How do commercial banks raise cash and how quickly?
Importance of ensuring adequate liquidity
One reason, in short – match funding or gap management:
Asset/liability maturity matching
How do banks make money?
- Banks take short-term deposits and funding sources, then turn them in long term loans (let say 30 years…)
- Banks collect spread, the difference in the rates, as profit.
Banks add value and earn money from two main activities that are in compassed by their lending and depositing activities. Thus, there’s a maturity transformation here, and this is how and why banks generate value.
Banks are giving you money for the long term if you borrow it. However, they’re also saying, “We’re not going to require you to keep a certain amount of money in here for the long term. We have so many customers that we don’t need to impose those individual requirements on specific individuals. Instead, you can have your money here and you can withdraw it and deposit it as you want.”
Due to maturity transformation, banks must ensure adequate liquidity to match their liabilities.
Repricing of assets vs repricing of liabilities
Banks value their assets and liabilities based on market value, and the updated value must be reflected. Adequate liquidity will cover the risks of significant changes in liabilities.
Magnitude of mismatched positions
- Interest rate and yield curve effects
- Foreign exchange
How to Raise Cash?
Among all the channels, this is the cheapest channel to acquire additional deposits. However, the process is slow, and on-going. Generally, banks will do the following (not an exhaustive list):
- Targeted marketing – Analyze their existing customers and figure out which demographic will be their focus for certain period or marketing campaign, and then promote services they offer that are most appealing to existing customers. Also, banks also acquire leads through many acquisition channels.
- Offer higher deposit rate – This isn’t the end-all of marketing strategies, but it is the one that speaks most plainly and has the easiest pitch. However, chances are a rate may get a potential lead in the door but won’t keep them for long term.
- Invest in local community
- Offer additional incentive:
- Offer bonuses for signing up or referring people
- Offer progressive rates depending on the amount in an account.
- Remove or eliminate overdraft fees.
- Give members free checks.
- Offer mobile deposits.
- Don’t charge for transfers.
- Make sure your online portal is easy to use and makes getting new accounts easy.
- Offer free identity theft protection.
Borrow from banks
This refers to interbank lending market – a market in which banks lend funds to one another for a specified term. Most interbank loans are for maturities of one week or less, the majority being over day. Such loans are made at the interbank rate (also called the overnight rate if the term of the loan is overnight).
Access capital markets
Go for IPO or raise capitals from stock market through right issues. Quite expensive in long term because have to pay dividend, conduct AGM, please so many shareholders, etc.
Sell assets – which ones?
In some circumstances, banks can use repos if they have very good assets.
Lender of last resort
A central bank offers extension of credit to banks experiencing financial difficulties which are unable to obtain necessary funds elsewhere. This definition comes from the OECD (Organisation for Economic Co-operation and Development): “A lender of last resort is a lender, typically a central bank, which provides financial institutions with funds when they cannot borrow from the market. The availability of such lending is intended to prevent systemic problems due to liquidity shortage in individual institutions.”
Bank sources of funding and their stability
Below are bank sources of funding and order from the most stable to the least stable:
- Ordinary shares – the most stable of funding, but the most expensive. Have to pay dividend, conduct AGM, please so many shareholders, etc.
- Perpetual subordinated debt – No maturity. A type of junior debt that continues indefinitely and has no maturity date. Perpetual subordinated loans pay creditors a steady stream of interest forever. Since the loan is perpetual, the principal is never repaid. The interest rate is based on the borrower’s creditworthiness as well as prevailing market interest rates. they are relatively risky for the creditor. The creditor won’t be able to get principal back, but bank will pay them interest forever.
- Retail deposits – Cheapest funding
- Wholesale deposits – include, but are not limited to, Federal funds, public funds (such as state and local municipalities), U.S. Federal Home Loan Bank advances, the U.S. Federal Reserve’s primary credit program, foreign deposits, brokered deposits, and deposits obtained through the Internet or CD listing services.
- Senior medium-term debt – A type of fixed income security with a maturity, or date of principal repayment that is set to occur in the next 3-10 years.
- Dated subordinated debt – Dated subordinated (or Lower Tier 2) debt is a category of debt issued by financial institutions which ranks behind depositors, senior secured and senior unsecured creditors. It can be included in the makeup and calculation of capital ratios for regulatory purposes.
- Repos – just slightly stable than inter-bank deposits
- Inter-bank deposits – the least stable
Below figure illustrate weightage of funding sources of different type of banks in general.
General views on the confidence sensitivity of various instrument types
- Money market funds – These can be quite volatile because of their open-ended nature, short-term horizon (often investing overnight or for very short terms), sensitivity to credit ratings and the credit sensitive nature of their own investor base.
- Interbank funding – Relationships can often be reciprocal, affording a certain stickiness (stability) to interbank deposits. However, because interbank funding is typically unsecured, it tends to be withdrawn in periods of stress. Moreover, due to the typically high correlation among banks, distress at one bank is often shared by others, meaning that all banks in a given system tend to withdraw funding at the same time and reduce their exposure to others.
- Foreign investors – These can be less stable because investor/issuer relationships are often less developed. When risk aversion is higher, investors tend to repatriate cash, making such funding inherently less reliable than funding from domestic investors. Domestic investors may extend beyond national boundaries in a single-currency area.
- Domestic unsecured local-currency investors – These can be relatively sticky because relations between investor and issuer are often stronger, and investors may have relatively limited choice. Hence, a larger proportion of such investors within the market-funds base tend to improve the quality of this funding. As noted above, domestic investors may extend beyond national boundaries in a currency union.
- Repo funding – This kind of secured funding has traditionally been considered to be insensitive to concerns about the creditworthiness of the counterparty, because it is collateralized by securities. However, in practice, even this kind of funding has been withdrawn or shortened when there are counterparty credit concerns, particularly when the agreement is secured by non-traditional collateral.
- Covered bond investors – These are relatively sticky because they benefit from collateral and are thus less sensitive to credit developments. In some banking systems, covered bond funding is the primary form of institutional investment and hence more reliable because investors have little choice but to invest in these instruments. The funding is also typically long term (discussed further below).
- Small denomination bonds – Such bonds are often held by retail investors and hence behaviourally are similar to retail deposits. Sometimes they benefit from deposit insurance, further reducing the credit sensitivity of the bondholders. Where the information is available, we may reclassify such bonds as deposits rather than as market funds.
Basel III Regulatory Standards on Liquidity
We don’t need to calculate the following ratios by ourselves. Banks will do the calculation and report the Basel III figures. Our best bet is the auditors do their job.
Liquidity Coverage Ratio (LCR)
Bank must maintain enough “high-quality assets” to cover 100% of net cash outflows over a 30-day “stress period”. Click to learn more about LCR.
Net Stable Funding Ratio (NSFR)
Funding and Liquidity Ratios
- Loans/Customer Deposits (%) – The loans/deposits ratio can provide an overview as to what extent a bank, whose assets are dominated by, or which has a sizeable, loan portfolio, is dependent on more credit-sensitive wholesale funding. It tells us to what extent customer deposits, which are generally regarded as a cheap, stable, and core funding source, do not fully fund lending. This means the bank has to access more expensive market (or wholesale) funding, which can be very credit and/or confidence sensitive.
- Customer Deposits/Total Funding (%) – This ratio provides simple analysis of funding composition. If the ratio is high, this tells us that large portion of funding is from customer deposits, which is more stable. Low ratio indicates majority funding of the bank was from more expensive and more volatile instruments.