Banks CH
Banks CH
Banks CH
The banking community learned long ago the importance of the customer relationship
doctrine. This doctrine proclaims that the first priority of a lending institution is to make
loans to all those customers from whom the lender expects to receive positive net
earnings. If 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.
Today, however, correspondent deposits that depository institutions hold with each other
also can be moved around the banking system the same day a request is made. The same
is true of large collected demand deposit balances that securities dealers and governments
own, which also can be transferred by wire. All three of these types of deposits make up
the raw material that is traded in the market for Federal funds. In technical terms, federal
funds are simply short-term borrowings of immediately available money.
Banks, thrifts, securities houses and other firms in need of immediate funds can negotiate
a loan with a holder of surplus inter-bank deposits or reserves at the Fed, promising to
return the borrowed funds the next day if need be.
The main use of the Federal funds market today is still the traditional one: a mechanism
that allows banks and other depository institutions short of reserves to meet their legal
reserve requirements or to satisfy customer loan demand by tapping immediately usable
funds from other institutions possessing temporarily idle funds.
To help suppliers and demanders of Federal funds find each other, funds brokers soon
appeared to trade Federal funds in return for commissions. Large correspondent banks,
known as accommodating banks, play a role similar to that of funds brokers for smaller
depository institutions in their region. An accommodating bank buys and sells Federal
funds simultaneously in order to make a market for the reserves of its customer
institutions, even though the accommodating bank itself may have no need for extra
funds.
Borrowing and lending institutions communicate either directly with each other or
indirectly through a correspondent bank or funds broker. Once borrowing and lending
institutions agree on the terms of a Federal funds loan –especially its interest rate and
maturity- the lending institution arranges to transfer reserves from a deposit it holds,
either at the Federal Reserve bank in its district or with a correspondent bank, into a
deposit controlled by the borrowing institution. This may be accomplished by wiring
Federal funds if the borrowing and lending institutions are in different regions of the
country. If both lender and borrower hold reserve deposits with the same Federal Reserve
bank to transfer funds from its reserve account to the borrower’s reserve account –a series
of bookkeeping entries accomplished in seconds via computer. When the loan comes due,
the funds are automatically transferred back to the lending institution’s reserve account.
The interest rate on a federal funds loan is subject to negotiation between borrowing and
lending institutions. While the interest rate attached to each Federal funds loan may differ
from the rate on any other loan, most of these loans use the effective interest rate
prevailing each day in the national market.
Term loans: are longer-term Federal funds contracts lasting several days, weeks, or
months, often accompanied by a written contract.
Continuing contracts: are automatically renewed each day unless either the borrower or
the lender decides to end this agreement.
The interest cost for both Federal funds transactions and repurchase agreements can be
calculated from the following formula:
Interest Cost of RP = Amount borrowed x Current RP rate x No of days in RP borrowing
360 days
For example, suppose the commercial bank borrows $50 million through an RP
transaction collateralized by government bonds for 3 days and the current RP rate in the
market is 6%. Then this bank’s total interest cost would be as follows:
Three types of Federal Reserve loans are available from the discount window:
1. Primary credit: loans available for very short terms (usually overnight but
occasionally extending over a few weeks) to depository institutions in sound financial
condition. The primary credit loan rate is established at least every two weeks, subject to
review by the Board of Governors of the Federal Reserve System.
Users of primary credit do not have to show that they have exhausted other sources of
funds before asking the Fed for a loan. Moreover, the borrowing institution is no longer
prohibited from borrowing from the Fed and then loaning that money to other depository
institutions in the Federal funds market.
3. Seasonal Credit: Loans covering longer time periods than primary credit for small and
medium-sized depository institutions experiencing seasonal swings in their deposits and
loans.
As noted above, each type of discount-window loan carries its own loan rate, with
secondary credit generally posting the highest interest rate and seasonal credit the lowest.
During the 1960s, faced with slow or nonexistent growth in checkbook deposits.
Citigroup, one of the most innovative banks in the world, was the first to develop the
large ($100,000+) negotiable CD in 1961.
Negotiable CDs would be confined to short maturities, ranging from 7 days to 1-2 years
in most cases, but concentrated mainly in the 1-to-6 month maturity range for the
convenience of the majority of CD buyers. And the new instrument would be negotiable
–able to be sold in the secondary market any number of times before reaching maturity –
in order to provide corporate customers with liquidity in case their cash surpluses proved
to be smaller or less stable than originally forecast. To make the sale of negotiable CDs in
advance of their maturity easier, they were issued in bearer form.
Interest rates on fixed-rate CDs, which represent the majority of all large negotiable CDs
issued, are quoted on an interest-bearing basis, and the rate is computed assuming a 360-
day year. For example, suppose a bank promises an 8% annual rate to the buyer of a
$100,000 six-month (180 days) CD. The depositor will have the following at the end of
six months:
CDs that have maturities over one year normally pay interest to the depositor every six
months. Variable-rate CDs have their interest rates reset after a designated period of time
(called a leg or roll period). The new rate is based on a mutually accepted reference
interest rate, such as the London Inter-bank Offer Rate (LIBOR) attached to borrowings
of Eurodollar deposits or the average interest rate prevailing on prime-quality CDs traded
in the secondary market.
The net result of CD sales to customers is often a simple transfer of funds from one
deposit to another within the same depository institution, particularly from checkable
deposits in CDs. The selling institution gains loanable funds even from this simple
transfer because, in the US at least, legal reserve requirements are currently zero for CDs,
while checking accounts at the largest depository institutions carry a reserve requirement
of 10%. Also, deposit stability is likely to be greater for the receiving bank because the
CD has set maturity and normally will not be withdrawn until maturity. In contrast,
checkable (demand) deposits can be withdrawn at any time.
However, the cost of negotiable CDs, measured by their market interest rates, is sensitive
to competition among depository institutions, the credit rating of the offering institutions,
and economic conditions.
The banks accepting these deposits may be foreign banks, branches of US banks
overseas, or international banking facilities (IBF s) set up on US soil. The heart of the
worldwide Eurodollar market is ion London, where British banks compete with scores of
American and other foreign banks for Eurodollar deposits. The Eurocurrency market is
the largest unregulated financial marketplace in the world, which is one reason it has
been one of the faster-growing financial markets.
A domestic bank can tap the Euro-market for funds by contacting one of the major
international banks that borrow and lend Eurocurrencies every day. The largest US banks
also use their own overseas branches to tap this market. When one of these branches
lends a Euro-deposit to its home office in the US, the home office records the deposit in
an account labeled liabilities to foreign branches. When a US bank borrows Euro-
deposits from a bank operating overseas, the transaction takes place through the
correspondent banking system. The lending bank will instruct a US correspondent bank
where it has a deposit to transfer funds in the amount of the Eurocurrency loan to the
correspondent account of the borrowing institution. These borrowed funds will be quickly
loaned to qualified borrowers or perhaps used to meet a reserve deficit.
The second decision that must be made is how much in deposits is likely to be attracted
in order to finance the desired volume of loans and security investments. Again,
projections must be made of customer deposits and withdrawals, with special attention to
the largest depositors. Deposit projections must take into account current and future
economic conditions, interest rates, and the cash flow requirements of the largest
depositors.
The difference between current and projected credit and deposit flows yields an estimate
of each institution’s funds gap. Thus,
The funds Gap = Current & Projected loans and investments the lending institution
desires to make – Current & expected deposit inflows
For 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 received today total &185 million, and those
expected in the coming week will bring in another $100 million. This bank’s estimated
funds gap (FG) for the coming week will be as follows (in millions of $):
FG = ($10 + $75 + $135) – ($185 +$100) = $75
Most institutions will add a small amount to this funds gap estimate to cover unexpected
credit demands or unanticipated shortfalls in deposit inflows.