Funding Strategies of Banks

Deposit vs non deposit funding

On the liabilities side of Banks balance sheets, deposits provide source of funding but due to decline in deposits, banks have moved to other sources of funding mainly from wholesale money markets.

This has caused the problems.

From Short-term Wholesale Funding and Systemic Risk: A Global CoVaR Approach

 

Financial institutions use short-term wholesale funding to supplement retail deposits and expand their balance sheets. These funds are typically raised on a short-term rollover basis with instruments such as large-denomination certificates of deposit, brokered deposits, central bank funds, commercial paper and repurchase agreements. Whereas it is agreed that wholesale funding provides certain managerial advantages (see Huang and Ratnovski, 2011, for a discussion), the effects on systemic risk of an overreliance on these liabilities were under-recognized prior to the recent financial crisis. Banks with excessive short- term funding ratios are typically more interconnected to other banks, exposed to a high degree of maturity mismatch, and more vulnerable to market conditions and liquidity risk. These features can critically increase the vulnerability not only of interbank markets and money market mutual funds, which act as wholesale providers of liquidity, but eventually of the whole financial system.

From THE DARK SIDE OF BANK WHOLESALE FUNDING

 

Banks increasingly borrow short-term wholesale funds to supplement retail deposits (Feldman and Schmidt, 2001). Through wholesale money markets, they attract cash surpluses from non financial corporations, households (via money market mutual funds), other financial institutions, etc. Wholesale funds are usually raised on a short-term rollover basis with instruments such as large-denomination certificates of deposits, brokered deposits, repurchase agreements, Fed funds, and commercial paper.

From this paper:  Lenders on the storm of wholesale funding shocks: Saved by the central bank?

The purpose of this paper is to add to a better understanding of the risks posed by banks’ reliance on wholesale funding. Wholesale funding refers to the use of deposits and other liabilities from institutions such as banks, pension funds, money market mutual funds and other financial intermediaries. When a bank relies on short-term wholesale funds to support long-term illiquid assets, it becomes vulnerable to runs by wholesale creditors. This risk manifested itself since the start of the financial crisis in 2007, when banks were confronted with severe strains in funding liquidity. Interbank funding dried up, causing interbank money market spreads to soar (Figure 1). After the failure of Lehman Brothers in 2008, this was soon followed by the drying up of wholesale funding markets. The functioning of those markets was severely undermined by increased counterparty risk and a shortage of high-quality collateral. From 2011 onward, when the financial crisis was followed by the sovereign debt crisis, banks in peripheral euro area countries even faced an accelerating outflow of retail funding, normally one of the most stable funding sources. Those funding strains forced banks to adjust their balance sheets in various ways. They responded by reducing maturity mismatches, switching to alternative sources of finance and by deleveraging. This activated the so-called liquidity channel of financial transmission through which funding liquidity shocks are propagated to bank lending and the real economy (BCBS, 2011). Our paper provides new empirical insights into the working of the liquidity channel.

From this paper: Executive Compensation and Systemic Risk: The Role of Non-Interest Income and Wholesale Funding

Furthermore, if the non-interest activities are financed through an unstable source of funds, the higher the non-traditional activity, the higher the liquidity exposure. In fact, the excessive overreliance on unstable wholesale funding makes banks more vulnerable to liquidity shocks in money markets. This proved to be a major driver in amplifying and transmitting the idiosyncratic shocks initiated in the U.S. real estate sector to a global scale during the recent financial crisis, generating large externalities to the real economy.

 

From this paper: Executive Compensation and Systemic Risk: The Role of Non-Interest Income and Wholesale Funding

While wholesale markets seem to provide an unlimited source of fast and cheap funding that banks use to expand their balance sheets, non-interest activities largely increase banking profitability, all together granting constant dividends and substantial bonus payments in the sector. A likely explanation is that bank managers may have imprudently over-relied on non- interest income sources and whole-sale funding owing to personal objectives, leading their firms (and the whole sector) to an inappropriate level of risk-taking. In spite of the considerable attention this moral hazard problem attracts, the empirical relation between managerial compensation and abnormal risk-taking, sourced in income-generating activities and funding strategies, must still be formally analyzed.

 

Key Research/Analysis Sources:

 

Short-term Wholesale Funding and Systemic Risk: A Global CoVaR Approach

German Lopez-Espinosa, Antonio Moreno, Antonio Rubia, Laura Valderrama

February 2012

https://www.imf.org/external/pubs/ft/wp/2012/wp1246.pdf

 

 

The Dark Side of Bank Wholesale Funding

Rocco Huang and Lev Ratnovski

2010

https://www.imf.org/external/pubs/ft/wp/2010/wp10170.pdf

 

Lenders on the storm of wholesale funding shocks: Saved by the central bank?

 

https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1884.en.pdf

May 2016

 

BANK ACTIVITY AND FUNDING STRATEGIES: THE IMPACT ON RISK AND RETURN

By Asli Demirgüç-Kunt, Harry Huizinga

January 2009

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1350235

 

BANK RISK DURING THE FINANCIAL CRISIS

DO BUSINESS MODELS MATTER?

by Yener Altunbas, Simone Manganelli and David Marques-Ibanez

https://www.newyorkfed.org/medialibrary/media/research/conference/2011/global_sys_risk/Bank_risk%20during_financial_crisis_business_models_matter_European_Central_Bank.pdf

 

Bank Funding Structures and Risk: Evidence from the Global Financial Crisis

Francisco Vazquez and Pablo Federico

https://www.imf.org/external/pubs/ft/wp/2012/wp1229.pdf

 

Is There a Role for Funding in Explaining Recent U.S. Banks’ Failures?

Pierluigi Bologna1

July 2011

https://www.imf.org/external/pubs/ft/wp/2011/wp11180.pdf

 

Executive Compensation and Systemic Risk: The Role of Non-Interest Income and Wholesale Funding

Marina Balboa, Germán López-Espinosa, Korok Ray, Antonio Rubia

Working Paper No.04/12

October 2012

 

http://www.unav.edu/documents/10174/6546776/1352748639_WP_UNAV_04_12.pdf

 

Bank funding costs: what are they, what determines them and why do they matter?

 

http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q4prereleasebankfundingcosts.pdf

 

CHANGES IN BANK FUNDING PATTERNS AND FINANCIAL STABILITY RISKS

 

Global Financial Stability Report 2013, Chapter 3

https://www.imf.org/External/Pubs/FT/GFSR/2013/02/pdf/c3.pdf

 

“Short-Term Wholesale Funding Risks”

Eric S. Rosengren

Global Banking Standards and Regulatory and Supervisory Priorities in the Americas

Lima, Peru November 5, 2014

https://www.bostonfed.org/news/speeches/rosengren/2014/110514/110514text.pdf

https://www.bostonfed.org/news/speeches/rosengren/2014/110514/

 

Deposit Market Competition, Wholesale Funding, and Bank Risk

Ben R. Craig  and Valeriya Dinger

 

https://www.newyorkfed.org/medialibrary/media/research/conference/2010/mp/Craig_Dinger.pdf

The Effect of Monetary Policy on Bank Wholesale Funding

Dong Beom Choi  Hyun-Soo Choi

February 23, 2016

 

Wholesale Funding Runs

Christophe Pérignon David Thesmar  Guillaume Vuillemey

November 21, 2015

 

https://acpr.banque-france.fr/fileadmin/user_upload/acp/Chaire-ACP/20151201-Article.pdf

 

When the Rivers Run Dry: Liquidity and the Use of Wholesale Funds in the Transmission of the U.S. Subprime Crisis

Claudio Raddatz

December, 2010

 

The Risks of Bank Wholesale Funding

Rocco Huang Lev Ratnovski

April 2008

http://www.rug.nl/research/events/workshopkoetter/s2p1-ratnovski.pdf

 

 

 

 

 

 

Advertisements

Author: Mayank Chaturvedi

You can contact me using this email mchatur at the rate of AOL.COM. My professional profile is on Linkedin.com.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s