Banking Management

Unit-SEVEN

Managing Non-Deposit Liabilities and

Equity Capital of Bank

By
Arpan Paudel
The purpose of this chapter is:
A. To know about financial resources collection from different non
depository sources and appropriate management strategies/skills.
B. To discover why capital – particularly equity capital – is so important in
banking, to learn how bankers and regulators assess the adequacy of a
bank’s capital position and to explain the ways that bank management
can raise new capital.
Aggregate Statement of Liabilities- Banks and Financial Institution (Nepal)

NPR’ Million

Source: NRB
 Customer Relationship Doctrine (CRD)
Deposit
Placement

Loan
Requests

Adequate Deposit = Acceptance of qualified credit demands

Inadequate Deposit = Denial of qualified credit demands or what????

Attention!!: Denial of a loan request often means the immediate opportunity income loss
and perhaps the loss of any future business from the disappointed customer as well.

“Lending decision often precedes funding decision”

The first priority of the Bank is to make loans to all
qualified customers and if available funds are inadequate
the Bank should seek out the lowest cost funding source to
meet customers’ demands.
Liability Management
CRD emerged an even boarder view of bank
management strategy between 1960 and 1970……………
Liability Management. It consists of buying funds,
mainly from other financial institutions, in order to
cover good quality loan requests and satisfy deposit
reserve requirement.

Key Features
 The Bank buys funds in order to satisfy loan requests and reserve requirements
 It is an interest-sensitive approach to raise Bank funds
 It is flexible – the Bank can decide exactly how much they need and for how long
 The control mechanism to regulate incoming funds is the price of funds
Non deposit Sources of Bank Funds

1. Federal Funds Market

2. Central/Federal Reserve Bank
3. Negotiable CDs
4. Commercial Paper
5. Repurchase Agreements
6. Long Term Sources
 1. Federal Funds Market
Short-term borrowings from immediately
available money consisting following sources.
• Deposits held by banks at federal reserve/ central
banks,
• Deposits with correspondent banks
• Demand deposit balances of security dealers and
governments
Types of Fed Funds Loan Agreements

Types Description
Overnight Loan Unwritten agreements, negotiated via wire or
telephone with the borrowed fund returned the next
day.

Term Loans Written contracts having the maturity of several

days, weeks or months.

Continuing Automatically renewal contracts till the mutual

Contracts understanding
 2. Borrowing from Central/
Federal Reserve Bank
Short-term borrowing of around two weeks (at most)
against the reserve maintained at federal/central bank
and or government securities….

 Bank having immediate reserve requirement can borrow

from the Federal/Central Reserve.
 There are restrictions on the frequency of borrowing at
the Federal/Central Reserve.
 Based on the different needs of banks, there are three
types of loans, each with its own interest rate.
Types of Federal Reserve Loans

1. Adjustment Credit– This facility is only for few days

and is to provide immediate relief in reserve
requirement.
2. Seasonal Credit– Extended for longer periods than
adjustment credit for banks with seasonal swings in
deposit and loans (such as those experienced by farm
banks during planting or harvesting time)
3. Extended Credit– Provisioned for the banks experiencing
longer term funding problems (perhaps due to a
downturn in the local economy)
 3. Negotiable CD

An interest-bearing receipt evidencing the deposit

of funds in the Bank for a specified period of time
for a specified interest rate. It is considered a
hybrid account since it is legally a deposit

Negotiable certificates of deposit are CDs with a minimum face value of $100,000. They are
guaranteed by banks, cannot be redeemed before their maturation date, and can usually be sold
in highly liquid secondary markets. Along with U.S. Treasury bills, they are considered a low-
risk, low-interest security.
Types of Negotiable CDs
1. Domestic CDs – Issued By Domestic Banks in the U.S.

2. Euro CDs – Dollar Denominated CDs Issued Outside the U.S.

3. Yankee CDs – Issued By Foreign Banks in the U.S.

 The nicknames used for various foreign markets are:
 United States - Yankee market United Kingdom (UK)- Bulldog market

 Japan- Samurai market Netherlands- Rembrandt market

 Spain- Matador market

4. Thrift CDs – Issued By Large Savings and Loans and Other Nonbanks in the U.S.
 Eurocurrency Deposit
Market

Eurodollars are Dollar-Denominated

Deposits Placed in Banks Outside the U.S.
Eurocurrency Deposits Originally Were
Developed in Western Europe to Provide
Liquid Funds to Swap Among Institutions
or Lend to Customers
 4. Commercial Paper
 Short-term notes with the maturities ranging from
3 or 4 days to 9 months.
 Issued by well-known companies with the highest
credit ratings.
 Banks cannot issue these directly but affiliated
companies can issue them.
• Preferred to invest by smaller banks
• Issued at a discount form
 5. Repurchase Agreement

Temporary sale of high-quality, easily-liquidated

assets accompanied by an agreement to buy back
those assets on a specific future date at a
predetermined price.
6. Long-Term Non deposit Sources of
Funds

Mortgages issued to fund the construction of new

buildings, capital notes and debentures are
examples of long term sources of funds
The Fund Gap

Current and Projected Current and

Gap = Demand and Expected Deposit
Investments the bank - Inflow
desires to make
Factors to be Considered : Non-deposit Funding
Source

1. Relative costs of raising funds from each source

2. Risk of each funding source
3. Length of fund needed time
4. Size of the bank
5. Regulations limiting the use of various funding
sources
Bank Capital
Banker-Capital refers principally to fund contributed by the bank’s owner,
consisting mainly of stock, reserves and those earnings that are retained in bank.

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Managing Equity Capital of Bank

Tasks Performed By Bank Capital

 Provides a cushion against risk of failure
 Provides funds to help banks get started
 Promotes public confidence
 Provides funds for growth
 Regulator of bank growth
 Role in growth of bank mergers
 Regulatory tool to limit risk exposure
 Protects the government’s deposit insurance system
Bank Capital Bank Defense
and Risk against Risk

Credit Risk Quality Management

Diversification
Liquidity Risk
Geographic Portfolio

Interest Rate and

Deposit Insurance
Exchange Risk

Operating and
Owner's Capital
Crime Risk
Types of Bank Capital
Common Stock: Measured by par value, pay a variable return, possess voting
right

Preferred Stock: Pay a fixed rate of return (dividend), may be perpetual

or limited life, convertible or non-convertible

Surplus (Share Premium)

Undivided Profits and Equity Reserve

Equity Commitment Notes : debt securities repayable only from the

sale of stock

Subordinated Debentures: Long-term debt capital whose claims follow

the claims of depositors, may carry convertible feature

Minority Interest in Consolidated Subsidiaries: hold ownership shares in other

business
Measuring the Size of Bank Capital

1. Book or GAAP Capital

(GAAP: Generally Accepted Accounting Principles)

Undivided Reserves
Par Value
Profits (or for Losses
= of Equity + Surplus + +
Retained on Loans
Capital
Earnings) and Leases

2. RAP or Regulatory Capital

(RAP: Regulatory Accounting Principles)
Reserves for Subordinated
Total Perpetual Debentures
Losses on
= Stockholders' + Perferred +
Loans and + Mandatorily + Miscellaneou
Equity Stock Converted to s Items
Leases
Common
Stock
Market Value Capital

Current
Number of
Market Price
Equity Shares
= Per Share of X
Issued and
Stock
Outstanding
Outstanding

 Highly volatile capital figure…large banks whose stocks

are traded actively.
 It is a reflection of the amount of real protection each
bank has against the risk of failure.
 Depositors would be better able to gauge and make a
rational decision on which bank should receive their
deposit business.
How Much Capital Does a Bank Need?

Regulatory Research Alternative The Judgment

Approach Evidence Strategies Approach
• To limit the risk • Private entities • Cross Sectional • Management
of bank failures. seeks more Analysis Quality
regulation • Time Series Analysis • Asset Liquidity
• To prevent • True information to • Earning History
public be assess • Quality of
confidence in • Risk taking attitude • Equal Capital base ownership
banks. to be examined generally reports • Occupancy Cost
• To limit losses • Operational aspects strength to small • Quality of Operating
to the federal to be examined banks…… question Procedures
government to big bank • Deposit Volatility
arising from • Local Market
deposit Condition
insurance
claims.
 Imposition of Minimum Capital Requirements

International lending and supervision Act of 1983 –

federal law that imposed minimum capital
requirements upon all U.S. banks and called for
special reserves behind their foreign loans…………….
Primary Capital
Leverage Ratio

Core Capital
=
Total Assets

The leverage ratio (or capital assets ratio)

 Measures the ratio of a bank’s book value of primary
or core capital to its assets.
• If L > 5= well capitalized,
• If L ≥ 4%= adequately capitalized,
• If L< 4= undercapitalized

In 1987 US banks were required to meet leverage ratio

 The Basel Agreement on International
Capital Standards

In 1987 the federal reserve board, representing the US and

representatives from 11 other leading industrialized countries
(Belgium, Canada, France, Germany, Italy, Japan, Netherlands,
Sweden, Switzerland, UK and Luxembourg) announced
preliminary agreement on new capital standard which is
commonly known as Basel Agreement.

• Designed to encourage leading banks to strengthen their capital position.

• Reduce inequality in the regulatory rules of different nations
• Consider the risk to bank of the off-balance sheet commitments
Types of Capital
Core Capital (Tier I) Supplementary Capital (Tier II)
• Common Stock and Surplus(Paid up •General Loan Loss Provision
capital) •Assets Revaluation Fund
•Undivided Profits •Exchange Equalization Fund
•Irredeemable Preferred Stock •Subordinated Term Debt
•General Reserve Fund •Investment Adjustment Fund
•Retained Profit
•Accumulated Profit/loss
•Capital Redemption Reserve
•Capital Adjustment Fund
•Calls in advance
•Other free reserves
•Minority Interests in the Equity Accounts
of Consolidated Subsidiaries

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Capital Fund=Core + Supplementary

Basel Agreement Capital Requirements
Calculating Risk-Weighted Assets

 Compute credit-equivalent amount

of each Off-Balance Sheet (OBS)
items
 Find the appropriate risk-weight
category for each balance sheet and
OBS Item
 Multiply each balance sheet and
credit-equivalent OBS Item by the
correct risk-weight
 Add to find the total amount of risk-
weighted assets
What is Left Out of the Original Basel Agreement
 The most glaring hole with the original Basle Agreement (1988)
is its failure to deal with market risk
 In 1995 the Basle Committee announced new market risk
capital requirements for their banks (Amend in 1996)
 In the U.S. banks can create their own In-House models to
measure their market risk exposure
 Regulators would then determine the amount of capital
required based upon their estimate
 Banks that continuously estimate their market risk poorly
would be required to hold extra capital
 Basel II (2004 – finalize in 2006)
New Capital Standards Proposed to Follow Basle
 Growing international awareness that the old capital standards
have too many weaknesses
 Some proposed changes include using new risk weights based on
external credit ratings
 It also calls for simplifying current capital requirements for
community banks
 Another proposal is to require Money-Center banks to issue at
least a minimum amount of subordinated debt capital
 Gives rise to Basel III (2011) in response to the credit crisis
(2008) aims to correct deficiencies of Basel II.
 More rigorous process for determining risk-weighted assets
 It also demands for liquidity requirement to survive in economic
crisis.
 Focused on - Risk based capital requirement
Planning to Meet a Bank’s Capital Needs
 Raising Capital Internally
• Dividend Policy
• Internal Capital Growth Rate ( ROE x Retention Ratio)
 Raising Capital Externally
• Issuing Common Stock
• Issuing Preferred Stock
• Issuing Subordinated Notes and Debentures
• Selling Assets and Leasing Facilities
• Swapping Stock for Debt Securities
• Choosing the Best Alternative
GROUP ASSIGNMENT: (TEAM- RESOURCE MANAGEMENT)
A Leading commercial bank has recently announced a vacancy for post of “Resource Manager”. Eligible candidates are
requested to send their resume along with the initial study paper having following coverage.
A. Deposit Collection
• Types of deposit schemes practiced by Nepali Banking Industry.
• Nature-based deposit mobilization trend reflected during last 20 quarters in Nepali banking industry.
• Deposit pricing tendencies witnessed during last 20 quarters in Nepali banking industry.
• Prevailing regulation relating with deposit pricing and volume collection.
• Initial concept paper/product paper of suitable savings deposit scheme covering at least following parameters.
• Name of Scheme
• Target Group/Market Segment
• Product Feature (Minimum Balance, Interest Rate, Interest Payment Frequency, other sweeteners)
• Unique Selling Proposition and Marketing Strategies
• Expected Deposit Collection and Timing
B. Non-deposit Resource Management
 Highlight the major sources of non-deposit resource collection available in Nepali Banking.
 Latest trend developed/ witnessed in capital and borrowing volume during last 20 quarters.
 Regulatory provision relating with non-deposit resource collection.
 Emerging opportunities and threats of non deposit resource collection.
Now, being a student/ practitioner of banking study you are advised to put your candidacy showing your eligibility with in 7
35
days.

Guideline: Unified Directives 2077, Basic Text Book, NRB office/website and other relevant source.
Instructions:

Team –member will be as arranged in virtual class room. Proposed group work is supposed to complete in
following way.

• Team will nominate a group leader for the overall co-ordination.

• Group leader will assign issue/heading to each member for individual study/presentation/report.
• Upon completion of individual study/presentation/report, group leader will compile and draft final study/
presentation/ report.
• Compiled study/presentation/report will be discussed within team for final self evaluation.
• Each member will be assessed individually by participating crews (please refer assessment/evaluation
sheet in Virtual class room.
•Final study/presentation/report will be presented in class room by team.
• Attending members will raise their queries relating with their group assignment.
• Finally, report/presentation/study will be updated in virtual class for the final assessment.
• Deadline of group assignment will be of one week.

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