Contrast the short-term financing options open to companies and to financial institutions
The idea
Short-term funding choices differ between non-financial companies and financial institutions. Companies can draw on bank lines of credit, which may be uncommitted, committed with a fee, or formal multi-year revolving credit agreements. They can also secure loans against receivables or inventory, and larger, well-rated companies issue commercial paper, which is short-term, unsecured and usually backed by a liquidity line to cover rollover risk. Banks fund themselves mainly with deposits, which are cheap and relatively stable, supplemented by wholesale funding: certificates of deposit, interbank borrowing, central bank facilities and repo. Negotiable CDs can be sold in the secondary market, whereas non-negotiable CDs carry a penalty for early withdrawal. The choice balances cost against availability: the cheapest sources are often the least certain, and funding that is guaranteed to be there costs more in fees or spread.
A practice question
Commercial paper is best described as:
- long-term secured debtWhy not: Commercial paper is short-term, typically well under a year, and usually unsecured.
- a committed bank lineWhy not: A bank line is a loan facility; commercial paper is sold directly to investors.
- short-term unsecured debt — correct
Commercial paper is short-term, unsecured debt sold by well-rated issuers, generally at a discount and often backed by a bank liquidity line.
A harder one
Issuers of commercial paper typically arrange a backup line of credit mainly to manage:
- currency riskWhy not: A backup line provides cash in the same currency; it does not hedge exchange rates.
- rollover risk — correct
- reinvestment riskWhy not: That is an investor's risk on reinvesting cash flows, not an issuer's funding risk.
If the issuer cannot sell new paper to repay maturing paper, the backup line supplies the cash, which is also why rating agencies require it.
The hardest tier
A company wants the greatest certainty that short-term bank funding will be available over the next three years. It should choose:
- a revolving credit agreement — correct
- an uncommitted line of creditWhy not: The bank can refuse to lend under an uncommitted line, so it offers little certainty.
- rolling commercial paperWhy not: Access depends on market conditions each time the paper matures.
A revolving credit agreement is a formal, multi-year commitment, so the bank must lend on request within its terms. The certainty is paid for with commitment fees.
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