1.3 Bonds and syndicated loans as the main sources of non-deposit funds

Sources of bank’s funds

A bank is a business firm. Its main aim is to earn profit. In order to achieve this objective it provides services to the customers. It offers a variety of interest bearing obligations to the public. These obligations are the sources of funds for the bank and are shown on the liability side of the balance sheet of a commercial bank. The main sources which supply funds to a bank are as follows: Bank’s Own Funds and Borrowed Funds.

1. Bank’s own funds. 

(A) Banks Own Funds. Bank’s own paid up capital. The amount with which a banking company is registered is called nominal or authorized capital.

2. Reserve fund. Reserve is another source of fund which is maintained by all commercial banks.

3. Profit. Profit is another source to a bank for the purpose of business. Profits signify the credit balance of the profit and loss account which has not been distributed.

(B) Borrowed Funds. The borrowed capital is a major and an important source of fund for any banking business. It mainly comes from deposits which are accepted on varying terms in different accounts.

1. Borrowing from central bank. The commercial banks in times of emergency borrow loans from the central bank of the country. The central bank extends help as and when financial help is required by the commercial banks.

2. Other sources. Bank also raise funds by issuing bonds, debentures, cash certificates etc. etc. Though it is not common but is a dependable source of borrowing.

3. Deposits. Public deposits are a powerful source of funds to a bank. There are’ three types of bank deposits (i) current deposits (ii) saving deposits and (iii) time deposits. Due to the spread of literacy, banking habits and growth in the volume of business operations, there is a marked increase in deposit money with banks. /1, p.154/

Borrowed funds

The borrowed capital is a major and an important source of fund for any banking business. It mainly comes from deposits which are accepted on varying terms in different accounts.

Federal funds

In the United States, federal funds are overnight borrowings by banks to maintain their bank reserves at the Federal Reserve. Banks keep reserves at Federal Reserve Banks to meet their reserve requirementsand to clear financial transactions.

Federal Reserve borrowing

When countries issue currency, especially fiat currency that is not specifically backed by any commodity, it is necessary to have a central bank whose job it is to monitor and regulate the supply, distribution, and transacting of currency.

Repos

A repurchase agreement, also known as a repo, RP, or sale and repurchase agreement, is the sale of securitiestogether with an agreement for the seller to buy back the securities at a later date. The repurchase price should be greater than the original sale price, the difference effectively representing interest, sometimes called the repo rate. The party that originally buys the securities effectively acts as alender. The original seller is effectively acting as aborrower, using their security ascollateralfor a secured cashloanat a fixed rate ofinterest. A repo is equivalent to aspot salecombined with aforward contract. The spot sale results in transfer of money to the borrower in exchange for legal transfer of the security to the lender, while the forward contract ensures repayment of the loan to the lender and return of the collateral of the borrower. The difference between theforward priceand thespot priceis effectively the interest on the loan, while thesettlement dateof the forward contract is thematuritydate of the loan.

There are three types of repo maturities: overnight, term, and open repo. Overnight refers to a one-day maturity transaction. Term refers to a repo with a specified end date. Open simply has no end date. Although repos are typically short-term, it is not unusual to see repos with a maturity as long as two years. [App.3]

Eurodollar borrowing

Many foreign banks as well as foreign branches of U.S. banks accept deposits of U.S. dollars and grant the depositor an account denominated in dollars. Those dollars are called Eurodollars. As we will see, they exist under quite different constraints from domestic dollars. While Eurodollar banking got its start in Europe, such banking is now active in major financial centers around the world. /2, p.144/

Bonds and syndicated loans as the main sources of non-deposit funds

Bond - a debt investment in which an investor loans money to an entity (corporate or governmental) that borrows the funds for a defined period of time at a fixed interest rate. Bonds are used by companies, municipalities, states and U.S. and foreign governments to finance a variety of projects and activities. Bonds are commonly referred to as fixed-income securities and are one of the three main asset classes, along with stocks and cash equivalents.

The indebted entity (issuer) issues a bond that states the interest rate (coupon) that will be paid and when the loaned funds (bond principal) are to be returned (maturity date). Interest on bonds is usually paid every six months (semi-annually). The main categories of bonds are corporate bonds, municipal bonds, and U.S. Treasury bonds, notes and bills, which are collectively referred to as simply "Treasuries." Two features of a bond - credit quality and duration are the principal determinants of a bond's interest rate. Bond maturities range from a 90-day Treasury bill to a 30-year government bond. Corporate and municipals are typically in the three to 10-year range.

Issuance

Bonds are issued by public authorities, credit institutions, companies and supranationalinstitutions in theprimary markets. The most common process for issuing bonds is throughunderwriting. When a bond issue is underwritten, one or more securities firms or banks, forming asyndicate, buy the entire issue of bonds from the issuer and re-sell them to investors. The security firm takes the risk of being unable to sell on the issue to end investors. Primary issuance is arranged bybook runnerswho arrange the bond issue, have direct contact with investors and act as advisers to the bond issuer in terms of timing and price of the bond issue. The book runners' willingness to underwrite must be discussed prior to any decision on the terms of the bond issue as there may be limited demand for the bonds.

In contrast, government bonds are usually issued in an auction. In some cases both members of the public and banks may bid for bonds. In other cases only market makers may bid for bonds. The overall rate of returnon the bond depends on both the terms of the bond and the price paid. The terms of the bond, such as the coupon, are fixed in advance and the price is determined by the market.

Nominal, principal, par or face amount the amount on which the issuer pays interest, and which, most commonly, has to be repaid at the end of the term. Some structured bonds can have a redemption amount which is different from the face amount and can be linked to performance of particular assets such as a stock or commodity index, foreign exchange rate or a fund. This can result in an investor receiving less or more than his original investment at maturity. The issuer has to repay the nominal amount on the maturitydate. Most bonds have a term of up to 30 years. Some bonds have been issued with terms of 50 years or more, and historically there have been some issues with no maturity date (irredeemable). In the market for United States Treasury securities, there are three categories of bond maturities:

- short term (bills): maturities between one to five year; (instruments with maturities less than one year are called Money Market Instruments)

- medium term (notes): maturities between six to twelve years;

- long term (bonds): maturities greater than twelve years.

The coupon is the interest rate that the issuer pays to the bond holders. Usually this rate is fixed throughout the life of the bond. It can also vary with a money market index, such as LIBOR, or it can be even more exotic. The name "coupon" arose because in the past, paper bond certificates were issued which coupons had attached to them, one for each interest payment. On the due dates the bondholder would hand in the coupon to a bank in exchange for the interest payment. Interest can be paid at different frequencies: generally semi-annual, i.e. every 6 months, or annual. The yield is the rate of return received from investing in the bond. It usually refers either to:

- the current yield, or running yield, which is simply the annual interest payment divided by the current market price of the bond (often theclean price), or to

- the yield to maturityorredemption yield, which is a more useful measure of the return of the bond, taking into account the current market price, and the amount and timing of all remaining coupon payments and of the repayment due on maturity. It is equivalent to theinternal rate of returnof a bond.

Optionality: Occasionally a bond may contain an embedded option; that is, it grantsoption-likefeatures to the holder or the issuer:

Call ability some bonds give the issuer the right to repay the bond before the maturity date on the call dates; see call option. These bonds are referred to ascallable bonds. Most callable bonds allow the issuer to repay the bond atpar. With some bonds, the issuer has to pay a premium, the so-calledcall premium. This is mainly the case for high-yield bonds. These have very strict covenants, restricting the issuer in its operations. To be free from these covenants, the issuer can repay the bonds early, but only at a high cost.

Put ability - some bonds give the holder the right to force the issuer to repay the bond before the maturity date on the put dates; see put option. These are referred to as retractable orput able bonds.

Bond indices

A number of bond indices exist for the purposes of managing portfolios and measuring performance, similar to the S&P 500 or Russell Indexes for stocks. The most common American benchmarks are the Barclays Capital Aggregate, Citigroup BIG and Merrill Lynch Domestic Master. Most indices are parts of families of broader indices that can be used to measure global bond portfolios, or may be further subdivided by maturity or sector for managing specialized portfolios.

Syndicated loans

A syndicated loan is one that is provided by a group of lenders and is structured, arranged, and administered by one or several commercial banksorinvestment banksknown as arrangers.

At the most basic level, arrangers serve the investment-banking role of raising investor funding for an issuer in need of capital. The issuer pays the arranger a fee for this service, and this fee increases with the complexity and risk factors of the loan. As a result, the most profitable loans are those to leveraged borrowers—issuers whose credit ratingsarespeculative gradeand who are paying spreads (premiums or margins above the relevantLIBORin the U.S. and UK,Euriborin Europe or another base rate) sufficient to attract the interest of non-bank term loan investors. Though, this threshold moves up and down depending on market conditions.

Types of syndications.

Globally, there are three types of underwriting for syndications: an underwritten deal, best-efforts syndication, and a club deal. The European leveraged syndicated loan market almost exclusively consists of underwritten deals, whereas the U.S. market contains mostly best-efforts.

Underwritten deal.

An underwritten deal is one for which the arrangers guarantee the entire commitment, and then syndicate the loan. If the arrangers cannot fully subscribe the loan, they are forced to absorb the difference, which they may later try to sell to investors. This is easy, of course, if market conditions, or the credit’s fundamentals, improve. If not, the arranger may be forced to sell at a discount and, potentially, even take a loss on the paper. Or the arranger may just be left above its desired hold level of the credit. Arrangers underwrite loans for several reasons. First, offering an underwritten loan can be a competitive tool to win mandates. Second, underwritten loans usually require more lucrative fees because the agent is on the hook if potential lenders balk. Of course, with flex-language now common, underwriting a deal does not carry the same risk it once did when the pricing was set in stone prior to syndication.