, Treasurer at Palm Air Bank and Trust, is considering ways to meet a funding gap created by greater than expected loan demand. Palm Air is a medium sized bank located in Florida. The funding gap is approximately $850,000. Gaines is choosing between several non depository funding types. The funds are needed immediately. Which type of funding is most appropriate in this
situation?
A. Commercial paper.
B. Negotiable certificates of deposit (CDs).
C. Federal funds borrowing.
D. Eurodollar deposits.

Practice Questions: Q1 Answer

Explanation: C is correct.

Federal (fed) funds are likely the best funding choice for three reasons. First, because Palm Air Bank and Trust is a medium-sized bank, it may not have access to commercial paper, negotiable CDs, and Eurodollar deposits. Second, these funding sources come in units of $1 M or more. Because the bank needs less than $1 M, commercial paper, negotiable CDs, and Eurodollar deposits are not necessarily appropriate. Third, the funds are needed immediately. Fed funds are available in smaller denominations and are usually immediately available.

Practice Questions: Q2

Q2. Blue Star Bank expects to raise $300 M, $250 M of which will be invested in earning assets. The total expected interest and overhead costs on the newly raised funds is forecasted to be $22 M. The pooled deposit and non deposit funds expense and hurdle rate over all earning assets are, respectively:
A. 7.33%; 7.33%.
B. 7.33%; 8.80%.
C. 8.80%; 7.33%.
D. 8.80%; 8.80%.

Practice Questions: Q2 Answer

Explanation: B is correct.

Pooled deposit and non deposit funds expenses = all expected operating expenses/all new funds expected = $22/$300 = 7.33%
hurdle rate over all earning assets = expected operation expenses/dollars invested in earning assets = $22/$250 = 8.80%