UNIT 2: COMMERCIAL BANK SOURCES AND USES OF FUNDS

Content
2.0 Aims and Objectives
2.1 Introduction
2.2 Bank Sources of Funds
2.3 Uses of funds by Banks
2.4 Off -Balance Sheet Activities
2.5 Summary
2.6 Answers to Check Your Progress Exercises
2.6 Model Examination Questions

2.0 AIMS AND OBJECTIVES

The specific objectives of this chapter are to:

 Describe the most common sources of funds for commercial banks
 Describe the most common uses of funds for commercial banks, and
 Describe typical off-balance sheet activities for commercial banks.

2.1 INTRODUCTION

Commercial banks represent the most important financial intermediary when measured
by total assets. Like other financial intermediaries, they perform a critical function of
facilitating the flow of funds from surplus units to deficit units.

2.2 BANK SOURCES OF FUNDS

The major sources of commercial bank funds are summarized follows:

Deposit Accounts
1. Transaction deposits
2. Savings deposits
3. Time deposits
4. Money market deposit accounts

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Borrowed funds
1. Federal funds purchased (borrowed)
2. Borrowing from the Federal Reserve banks
3. Repurchase agreements
4. Eurodollar borrowings

Long-term Sources of Funds

1. Bonds issued by the bank
2. Bank capital

Each source of funds is briefly described in the following subsections.

Transaction Deposits
The demand deposit account, or checking account, is offered to customers who desire to
write checks against their account. The conventional type of demand deposit account
requires a small minimum, balance and pays no interest. From the bank’s perspective,
demand deposit accounts are classified as transaction accounts that provide source of
funds that can be used until withdrawn by customers (as checks are written).
Another type of transaction deposit is the negotiable order of with drawl (NOW) account,
which provides checking services as well as interest. As of 1981, commercial banks and
other depository institutions throughout the entire country were given the authority to
offer them. Because NOW accounts at most financial institutions require a minimum
balance beyond what some consumers are willing to maintain in a transaction account,
the traditional demand deposit account is still popular.

Savings deposits
The traditional savings account is the passbook savings account, which does not permit
check writing. Until 1986, Regulation Q restricted the interest rate banks could offer on
passbook savings with the intent of preventing excessive competition that could cause
bank failures. Actually, the ceilings prevented commercial bands from competing for
funds during periods of higher interest rates. In 1986, Regulation Q was eliminated. The
passbook savings account continues to attract savers with a small amount of funds, as it

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often has no required minimum balance. Although it legally requires a 30-day written
notice by customers to with draw funds, most banks will allow withdrawals from these
accounts on a moment’s notice.

Another savings accounts is the automatic transfer service (ATS) account, created in
November 1978. It allows customers to maintain an interest-bearing savings account that
automatically transfers funds to their checking account when checks are written. Only the
amount of funds needed is transferred to the checking account. Thus, the ATS provides
interest and check-writing ability to customers. Some ATS accounts were eliminated
when the NOW accounts were established.

Time deposits
A common type of time deposit known as a retail certificate of deposit (or retail CD)
requires a specified minimum amount of funds to be deposited for a specified period of
time. Banks offer a wide variety of CDs to satisfy depositors’ needs. Annualized interest
rates offered on CDs vary among banks, and even among maturity types within a single
bank. An organized secondary market for retail CDs does not exist. Depositors must
leave their funds in the bank until the specified maturity or they will normally forgo a
portion of their interest as a penalty.

The interest rates on retail CDs have historically been fixed. However, more exotic retail
CDs have been offered in recent years. There are bull-market CDs that reward depositors
if the market performs well and bear-market CDs that reward depositors if the market
performs well and bear-market CDs that reward depositors if the market performs poorly.
These new types of retail CDs typically have a minimum deposit insurance (assuming
that the depository institution of concern is insured).

Another type of time deposit is the negotiable CD (NCD), offered by some large banks to
corporations. NCDs are similar to retail CDs in that they require a specified maturity date
and a minimum deposit requirement is $100,000. a secondary market for NCDs does
exist.

The level of large time deposits is much more volatile than that of small time deposits,
because investors with large sums of money frequently shift their funds to wherever they

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can earn higher rates. Small investors do not have as many options as large investors and
are less likely to shift in and out of small time deposits.

The deposit size distribution among banks is shown in Exhibit 16.1. Notice that 12.4
percent of all deposits are in banks that have less than $100 million in deposits. At the
other extreme, 14.6 percent of all deposits are in banks that have more than $50 billion in
deposits. The remaining 73 percent of deposits are in banks that have deposits ranging
from $100 million to more than $50 billion.

Money market deposit accounts

The money market deposit account (MMDA) was created by a provision of the Garn-St
Germaine Act of December 1982. It differs from conventional time deposits in that it
does not specify a maturity. MMDAs are more liquid than retail CDs from the depositor’s
point of view. Because banks would prefer to know how long they will have use of a
depositor’s funds, they normally pay a higher interest rate on CDs. MMDAs differ from
NOW accounts in that they have limited check-writing ability (they allow only a limited
number of transactions per month ), require a larger minimum balance, and offer a higher
yield.

The remaining sources of funds to be described are of a no depository nature. Such

sources are necessary when a bank temporarily needs more funds than are being
deposited. Some banks use no depository funds as a permanent source of 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 (or borrowed)
represent a liability to the borrowing bank and an asset to the lending bank that sells
them. Loans in the federal funds market are typically for one to seven days. Such loans
can be rolled over so that a series of one-day loans could take place. Yet, the intent of
federal funds transactions is to correct short-term fund imbalances experienced by banks.
A bank may act as a lender of federal funds on one day and as a borrower shortly
thereafter, as its fund balance changes on daily basis.

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The interest rate charged in the federal funds market is called the federal funds rate. Like
other market interest rates, it moves in reaction to changes in the demand or the supply or
both. If many banks have excess funds and few banks are short of funds, the federal funds
relative to a small supply of excess funds available at other banks will result in a higher
federal funds rate. Whatever rate ket, although a financially troubled bank may have to
pay a higher rate to obtain federal funds (to compensate for its higher risk). The federal
funds rate is quoted in multiples of one-sixteenth, on an annualized basis (using a 360-
day year). Exhibit 16.2 shows that the federal fund rate is generally between 25 percent
and 1.00 percent above the treasury bill rate. The difference normally mereases when the
perceived risk of banks increases.

The federal funds market is typically most active on Wednesday, because it is the final
day of each particular settlement period for which each bank must maintain a specified
volume of reserves required by the Fed. Those banks that were short of required reserves
on the average over the period must compensate with additional required reserves before
the settlement period ends. Large banks frequently need temporary funds and therefore
are common borrowers in the federal funds market.

Borrowing from the Federal Reserve banks

Another temporary source of funds for banks is the Federal Reserve System which serves
as the U.S. central bank. Along with other bank regulators, the Federal Reserve district
banks regulate certain activities of banks yet, they will also provide short-term loans to
banks (as well as to some other depository institutions). 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 window are short term, commonly from one day to a few weeks.
Banks that wish to borrow at the discount window must first be approved by the Fed
before a loan is granted. This is intended to make sure that the bank’s need for funds is
justified. Like the federal funds market, the discount window is mainly used to resolve a
temporary shortage of funds. If a bank needed more permanent sources of funds, it would
develop a strategy to increase its level of deposits.

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When a bank needs temporary funds, it must decide whether borrowing through the
discount window is more feasible than alternative no 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 and supply conditions on a daily
basis. Conversely, the discount rate is set by the Federal Reserve and adjusted only
periodically to keep it in line with other market rates (such as the federal funds rate).

Banks commonly borrow in the federal funds market rather than through the discount
window, even though the federal funds rate typically exceeds the discount rate. This is
because the Fed offers the discount window as a source of funds for banks that
experience unanticipated shortages of reserves. If a bank frequently borrows to offset
reserve shortages, these shortages should have been anticipated. Such frequent borrowing
implies that the commercial bank has a permanent rather than a temporary need for funds
and should therefore satisfy this need with rater than a temporary need for funds and
should therefore satisfy this need with a more permanent source of funds. The Fed may
disapprove of continuous borrowing by a bank unless there were extenuating
circumstances, such as if the bank was experiencing financial problems and could not
obtain temporary financing from other financial institution.

Repurchase agreements
A repurchase agreement (repo) represents the sale of securities by one party to another
with an agreement to repurchase the securities at a specified date and price. Banks often
use a repo as a source of funds when they expect to need funds for just a few days. They
would simply sell some of their government securities (such as their Treasury bills) to a
corporation with a temporary excess of funds and buy those securities back shortly
thereafter. The government securities involved in the repo transaction serve as collateral
for the corporation providing funds to the bank.

Repurchase agreement transactions occur through a telecommunications network

connecting large banks, other corporations, government securities dealers, and federal
funds (wish to sell and later repurchase their securities) with those who have excess funds
(are willing to purchase securities now and sell them back on a specified date.)
transactions are typically in blocks of $1 million. Like the federal funds rate, the yield on

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repurchase agreements is quoted in multiples of one-sixteenth on an annualized basis
(using a 360-day year). The yield on repurchase agreements is slightly less than the
federal funds rate at any given point in time, because the funds loaned out are backed by
collateral and are there fore less risky.

Eurodollar borrowings
If a U.S. bank is in need of short-term funds, it may borrow dollars from those banks
outside the United States that accept dollar-denominated deposits, or Eurodollars. Some
of these so-called Eurobanks are foreign banks or foreign branches of U.S. banks that
participate in the Eurodollar market by accepting large short-term deposits and making
short-term loans in dollars. Because U.S. dollars are widely used as an international
medium of exchange, the Eurodollar market is very active. Some U.S. banks commonly
obtain short-term funds from Eurobanks.

Bonds issued by the bank

Like other corporations, bank 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.
Common purchasers of such bonds are households and various financial institutions,
including life insurance companies and pension funds. Banks do not finance with bonds
as much as most other corporations, because their fixed assets are less than those of
corporations that use industrial equipment and machinery for production. Therefore, they
have less of a need for long-term funs.

Bank capital
Bank capital generally represents funds attained through the issuance of stock or through
retaining earnings. Either form has no obligation to pay out funds in the future. This
distinguishes bank capital from all the other bank sources of funds that represent a future
obligation by the bank to pay out funds. Bank capital as defined here represents the
equity or-net worth of the bank. Capital can be classified into primary or secondary types.
Primary capital results from issuing common or preferred stock or retaining earnings,
while secondary capital results from issuing subordinated notes and debentures.

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A bank’s capital must be sufficient to absorb operating losses in the event that expenses
or losses have exceeded revenues, regardless of the reason for the losses. Although long-
term bonds are sometimes considered as secondary capital, they are a liability to the bank
and therefore do not appropriately cushion against operating losses.

When banks issue new stock, they dilute the ownership of the bank because the
proportion of the bank owned by existing shareholders decreases. In addition, the bank’s
reported earnings per share are reduced when additional shares of stock are issued, unless
earnings increase by a greater proportion than the increase in outstanding shares. For
these reasons, banks generally attempt to avoid issuing new stock unless absolutely
necessary.

Bank regulators are concerned that banks may maintain a lower level of capital than they
should and have therefore imposed capital requirements on them. Because capital can
absorb losses, a higher level of capital is thought to enhance the bank’s safety and many
increase the public’s confidence in the banking system. In 1981 regulators imposed a
minimum primary capital requirement of 5.5 percent of total assets and a minimum total
capital requirement of 6 percent of total assets. Because of regulatory pressure, banks
have increased their capital ratios in recent years.

In 1988, regulators imposed risk-based new capital requirements that were completely
phased in by 1992, in which the required level of capital for each bank was dependent on
its risk. Assets with low risk were assigned relatively low weights, while assets with high
risk were assigned high weights. The capital level was set as a percentage of the risk-
weighted assets. Therefore, riskier banks were subject to higher capital requirements. The
same risk-based capital guidelines were imposed in several industrialized countries.
Additional details are provided in the following chapter.

Sources of Funds

Because banks cannot completely dictate the amount of deposits to be received, they may
experience a shortage of funds. For this reason, the no depository sources of funds are
useful. To support the acquisition of fixed assets, long-term funds are obtained by either
issuing long-term bonds, issuing stock, or retaining a sufficient amount of earnings.

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Exhibit 16.3 provides the distribution of fund sources. Transaction and savings deposits
make up less than half of all bank liabilities. The distribution of bank sources of funds is
influenced by bank size. Smaller banks rely more heavily on savings deposits than larger
banks. This results from small bank concentration on household savings and therefore on
small deposits much of this differential is made up in large time deposits (such as NCDs)
for very large banks. In addition, the larger banks rely more on short-term borrowings
than do small banks. The impact of the differences in composition of fund sources on
bank performance is discussed in Chapter 19.

2.3 USES OF FUNDS BY BANKS

Hiving identified the main sources of funds, bank uses of funds can be discussed. The
more common uses of funds by banks include
 cash
 bank loans
 investment in securities
 federal funds sold (loaned out)
 repurchase agreements
 Eurodollar loans
 Fixed assets

Cash
Banks are required to hold some cash as reserves because they must abide by reserve
requirements enforced by the Federal Reserve. Banks also hold cash to maintain some
liquidity and accommodate any withdrawal requests by depositors. Because banks of not
earn income form cash, they will hold only as much cash as necessary to maintain a
sufficient degree of liquidity. They can tap various sources for temporary funds and
therefore are not overly concerned with maintaining excess reserves.
Banks hold cash in their vaults and at their Federal Reserve district bank. Vault cash is
useful for accommodating withdrawal requests by customers or for qualifying as required
reserves, while cash placed at the Federal Reserve district banks represents the major
portion of required reserves. The required reserves are mandated by the Fed because they

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provide a medium by which the Fed can control the money supply. The required reserves
of each bank are dependent on the bank’s composition of deposits.

Bank loans
The main use of bank funds is for loans. The loan amount and maturity can be tailored to
the borrower’s needs.

Types of business loans

A common type of business loan is the working capital loan (sometimes called a self-
liquidating loan), designed to support ongoing business operations. There is a lag
between the point at which a firm needs cash to purchase raw materials used in
production and the point at which it receives cash inflows from the sales of finished
products. 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 purpose. The assets purchased with the
borrowed funds may serve as partial or full collateral on the loan. Maturities on term
loans commonly range from two to five years and are sometimes as long as ten years.

Because of the long-term nature of a term loan, sufficient documentation is needed to

specify any conditions by which the borrower must abide. These conditions, often
referred to as protective covenants, may specify a maximum level of dividends that the
borrower can pay to shareholders per year, require bank approval on some of the
borrowing firm’s major decisions (such as mergers), and limit the additional debt that the
firm can accumulate. Term loans can be amortized so that fixed periodic payments are
made by the borrower over the life of the loan. Alternatively, the bank can periodically
request interest payments, with the loan principal to be paid off in one lump sum (called a
balloon payment) at a specified date in the future. This is known as a bullet loan. There
are also several combinations of these payment methods possible. For example, a portion
of the loan may be amortized over the life of the loan, while the remaining portion could
be covered with a balloon payment.

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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 a direct lease loan, may be
especially appropriate when the firm wishes to avoid further additions of debt on its on its
balance sheet. Because the bank would serve as owner of the assets, it could depreciate
the assets over time for tax purposes.

A more flexible financing arrangement provided by banks is the informal line of credit,
which allows the business to borrow up to a specified amount within a specified period of
time. This is useful for firms that may experience a sudden need for funds but do not
know precisely when. The interest rate charged on any borrowed funds is typically
adjustable in accordance with prevailing market rates. Banks are not legally obligated to
provide funds to the business, yet they usually honor the arrangement to avoid harming
their reputation.

An alternative financing arrangement to the informal line of credit is the revolving credit
loan, which obligates the bank to offer up to some specified maximum amount of funds
over a specified period of time (typically less than five years). Because the bank is
committed to provide funds when requested, it normally charges businesses a
commitment fee (of about one-half of one percent) on any unused funds.

The interest rate charged by banks on loans to their most creditworthy customers is
known as the prime rate. The prime rate is periodically revised by bank’s cost of funds.
Thus, the prime rate moves in tandem with the Treasury bill rate. Note that a higher
prime rate does not necessarily lead to higher bank profitability. During recessionary
periods, the spread between the prime rate and the bank’s cost of funds tends to widen, as
banks require a greater premium to compensate for the risk of loan default.

Loan participations
Some large corporations wish to borrow an amount of funds that exceeds what any
individual bank is willing to provide. 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. Although there are various forms of loan participations, the most common
form calls for one of the banks to serve as a lead bank by arranging for the

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documentation, disbursement, and payment structure of the loan. The main role of the
other banks is to supply funds to the lead bank which are channeled to the borrower. The
borrower may not even realize that much of the funds have been provided by other banks.
As interest payments are received, the lead bank passes the payments on the other
participants in proportion to the original loan amounts provided by them. The lead bank
receives not only its share of interest payments but also fees for servicing the loan.
The lead bank is expected to ensure that the borrower repays the loan. However, the lead
bank is normally not required to guarantee the interest payments. Thus, all participating
banks are exposed to default risk.

Loans supporting leveraged buyouts

One of the latest fads in commercial banking is financing leveraged buyouts (LBOs). The
loan amount provided by a single bank to support an LBO is usually between $15 million
and $40 million. The exposure to LBO loans exceeds $1 billion for some large
commercial banks. An attractive feature of LBO financing is a relatively high loan rate
that can be charged. In addition, some fee income can be generated from the
administrative services performed by commercial banks when financing LBOs.
Although LBO financings have generally performed well so far, there is some concern
that they will increase the risk of individual banks. Some critics may even suggest the
possibility of an LOB debt crisis at some point in the future in which massive
rescheduling of loans will be required.

In a sense, financing part of an 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. Their high degree of financial leverage
causes cash outflows to be some what insensitive to business cycles.

Firms request LBO financing because they perceive the market value of publicly held
shares to be too low. The accessibility of these firms to equity funds is desirable because
it can serve as a cushion under poor economic conditions. Although these firms would
prefer not to go public again during such conditions, they are at least capable of doing so.
Banks financing these firms could, as a condition of the loan, require that the firms
reissue stock if they experience cash flow problems.

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Many firms involved in LBOs represent diversified conglomerates that will be split into
various divisions and sold. This may enable banks to spread their lending base by lending
to divisions that have been sold. The separation of businesses may result if the sum of the
parts appears to be worth more than the whole. Yet, the failure of a single division could
be absorbed by a conglomerate company. If the division is independent, its failure is
absorbed by its creditors.

A commercial bank’s risk may rise as it increases its financing of LBOs. Banks that
reduce their more conservative assets to finance LBOs will incur a higher degree of risk.
Many LBOs were financed with junk bonds, which suggests a high degree of risk. Thus,
bank-borrower relationship may allow for more personalized guidance of firms
experiencing financial problems. In addition, banks may have first claim to the firm’s
assets if the firm fails. Thus, these bank loans are considered to be less risky.

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 (HLTs) are defined by the Federal Reserve as
credit that results in a debt-to-asset ratio of at least 75 percent. In other words, the level of
debt is at least three times the level of equity. About 60 percent of HLT funds are used to
finance LBOs, while some of the funds are used to repurchase only a portion of the
outstanding stock. HLTs are usually originated by a large commercial bank, which
provides 10 percent to 20 percent of the financing itself. Other financial institutions
participate by providing the remaining 80 percent to 90 percent of the funds needed.

Collateral requirements on business loans

Commercial banks are increasingly accepting intangible assets (such as patents, brand
names, and licenses to franchises and distributorships) as collateral for commercial loans.

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This change is especially important to service-oriented companies that do not have
tangible assets.

Lender liability on business loans

In recent years, businesses that previously obtained loans from banks are filing lawsuits,
claiming that the banks terminated further financing without sufficient notice. These so-
called lender liability suits have been prevalent in the farming industry. Some farmers
claimed that they were encouraged by banks to borrow, but they were then cut off from
additional financing necessary to make their projects successful and thus lost the land and
equipment representing collateral. Lender liability lawsuits have also been filed by
companies in other industries, including grocery, clothing, and oil.

Types of consumers loans

Commercial banks provide installment loans to individuals to finance purchases of cars
and household products. These loans require the borrowers to take periodic payments
over time.

Banks also provide credit cards to consumers who qualify, enabling purchases of various
goods without the customer reapplying for credit on each purchase. A maximum limit is
assigned to credit card holders, depending on their income and employment record, and a
fixed annual fee is usually charged. This service often involves an agreement with VISA
or Master Card. If consumers pay off the balance each month, they are not normally
charged interest. Bank rates on credit card balance are sometimes about double the rate
charged on business loans. State regulators can impose usury laws that restrict the
maximum rate of interest charged by banks, and these usury laws may be applied to
credit card loans as well. A federal law requires that banks abide by the usury laws of the
state where they are located rather than the state of the consumers. Many states have
recently lifted their ceilings on credit card loans.
The process of credit assessment on consumer loan applicants is typically much higher
than the cost of funds, many commercial banks have pursued these types of loans as a
means of increasing their earnings. The most common method of increasing such loans is
to use more lenient guidelines when assessing the creditworthiness of potential
customers. However, there is an obvious trade-off between the potential return and

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exposure to default on credit card loans and other personal loans. Some commercial
banks responded by increasing their standards for extending credit card loans and
personal loans. This results in a reduced allocation of funds to credit card loans, which
also reduces the potential returns of the bank. As economic conditions change,
commercial banks continue to reassess the allocation of funds toward credit card loans
versus other less risky uses of funds.

Real estate loans

Another type of loan provided by banks is the real estate loan. For residential real estate
loans, the maturity on a mortgage is typically 15 to 30 years, although shorter-term
mortgages with a balloon payment are also common. The loan is backed by the residence
purchased. Banks also provide some commercial real estate loans to fiancé commercial
development. Real estate loans by banks generally increased throughout the 1980s.
however, in the early 1990s defaults on numerous real estate loans caused banks to
reduce these type of loans.

Investment in 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. Furthermore, government
agency securities are not a direct obligation of the federal government. Therefore, default
risk exists, although it is normally thought to be very low. Banks that are willing to
accept the slight possibility of default risk and less liquidity from investing in
government agency securities can earn a higher return than on Treasury securities with a
similar maturity.

Federal agency securities are commonly issued by federal agencies, such as the Federal
Home Loan Mortgage Corporation (called Freddie Mac) and the Federal National
Mortgage Association (called Fannie Mae). Funds received by the agencies issuing these
securities are used to purchase mortgages from various financial institution. Such
securities can rang from one month to 25 years. Unlike interest income of Treasury

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securities, interest income of federal agency securities is subject to state and local income
taxes.

Banks also purchase corporate and municipal securities. Although corporate bonds are
subject to default risk, they offer a higher return than Treasury or government agency
securities. Municipal bonds exhibit some degree of risk but can also provide an attractive
return to banks, especially when considering their after-tax return. The interest income
earned from municipal securities is exempt from federal taxation. Banks purchase only
investment-grade securities, which are rated as “medium quality” or higher by rating
agencies.

Exhibit 16.4 shows how the bank allocation of loans versus securities changes in
response to economic conditions. Banks tend to reduce their loans during recessionary
periods, as loans demand declines and the perceived risk of potential borrowers rises. As
banks reduce their loans, they allocate more funds to government securities. Banks tend
to allocate more funds for loans and less funds for government securities during periods
of large economic expansion.

Federal funds sold

Banks often lend funds in the federal funds market. The funds sold, or lent out, will be
returned at the time specified in the loan agreement, with interest. Small banks are
common providers of funds in the federal funds market. If the transaction was executed
by a broker, the borrower’s cost on a federal funds loan is slightly higher than the
lender’s return, because the federal funds broker matching up the two parties would
charge a transaction fee.

Repurchase agreements
Recall that from the borrower’s perspective, the repurchase agreement (repo) transaction
involves repurchasing the securities it had previously sold. From a lender’s perspective,
the repo represents a sale of securities that it had previously purchased. Banks can act as
the lender (on a repo) by purchasing a corporation’s holdings of Treasury securities and
selling them back at a later date. This provides short-term funds to the corporation, and
the bank’s loan is backed by these securities.

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Eurodollar loans
Branches of U.S. banks located outside the United States and some foreign-owned banks
provide dollar-denominated loans to corporations and governments. These so-called
Eurodollar loans are common because the dollar is frequently used for international
transactions. Eurodollar loans are of a short-term nature and denominated in large
amounts, such as $1 million or more. Some U.S. banks may even establish Eurodollar
deposits at a foreign bank as a temporary use of funds.

Fixed assets
Banks must maintain some amount of fixed assets, such a s office buildings and land, so
that they can conduct their business operations. However, this is not a concern to those
bank managers who decide how day-to-day incoming funds shall be used. They will
direct these into the other types of assets already identified.

Summary of bank uses of funds

The distribution of bank uses of funds is illustrated in Exhibit 16.5. All types of loans
make up about 64 percent of bank assets, while all security wakeup about 22 percent of
bank assets. The distribution of assets per bank varies with the type of bank. For example,
smaller banks tend to have a relatively large amount of individual loans and government
securities, while larger banks have a higher level of business loans (including loans to
foreign firms).

The distribution of bank uses of funds indicates how commercial banks operate.
However, in recent years banks have begun providing numerous services that are not
indicated on their balance sheet. These services differ distinctly from their traditional
operations that focus mostly on the investment of deposited funds. Some of the more
popular services offered by banks in recent years include discount brokerage, sales of
mutual funds, insurance, and real estate activities. Many large banks are involved in
underwriting government and corporate securities. Some banks also serve as advisers for
merger and acquisitions.

They desire by commercial banks to offer nonbanking services escalated in the early
1990s, when very low interest rates caused depositors to withdraw deposits and invest the

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proceeds in stocks and bonds. Many banks attempted to retain the business of those
depositors by having their subsidiaries offer discount brokerage services or mutual fund
services. Thus, even though the funds were withdrawn from banking operations, they
were commonly reinvested in the bank’s subsidiaries.

Exhibit 16.6 discloses the common balance sheet items for commercial banks, and it
therefore summarizes the main sources of bank funds (bank liabilities and stockholder’s
equity) and uses of bank funds (bank assets).

2.4 OFF-BALANCE SHEET ACTIVITIES

Banks commonly engage in off-balance sheet activities which generate fee income
without requiring an investment of funds. However, these activities do create a contingent
obligation for bank. Some of the more popular off-balance sheet activities are.
 Loan commitments
 Stand by letters of credit
 Forward contracts
 Swap contracts

Loan Commitments
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 fro offering the commitment.

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Asset Liabilities and Stockholders’ Equity
Cash Demand deposits
Loans Savings deposits
Securities Time deposits
Federal funds purchased (loaned out) Money market deposit accounts
Repurchase agreement Federal l funds purchased (borrowed)
Eurodollar loans Other short-term funds borrowed
Fixed assets Long-term debt
Stockholders’ equity

One type of loan commitment is a note issuance facility (NIF), in which the bank agrees
to purchase the commercial paper of a firm if the firm cannot place its paper in the
market at an acceptable interest rate. Although banks earn fees for their commitments,
they could experience illiquidity if numerous firms request their loans at the same time.

Standby Letters Of Credit

A standby letter of credit (SLC) 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. For example, consider a
municipality that wants to issue bonds. To ensure that the bonds are easily place, a bank
could provide an SLC that guarantees payment of interest and principal. In return for the
bank’s guarantee, a fee is charged perceived safety of the bonds. In retune for the bank’s
guarantee, a fee is charged to the municipality. The bank should be willing to provide
SLCs only if the fee received compensates for the possibility that the municipality
defaults on its obligation.

Forward Contracts
A forward contract is an agreement between a customer and a bank to exchange one
currency for another on a particular future date at a specified exchange rate. Banks
engage in forward contracts with customers because customers desire to hedge their
exchange rate risk. For example, a U.S. bank may agree to purchase five million German

53
marks in one year from a firm for $0.60 per mark. The bank nay simultaneously find
another firm that wishes to exchange five million marks for dollars in one year. The bank
can serve as an intermediary and accommodate both requests, earning a transaction fee
for its services. However, it is exposed to the possibility that one of the parties defaults on
its obligation.

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.
Once again, the bank receives a transaction fee for its services. If it guarantees payment
to both parties, it is exposed to the possibility that one of the parties defaults on its
obligation. In such a case, it must assume the role of that party to fulfill the obligation to
the other party.

Some banks facilitate currency swaps (for a fee) by finding parties with opposite future
currency needs and executing a swap agreement. Currency swaps are some what similar
to forward contracts, except that they are usually for more distant future dates.

Check your progress

1. Create a balance sheet for a typical bank, showing its main liabilities (sources of
funds) and asset (uses of funds).
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
2. What are four major sources of funds for banks?
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
3. Name two examples of transaction deposits.
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………

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4. Briefly explain the automatic transfer service (ATS) account.
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
5. Compare and contrast the retail CD and the negotiable CD.
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
6. How does the money market deposit account vary from other bank sources of
funds?
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
7. How does the yield on a repurchase agreement differ from a loan in the federal
funds market? Why?
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
8. What alternatives does a bank have if it needs temporary funds?
funds
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
9. Why would banks most often issue bonds?
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………
10. What is a bullet loan?
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………

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 11. Why do banks invest in securities, when loans typically generate a higher return?
…………………………………………………………………………………………
…………………………………………………………………………………………
…………………………………………………………………………………………

2.5 SUMMARY

 The most common sources of commercial bank funds are deposit accounts,
borrowed funds, and long-term sources of funds. The common type of deposit
accounts are transaction deposits, savings deposits, time deposits, and money
market deposit accounts. These accounts vary in terms of liquidity (for the
depositor) and the interest rates offered.
 Commercial banks can solve temporary deficiencies in funds by borrowing from
other banks (federal funds market), from the Federal Reserve, or from other
sources by issuing short-term funds to support expansion, they may use retained
earnings, issue new stock, or issue new bonds.
 The most common uses of funds by commercial banks are bank loans and
investment in securities. Banks can use excess funds by providing loans to other
banks, or by purchasing short-term securities.
 Banks engage in off-balance sheet activities such as loan commitments, standby
letters of credit, forward contracts, and swap contracts. These types of activities
generate fees for commercial banks. However, they also reflect commitments by
the bank, which can expose them to more risk.

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2.6 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

1. Balance sheet of a typical Banks

Assets (Uses of Funds) Liabilities (Sources of Funds)
Cash assets: Deposits:
 Vault cash  Transactions deposits
 Deposits with Federal Reserve  No transaction deposits
Deposits with other banks and
 Cash items in process of collection Borrowings
Loans: Other liabilities
 Real estate Capital accounts
 Business
Consumer
 All other
Securities:
 U.S. government
 State and local government and other

Other assets
Total liabilities and capital
Total assets

2. The four major sources of funds for banks are:

a. Deposits:
i. Transactions deposits
ii. No transaction deposits
b. Borrowings
c. Other liabilities
d. Capital accounts

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3. The two examples of transaction deposits accounts are:
 The demand deposit account or checking account
 Negotiable order of withdrawal accounts
4. Another savings accounts are the automatic transfer service (ATS) account,
created in November 1978. It allows customers to maintain an interest-bearing
savings account that automatically transfers funds to their checking account when
checks are written. Only the amount of funds needed is transferred to the checking
account. Thus, the ATS provides interest and check-writing ability to customers.
Some ATS accounts were eliminated when the NOW accounts were established.

5. A common type of time deposit known as a retail certificate of deposit (or retail
CD) requires a specified minimum amount of funds to be deposited for a specified
period of time. Banks offer a wide variety of CDs to satisfy depositors’ needs.
Annualized interest rates offered on CDs vary among banks, and even among
maturity types within a single bank. An organized secondary market for retail
CDs does not exist. Depositors must leave their funds in the bank until the
specified maturity or they will normally forgo a portion of their interest as a
penalty.
The interest rates on retail CDs have historically been fixed. However, more
exotic retail CDs has been offered in recent years. There are bull-market CDs that
reward depositors if the market performs well and bear-market CDs that reward
depositors if the market performs well and bear-market CDs that reward
depositors if the market performs poorly. These new types of retail CDs typically
have a minimum deposit insurance (assuming that the depository institution of
concern is insured).
Another type of time deposit is the negotiable CD (NCD), offered by some large
banks to corporations. NCDs are similar to retail CDs in that they require a
specified maturity date and a minimum deposit requirement is $100,000. a
secondary market for NCDs does exist
6. The money market deposit account (MMDA) was created by a provision of the
Garn-St Germaine Act of December 1982. It differs from conventional time

58
 deposits in that it does not specify maturity. MMDAs are more liquid than retail
CDs from the depositor’s point of view. Because banks would prefer to know how
long they will have use of a depositor’s funds, they normally pay a higher interest
rate on CDs. MMDAs differ from NOW accounts in that they have limited check-
writing ability (they allow only a limited number of transactions per month),
require a larger minimum balance, and offer a higher yield.
7. A repurchase agreement (repo) represents the sale of securities by one party to
another with an agreement to repurchase the securities at a specified date and
price. Banks often use a repo as a source of funds when they expect to need funds
for just a few days. They would simply sell some of their government securities
(such as their Treasury bills) to a corporation with a temporary excess of funds
and buy those securities back shortly thereafter. The government securities
involved in the repo transaction serve as collateral for the corporation providing
funds to the bank.
Repurchase agreement transactions occur through a telecommunications network
connecting large banks, other corporations, government securities dealers, and
federal funds (wish to sell and later repurchase their securities) with those who
have excess funds (are willing to purchase securities now and sell them back on a
specified date.) transactions are typically in blocks of $1 million. Like the federal
funds rate, the yield on repurchase agreements is quoted in multiples of one-
sixteenth on an annualized basis (using a 360-day year). The yield on repurchase
agreements is slightly less than the federal funds rate at any given point in time,
because the funds loaned out are backed by collateral and are there fore less risky.
8. If a bank is in need of short-term funds, it may borrow dollars from those banks
outside the country that accept dollar-denominated deposits, or Eurodollars. Some
of these so-called Euro banks are foreign banks or foreign branches of U.S. banks
that participate in the Eurodollar market by accepting large short-term deposits
and making short-term loans in dollars. Because U.S. dollars are widely used as
an international medium of exchange, the Eurodollar market is very active. Some
U.S. banks commonly obtain short-term funds from Euro banks.

59
9. Like other corporations, bank 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. Common purchasers of such bonds are households and various financial
institutions, including life insurance companies and pension funds. Banks do not
finance with bonds as much as most other corporations, because their fixed assets
are less than those of corporations that use industrial equipment and machinery
for production. Therefore, they have less of a need for long-term funds.
10. Because, the bank can periodically request interest payments, with the loan
principal to be paid off in one lump sum (called a balloon payment) at a specified
date in the future. This is known as a bullet loan. There are also several
combinations of these payment methods possible. For example, a portion of the
loan may be amortized over the life of the loan, while the remaining portion could
be covered with a balloon payment.
11. 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.
Furthermore, government agency securities are not a direct obligation of the
federal government. Therefore, default risk exists, although it is normally thought
to be very low. Banks that are willing to accept the slight possibility of default
risk and less liquidity from investing in government agency securities can earn a
higher return than on Treasury securities with a similar maturity.
Federal agency securities are commonly issued by federal agencies, such as the
Federal Home Loan Mortgage Corporation (called Freddie Mac) and the Federal
National Mortgage Association (called Fannie Mae). Funds received by the
agencies issuing these securities are used to purchase mortgages from various
financial institution. Such securities can rang from one month to 25 years. Unlike
interest income of Treasury securities, interest income of federal agency securities
is subject to state and local income taxes.
Banks also purchase corporate and municipal securities. Although corporate
bonds are subject to default risk, they offer a higher return than Treasury or

60
 government agency securities. Municipal bonds exhibit some degree of risk but
can also provide an attractive return to banks, especially when considering their
after-tax return. The interest income earned from municipal securities is exempt
from federal taxation. Banks purchase only investment-grade securities, which are
rated as “medium quality” or higher by rating agencies.
Banks tend to reduce their loans during recessionary periods, as loans demand
declines and the perceived risk of potential borrowers rises. As banks reduce their
loans, they allocate more funds to government securities. Banks tend to allocate
more funds for loans and fewer funds for government securities during periods of
large economic expansion.

2.7 MODEL EXAMINATION QUESTIONS

1. Create a balance sheet for a typical bank, showing its main liabilities (sources of
funds) and asset (uses of funds).
2. What are four major sources of funds for banks?
3. Name two examples of transaction deposits.
4. Briefly explain the automatic transfer service (ATS) account.
5. Compare and contrast the retail CD and the negotiable CD.
6. How does the money market deposit account vary from other bank sources of
funds?
7. Define federal funds, federal funds market, and federal funds rate.
8. Who sets the federal funds rate?
9. Why is the federal funds market more active on Wednesday?
10. Explaining the use of the federal funds market in facilitating bank operations.
11. Describe the process of borrowing at the discount window. What rate is charged,
and who sets it?
12. Why do banks commonly borrow in the federal funds market rather than through
the discount window?
13. How does the yield on a repurchase agreement differ from a loan in the federal
funds market? Why?
14. What alternatives does a bank have if it needs temporary funds?

61
15. Why would banks most often issue bonds?
16. What is a bullet loan?
17. Why do banks invest in securities, when loans typically generate a higher return?
18. Is there a formula used to decide a bank’s appropriate percentage of each source
and use of funds? Explain.
19. Explain the dilemma faced by banks when determining the optimal amount of
capital to hold.
20. Use recent issues of a business periodical to determine the federal funds rate and
discount rate on a weekly basis over the past month. Compare the volatility of
these rates and explain the difference in degree of volatility.
21. Would you expect a bank to pay a lower rate on funds borrowed from repurchase
agreements or the federal funds market? Why?
22. Obtain recently quoted interest rates from a business periodical on the bank’s
main sources and uses of funds. Use these rates along with the average
composition of liabilities and assets disclosed i9n this chapter to estimate the
differential between the interest revenue percentage and the interest expense
percentage.
23. The level of capital as a percentage of assets for commercial banks is less than 10
percent. How do you think this would compared to date of manufacturing
corporations? How would you explain this difference?

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