Fund Sources & Deposit Management: Types, Pricing, Risks & ALM Link

TAKEAWAYS:

• Deposits are the lifeblood of banks: Core deposits (savings, current accounts) are stable; volatile deposits (call deposits, CDs) require hedging.
• Pricing deposits = balancing cost and competition: Banks use benchmark rates (e.g., NMB’s 6% savings vs. Ncell’s 8% call deposits) while managing liquidity.
• Risk management is non-negotiable: Interest rate risk (from deposit/loan mismatches) and liquidity risk (from sudden withdrawals) force banks to use tools like call deposits and ALM.
• Regulations shape deposit rules: Nepal Rastra Bank (NRB) caps deposit rates (e.g., 8% max for term deposits) to curb inflation.
• Tech transforms deposits: eSewa’s instant deposit transfers and Ncell’s digital savings accounts reduce branch dependency.
• Worked examples > theory: Always trace how a deposit (e.g., ₹500K in NMB’s 1-year FD) flows into the bank’s balance sheet and affects ALM.

1. Sources of Funds for Commercial Banks in Nepal

Banks raise funds from internal (capital, reserves) and external (deposits, borrowings) sources. For deposit management, external sources dominate (90%+ of liabilities). The primary sources are:

mindmap
  root((Sources of Bank Funds))
    Internal
      Capital: Paid-up share capital, retained earnings
      Reserves: Statutory reserves, revaluation reserves
    External
      Deposits: Core (savings, current) vs. Volatile (call, term)
      Borrowings: Interbank loans, central bank (NRB) advances
      Other: Short-term commercial papers, bonds

Why this matters:

• Deposits are the cheapest and most stable long-term source (e.g., NMB’s savings accounts).
• Borrowings (e.g., from NRB) are expensive (9–12% in 2023) but used for liquidity crises.
• Capital/reserves act as a cushion against losses (NRB mandates 8%+ capital adequacy ratio).

2. Types of Deposits: Core vs. Volatile

Deposits are classified based on stability, interest, and withdrawal terms. Nepalese banks offer:

Key Insight:

• Core deposits are stable (customers won’t withdraw easily) but pay lower interest.
• Volatile deposits (call deposits, short-term TDs) are priced higher to attract funds but risk sudden withdrawal.

WORKED EXAMPLE: NMB Bank’s Deposit Mix Assume NMB Bank has:

• ₹500M in savings accounts (5% interest)
• ₹300M in 1-year term deposits (8% interest)
• ₹200M in call deposits (9% interest)

Question: Calculate the weighted average cost of deposits (WACD) and explain why NMB might prefer savings over call deposits.

Solution:

1. Calculate interest expense:

   • Savings: ₹500M × 5% = ₹25M
   • TD: ₹300M × 8% = ₹24M
   • Call: ₹200M × 9% = ₹18M
   • Total interest = ₹25M + ₹24M + ₹18M = ₹67M

2. WACD = (Total Interest / Total Deposits) × 100 = (₹67M / ₹1B) × 100 = 6.7%

3. Why prefer savings?

   • Lower cost: Savings (5%) vs. call deposits (9%).
   • Stability: Call deposits can be withdrawn anytime, forcing NMB to keep liquid assets (e.g., cash reserves), reducing profitability.

3. Deposit Pricing: How Banks Set Rates

Banks cannot set deposit rates arbitrarily—they must balance:

1. Cost of funds (what the bank pays to borrow or hold cash).
2. Competition (e.g., Ncell’s 9% call deposit vs. NMB’s 7%).
3. Regulatory caps (NRB limits term deposit rates to 10% to curb inflation).

Factors Affecting Deposit Pricing

Real-World Example: eSewa’s Deposit-Like Feature

• Product: eSewa’s "eSewa Savings" (partnered with NMB).
• How it works: Users park money in eSewa (via mobile) and earn 5–7% interest, linked to NMB’s savings accounts.
• Why it’s innovative:
  • Digital deposits: No branch visits needed (reduces NMB’s branch costs).
  • Targeted pricing: Higher rates for low-balance users (e.g., ₹1K min vs. NMB’s ₹10K).
  • Liquidity risk: eSewa holds only 20% in cash, lending the rest to NMB at 6%, keeping its own margin.

1. User deposits ₹5K in eSewa app,
2. eSewa transfers ₹1K to NMB (cash reserve),
3. eSewa lends ₹4K to NMB at 6%,
4. User earns 7% (1% margin for eSewa).**

4. Risks in Deposit Management

Banks face two critical risks when managing deposits:

A. Interest Rate Risk (IRR)

• What it is: Mismatch between deposit rates (liabilities) and loan rates (assets).
• Example:
  • NMB offers 5% on savings but lends at 8%.
  • If NRB cuts rates to 4%, NMB’s cost of deposits rises, squeezing profits.

How banks hedge IRR:

• Asset-Liability Management (ALM): Match deposit maturities with loan maturities.
• Call deposits: Short-term deposits (e.g., 30-day call) to adjust to rate changes.

B. Liquidity Risk

• What it is: Inability to meet sudden withdrawal demands (e.g., bank run).
• Example:
  • If ₹100M in call deposits are withdrawn, NMB must sell assets (e.g., bonds) at a loss.

How banks manage liquidity:

• Liquidity coverage ratio (LCR): NRB requires banks to hold high-quality liquid assets (HQLA) worth 100% of 30-day outflows.
• Borrowing from NRB: Emergency liquidity facility (ELF) at 9–12%.

• X-axis: Time (2020–2024),
• Y-axis: Interest rates (%),
• Blue line: Deposit rates (falling from 8% to 5%),
• Red line: Loan rates (falling from 10% to 7%),
• Shaded area: Profit squeeze (2023–24).**

5. Regulatory Framework in Nepal

NRB governs deposit management via:

1. Deposit Insurance Scheme (DIS): Covers up to ₹1M per depositor (since 2016).
2. Interest Rate Caps:
   • Term deposits: Max 10% (adjusts with NRB repo rate).
   • Call deposits: Uncapped but must disclose minimum notice period (e.g., 7-day call).
3. Reserve Requirements:
   • Cash Reserve Ratio (CRR): 3% (banks must keep 3% of deposits with NRB).
   • Statutory Liquidity Ratio (SLR): 25% (must hold liquid assets like govt. bonds).

Why this matters:

• Prevents bank runs: DIS ensures depositors won’t panic.
• Controls inflation: Capping TD rates prevents excessive lending.

6. The Accounting Cycle: From Deposit to Loan

Trace how a ₹500K term deposit in Kathmandu’s Siddhartha Bank flows into the bank’s balance sheet and affects ALM.

Step 1: Journal Entry for Deposit

When a customer deposits ₹500K for 1 year at 8%:

| **Date**       | **Particulars**               | **Dr (₹)** | **Cr (₹)** |
|----------------|-------------------------------|------------|------------|
| 2024-01-01     | Cash A/c                      | 500,000    |            |
|                | To Term Deposit A/c           |            | 500,000    |
|                | (Being: ₹500K received as 1-year TD) |            |            |

Step 2: Interest Accrual (Yearly)

At year-end, Siddhartha Bank accrues interest (but doesn’t pay yet):

| **Date**       | **Particulars**               | **Dr (₹)** | **Cr (₹)** |
|----------------|-------------------------------|------------|------------|
| 2024-12-31     | Interest Expense A/c          | 40,000     |            |
|                | To Interest Payable A/c       |            | 40,000     |
|                | (Being: ₹500K × 8% = ₹40K interest accrued) |            |            |

Step 3: Loan Disbursement (ALM Matching)

Siddhartha Bank lends the ₹500K to a retailer at 10% (1-year loan):

| **Date**       | **Particulars**               | **Dr (₹)** | **Cr (₹)** |
|----------------|-------------------------------|------------|------------|
| 2024-01-01     | Loan A/c                      | 500,000    |            |
|                | To Cash A/c                   |            | 500,000    |
|                | (Being: ₹500K loan disbursed to retailer) |            |            |

Step 4: Net Profit Calculation

• Interest earned on loan: ₹500K × 10% = ₹50K
• Interest paid on deposit: ₹500K × 8% = ₹40K
• Net profit: ₹10K (before taxes/expenses)

ALM Impact:

• Perfect match: 1-year deposit funds a 1-year loan → no interest rate risk.
• If rates rise: New deposits cost more, but existing loans (at 10%) still earn ₹50K.

In the Real World

1. Ncell’s Digital Deposits

   • Idea Used: Core deposits + tech integration
   • How: Ncell partners with NMB Bank to offer "Ncell Savings" (5% interest) via mobile. Users deposit via Ncell app, and Ncell earns a 1% margin (lending to NMB at 4%).
   • Why it matters: Banks like NMB reduce branch costs while Ncell monetizes its user base.

2. Khalti’s Merchant Deposits

   • Idea Used: Call deposits for liquidity
   • How: Khalti’s "Khalti Business Account" lets merchants park idle cash (e.g., ₹200K) as 7-day call deposits at 7.5%. Khalti re-lends this to banks at 6%, keeping 1.5% profit.
   • Risk: If merchants withdraw en masse (e.g., during Diwali), Khalti must borrow from NRB at 9%, cutting profits.

3. NMB Bank’s ALM During Remittance Booms

   • Idea Used: Mismatch risk hedging
   • Scenario: After a remittance surge (₹200B in 2023), NMB sees ₹50B in new deposits (mostly savings accounts).
   • Problem: If NMB lends all ₹50B long-term (5-year loans at 10%), but deposit rates fall to 4%, it faces a ₹2B annual loss (₹50B × (10%–4%)).
   • Solution: NMB issues 3-month call deposits at 8% to match short-term liabilities with short-term loans (e.g., working capital for traders).

Exam Tip

How to Score Full Marks in TU/PU Exams for This Unit

1. Define + Classify: Always start with core vs. volatile deposits and ALM’s role in deposit management.

   • Example: "Core deposits are stable funds like savings accounts, while volatile deposits like call deposits require hedging via ALM tools such as duration matching."

2. Worked Examples Are Mandatory:

   • Trace the accounting cycle (journal entries for deposits/loans).
   • Calculate WACD (weighted average cost of deposits) and explain its impact on net interest margin (NIM).
   • Example Question: "Nepal Bank has ₹800M in savings (5%) and ₹200M in call deposits (9%). Calculate WACD and suggest how Nepal Bank can reduce IRR."

3. Link to Nepal Context:

   • Regulations: Mention NRB’s 10% TD cap, DIS (₹1M), and CRR/SLR.
   • Real Banks: Use NMB, Global IME, or Ncell in examples.
   • Example: "NMB Bank uses call deposits to manage liquidity risk during remittance season, as seen in 2023 when ₹200B in deposits required short-term hedging."

4. Risk Management > Theory:

   • Exams love IRR and liquidity risk. Always explain:
     • IRR: "If NRB cuts rates, NMB’s cost of deposits rises, squeezing NIM."
     • Liquidity: "Call deposits increase withdrawal risk, so banks hold HQLA per NRB’s LCR rules."

5. Diagrams Save Marks:

   • Draw a T-account for deposit entries.
   • Use a flowchart for ALM (deposit → loan → profit).
   • Pro Tip: Label every arrow with ₹ amounts (e.g., "₹500K loan at 10%").

Common Pitfalls to Avoid:

• ❌ Saying "all deposits are equal" → Distinguish core vs. volatile.
• ❌ Ignoring NRB rules → Always mention DIS, CRR, or interest caps.
• ❌ Skipping calculations → WACD, NIM, and IRR are exam favorites.
• ❌ Generic examples → Use Nepalese banks (NMB, Global IME) and apps (eSewa, Khalti).