Transcript Liability Management - HKUST HomePage Search

Liability Management
3-6-3 Rule
• During 1960’s, banking in the USA was
said to operate according to the 3-6-3 rule.
• Take deposits at 3%, make mortgage
loans at 6%, and be on the golf course at
3 o’clock.
• Since then, increasing financial market
technology and banking deregulation have
led to a more complicated environment in
terms of search for funds.
Students should be able to
• Identify different types of liabilities, their risk
characteristics, and general trends.
• Calculate the historical and marginal cost of
different sorts of funds.
• Calculate the weighted costs of funds.
• Source: Bank Management by Timothy W.
Koch and Scott S. Macdonald.
Deposit Liabilities
• Demand Deposit: Checking account services
that permit depositors to write drafts in payment
that the bank must honor immediately upon
presentation (UK: Current Account)
• Savings Deposit: Interest bearing funds left
indefinitely with a bank with no minimum
required maturity.
• Time Deposit: Interest bearing accounts with
stated maturities which may carry penalties in
the case of early withdrawal.
• Negotiable Certificate of Deposit: A type of
interest bearing deposit that may be sold any
number of times before maturity.
Trends in Demand Deposits in HK
History of Deposit Liabilities
80.00%
70.00%
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
Demand Deposits
Savings
1980
Time Deposits
1990
2005
NCDs
Structure of Liabilities
Banks can control the flow of
deposits by offering only
products with specific
maturities and minimum
balances and varying the
relative rates paid according to
these terms.
Liabilities Bank of East Asia 2004
Deposits from Banks
5.39%
Demand Deposits
6.72%
Savings Deposits
27.46%
Time Depocits
58.08%
NCDs
2.35%
Maturity Structure of Time Deposits - Bank of East Asia 2004
100.00%
90.00%
80.00%
70.00%
60.00%
50.00%
40.00%
30.00%
20.00%
10.00%
0.00%
Demand
3 Months
3Mo-1Year
1-5 Years
December 2005, HK
Source:
Interest Cost of Funds
3.5
3
2.5
Savings
2
< 100K
> 100K
1.5
> 500K
1
0.5
0
7 Days
1 Month
3 Months
6 Months
Calculating the net cost of transaction accounts
• Annual historical net cost of bank liabilities is
historical interest expense plus noninterest
expense (net of noninterest income) divided by
the investable amount of funds:
Net Cost of Bank Liabilitie s

Interest Expense  Noninterest Expense - Noninterest Income
Average Balance net of float x (1 - required reserve ratio)
• A regular check account that does not pay
interest, has $20.69 in transaction costs charges
$7.75 in fees, an average balance of $5,515, 5%
float would have a net cost of:
% net cost of regular checking 
$0  $20.69 - $7.75
x12  4.66%
$5,515 x. 0.95 x 0.90
Required reserves on transactions account are 10%.
Historical Cost of Funds, terms.
• Required Reserve Ratio: Percentages
applied to transactions accounts and time
deposits to determine the dollar amount of
required reserve assets, including vault
cash and deposits at the central bank.
• Float: Dollar amount of checks in process
of collection, net of deferred availability
amouns, to depositors.
Demand Accounts
Monthly
Income /
Unit Cost Expenses
Income
Interest Income (estimated 7.5% earnings credit)
Non-Interest Income
Service Charges
Penalty Fees
Other
Total Non-Interest Income
Expenses
Activity Charges
Deposit - Electronic
Deposit - Non Electronic
Withdrawal - Electronic
Withdrawal - Non Electronic
Transit Check Deposited
Transit Check Cashed
Account Opened
Account Closed
On-Us Checks Cashed
Account Maintenance (Truncated) monthly
Account Maintenance (Non truncated) monthly
Official check issued
Total Activity Expense
Net Indirect Expense
Total Non-Interest Expense
Interest Expense
Total Expense
Net Income (expense) Before Earnings Credit
Net Revenue Per Month
$
$
$
$
$
$
$
$
$
$
$
$
0.0089
0.2219
0.1073
0.2188
0.1600
0.2562
9.46
5.67
0.2412
2.42
8.60
1.02
Savings Accounts
Monthly
Income /
Unit Cost Expenses
Time Deposits
Monthly
Income /
Unit Cost Expenses
$
29.47
$
34.04
$
121.84
$
$
$
$
2.80
4.32
0.63
7.75
$
$
$
$
0.44
0.28
0.16
0.88
$
$
$
$
0.11
0.27
0.05
0.42
$
$
$
$
$
$
$
$
$
$
$
0.02
0.66
0.43
3.63
1.71
0.50
0.20
0.07
0.42
1.67
7.03
$ 16.34
$
4.35
$ 20.69
1.25% $
5.38
$ 26.07
$
$
(18.32)
11.15
$
$
$
$
$
0.0502
0.7777
0.4284
0.7777
0.5686
$
$
$
$
$
0.01
0.46
0.07
0.39
1.09
$
$
$
$
0.1650
3.1425
0.5400
1.4933
$
$
$
$
0.1296
2.2016
0.2840
0.5875
$
$
33.63
20.18
$
$
0.53
0.26
$
$
5.78
3.38
$
$
1.73
1.02
$
4.10
$
3.56
$
1.99
$
1.99
$
6.37
$
1.81
$
8.18
2.96% $ 13.45
$ 21.63
$ (20.75)
$ 13.29
Average Account Balance
$5,515.00
$5,557.00
a
Average Annual Net Cost
4.66%
4.57%
Average Interest Cost
1.37%
2.96%
Average Non-interest Cost
5.27%
1.80%
Average Non-interest Income
1.97%
0.19%
a
Required reserves are assumed to be 10 percent for demand accounts and zero for others. Float is assumed to be 5
percent for demand accounts, 2 percent for savings accounts and zero for time accounts.
Source: Functional Cost and Profit Analysis, Based on data furnished by participating banks in
twelve Federal Reserve Districts, 1999 National Average Report,
$
$
$
5.18% $
$
$
$
7.94
18.38
26.32
69.79
96.11
(95.69)
26.16
$19,495.00
5.89%
4.30%
1.62%
0.03%
Time Deposits
• During the 1980’s, Time deposits became
the dominant source of funding for HK
banks.
• Time deposits have higher interest rate
costs but lower transactions costs.
• Time deposits are often volatile liabilities
i.e. large investments made by depositors
who are intensively sensitive to interest
rates and risk.
Time deposits and …
• Interest Rate Risk Time deposits more
interest sensitive than core deposits. Must
be repriced rapidly when rates change.
• Liquidity Risk Reliance on volatile deposits
makes it easy to have a liquidity shortfall.
• Credit Risk Vicious cycle. Banks may try to
acquire high risk/return assets to pay high
deposit costs. Higher credit risk may
cause interest costs to rise.
Historical Cost vs. Marginal Cost
• To consider whether it is profitable to make an additional
loan, bank should compare marginal cost with marginal
revenue from source of loans.
• Marginal cost of debt
…a measure of the borrowing cost paid to acquire one
additional unit of investable funds
• Marginal cost of equity capital
…a measure of the minimum acceptable rate of return
required by shareholders.
• Together, the marginal costs of debt and equity constitute
the marginal cost of funds, which can be viewed as
independent sources or as a pool of funds.
Costs of independent sources of funds
• Marginal costs include both the interest
and noninterest costs it expects to pay and
identify which portion of the acquired funds
can be invested in earning assets.
• Conceptually, marginal costs may be
defined as :
Marginal Cost
Interest Rate + Servicing costs + Acquisition costs

1 - % of funds in nonearning assets
Example:
Marginal costs of a hypothetical
saving account
• Assume:
– market interest rate = 1.9%
– servicing costs = 4.1%
– acquisition costs = 1.0% of balances
– percentage in nonearning assets = 2.0%
(2% held in reserves)
• The estimated marginal cost is 7.14%:
0.019  0.041 0.01
marginal cost 
 0.0714
0.98
WMC is computed in three stages.
1. Forecasts shares of financing from equity and different
kinds of deposits and debt. (wj)
2. Estimate the marginal cost of each independent source
of funds. (kj)
3. Combine the individual estimates to project the
weighted cost, which equals the weighted sum of the
component costs across all sources.
m
WMC   w jk j
•
j1
Each source’s weight (wj) equals the expected dollar
amount of financing from that source divided by the
dollar amount of total liabilities and equity and kj equals
the single-source j component cost of financing:
(WMC) …the best cost measure for total
assets is a weighted marginal cost of funds
• This measure recognizes both explicit and
implicit costs associated with any single
source of funds.
• It assumes that all assets are financed
from a pool of funds and that specific
sources of funds are not tied directly to
specific uses of funds.
Calculate the cost of subordinated
debt
• Assume the bank will issue:
– $10 million in par value subordinated notes
– paying $700,000 in annual interest and
– carrying a 7-year maturity.
– It must pay $100,000 in flotation costs to an
underwriter.
• The effective cost of borrowing (kd), where
t equals the time period for each cash flow,
$700,000 $10,000,000
is 7.19%:
$9,900,000 

7
t 1
or
(1  k d )t
k d  7.19%
(1  k d )7
Calculating Yield to Maturity
• YIELD
•
•
•
•
•
•
Borrower Coupon
HK Prop
5.28
SHK Prop
5.75
HK SAR
3.75
HK SAR
5.13
Frequency Maturity
Q
20-07-09
Q
18-07-12
S
23-07-09
S
23-07-19
k (Yield to Maturity)
4.76%
4.90%
4.26%
4.74%
•
•
•
•
•
•
•
•
•
•
See Also
Returns the yield on a security that pays periodic interest. Use YIELD
to calculate bond yield.
If this function is not available, and returns the #NAME? error, install
and load the Analysis ToolPak add-in.
How?
On the Tools menu, click Add-Ins.
In the Add-Ins available list, select the Analysis ToolPak box, and
then click OK.
If necessary, follow the instructions in the setup program.
Syntax
YIELD(settlement,maturity,rate,pr,redemption,frequency,basis)
Important Dates should be entered by using the DATE function, or
as results of other formulas or functions. For example, use
DATE(2008,5,23) for the 23rd day of May, 2008. Problems can occur
if dates are entered as text.
Settlement is the security's settlement date. The security settlement
date is the date after the issue date when the security is traded to the
buyer.
Maturity is the security's maturity date. The maturity date is the date
when the security expires.
Rate is the security's annual coupon rate.
Pr is the security's price per $100 face value.
Redemption is the security's redemption value per $100 face value.
Frequency is the number of coupon payments per year. For annual
payments, frequency = 1; for semiannual, frequency = 2; for
quarterly, frequency = 4.
Targeted return on equity model
…investors require higher pretax returns on common stock
than on debt issues because of the greater assumed credit
risk.
• Many banks use a targeted return on
equity guideline based on the cost of debt
plus a premium to evaluate the cost of
equity.
Targeted income before taxes
Pretax required return 
Stockholde rs Equity
Since 2003, HKMA constructs a composite
interest rate for use as a base rate
HK: Composite Interest Rate
% pa
2.4
2.2
2.0
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
Dec-2003
Mar-2004
Jun-2004
Sep-2004
Dec-2004
Mar-2005
Jun-2005
Sep-2005
Interbank Market:USA
• Federal funds are reserve balances at
US Federal Reserve Banks that
depository institutions can lend to one
another.
• The most common federal funds
transaction is an overnight, unsecured
loan between two financial institutions.
• Hong Kong InterBank Offered Rate: The rate
on which one bank deposits money at another
reason for short-term lending.
HK: Interbank Offered Rate: 3 Month
% pa
16
14
12
10
8
6
4
2
0
Dec-1984
Dec-1987
Dec-1990
Dec-1993
Dec-1996
Dec-1999
Dec-2002
Dec-2005
Deposit Protection Scheme
• Hong Kong will implement a scheme of
insurance for bank deposits less than
HK$100K.
• Banks pay some insurance fee and if the
bank goes bankrupt, the bank regulator
pays depositors up to some limit.
• Only protects very small depositors, up to
84% of deposits by value are in accounts
in excess of $100K
Loan Pricing
Price Leadership Model
Loan
Interest
Rate
=
Default
Risk
Term Risk
Premium
Premium for
+
+
for NonLonger
Prime
Term Credit
Borrowers
Base or
Prime Rate
Loan
Interest
Rate
=
Marginal
Cost of
Raising
Loanable
Funds to
Lend to
Borrower
Nonfund
Bank
+
+
Operating
Costs
Bank's
Desired
Profit
Margin
Below Prime Pricing
• Traditionally, prime rate is rate offered to a
bank’s best commercial borrowers.
• Recently, banks have been lending at rates
below their posted prime interest rate.
Bank of America Lending Rates Hong Kong
9
8
7
6
5
4
3
2
1
Best Lending Rate
Mortgage Rate
11/21/2005
8/21/2005
5/21/2005
2/21/2005
11/21/2004
8/21/2004
5/21/2004
2/21/2004
11/21/2003
8/21/2003
5/21/2003
2/21/2003
11/21/2002
8/21/2002
5/21/2002
2/21/2002
11/21/2001
8/21/2001
5/21/2001
0