Funding sources for banks – Wholesale Funding… writing so I can remember (hopefully)
In the previous post I wrote about the ‘primary’ source of funding for Banks i.e. Demand Deposits… In this post I will enumerate on Wholesale Funding sources. The level of detail might be random because my goal is to get a basic understanding and then try to look at the Euro crisis from this understanding… and also refer to it later. There are many blogs and sites that have done a fantastic job of explaining the details and the mechanics.
There are many types of Wholesale Funding sources available to a commercial bank:
– Interbank Market at or near the Central Bank’s overnight target rate
– REPO (Repurchase Agreement) – “…is the sale of securities together 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…”
– Central Bank – various programs and facilities since the 2008 financial crisis
– Central Bank Discount Window at the Discount Rate
The Central bank becomes the clichéd ‘lender of last resort’ when wholesale funding disappears.
Typical characteristics of wholesale funding:
– usually very sensitive to interest rate fluctuations and hence more expensive
– Less stable than demand deposits. The risk of wholesale funding is that can disappear anytime as is happening for some of the European banks and is also what exacerbated the 2008 financial crisis.
Q – What does a bank’s balance sheet look like when any of the wholesale funding sources are present?
– The economic effect of wholesale funding is identical to the bank receiving a loan from another financial institution. As far as the balance sheet goes, a matching asset and liability are created which expands the bank’s balance sheet.
There is one more avenue a commercial bank can pursue and that is to raise capital by issuing Bonds, Debentures, Preferred shares, Common Shares, etc. Typically raising capital is the last resort and/or is reserved for long term investments or long term projects (e.g. new building)
Q – What happens to a bank’s balance sheet when a bank raises capital by issuing bonds or stock?
Let’s say, the Bank (from previous post) raises capital by issuing $100 of equity, the balance sheet looks like
A = Loan + Reserves + Cash = 90 + 10 + 100 = 200
L+E = Deposit + Equity = 100 + 100 = 200
(assume, $100 deposit, $90 loan and $10 reserves)
Q – Now, what can the bank do with the $100 capital? Can the bank lend it to a borrower?
Q – Does the bank have to maintain a reserve on the full $200 or only on the $100?
– The bank needs to maintain reserves against the deposits so only on $100.
Q – Why and how does a bank hold government securities?
– The bank lends money to the government by buying government issued securities – this shows as an asset on the banks BS