Solution manual bank management and financial services 9th edition by rose, peter chap013

Chapter 13 - Managing Nondeposit Liabilities

CHAPTER 13
MANAGING NONDEPOSIT LIABILITIES
Goal of This Chapter: The purpose of this chapter is to learn about the principal nondeposit
sources of funds that financial institutions can borrow from, to help finance their activities and to
see how managers choose among the various nondeposit funds sources currently available to
them.
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•
•
•
•
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Key Topics in this Chapter
Liability Management
Customer Relationship Doctrine
Alternative Nondeposit Funds Sources
Measuring the Funds Gap
Choosing Among Different Funds Sources
Determining the Overall Cost of Funds

Chapter Outline
I. Introduction
II. Liability Management and the Customer Relationship Doctrine
A. Customer Relationship Doctrine
B. Liability Management
III. Alternative Nondeposit Sources of Funds
A. Federal Funds Market (“Fed Funds”)
B. Repurchase Agreements as a Source of Funds

C. Borrowing from Federal Reserve Banks
1. Primary Credit
2. Secondary Credit
3. Seasonal Credit
D. Advances from Federal Home Loan Banks
E. Development and Sale of Large Negotiable CDs
F. The Eurocurrency Deposit Market
G. Commercial Paper Market
H. Long-Term Nondeposit Funds Sources
IV. Choosing Among Alternative Nondeposit Sources
A. Measuring a Financial Firm’s Total Need for Nondeposit Funds: The Available Funds
Gap
B. Nondeposit Funding Sources: Factors to Consider
1. Relative Costs
2. The Risk Factor
3. The Length of Time Funds Are Needed
4. The Size of the Borrowing Institution
5. Regulations
V. Summary of the Chapter

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Chapter 13 - Managing Nondeposit Liabilities

Concept Checks
13-1. What is liability management?
Liability management involves conscious control of the funding sources of a financial institution,
using the interest rates (yields) offered on deposits and other borrowings to regulate the inflow of
funds to match the bank's immediate funding needs.

13-2. What advantages and risks does the pursuit of liability management bring to a borrowing
institution?
Improved control over funding sources enables a borrowing institution to plan its growth more
accurately. This is because funds raised by liability management techniques are flexible in terms
of the amounts raised and their maturity. However, liability management opens up certain risks,
particularly of the interest-rate risk variety, because it tends to be more sensitive to changes in
market interest rates.
13-3. What is the customer relationship doctrine, and what are its implications for fund-raising
by lending institutions?
The customer relationship doctrine places lending to customers at the top of the priority list,
which 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. It argues that a lending
institution should make all good loans—all loans that meet the institution's quality and
profitability standards. It must then find the funds needed to fund those loans. How the funds are
used takes a higher priority than how the funds are raised.
13-4. For what kinds of funding situations are Federal funds best suited?
Federal funds are best suited for institutions short of reserves to meet their legal reserve
requirements or to satisfy customer loan demand. It satisfies this demand by tapping immediately
usable funds.
13-5. Chequers State Bank loans $50 million from its reserve account at the Federal Reserve
Bank of Philadelphia to First National Bank of Smithville, located in the New York Federal
Reserve Bank's district, for 24 hours, with the funds returned the next day. Can you show the
correct accounting entries for making this loan and for the return of the loaned funds?

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Chapter 13 - Managing Nondeposit Liabilities

Step 1 - Lending the $50 million

Chequers State Bank
Assets
Liabilities and Net Worth
Federal funds sold
+50 million
Reserves at Fed
-50 million
Using the borrowed funds can also be shown, though it is not mentioned in the problem. You
could show First National Bank of Smithville making a loan for $50 million under Assets, giving
up $50 million from its reserve account.
First National Bank of Smithville
Assets
Liabilities and Net Worth
Reserves at Fed

Federal funds purchased
+50 million
+50 million

Step 2 - Repaying the loan of Federal funds
Chequers State Bank
Assets
Liabilities and Net Worth
Reserves at Fed
+50 million
Federal funds sold
-50 million
First National Bank of Smithville
Assets
Liabilities and Net Worth

Reserves at Fed
-50 million

Federal funds purchased
-50 million

13-6. Hillside Savings Association has an excess balance of $35 million in a deposit at its
principal correspondent, Sterling City Bank, and instructs the latter institution to loan the funds
today to another institution, returning them to its correspondent deposit the next business day.
Sterling loans the $35 million to Imperial Security National Bank for 24 hours. Can you show

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Chapter 13 - Managing Nondeposit Liabilities

the proper accounting entries for the extension of this loan and for the recovery of the loaned
funds by Hillside Savings?
Step 1 - Lending Federal funds to Sterling City Bank
Hillside Security Bank
Assets
Liabilities and Net Worth
Deposit with Sterling City
Bank
-35 million
Federal funds sold
+35 million
Sterling City Bank
Assets
Liabilities and Net Worth

Federal funds purchased
+35 million
Hillside Security Bank's
deposit
-35 million
Step 2 - Sterling City Bank loans funds to Imperial Security National Bank
Sterling City Bank
Assets
Liabilities and Net Worth
Reserves
-35 million
Federal funds sold
+35 million
Imperial Security National Bank
Assets
Liabilities and Net Worth
Reserves

Federal funds purchased
+$35 million
+35 million

Step 3 -Sterling City Bank receives funds loaned to Imperial Security National Bank
Assets

Sterling City Bank
Liabilities and Net Worth

Reserves

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Chapter 13 - Managing Nondeposit Liabilities

+35 million
Federal funds sold
-35 million
Imperial Security National Bank
Assets
Liabilities and Net Worth
Reserves
-35 million

Federal funds purchased
-35 million

Step 4 - Repaying the loan to Hillside Security Bank
Hillside Security Bank
Assets
Liabilities and Net Worth
Deposit with Sterling City
Bank
+35 million
Federal funds loaned
-35 million
Assets

Sterling City Bank
Liabilities and Net Worth

Federal funds purchased
-35 million
Hillside Security Bank's
deposit
+35 million

13-7. Compare and contrast Fed funds transactions with RPs.
Less popular than Fed funds and more complex are repurchase agreements (RPs). RPs are
agreements to sell securities temporarily by a borrower of funds to the lender of funds with the
borrower agreeing to buy back the securities at a guaranteed price at a set time in the future.
Both are instruments available for short term borrowing. However, RP agreements are
collateralized loans and thus, the lender is not exposed to credit risk as they are with Federal
funds transactions. Most RPs are transacted across the Fedwire system, just as are Fed funds
transactions. RPs may take a bit longer to transact than a Fed funds loan because the seller of
funds (the lender) must be satisfied with the quality and quantity of securities provided as
collateral.
13-8. What are the principal advantages to the borrower of funds under an RP agreement?
RPs are a low-cost source of borrowing loanable funds for short periods of time (usually 3 or 4
days). Since the securities that are sold as part of the agreement act as collateral, the interest rate

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Chapter 13 - Managing Nondeposit Liabilities

is lower than Fed funds rate. Also, borrowers with lower credit ratings who can provide
equivalent securities as collateral can borrow at these low rates.
13-9. What are the advantages of borrowing from the Federal Reserve banks or other central
banks? Are there any disadvantages? What is the difference between primary, secondary, and
seasonal credit? What is a Lombard rate and why might such a rate be useful in achieving

monetary policy goals?
Borrowing from the Federal Reserve banks is a viable alternative to the Federal funds market.
These loans are made for a short term (usually two weeks). Advantages of borrowing from the
Federal Reserve banks though depend on the category of loans a borrower is eligible for.
Institutions accessing primary credit can loan the money to other depository institutions in the
fed funds market. Users of secondary credit can use the borrowings to strengthen their ability to
borrow funds in the open market. Users accessing seasonal credit can borrow funds for longer
periods than primary credit. Despite these advantages, stringent regulations regarding the
borrower’s credit quality, collateral requirements and cost of loans has made the Fed’s discount
window unpopular.
Primary credits are short term loans available to sound depositary institutions at rates slightly
above the Federal Reserve’s target Fed funds interest rate. Secondary credits are short term loans
available to institutions that do not qualify for primary credit but need funds to strengthen their
books. Seasonal credit refers to loans given to small and medium sized institutions to cover
seasonal swings in their deposits and loans.
The Lombard rate is the Fed’s discount rate for primary credit which is set slightly higher than
the Federal funds rate on overnight loans. Since Lombard rate is the rate at which the banks will
borrow money from the central bank, the Federal Reserve can effectively use this rate as a
monetary policy tool. It can increase the rate and desist the depository institutions to borrow in
an inflationary scenario to reduce the money supply in the economy. To pursue an expansionary
monetary policy, on the other hand, the Fed can reduce the rates and encourage the banks to
borrow more, thereby ensuring larger money supply
13-10. How is a discount window loan from the Federal Reserve secured? Is collateral really
necessary for these kinds of loans?
A discount window loan must be secured by collateral deposits acceptable to the Federal Reserve
banks. The Fed in turn makes the loan by crediting the borrower’s reserve account. Collateral
against each loan is mandatory. Though usually the collateral is in the form of U.S. government
securities, the Federal Reserve also accepts some government agency securities and high-grade
commercial paper as collateral.
13-11. Posner State Bank borrows $10 million in primary credit from the Federal Reserve Bank

of Cleveland. Can you show the correct entries for granting and repaying this loan?
The appropriate entries for this transaction are:

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Chapter 13 - Managing Nondeposit Liabilities

Step 1 - Securing a loan from the Fed.
Posner State Bank
Assets
Liabilities and Net Worth
Reserves on deposit at the
Notes payable
Federal Reserve Bank
+10 million
+10 million
Federal Reserve Bank of Cleveland
Assets
Liabilities and Net Worth
Loans and advances
Bank reserve accounts
+10 million
+10 million
Step 2 - Repaying the loan to the Fed
Posner State Bank
Assets
Liabilities and Net Worth
Reserves on deposit at the
Notes payable

Federal Reserve Bank
-10 million
-10 million
Federal Reserve Bank of Cleveland
Assets
Liabilities and Net Worth
Loans and advances
Bank reserve accounts
-10 million
-10 million
13-12. Which institutions are allowed to borrow from the Federal Home Loan Banks? Why is
this source so popular for many institutions?
Institutions involved in mortgage lending can access credit from Federal Home Loan Banks by
posting mortgages as collateral to the banks. These loans are very popular because they represent
a stable source of funds for institutions at below market lending rates.
13-13. Why were negotiable CDs developed?
Due to slow growth in checkbook savings in 1960s as a result of funds being diverted in other
high yielding assets, banks developed negotiable CDs (which carried a higher rate of interest) to
attract large corporate deposits and savings from wealthy individuals.
13-14 What are the advantages and disadvantages of CDs as a funding source?

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Chapter 13 - Managing Nondeposit Liabilities

For borrowers, negotiable CDs offer a way to attract large amounts of funds quickly and for a
known time period. Also, deposit stability is likely to be greater because, unlike demand deposits
which can be withdrawn anytime, the CD will normally be held till maturity. However, these
funds are highly interest sensitive and depository institutions face the challenge of managing the

yields through active rate-hedging techniques to retain the deposits.
13-15. Suppose a customer purchases a $1 million 90-day CD, carrying a promised 6 percent
annualized yield. How much in interest income will the customer earn when this 90-day
instrument matures? What total volume of funds will be available to the depositor at the end of
90 days?
Interest income for the customer:
90
= $1,000,000 ×
× .06  = $15,000
360
Volume of funds available to the investor at the end of 90 days is principal amount plus interest;
$1,000,000 + $15,000 = $1,015,000.
13-16. Where do Eurodollars come from?
Eurodollars arise from dollar denominated deposits made in financial institutions outside U.S.
territory. It can be a dollar deposit by a U.S. based bank in its foreign branch or any other bank
based outside of United States.
13-17. How does a bank gain access to funds from the Eurocurrency markets?
A bank can borrow funds in a Eurocurrency market by either from one of its own subsidiaries in
the international market or from another bank operating overseas through correspondent banking
system. If the funds are borrowed from one of its own branches or subsidiaries, it records it as a
liability to foreign branch. In a correspondent banking system, the lending bank instructs a
domestic bank where it has a deposit to transfer funds in the account of Eurocurrency loan to the
correspondent account of the borrowing institution.
13-18. Suppose that JP Morgan Chase Bank in New York elects to borrow $250 million from
Barclays Bank in London and loans the borrowed funds for a week to a security dealer, and then
returns the borrowed funds. Can you trace through the resulting accounting entries?
When, JP Morgan Chase Bank borrows from Barclays Bank in London, the entries would appear
as follows:
JP Morgan Chase Bank
Assets

Liabilities and Net Worth
Deposits held at other banks
Deposits due to foreign banks
+250 million (Eurodollars borrowed)
+250 million

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Chapter 13 - Managing Nondeposit Liabilities

U.S. Bank Serving as Correspondent to Barclays Bank
Assets
Liabilities and Net Worth
Deposits due to foreign bank
-250 million
Deposits of JP Morgan Chase
Bank
+250 million
Barclays Bank in London
Assets
Liabilities and Net Worth
Deposit at U.S.
correspondent bank
-250 million
Eurodollar loan to JP
Morgan Chase Bank
+250 million
Entries when JP Morgan Chase Bank lends the funds to a security dealer
JP Morgan Chase Bank

Liabilities and Net Worth

Assets
Loan to security
dealer
+250 million
Deposit held at other bank
-250 million

Entries when JP Morgan Chase Bank receives loaned funds from the security dealer
JP Morgan Chase Bank
Assets
Liabilities and Net Worth
Loan to security dealer
-250 million
Deposit held at other bank
+250 million

Entries when JP Morgan Chase Bank repays its loans:
Assets

JP Morgan Chase Bank
Liabilities and Net Worth

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Chapter 13 - Managing Nondeposit Liabilities

Deposits held at other

Deposits due to Barclays Bank
banks
(Eurodollars borrowed)
-250 million
-250 million
U.S. Bank Serving as Correspondent to Barclays Bank
Assets
Liabilities and Net Worth
Deposits due to Barclays Bank
+250 million
Deposits of JP Morgan Chase
Bank
-250 million
Barclays Bank in London
Assets
Liabilities and Net Worth
Deposits at U.S.
correspondent bank
+250 million
Eurodollar loan to JP
Morgan Chase Bank
-250 million
13-19. What is commercial paper? What types of organizations issue such paper?
Commercial paper consists of short-term notes, with maturities ranging from three or four days
to nine months, issued by well-known companies to raise working capital. The notes are
generally sold at a discount from their face value through security dealers or through direct
contact with the issuing company.
There are two types of commercial paper. Industrial paper is issued by non-financial companies
to purchase inventories of goods or raw materials while finance paper is issued mainly by
finance companies or financial holding companies. Financial holding companies can use the

proceeds from issuing finance paper to purchase loans off the books of other financial firms in
the same organization to make more funds available for making loans.
13-20. Suppose that the finance company affiliate of Citigroup issues $325 million in 90 day
commercial paper to interested investors and uses the proceeds to purchase loans from Citibank.
What accounting entries should be made on the balance sheets of Citibank and Citigroup’s
finance company affiliate?
The appropriate entries for the above transaction are:
Step 1 - Commercial Paper is sold by the Affiliated Finance Company

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Chapter 13 - Managing Nondeposit Liabilities

Assets

Citibank
Liabilities and Net Worth

Assets

Affiliated Company
Liabilities and Net Worth

Cash account
Commercial paper
+325 million
+325 million
Step 2 - The Affiliated Finance Company purchases loans from Citibank
Assets

Citibank
Liabilities and Net Worth

Loans
-325 million
Reserves
+325 million
Affiliated Company
Assets
Liabilities and Net Worth
Cash account
-325 million
Loans purchased from
Citibank
+325 million
13-21. What long-term nondeposit funds sources do banks and some of their closest competitors
draw upon today? How do these interest costs differ from those costs associated with most
money market borrowings?
Long-term nondeposit funds include mortgages, capital notes, and debentures. Generally, the
interest costs on these funds sources are substantially higher than money market loans but are
usually more stable.
13-22. What is the available funds gap?
The available funds gap is the estimated difference between current and projected outflows and
inflows of an institution.
13-23. Suppose J.P. Morgan Chase Bank of New York discovers that projected new loan demand
next week should total $325 million and customers holding confirmed credit lines plan to draw
down $510 million in funds to cover their cash needs next week, while new deposits next

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Chapter 13 - Managing Nondeposit Liabilities

week are projected to equal $680 million The bank also plans to acquire $420 million in
corporate and government bonds next week. What is the bank's projected available funds gap?
The projected available funds gap will be:
( $325 + $510 + $420 ) - $680  = $575 million
13-24. What factors must the manager of a financial institution weigh in choosing among the
various nondeposit sources of funding available today?
A manager must weigh factors such as relative costs and risks of each funding source, length of
time for which the funds are needed, size of the borrowing institution, and regulations in
choosing what nondeposit funds sources to use. Other factors held constant, management will
seek out the lowest cost nondeposit funding sources available subject to credit availability and
the interest-rate volatility risks.
When funds are needed for longer periods, negotiable CDs and Eurodollars are usually the
preferred sources whereas very short-term cash needs usually will be met by Federal funds and
RPs or by borrowing from the Federal Reserve banks. However, regulations impose reserve
requirements on some funding sources (e.g., CDs) which increases their cost and these rules limit
access to some sources (e.g., borrowings from the Fed's Discount Window).
Problems and Projects
13-1. Robertson State Bank decides to loan a portion of its reserves in the amount of $70
million held at the Federal Reserve Bank to Tenison National Security Bank for 24 hours. For its
part, Tenison plans to make a 24-hour loan to a security dealer before it must return the funds to
Robertson State Bank. Please show the proper accounting entries for these transactions.
Step 1 - Lending the $70 million
Robertson State Bank
Assets
Liabilities and Net Worth
Federal Funds sold

+70 million
Reserves at Fed.
-70 million.
Tenison National Security Bank
Assets
Liabilities and Net Worth
Reserves at Fed.
Federal funds purchased
+70 million
+70 million
Step 2 - Loaning the borrowed funds
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Chapter 13 - Managing Nondeposit Liabilities

Tenison National Security Bank
Assets
Liabilities and Net Worth
Reserves at Fed.
-70 million
Loans made
+70 million
Step 3 - Received funds loaned
Tenison National Security Bank
Assets
Liabilities and Net Worth
Reserves at Fed.
+70 million
Loans made

-70 million
Step 4 - Repaying the loan of Federal funds
Assets

Robertson State Bank
Liabilities and Net Worth

Reserves on deposits at
Fed.
+70 million
Federal funds sold
-70 million
Tenison National Security Bank
Assets
Liabilities and Net Worth
Reserves on deposits at
Federal funds purchased
Fed.
-70 million
-70 million
13-2. Masoner Savings, headquartered in a small community, holds most of its correspondent
deposits with Flagg Metrocenter Bank, a money center institution. When Masoner has a cash
surplus in its correspondent deposit, Flagg automatically invests the surplus in Fed funds loans to
other money center banks. A check of Masoner’s records this morning reveals a temporary
surplus of $11 million for 48 hours. Flagg will loan this surplus for two business days to Secoro
Central City Bank, which is in need of additional reserves. Please show the correct balance sheet
entries to carry out this loan and to pay off the loan when its term ends.
Step 1 - Lending Federal Funds to Flagg Metrocenter Bank

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Chapter 13 - Managing Nondeposit Liabilities

Assets

Masoner Savings
Liabilities and Net Worth

Deposits with
Flagg Metrocenter Bank
-11 million
Federal funds loaned
+11 million
Flagg Metrocenter Bank
Assets
Liabilities and Net Worth
Federal funds purchased
+11 million
Masoner Savings’ Bank
deposit
-11 million
Step 2 - Flagg Metrocenter Bank loans funds to Secoro Central City Bank
Flagg Metrocenter Bank
Assets
Liabilities and Net Worth
Reserves
-11 million
Federal funds loaned
+11 million

Secoro Central City Bank
Assets
Liabilities and Net Worth
Reserves
+11 million

Federal funds purchased
+11 million

Step 3 - Flagg Metrocenter Bank receives loaned funds from Secoro Central City Bank
Flagg Metrocenter Bank
Assets
Liabilities and Net Worth
Reserves
+11 million
Federal funds loaned
-11 million
Secoro Central City Bank
Assets
Liabilities and Net Worth

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Chapter 13 - Managing Nondeposit Liabilities

Reserves
-11 million

Federal funds purchased

-11 million

Step 4 - Repaying the loan to the Masoner Savings
Masoner Savings
Liabilities and Net Worth

Assets

Deposit with Flagg
Metrocenter Bank
+11 million
Federal funds loaned
-11 million
Flagg Metrocenter Bank
Assets
Liabilities and Net Worth
Federal funds purchased
-11 million
Masoner Savings’ Bank
deposit
+11 million
13-3. Relgade National Bank secures primary credit from the Federal Reserve Bank of San
Francisco in the amount of $32 million for a term of seven days. Please show the proper entries
for granting this loan and then paying off the loan.
The correct entries are:
Step 1 - On receiving loan from the Fed
Assets

Relgade National Bank
Liabilities and Net Worth

Reserves on deposit at
Notes payable
the Federal Reserve Bank
+32 million

+32 million

Federal Reserve Bank of San Francisco
Assets
Liabilities and Net Worth
Loans and advances
Bank reserve accounts
+32 million
+32 million

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Chapter 13 - Managing Nondeposit Liabilities

Step 2 - Repaying the loan to the Fed.
Relgade National Bank
Assets
Liabilities and Net Worth
Reserves on deposit at
Notes payable
the Federal Reserve Bank
-32 million

-32 million

Federal Reserve Bank of San Francisco
Assets
Liabilities and Net Worth
Loans and advances
Bank reserve accounts
-32 million
-32 million
13-4. Shad Corporation purchases a 60-day negotiable CD with a $5 million denomination
from Bait Bank and Trust, bearing a 2.95 percent annual yield. How much in interest will the
bank have to pay when this CD matures? What amount in total will the bank have to pay back to
Shad at the end of 60 days?
Amount of interest for the bank on CD:
60
$5,000,000 ì 0.0295 ì
ữ = $24,583.33
360 
Amount to be repaid by the bank to Rockfish:
$5,000,000 + $24,583.33 = $5,024,583.33
13-5. Deep Valley Bank borrows $125 million overnight through a repurchase agreement (RP)
collateralized by Treasury bills. The current RP rate is 2.50 percent. How much will the bank pay
in interest cost due to this borrowing?
Interest cost for Lost Valley Bank will be:
 1 
$125,000,000 × 0.025 × 
÷ = $8,680.56
 360 
13-6. Thyme Bank of New York expects new deposit inflows next month of $265
million and deposit withdrawals of $425 million The bank's economics department has projected

that new loan demand will reach $400 million and customers with approved credit lines will
need $175 million in cash. The bank will sell $450 million in securities, but plans to add $60
million in new securities to its portfolio. What is its projected available funds gap?
The estimated available funds gap is the difference between estimated cash outflows and inflows
for an institution. It can be calculated as:
Current and projected loans and investments - Current and expected inflows

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Chapter 13 - Managing Nondeposit Liabilities

Therefore, the available funds gap for Thyme Bank will be ( $425 + $400 + $175 + $60 ) - ( $265 + $450 ) = $345 million
13-7. Wells Fargo Bank borrowed $150 million in Fed funds from JP Morgan Chase Bank in
New York City for 24 hours to fund a 30 day loan. The prevailing Fed funds rate on loans of this
maturity stood at 2.25 percent when these two institutions agreed on the loan. The funds loaned
by Morgan were in the reserve deposit that the bank keeps at the Federal Reserve Bank of New
York. When the loan to Wells Fargo was repaid the next day, JP Morgan used $50 million of the
returned funds to cover its own reserve needs and loaned $100 million in Fed funds to Bank of
America, Charlotte, for a two day period at the prevailing Fed funds rate of 2.40 percent. With
respect to these transactions,
(a) Construct T-account entries similar to those you encountered in this chapter, showing the
original Fed funds loan and its repayment on the books of JP Morgan, Wells Fargo, and Bank of
America and (b) calculate the total interest income earned by JP Morgan on both Fed funds
loans.
Entries in the books of JP Morgan Chase Bank:
JP Morgan Chase Bank
Assets
Liabilities and Net Worth
Fed funds sold to Wells Fargo

Bank
Day 1
+150 million
Reserves at Fed
-150 million
Reserves at Fed
Day 2

+150 million
Fed funds sold to Wells Fargo
Bank
-150 million
Fed funds sold to Bank of
America
+100 million
Reserves at Fed
-100 million
Reserves at Fed.

Day 4

+100 million
Fed funds sold to Bank of
America
-100 million

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Chapter 13 - Managing Nondeposit Liabilities

Entries in the books of Wells Fargo Bank:
Wells Fargo Bank
Assets
Liabilities and Net Worth
Day Reserves on deposit at Fed.
Fed funds purchased
1
+150 million
+150 million
Reserves on deposit at Fed.
Fed funds purchased
Day 2
-150 million
-150 million
Entries in the books of Bank of America:
Bank of America
Assets
Liabilities and Net Worth
Reserves on deposit at Fed.
Fed funds purchased
Day 2
+100 million
+100 million
Day Reserves on deposit at Fed
Fed funds purchased
4
-100 million
-100 million
(b) Interest earned by JP Morgan Chase Bank on1. Wells Fargo Bank loan:

1 

 $150,000,000 × 0.0225 ×
÷ = $9,375
360 

2. Bank of America loan:
2

$100,000,000 ì 0.024 ì
ữ = $13,333.33
360

13-8. Blue Skies Bank of Florida issues a three-month (90-day) negotiable CD in the amount of
$20 million to ABC Insurance Company at a negotiated annual interest rate of 2.75 percent (360
day basis). Calculate the value of this CD account on the day it matures and the amount of
interest income ABC will earn. What interest return will ABC Insurance earn in a 365 day year?
Interest amount on the CD:
90

20,000,000ì0.0275ì
ữ = $137,500
360

Therefore, value of the CD account on maturity will be:
$20,000,000 + $137,500  = $20,137,500
Given 365 days per year, interest amount on CD will be:
90

20,000,000 ì 0.0275 ì

ữ = $165, 616.44
365 

and, value of the CD account on maturity will be:
$20,000,000 + $165, 616.44  = $20,165, 616.44

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Chapter 13 - Managing Nondeposit Liabilities

13-9. Banks and other lending affiliates within the holding company of Best-of-Times
Financial are reporting heavy loan demand this week from companies in the southeastern United
States that are planning a significant expansion of inventories and facilities before the beginning
of the fall season. The holding company plans to raise $775 million in short-term funds this
week, of which about $700 million will be used to meet these new loan requests. Fed funds are
currently trading at 2.25 percent, negotiable CDs are trading in New York at 2.40 percent, and
Eurodollar borrowings are available in London at all maturities under one year at 2.30 percent.
One-month maturities of directly placed commercial paper carry market rates of 2.35 percent,
while the primary credit discount rate of the Federal Reserve Bank of Richmond is currently set
at 2.75 percent — a source that Best-of-Times has used in each of the past two weeks.
Noninterest costs are estimated at 0.25 percent for Fed funds, discount window borrowings, and
CDs; 0.35 percent for Eurodollar borrowings; and 0.50 percent for commercial paper. Calculate
the effective cost rate of each of these sources of funds for Best-of-Times and make a
management decision on what sources to use. Be prepared to defend your decision.
 $775 × 0.0225 + $775 × 0.0025

× 100 ÷ = 2.768%
Effective Federal Funds cost rate: 
$700



 $775 × 0.024 + $775 × 0.0025

× 100 ÷ = 2.934%
Effective CD cost rate: 
$700


 $775 ì 0.023 + $775 ì 0.0035

ì 100 ữ = 2.934%
Effective Eurodollar cost rate: 
$700


 $775 × 0.0235 + 775 × 0.005

× 100 ÷ = 3.155%
Effective Commercial Paper cost rate:
$700


$775 ì 0.0275 + 775 ì 0.0025

ì 100 ữ = 3.321%
Effective cost of borrowing from the Fed: 
$700



The cheapest source of all would be borrowing from the Fed Funds Market. However, since the
inventory expansion for the companies is not a loan which is going to be repaid in a day or two,
the bank can also consider funding through CD or Eurodollar, both of which cost the same.
13-10.Surfs-Up Security Savings is considering the problem of trying to raise $80 million in
money market funds to cover a loan request from one of its largest corporate customers, which
needs a six-week loan. Assume that market interest rates are at the levels indicated below:
Federal funds, average for week just concluded
Discount window of the Federal Reserve bank
CDs (prime rated, secondary market):
One month

13-19

1.98%
2.25%
2.52%


Chapter 13 - Managing Nondeposit Liabilities

2.80%
3.18%
3.00%

Three months
Six months
Eurodollar deposits (three months)
Commercial paper (directly placed):
One month
Three months

2.33%
2.70%

Unfortunately, Surfs-Up’s economics department is forecasting a substantial rise in money
market interest rates over the next six weeks. What would you recommend to its funds
management department regarding how and where to raise the money needed? Be sure to
consider such cost factors as legal reserve requirements, regulations, and what happens to the
relative attractiveness of each funding source if interest rates rise continually over the period of
the proposed loan.
Federal funds could be used to fund this loan. They happen to be the least expensive source in
terms of interest cost right now, However, Fed funds rate is very sensitive to market pressures
and, therefore, will rise along with other market interest rates if the bank's forecast turns out to be
correct. Discount window loans have very high regulations and are mostly used in case all the
other sources of funding are exhausted.
Assuming that the expectations of the bank that interest rates will rise over the next six weeks
actualize, the bank will very likely have to pay a premium over the current rates on either the
one-month CDs or commercial paper. Either a 3-month CD or 3-month commercial paper appear
to represent good alternatives because the bank, presumably, can lock in the interest cost to fund
this loan for the entire life of the loan
Alternative scenario:
What if Surfs-Up's economists are wrong and money market rates decline significantly over the
next six weeks? How would your recommendation to the funds management department change
on how and where to raise the funds needed?
Significantly declining interest rates would make short-term sources of funding much more
attractive to the bank. Federal funds, for example, may well be a good alternative as it is highly
sensitive to interest rate changes. One-month CDs would also be a good alternative, as would
one-month commercial paper. With the shorter maturities, the bank could readjust its costs
downward as the interest rates continue to fall.
13-11. June Bug Bank and Trust has received $750 million in total funding, consisting of $200

million in checkable deposit accounts, $400 million in time and savings deposits, $100 million in
money market borrowings, and $50 million in stockholders’ equity. Interest costs on time and
savings deposits are 2.50 percent, on average, while noninterest costs of raising these particular
deposits equal approximately 0.50 percent of their dollar volume. Interest costs on checkable
deposits average only 0.75 percent because many of these deposits pay no interest, but
noninterest costs of raising checkable accounts are about 2 percent of their dollar total. Money
market borrowings cost June Bug an average of 2.75 percent in interest costs and 0.25 percent in
13-20


Chapter 13 - Managing Nondeposit Liabilities

noninterest costs. Management estimates the cost of stockholders’ equity capital at 12 percent
before taxes. (The bank is currently in the 35-percent corporate tax bracket.) When reserve
requirements are added in, along with uncollected dollar balances, these factors are estimated to
contribute another 0.75 percent to the cost of securing checkable deposits and 0.50 percent to the
cost of acquiring time and savings deposits. Reserve requirements (on Eurodeposits only) and
collection delays add an estimated 0.25 percent to the cost of the money market borrowings.
(a) Calculate June Bug’s weighted average interest cost on total funds raised, figured on a beforetax basis.
(b) If the bank's earning assets total $700 million, what is its break-even cost rate?
(c) What is June Bug's overall historical weighted average cost of capital?
Sources of funds
Funds
Checkable deposits
200
Time and Savings deposits 400
Money market borrowings 100
Total
700

Interest
costs (%)
0.75%
2.50%
2.75%

Interest
costs ($)
1.5
10
2.75
14.25

Noninterest
Operating
costs
Other costs costs
2.00%
0.75%
5.5
0.50%
0.50%
4.0
0.25%
0.25%
0.5
10.0

a) Weighted average interest cost:
All interest paid

14.25

ì100 ữ = 2.0357%
ì100 Or 
Total funds raised
 700

b) Break-even cost rate on borrowed funds invested in earning assets:
Interest costs + other expenses
 14.25 + 10.00

ì100 Or
ì 100 ữ = 3.464%
Earning assets
700


c) June Bug's historical weighted-average cost of capital (Before-tax)
Stockholder's investment
Breakeven cost + Before-tax cost of stockholder's investment ×
Or
Total earnings asset
50 

3.46 + 12ì
ữ = 4.32%
700

13-12. Inspiration Savings Association is considering funding a package of new loans in the
amount of $400 million. Inspiration has projected that it must raise $450 million in order to have

$400 million available to make new loans. It expects to raise $325 million of the total by selling
time deposits at an average interest rate of 1.75 percent. Noninterest costs from selling time
deposits will add an estimated 0.45 percent in operating expenses. Inspiration expects another
$125 million to come from noninterest-bearing transaction deposits, whose noninterest costs are
expected to be 2.00 percent of the total amount of these deposits. What is the Association’s
projected pooled-funds marginal cost? What hurdle rate must it achieve on its earning assets?

13-21


Chapter 13 - Managing Nondeposit Liabilities

Source of Funds

Total
Total
Amount Interest Noninterest Interest Noninterest
($millions) Rate Cost Rate Expenses Expenses

Time deposits
$325
Noninterest-bearing transaction deposits 125
Total
$450

1.75%

0.45%
2.00%

$5.69
0.00
$5.69

$1.4625
2.5000
$3.9625

Projected pooled-funds marginal costs:
 ( 3.9625 + 5.69 )

All expected operating expenses
ì100 Or
ì 100 ữ = 2.144%
All new funds expected
450


Hurdle rate for the association can be calculated using:
All expected operating expenses
3.9625 + 5.69 )
×100 or (
× 100 = 2.4125%
Amount available to place in earning assets
400

13-22