How banks fund themselves short term

Where does a bank get its short-term money?

A bank sits between savers and borrowers. Most of its assets are loans and securities; most of its liabilities are deposits and short-term borrowing. It earns its living from the gap between the two.

Bank short-term fundingborrow short from many places to lend out

• Deposits Memorize core funding, from households and firms
  • Checking (demand) accounts Use it no maturity, little or no interest, stable thanks to attached services
  • Operational deposits Use it from clearing, custody and cash management, relatively stable
  • Savings deposits and CDs Memorize often a stated term; CDs pay interest at maturity
• Wholesale funding Memorize raised from other institutions and investors
  • Interbank market Use it unsecured loans, overnight to one year, priced off a reference rate
  • Central bank funds market Memorize surplus-reserve banks lend to short banks at the funds rate
  • Commercial paper Use it about 60% of issuance is by financial institutions
  • Asset-backed commercial paper Memorize issued by an SPE, backed by loans, bank backup line
  • Repos Use it secured interbank borrowing, next lesson
• Last resort: discount window Memorize central bank lends against collateral at a higher rate, with oversight

The net interest margin is what the bank keeps: the return on its assets minus the cost of its liabilities.

$$\text{NIM} = r_{\text{assets}} - r_{\text{liabilities}}$$

Which deposits are the stable core?

Household and commercial deposits are the primary short-term funding for most banks. Checking accounts have no stated maturity, pay little or no interest and can be withdrawn at any time. Even so, balances are stable in normal times, because the bank attaches services to them: fee rebates, uncommitted credit lines and so on. For large depositors, operational deposits generated by clearing, custody and cash management are also relatively stable. Other large demand deposits are less attractive, because rules require banks to hold liquidity reserves against them.

Savings deposits are held for non-transactional purposes and often have a stated term. A deposit with a set maturity and interest rate is a certificate of deposit (CD). CDs typically mature in under a year and pay interest at maturity.

Certificate of depositfixed term (under one year), interest paid at maturity

• Non-negotiable CD Memorize paid to the first depositor, penalty for early withdrawal
• Negotiable CD Memorize can be sold in the market before maturity
  • Small-denomination Know the idea aimed at retail investors
  • Large-denomination Use it wholesale funding from institutions

A non-negotiable CD pays principal and interest at maturity to the original depositor, with a penalty for early withdrawal. A negotiable CD lets the holder sell it in the open market before maturity. Large-denomination negotiable CDs are a common source of wholesale funding from institutional investors.

What is wholesale funding?

Wholesale funding comes from other financial institutions and investors rather than from depositors.

• The interbank market is short-term borrowing and lending among financial institutions, on a secured or unsecured basis. Unsecured loans run from overnight to a year at a rate tied closely to a market reference rate. Banks build credit risk into the rate and set counterparty limits.
• Banks must hold reserves at the central bank, and some run short while others hold a surplus. The central bank funds market solves the imbalance, at the central bank funds rate . Central banks target that rate (or a range) through open market operations or interest paid on reserves.
• A bank that cannot borrow from other banks can borrow directly from the central bank as a last resort at the discount window . This requires posting collateral, may bring greater oversight and restrictions on the bank’s activities, and costs more than the central bank funds rate.
• Commercial paper: large financial institutions dominate issuance, around 60% of the annual volume. They use it for short-term needs and sometimes to fund longer-term assets such as loans, so they face rollover risk too.
• Asset-backed commercial paper (ABCP) is a secured form of paper.
• Repurchase agreements are the most common secured interbank borrowing, covered in the next lesson.

How does ABCP work?

1. The bank agrees to transfer short-term loans to a special purpose entity (SPE) in exchange for cash.
2. The SPE issues ABCP to investors, with a backup credit line provided by the bank.

The financing is not recorded on the bank’s balance sheet. The bank gets cash when the paper is issued and cuts its capital cost by providing undrawn backup liquidity in place of holding the loans to maturity. Investors buy a liquid, short-term note paid from a loan portfolio they could not otherwise reach.

The market grew fast before the global financial crisis, partly because short-term notes were being used to fund long-term assets. Many issuers could not roll the paper at the peak of the crisis and numerous SPEs failed. Afterwards, ABCP went back to funding mainly short-term, generally high-quality loans and receivables.

Go deeper Why liquidity rules treat deposits differently

Rules that require liquidity reserves look at how likely a deposit is to leave in a stress. Retail balances and operational deposits tied to services are sticky, so they count as more reliable funding. Large demand balances held for no particular service can leave overnight, so the bank must hold more liquid assets against them. That is why the same dollar of deposit is worth different amounts to the bank.

Go deeper The ABCP freeze as a rollover case

ABCP is a clean example of rollover risk. Short-term paper funded long-term assets. When investors stopped buying new paper, maturing paper could not be repaid from new issuance, and sponsors’ backup lines were called on. No figures are needed: the lesson is that matching a short funding source to a long asset only works while the market stays open.

Go deeper How the central bank steers the funds rate

The central bank targets the funds rate by adjusting the supply of reserves through open market operations, or by changing the interest it pays on reserves. Repos are a common tool for temporary changes. This links bank funding to monetary policy, covered in the economics topic.