Question

As a consultant, you have been asked to assess a bank’s sources and uses of funds and to offer recommendations on how it can restructure its sources and uses of funds to improve its performance. This bank has traditionally focused on attracting funds by offering certificates of deposit. It offers checking accounts and money market deposit accounts, but it has not advertised these accounts because it has obtained an adequate amount of funds from the CDs. It pays about 3 percentage points more on its CDs than on its MMDAs, but the bank prefers to know the precise length of time it can use the deposited funds. (The CDs have a specified maturity whereas the MMDAs do not.) Its cost of funds has historically been higher than that of most banks, but it has not been concerned because its earnings have been relatively high. The bank’s use of funds has historically focused on local real estate loans to build shopping malls and apartment complexes. The real estate loans have provided a very high return over the last several years. However, the demand for real estate in the local area has slowed.

a. Should the bank continue to focus on attracting funds by offering CDs, or should it push its other types of deposits?

b. Should the bank continue to focus on real estate loans? If the bank reduces its real estate loans, where should the funds be allocated?

c. How will the potential return on the bank’s uses of funds be affected by your restructuring of the asset portfolio? How will the cost of funds be affected by your restructuring of the bank’s liabilities?

Answer 1

a) The banks should push for other types of deposits through which it can increase its deposit balance. In the past the bank as been able to manage its high cost because of the high earnings being received from the real estate but as the demand in real estate sector reduces and falls down its earnings are bound to be impacted and in that case paying high cost on CD would not be a feasible thing and it can create financial issues for the bank. The cost of other types of deposit is low in comparison to CD.

b) The bank should try to reduce its exposure to real state because as the demand slowed down in the real estate sectors its earnings will be negatively affected from that sectors and if it did not reduce its exposure or diversified it sources of revenue then the total earnings of the banks will be affected. The banks can focus on providing commercial loan for industry purposes or it can diversify its business model in such a way where it is providing different types of financial services to its customer like asset management, credit restructuring. As people’s income increases these types of services will be required.

c) The potential return from the investment in these areas in the short-term might not be high but as the bank is able to build a large customer base with large asset on its balance sheet, the per unit cost of providing those services would be reduced and the retune in the long term would be high. The cost funding might not be affected significantly because providing these services are not very risky, there is initial capital investment but these are less risky then the real estate investment so the cost should not increase much. Instead if the bank is able to attract deposit from the customers then the cost will decrease because the interest paid on deposit is significantly low then interest paid on other sources.