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Tell apart the different ways a bank can raise funds other than deposits.

FRM® Part II · Liquidity and Treasury Risk Measurement and Management · Managing Non-Deposit Liabilities · FRM2.LTR.12.a

The idea

A bank can raise money outside deposits in several ways, and they differ in collateral, lender and maturity. Federal funds purchased are overnight unsecured loans of reserve balances from other banks. A repurchase agreement is secured: the bank sells securities and agrees to buy them back at a higher price, the difference being the interest. The lender applies a haircut to the collateral, so the cash received follows from the next line. Cash = Collateral value × (1 − haircut). Commercial paper is short-term unsecured paper sold to investors, usually by the holding company and supported by a credit line. Federal Home Loan Bank advances and central bank discount window loans are collateralized loans from official or quasi-official lenders. Subordinated debt and medium-term notes give longer funding, and subordinated debt also counts toward regulatory capital. The usual mistake is treating all wholesale money as unsecured. On the exam, classify each source by secured or unsecured, lender and maturity.

Formulas

Cash raised in a repo

Cash = Value × (1 − Haircut)

Value
the market value of the collateral
Haircut
the haircut, as a fraction of market value

Interest is then charged on this cash, not on the collateral's market value. Where the haircut is maintained, a fall in value calls for more collateral.

A practice question

From the question bank, with the reason each wrong option is wrong.

A bank sells securities to a counterparty under an agreement to buy them back the next day at a slightly higher price. Which description of this funding is accurate?

  1. A collateralized borrowing, with the price difference serving as the interest cost. - correct
  2. An unsecured loan of reserve balances from another bank, priced at the federal funds rate with no collateral.Why not: Confuses a repo with federal funds purchased, which are unsecured; a repo is secured by securities.
  3. An unsecured note issued to money market investors and backed only by the issuer's credit standing.Why not: Describes commercial paper; a repo involves a sale and repurchase of securities, not an unsecured note.
  4. A permanent sale of securities that removes them from the balance sheet and creates no obligation to repurchase.Why not: Treats the repo as an outright sale; the agreement to repurchase makes it a secured financing.

A repurchase agreement is a sale with a commitment to repurchase at a higher price; economically it is borrowing secured by the securities, and the price difference is the interest.

A harder one

A bank has an unexpected USD 80 million shortfall late in the day. All of its eligible securities are already pledged, so it has no unencumbered collateral. Which source is best suited to the overnight need?

  1. An overnight repurchase agreement, because repos can be arranged against securities the bank already owns.Why not: Ignores the condition that a repo needs unencumbered collateral, and none is available.
  2. A new commercial paper issue, because paper can be sold the same day with no program in place.Why not: Commercial paper needs an established program, ratings and a back-up line; it is not an end-of-day fix.
  3. A five-year medium-term note, because it provides funding that cannot be withdrawn.Why not: Term funding does not fit an overnight need and takes time to issue; it confuses maturity with speed.
  4. Federal funds purchased, because overnight borrowing from another bank needs no collateral. - correct

With no unencumbered securities, secured sources are closed. Federal funds purchased are unsecured and overnight, so they match both the maturity and the collateral position.

The hardest tier

A bank pledges securities with a market value of USD 250 million in a 14-day repo. The lender applies a 5% haircut and the repo rate is 5.20% on an actual/360 basis. Closest to the interest cost of the funding, in USD thousands?

  1. 506Why not: Applies the rate to the full USD 250 million of collateral and ignores the haircut.
  2. 474Why not: Uses an actual/365 day count where the money market convention is actual/360.
  3. 480 - correct
  4. 25Why not: Applies the rate to the haircut amount (5% of collateral) instead of to the cash actually borrowed.

Cash raised = 250 x (1 - 0.05) = 237.5 million. Interest = 237.5 x 0.052 x 14/360 = 0.4803 million, about USD 480 thousand.

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