Examine what influences a bank's selection among non-deposit funding sources.
The idea
A bank chooses among non-deposit sources by weighing several influences together rather than looking at the rate alone. Cost means the all-in expense, including fees, back-up lines, reserve requirements and insurance, not just the quoted rate. Risk covers interest rate risk, credit risk and, above all, rollover risk, so funding maturity should be set against asset maturity and repricing. Availability is whether the amount can be raised when needed, which depends on the bank's credit rating, its market access and its stock of unencumbered collateral. Regulation and the speed of execution also matter. A weaker credit standing pushes a bank towards secured sources, but heavy repo use encumbers assets and shrinks the liquidity buffer. The usual mistake is to pick the cheapest quoted rate and ignore availability and rollover risk under stress. On the exam, expect to justify a choice with at least two of these influences.
Formulas
Effective cost of a source carrying a reserve requirement
Effective cost = Rate ÷ (1 − Reserve)
- Rate
- the quoted rate on the source
- Reserve
- the reserve requirement, as a fraction of funds raised, earning nothing
Only the funds left after the reserve can be lent, so the cost per usable dollar rises. Multiplying by one plus the reserve ratio, or by one minus it, is the trap.
A practice question
Which description matches 'availability' as an influence on a bank's choice among non-deposit funding sources?
- The total interest and non-interest expense per dollar of funds raised.Why not: Describes the cost factor, not availability.
- The match between the funding's maturity and the repricing of the assets it supports.Why not: Describes maturity and interest rate risk, not availability.
- Reserve requirements and insurance premiums that apply to the source.Why not: Describes regulatory cost, which is a separate influence.
- Whether the source can supply the needed amount at the time it is needed, including when markets are stressed. - correct
Availability is about volume and timing: market access, credit rating, counterparty limits and collateral. Cost, risk and regulation are separate influences.
A harder one
A bank funds a portfolio of seven-year fixed-rate loans. Which consideration argues most strongly for term funding such as medium-term notes instead of overnight federal funds?
- Overnight borrowing always carries a reserve requirement that term notes avoid.Why not: Federal funds purchased are not generally subject to a reserve requirement, so this is not the main driver.
- Matching funding maturity and repricing to the assets limits rollover and interest rate risk. - correct
- Regulators prohibit overnight borrowing from being used to finance loans.Why not: No such prohibition exists; the issue is risk, not legality.
- The yield curve always slopes downward, so term notes are cheaper than overnight money.Why not: Term funding usually costs more when the curve slopes upward; cost is not the reason to lengthen.
Funding a long fixed-rate asset with overnight money exposes the bank to refinancing risk and to rising rates. Term funding reduces both, at the possible price of a higher rate.
The hardest tier
A bank needs USD 120 million. Federal funds lines allow USD 40 million at 5.00%. The balance would come from commercial paper quoted at 4.70% plus a 0.40% back-up line fee and 0.20% dealer fees. Closest to the blended all-in cost of the funding?
- 5.20% - correct
- 4.80%Why not: Uses the quoted paper rate of 4.70% and leaves out the back-up line and dealer fees.
- 5.15%Why not: Takes a simple average of 5.00% and 5.30% instead of weighting by amounts raised.
- 5.30%Why not: Assumes all USD 120 million is raised as paper, ignoring the cheaper federal funds line.
Paper all-in = 4.70 + 0.40 + 0.20 = 5.30%. Blend = (40 x 5.00 + 80 x 5.30) / 120 = 5.20%.
In the app: 6 practice questions on this outcome, spaced review that brings it back before you forget it.
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