Chapter 10
Funding the Bank
Chapter Objectives
1. Describe the composition and characteristics of bank liabilities.
2. Compare the average interest cost and servicing cost of various bank liabilities.
3. Describe how to estimate the average cost of transactions accounts.
4. Demonstrate how Eurodollar deposits and loans originate.
5. Explain the nature and role of electronic money.
6. Explain the features of Check 21 and the likely impact on banks and depositors.
7. Provide a method for calculating the marginal cost of a single source of bank funds
8. Present an application of the calculation of the weighted-average marginal cost of funds.
9. Describe the usefulness and interpretation of historical cost of funds analysis.
10. Explain the relationship between the composition of bank funds and risk.
Key Concepts
1. Banks can pay market rates of interest on virtually all deposits except commercial demand
deposits.
2. Depositors have become increasingly rate conscious and move their balances between
institutions on the basis of relative yields offered.
3. Banks price transactions accounts and small time deposits by requiring minimum balances
before paying interest, charging monthly maintenance fees or service charges, and imposing
per check charges.
4. Most large transactions handled by banks are settled in immediately available funds, which
include collected deposits at banks and deposit balances held at Federal Reserve Banks.
5. Eurodollar deposits are dollar-denominated deposits in banks located outside the United
States. They arise when customers open a Eurodollar account outside the U.S., but the
deposit is supported by dollar balances at a bank located in the U.S.
6. Bank borrowing from the Federal Reserve discount window takes the form of adjustment
credit, seasonal credit, or emergency credit.
7. Electronic commerce has grown substantially while the volume of paper checks has actually
fallen.
8. Average interest costs are based on historical performance. They provide no information as to
whether future interest costs will rise or fall. Average costs should be used in evaluating historical
performance, but not current pricing decisions.
9. The marginal cost of debt is the effective cost paid to acquire one additional dollar of investable
funds. The marginal cost of equity is a measure of the minimum acceptable rate of return required
by shareholders.
10. Banks should use marginal costs as inputs in their deposit and asset pricing decisions.
11. The composition and cost of bank funds are closely associated with a banks risk profile. The lower
the amount of core deposits, the higher is the cost of funds and the greater is liquidity risk.
Teaching Suggestions
Students enjoy debating the merits of different transactions account pricing schemes. Have them
identify the characteristics of the average student’s monthly account activity, minimum balances,
and number of deposits. Using the data in Exhibit 10.6, have students calculate a bank’s monthly
cost of handling the average account. Estimate the amount of fee income and investment income
from investable deposit balances that a bank earns, on average. The typical conclusion is that
student activity is high, especially when ATM transactions are included, deposit balances are low,
and without fees such as insufficient funds charges, a bank would not earn a profit on the average
student’s account.
Also, the advent of Internet banking will intrigue many students who are more computer-literate
than the general population. Open a discussion of who the users of Internet accounts likely are
and the growth opportunities of this type of banking. Have students identify the costs and benefits
of Internet accounts and online sales, in general.
It is important to demonstrating why cost analysis is useful and which cost estimates are useful for
different purposes. Much of the material follows from topics and calculations presented in an introductory
corporate finance class on estimating a firm’s cost of capital. The basic calculations are the same except
for differences in the nature of some bank liabilities.
Students should compare the issues raised in measuring a small bank’s cost of funds versus measuring a
large bank’s cost of funds. Discuss differences in access to the money and capital markets, especially the
national versus local nature of the demand for bank stocks. Questions at the end of the chapter serve as a
useful stimulant to additional questions.
Students will enjoy a discussion of Check 21 and its impact. Many depositors have historically
written checks against which they didn’t already have the funds on deposit with the expectation
that they would make a deposit prior to the check clearing. Check 21 effectively shortens check
clearing time to the same day in many instances, such that such practices will not be effective.
Have students discuss the effects of Check 21 on consumer behavior and bank pricing.
Ask students to assess the value of federal deposit insurance. In 2008, the U.S. Congress
temporarily increased the insured amount to from $100,000 to $250,000 per depositor. Have
students discuss whether federal deposit insurance is truly insurance. Are premiums based on risk
in the traditional insurance context? What does the government does with the premiums paid by
banks and savings and loans? Have students suggest alternative schemes.
Discuss the correspondent banking relationship. Many students do not understand why a bank
might have a checking account at another bank. Use the information in the text to discuss the
different types of relationships between banks and how banks pay for any services. This is also a
good time to introduce Bankers Banks, which exist throughout the U.S. These institutions are
owned by member banks and generally provide correspondent banking services that community
banks once purchased from large superregional banks that are now often direct competitors.