Posts Tagged ‘balance sheets’

Funding sources for banks – Wholesale Funding… writing so I can remember (hopefully)

September 27, 2011 1 comment

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.

Wholesale Funding

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.

Raise Capital

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?

– Yes

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


Funding sources for banks – Demand Deposits… writing so I can remember (hopefully)

September 24, 2011 3 comments

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…

Do sovereign debt ratios matter?

July 23, 2010 Leave a comment

I have been trying to find an objective and easy to understand answer to this question and this is truly impressive… I’m always impressed with the truly analytical economic analysis by Michael Pettis and make it required weekly reading…

however, I have to admit that even with my slightly above average financial knowledge I have to read the article more than once to totally grasp the detailed concepts… and even more times to remember them!

So… to remember these concepts (& avoid spending 20 mins over a 5-page article) I’m going to summarize some of Michael’s articles, starting with the most recent one…

“Do soverign debt ratios matter?”

I think I can make [statement] with some confidence is that there is no threshold debt level that indicates a country is in trouble.  Many things matter when evaluating a country’s creditworthiness

These are the risk factors that affect a country’s ability to service its debts

  1. Of course debt levels – perhaps measured as total debt to GDP or external debt to exports
  2. The structure of the balance sheet matters[inverted or hedged], and this may be much more important than the actual level of debt (foreign currency debt, short-term borrowings – Mexican peso crisis 1994, Asian Currency Crisis 1997, Iceland 2010)
  3. The economy’s underlying volatility matters (think commodity dependent economies – Saudi Arabia, Canada, Australia, Iran, Nigeria, Russia, etc)
  4. The structure of the investor base matters (contagion due to highly leveraged investments)
  5. The composition of the investor base also matters (political cost of default, assets cannot be liquidated to pay debt even if assets are more than liabilities – Argentina 2002, Russia 1998)

The article is doesn’t name the likely countries to default but the recent Euro crisis has been primarily focused on the PIIGS nations (and their banks)