Funding sources for banks – Demand Deposits… writing so I can remember (hopefully)
Yesterday morning, I was reading a post on FTAV about Greek depositors fleeing Greek banks and with the Fed’s announcement of Operation Twist, I realized that I need to refresh my understanding of “how banks work”… and particularly the funding sources of a bank and eventually the role of central bank…
There are two primary source of bank funding:
– Demand Deposits (cheapest source of funding)
– Wholesale Funding – from other banks and providers of capital
In this post my goal is to get a basic understanding of Demand Deposits:
Q – How does a bank fund itself by using demand deposits? What does a bank’s balance sheet look like when I deposit $100?
In a fractional reserve banking system, a demand deposit is a bank’s liability to the depositor… the depositor can withdraw for his/her deposit at anytime. A bank can then loan out a portion of the deposit to a credible borrower (companies, persons, other banks, etc)… the portion of the deposit that is not lent is considered reserves… reserves appear as an asset on a bank’s balance sheet…
At Initiation, t = 0
Asset = Loan + Reserves = 90 + 10
Liability +Equity = Deposit = 100
In future, t = 1
Scenario A – Bank makes profit on the loan
The bank makes money by making a profit on the loan (assume bank does not have to pay interest to the depositor), let’s say the bank makes 5% on the loaned amount.
A = Loan + Reserves + Cash = 90 + 10 +5 = 105
L + E = Deposit + Profit (Retained Earning) = 100 + 5 = 105
Scenario B – Bank makes a loss on the loan
The bank loses $5 on the loan because the borrower will not be able to payback.
A = Loan + Reserves + Cash = 85 + 10 = 95
L + E = Deposit + Loss (Retained Earning) = 100 = 95
In this scenario, if the depositor demands his money, he must be paid $100 or the bank must go bankrupt. The bank has only $95 in assets…where and how does the bank get the ‘extra’ $5?
– The bank can fund the $5 in one or more of following ways:
– get more deposits
– borrow short-term money from other banks
– borrow from central
– raise capital in the open market (bonds, stocks, etc)
– Or the bank declares bankruptcy
– If this scenario happened after Scenario A, then the bank would have just enough ($5 profit cancels the $5 loss) to cover the deposit
Note that reserves only apply to demand deposits… The reserves ratio requirements imposed by some central banks create a ceiling on the amount that can be lent given a deposit amount… but if a bank has more credible borrowers than can be met by the level of its deposits, then the bank can fund these loans by raising capital or with wholesale funding…
Next post will be about wholesale funding…