CHAPTER 15
MANAGING NONDEPOSIT LIABILITIES AND OTHER SOURCES OF BANK FUNDS Goal of This Chapter: To discover the major nondeposit sources of borrowed funds banks use today and to learn the factors a banker must consider in choosing among various deposit and nondeposit funds sources.
Key Terms Presented in This Chapter
Customer Relationship Doctrine Commercial Paper Market
Liability Management Repurchase Agreement (RP)
Federal Funds Market Funds Gap
Discount Window Interest-Rate Risk
Negotiable CD Credit Availability Risk
Eurocurrency Deposit
Chapter Outline
I. Introduction: The Consequences of Deposit Shortfalls and the Need to Use Nondeposit
Sources of Funds
II. Liability Management
A. Customer Relationship Doctrine
B. Purpose of Liability Management
Ill. Alternative Nondeposit Sources of Bank Funds
A. Federal Funds Market
B. Borrowing from the Federal Reserve Bank in the District
C. The Development and Sale of Large Negotiable CDs
D. Eurocurrency Deposit Market
E. The Commercial Paper Market
F. Repurchase Agreements as a Source of Bank Funds
G. Long-Term Nondeposit Funds Sources
IV. Choosing Among Alternative Nondeposit Sources
A. Measuring a Bank's Total Need for Nondeposit Funds - The Funds Gap
B. Nondeposit Funding Sources: Factors to Consider
1. Relative Costs
2. The Risk Factor
3. Length of Time for Which Funds Are Needed
4. The Size of the Borrowing Bank and Its Funding Need
5. Regulations
V. Summary of the Chapter
Concept Checks
15-1. What is liability management?
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Liability management involves the conscious control of the funding sources of a bank,
using the interest rates (yields) offered on deposits and other borrowings to regulate the inflow of funds to match the bank's immediate funding needs.
15-2.  What advantages and risks does the pursuit of liability management bring to a bank?
Improved control over funding sources enables a bank to plan its growth more completely, but liability management opens up certain risks, particularly of the interest-rate risk and solvency (default or failure) risk variety, because it tends to be more sensitive to changes in market interest rates.
15-3.  What is the customer relationship doctrine and what are its implications for bank fund-raising?
The customer relationship doctrine places lending to customers at the top of a bank's priority list.  It argues that a bank should make all good loans - that is, all loans that meet the bank's quality and profitability standards - and then find the funds needed to fund those loans the bank decides to make.  Funds uses thus become a higher immediate priority item than funds sources.
15-4.  For what kinds of bank funding situations are federal funds best suited?
Federal funds are best suited for banks short of reserves to meet their legal reserve requirements or to satisfy customer loan demand.  It satisfies this demand by tapping immediately usable funds.
15-5.  Chequers State Bank loans $50 million from its reserve account at the Federal Reserve Bank of Philadelphia to First National Bank of Smithville, located in the New York Federal Reserve Bank's district, for 24 hours with the funds scheduled to be returned the next day. The proper accounting entries in this case would be:
Step 1 - Lending the $50 million
Chequers State Bank
Step 2 - Using the borrowed First National Bank of Smithville
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.
Step 3 - Repaying the Loan of Federal Funds
Chequers State Bank
First National Bank of Smithville
15-6. Hillside Security Bank has an excess balance of $35 million in a deposit at its principal correspondent, Sterling City Bank, and instructs the latter institution to loan the funds today to another bank, returning them to its correspondent deposit the next business day.  Sterling loans the $35 million to Imperial Security National Bank for 24 hours.  The proper accounting entries would be:
Step 1 - Lending Federal Funds to a Correspondent
Hillside Security Bank
Sterling City Bank
Assets Liabilities
Federal funds
purchased        +$35 mill.
Respondent
Bank's deposit  -$35 mill.
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Step 2 - The Correspondent Bank Loans Funds to Another Bank
Sterling City Bank
Imperial Security National Bank
Step 3 - Repaying the Loan to the Respondent Bank
Hillside Security Bank
Sterling City Bank
15-7.  What are the advantages of borrowing from the Federal Reserve banks?
Borrowing from the Federal Reserve banks is usually the lowest interest-cost source of funds.  However, there are strict rules for borrowing by banks and borrowing for rate arbitrage is prohibited, although there is some evidence it does occur.
15-8.  How is a discount window loan from the Federal Reserve secured?
A discount window loan must be secured by collateral acceptable to a Federal Reserve bank (usually U.S. government securities).  Most banks keep government securities in the vaults of the Federal Reserve for this purpose.  The Federal Reserve bank will also accept some government agency securities and high-grade commercial paper as collateral.
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15-9. Posner State Bank borrows $10 million in adjustment credit from the Federal Reserve Bank of Cleveland.  Can you show the correct entries for the granting and repayment of this loan? The proper entries are:
Step 1 - Securing a Loan from the Fed.
Posner State Bank
Federal Reserve Bank of Cleveland
Step 2 - Repaying the Loan to the Fed.
Posner State Bank
Federal Reserve Bank of Cleveland
15-10.  Why were negotiable CDs developed?
Negotiable CDs were developed by banks to attract large corporate deposits and savings from wealthy individuals.
securing
15-11.  What are the advantages and disadvantages of CDs as a bank funding source? Negotiable CDs offer a way to attract large amounts of funds quickly and for a known time period.  However, these funds are highly interest sensitive and often are withdrawn as soon as the maturity date arrives unless a banker aggressively bids in terms of yield to keep the CD.
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15-12. Suppose a bank customer purchases a $1 million, 90-day CD, carrying a promised 6 percent annual 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 90 days?
Interest Income = Principal * Days to Maturity * Annual Rate
To Customer 360 days Of Interest
x 0.06
= $1,000,000 x 1
360
= $15,000
Total amount = Principal +  Interest
due Customer = $1,000,000 + $15,000
= $1,015,000
15-13. Where do Eurodollars come from?
Eurodollars arise from dollar deposits made in banks and at branch offices outside U.S. territory.  Many Eurodollar deposits arise from U.S. balance-of-payments deficits that give foreigners claims on U.S. assets and from the need to pay in dollars for some international commodities (such as oil) that are denominated principally in U.S. dollars.
15-14. How does a bank gain access to funds from the Eurocurrency markets?
Access to these funds is obtained by contacting correspondent banks by telephone, wire, or cable.
15-15. Suppose that JP Morgan-Chase elects to borrow $250 million from one of its London branches, then loans the borrowed funds for a week to a security dealer, and then returns the borrowed funds to its branch office in London.  Can you trace through what accounting entries must be made?  What if JP Morgan-Chase had decided instead to borrow the $250 million from a foreign bank not related to JP Morgan-Chase?  How do the accounting entries differ in these two cases?
If JP Morgan-Chase borrows from its own branch office the entries would appear as possible:
Home Office of JP Morgan-Chase Bank
Foreign Branch Office of JP Morgan-Chase
Assets Liabilities
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