This is an unedited draft for my projected banking manuscript. It might be an idea to embed some of this content into earlier articles that discussed the self-funding nature of the banking system. Although I planned to do a different article first, I decided to add this discussion in response to some reader feedback. This article does not really stand on its own, the reader will need to go back to
Brian, what would be helpful here are clear definitions of "funding" and "liquidity." People (including myself) who have never worked in banking and finance have difficulty grasping what these terms mean at the operational level. (I suspect authors of economics textbooks have this problem as well.)
Let's take a situation I have faced myself. I've explained to students that the money supply is defined in such a way that most of the money supply is demand deposits; those demand deposits are mostly the result of bank decisions to lend; and banks decide to lend only when potentially profitable loan customers approach them. Hence, "loans create deposits, not the other way around." And at the level of the macro-economy, that explanation is generally very helpful.
"Why, then," I am asked (and ask myself), "do banks compete for deposits?" Why, when I was young, did banks give away a lot of swag like toasters if you opened an account with them? Doesn't that indicate that banks need deposits before they can lend? And, hence, that the role of banks is to serve as intermediaries between borrowers and savers?
I've never been satisfied with my own responses to such questions. Now I suspect that the reason for that is that I don't understand "funding" and "liquidity" at the micro-level of a given bank's operations. In this article, you use the term "liquidity" 12 times and "funding" 30 times. Could you set out some clear definitions of these concepts that laypeople could understand? Thanks.
The thing to keep in mind this would be the third/fourth section in a chapter that is showing up late in my book. Definitions should be done much earlier.
If I used "liquidity" as a stand-alone word, it was a mistake. There is no good definition. Only compound terms are useful.
Liquid asset - assets that one hopes that one could sell easily with little price impact. For our purposes here, these will be defined in regulations.
Liquidity portfolio: a portfolio of designated "liquid assets" that a bank holds. (Note that the bank might use its own definition of "liquid assets" when it is deciding what it wants to do.)
Liquidity ratio: a requirement in regulations to hold a certain amount of liquid assets as a percentage of demand deposits, etc. (In practice, there are multiple ratios.)
Liquidity drain: a cash outflow that normally results in the need to sell liquid assets in order to settle up with the payments system. Just a stylistic choice to use this.
Funding/financing: these are almost synonyms. In order to have assets, a financial firm needs matching liabilities/equity. Financing/funding refers to the emission of liabilities to match those assets. The difference between the terms in practice is that "financing" generally refers to the long-term balance sheet composition, e.g., "the purchase was financed with a mixture of bonds, money market instruments and new equity." Funding is usually reserved to short-term transactions in "funding markets": wholesale money markets, inter-bank markets, and eve derivatives (cross-currency swaps).
Why do banks compete for deposits? They are cheap funding/financing. You need to look at my example (in earlier articles): banks need to recharge their liquidity portfolio. The fact that loans create deposits explains why loanable funds is incorrect, but does not imply that a bank can ignore financing its balance sheet.
Hope you don't mind my input here. Loan deposits are bank liabilities because the actual deposit amount is being held by the bank as an Asset. And when the borrower draws down on the loan the drawdown is deducted from Assets. On average here in Australia about 60% of loan funding is derived from deposits.
A big consideration for banks is funding costs. This is guaged by the interest paid on deposits and the interest received on loans.
A banks profits will depend on the spread between cost of funding ( not just deposit funding)
and the loan interest rate returns.
This will determine the bank's profitability.
Liquidity is related to regulatory requirements of holding enough liquid (or money like assets) to meet any shocks that might occur in stressed financial markets. eg Bank run. See LCR.
This reply might be a bit mixed up because text kept going out of view and I could not edit.
As the borrower draws down the loan, why wouldn't that instead be *added* to assets, as a loan to a customer is of no use to a bank until the customer goes out and spends it on economic activity that will then provide a return to both the customer and its bank?
A loan is an asset since the customer has to pay it back, and pay interest on the loan. If the customer leaves the cash as a deposit, that’s even better. The bank want to make money, and doesn’t really care what the customer does with it (unless the loan was for a purchase that is collateral for the loan, in which case, they care about the collateral).
A line of credit is kept off balance sheet, and only shows up there when the customer draws on it. That is, it turns into loan at that point.
I see. The definition of "draw down." What I said was just a counterpoint to what she said, not a point in itself, though. But what she means by "draw down," I don't know, then. Thanks for answering our comments!
The reason banks give away swag is simply for promotional purposes. Banks make their money from making loans not taking deposits, and they figure that they’re more likely to loan money to existing customers.
"I own units in a Canadian gold mine fund at the time of writing, but I am not entirely sure why."
Ben Bernanke can answer that for you: "Tradition"
Brian, what would be helpful here are clear definitions of "funding" and "liquidity." People (including myself) who have never worked in banking and finance have difficulty grasping what these terms mean at the operational level. (I suspect authors of economics textbooks have this problem as well.)
Let's take a situation I have faced myself. I've explained to students that the money supply is defined in such a way that most of the money supply is demand deposits; those demand deposits are mostly the result of bank decisions to lend; and banks decide to lend only when potentially profitable loan customers approach them. Hence, "loans create deposits, not the other way around." And at the level of the macro-economy, that explanation is generally very helpful.
"Why, then," I am asked (and ask myself), "do banks compete for deposits?" Why, when I was young, did banks give away a lot of swag like toasters if you opened an account with them? Doesn't that indicate that banks need deposits before they can lend? And, hence, that the role of banks is to serve as intermediaries between borrowers and savers?
I've never been satisfied with my own responses to such questions. Now I suspect that the reason for that is that I don't understand "funding" and "liquidity" at the micro-level of a given bank's operations. In this article, you use the term "liquidity" 12 times and "funding" 30 times. Could you set out some clear definitions of these concepts that laypeople could understand? Thanks.
The thing to keep in mind this would be the third/fourth section in a chapter that is showing up late in my book. Definitions should be done much earlier.
If I used "liquidity" as a stand-alone word, it was a mistake. There is no good definition. Only compound terms are useful.
Liquid asset - assets that one hopes that one could sell easily with little price impact. For our purposes here, these will be defined in regulations.
Liquidity portfolio: a portfolio of designated "liquid assets" that a bank holds. (Note that the bank might use its own definition of "liquid assets" when it is deciding what it wants to do.)
Liquidity ratio: a requirement in regulations to hold a certain amount of liquid assets as a percentage of demand deposits, etc. (In practice, there are multiple ratios.)
Liquidity drain: a cash outflow that normally results in the need to sell liquid assets in order to settle up with the payments system. Just a stylistic choice to use this.
Funding/financing: these are almost synonyms. In order to have assets, a financial firm needs matching liabilities/equity. Financing/funding refers to the emission of liabilities to match those assets. The difference between the terms in practice is that "financing" generally refers to the long-term balance sheet composition, e.g., "the purchase was financed with a mixture of bonds, money market instruments and new equity." Funding is usually reserved to short-term transactions in "funding markets": wholesale money markets, inter-bank markets, and eve derivatives (cross-currency swaps).
Why do banks compete for deposits? They are cheap funding/financing. You need to look at my example (in earlier articles): banks need to recharge their liquidity portfolio. The fact that loans create deposits explains why loanable funds is incorrect, but does not imply that a bank can ignore financing its balance sheet.
Hope you don't mind my input here. Loan deposits are bank liabilities because the actual deposit amount is being held by the bank as an Asset. And when the borrower draws down on the loan the drawdown is deducted from Assets. On average here in Australia about 60% of loan funding is derived from deposits.
A big consideration for banks is funding costs. This is guaged by the interest paid on deposits and the interest received on loans.
A banks profits will depend on the spread between cost of funding ( not just deposit funding)
and the loan interest rate returns.
This will determine the bank's profitability.
Liquidity is related to regulatory requirements of holding enough liquid (or money like assets) to meet any shocks that might occur in stressed financial markets. eg Bank run. See LCR.
This reply might be a bit mixed up because text kept going out of view and I could not edit.
As the borrower draws down the loan, why wouldn't that instead be *added* to assets, as a loan to a customer is of no use to a bank until the customer goes out and spends it on economic activity that will then provide a return to both the customer and its bank?
A loan is an asset since the customer has to pay it back, and pay interest on the loan. If the customer leaves the cash as a deposit, that’s even better. The bank want to make money, and doesn’t really care what the customer does with it (unless the loan was for a purchase that is collateral for the loan, in which case, they care about the collateral).
A line of credit is kept off balance sheet, and only shows up there when the customer draws on it. That is, it turns into loan at that point.
I see. The definition of "draw down." What I said was just a counterpoint to what she said, not a point in itself, though. But what she means by "draw down," I don't know, then. Thanks for answering our comments!
The reason banks give away swag is simply for promotional purposes. Banks make their money from making loans not taking deposits, and they figure that they’re more likely to loan money to existing customers.