UNIT 3: COMMERCIAL BANK SOURCES OF FUNDS

3.1. INTRODUCTION

Commercial banks represent the most important financial intermediary when measured by total

assets. Like other financial intermediaries, they perform a critical function of facilitating the flow

of funds from surplus units to deficit units.

3.2. BANK SOURCES OF FUNDS

The major sources of commercial bank funds are summarized follows:

A. Deposit Accounts

1. Transaction Deposits

2. Savings Deposits

3. Time Deposits

4. Money Market Deposit Accounts

B. Borrowed funds

1. Federal Funds Purchased (Borrowed)

2. Borrowing from The Federal Reserve Banks

3. Repurchase Agreements

4. Eurodollar Borrowings

C. Long-term Sources of Funds

1. Bonds Issued by the Bank

2. Bank Capital

A. DEPOSIT ACCOUNTS

1. Transaction Deposits
The demand deposit account, or checking account, is offered to customers who desire to write

checks against their account. The conventional type of demand deposit account requires a small

minimum, balance and pays no interest. From the bank’s perspective, demand deposit accounts

are classified as transaction accounts that provide source of funds that can be used until

withdrawn by customers (as checks are written).

Another type of transaction deposit is the negotiable order of withdrawal (NOW) account, which

provides checking services as well as interest. As of 1981, commercial banks and other

depository institutions throughout the entire country were given the authority to offer them.

Because NOW accounts at most financial institutions require a minimum balance beyond what

some consumers are willing to maintain in a transaction account, the traditional demand deposit

account is still popular.

2. Savings Deposits
The traditional savings account is the passbook savings account, which does not permit check

writing. Until 1986, Regulation Q restricted the interest rate banks could offer on passbook

savings with the intent of preventing excessive competition that could cause bank failures.

Actually, the ceilings prevented commercial banks from competing for funds during periods of

higher interest rates. In 1986, Regulation Q was eliminated. The passbook savings account

continues to attract savers with a small amount of funds, as it often has no required minimum

balance. Although it legally requires a 30-day written notice by customers to with draw funds,

most banks will allow withdrawals from these accounts on a moment’s notice.

Another savings account is the automatic transfer service (ATS) account, created in November

1978. It allows customers to maintain an interest-bearing savings account that automatically

transfers funds to their checking account when checks are written. Only the amount of funds

needed is transferred to the checking account. Thus, the ATS provides interest and check-writing

ability to customers. Some ATS accounts were eliminated when the NOW accounts were

established.
 3. Time Deposits
A common type of time deposit known as a retail certificate of deposit (or retail CD) requires a

specified minimum amount of funds to be deposited for a specified period of time. Banks offer a

wide variety of CDs to satisfy depositors’ needs. Annualized interest rates offered on CDs vary

among banks, and even among maturity types within a single bank. An organized secondary

market for retail CDs does not exist. Depositors must leave their funds in the bank until the

specified maturity or they will normally forgo a portion of their interest as a penalty.

The interest rates on retail CDs have historically been fixed. However, more exotic retail CDs

has been offered in recent years. There are bull-market CDs that reward depositors if the market

performs well and bear-market CDs that reward depositors if the market performs well and bear-

market CDs that reward depositors if the market performs poorly. These new types of retail CDs

typically have a minimum deposit insurance (assuming that the depository institution of concern

is insured).

Another type of time deposit is the negotiable CD (NCD), offered by some large banks to

corporations. NCDs are similar to retail CDs in that they require a specified maturity date and a

minimum deposit requirement is $100,000 a secondary market for NCDs does exist.

The level of large time deposits is much more volatile than that of small time deposits, because

investors with large sums of money frequently shift their funds to wherever they can earn higher

rates. Small investors do not have as many options as large investors and are less likely to shift in

and out of small time deposits.

The deposit size distribution among banks is shown in Exhibit 16.1. Notice that 12.4 percent of

all deposits are in banks that have less than $100 million in deposits. At the other extreme, 14.6

percent of all deposits are in banks that have more than $50 billion in deposits. The remaining 73
percent of deposits are in banks that have deposits ranging from $100 million to more than $50

billion.

4. Money Market Deposit Accounts

Germaine Act of December 1982. It differs from conventional time deposits in that it does not

specify a maturity. MMDAs are more liquid than retail CDs from the depositor’s point of view.

Because banks would prefer to know how long they will have use of a depositor’s funds, they

normally pay a higher interest rate on CDs. MMDAs differ from NOW accounts in that they

have limited check-writing ability (they allow only a limited number of transactions per month ),

require a larger minimum balance, and offer a higher yield.

The remaining sources of funds to be described are of a no depository nature. Such sources are

necessary when a bank temporarily needs more funds than are being deposited. Some banks use

no depository funds as a permanent source of funds.

B. BORROWED FUNDS
1. Federal Funds Purchased

The federal funds market allows depository institutions to accommodate the short-term liquidity

needs of other financial institutions. Federal funds purchased (or borrowed) represent a liability

to the borrowing bank and an asset to the lending bank that sells them. Loans in the federal funds

market are typically for one to seven days. Such loans can be rolled over so that a series of one-

day loans could take place. Yet, the intent of federal funds transactions is to correct short-term

fund imbalances experienced by banks. A bank may act as a lender of federal funds on one day

and as a borrower shortly thereafter, as its fund balance changes on daily basis.

The interest rate charged in the federal funds market is called the federal funds rate. Like other

market interest rates, it moves in reaction to changes in the demand or the supply or both. If

many banks have excess funds and few banks are short of funds, the federal funds relative to a
small supply of excess funds available at other banks will result in a higher federal funds rate.

Whatever rate ket, although a financially troubled bank may have to pay a higher rate to obtain

federal funds (to compensate for its higher risk). The federal funds rate is quoted in multiples of

one-sixteenth, on an annualized basis (using a 360-day year). Exhibit 16.2 shows that the federal

fund rate is generally between 25 percent and 1.00 percent above the treasury bill rate. The

difference normally measures when the perceived risk of banks increases.

The federal funds market is typically most active on Wednesday, because it is the final day of

each particular settlement period for which each bank must maintain a specified volume of

reserves required by the Fed. Those banks that were short of required reserves on the average

over the period must compensate with additional required reserves before the settlement period

ends. Large banks frequently need temporary funds and therefore are common borrowers in the

federal funds market.

2. Borrowing from the Federal Reserve banks

U.S. central bank. Along with other bank regulators, the Federal Reserve district banks regulate

certain activities of banks yet, they will also provide short-term loans to banks (as well as to

some other depository institutions). This form of borrowing by banks is often referred to as

borrowing at the discount window. The interest rate charged on these loans is known as the

discount rate.

Loans from the discount window are short term, commonly from one day to a few weeks. Banks

that wish to borrow at the discount window must first be approved by the Fed before a loan is

granted. This is intended to make sure that the bank’s need for funds is justified. Like the federal

funds market, the discount window is mainly used to resolve a temporary shortage of funds. If a

bank needed more permanent sources of funds, it would develop a strategy to increase its level of

deposits.
When a bank needs temporary funds, it must decide whether borrowing through the discount

window is more feasible than alternative no depository sources of funds, such as the federal

funds market. The federal funds rate is more volatile than the discount rate because it is market

determined, as it adjusts to demand and supply conditions on a daily basis. Conversely, the

discount rate is set by the Federal Reserve and adjusted only periodically to keep it in line with

other market rates (such as the federal funds rate).

Banks commonly borrow in the federal funds market rather than through the discount window,

even though the federal funds rate typically exceeds the discount rate. This is because the Fed

offers the discount window as a source of funds for banks that experience unanticipated

shortages of reserves. If a bank frequently borrows to offset reserve shortages, these shortages

should have been anticipated. Such frequent borrowing implies that the commercial bank has a

permanent rather than a temporary need for funds and should therefore satisfy this need with

rater than a temporary need for funds and should therefore satisfy this need with a more

permanent source of funds. The Fed may disapprove of continuous borrowing by a bank unless

there were extenuating circumstances, such as if the bank was experiencing financial problems

and could not obtain temporary financing from other financial institution.

3. Repurchase Agreements
A repurchase agreement (repo) represents the sale of securities by one party to another with an

agreement to repurchase the securities at a specified date and price. Banks often use a repo as a

source of funds when they expect to need funds for just a few days. They would simply sell some

of their government securities (such as their Treasury bills) to a corporation with a temporary

excess of funds and buy those securities back shortly thereafter. The government securities

involved in the repo transaction serve as collateral for the corporation providing funds to the

bank.
Repurchase agreement transactions occur through a telecommunications network connecting

large banks, other corporations, government securities dealers, and federal funds (wish to sell

and later repurchase their securities) with those who have excess funds (are willing to purchase

securities now and sell them back on a specified date.) transactions are typically in blocks of $1

million. Like the federal funds rate, the yield on repurchase agreements is quoted in multiples of

one-sixteenth on an annualized basis (using a 360-day year). The yield on repurchase agreements

is slightly less than the federal funds rate at any given point in time, because the funds loaned out

are backed by collateral and are therefore less risky.

4. Eurodollar Borrowings
If a U.S. bank is in need of short-term funds, it may borrow dollars from those banks outside the

United States that accept dollar-denominated deposits, or Eurodollars. Some of these so-called

Euro banks are foreign banks or foreign branches of U.S. banks that participate in the Eurodollar

market by accepting large short-term deposits and making short-term loans in dollars. Because

U.S. dollars are widely used as an international medium of exchange, the Eurodollar market is

very active. Some U.S. banks commonly obtain short-term funds from Euro banks.

C. LONG-TERM SOURCES OF FUNDS

These assets often have an expected life of 20 years or more and are usually financed with long-

term sources of funds, such as through the issuance of bonds. Common purchasers of such bonds

are households and various financial institutions, including life insurance companies and pension

funds. Banks do not finance with bonds as much as most other corporations, because their fixed

assets are less than those of corporations that use industrial equipment and machinery for

production. Therefore, they have less of a need for long-term funds.

Bank capital generally represents funds attained through the issuance of stock or through

retaining earnings. Either form has no obligation to pay out funds in the future. This

distinguishes bank capital from all the other bank sources of funds that represent a future

obligation by the bank to pay out funds. Bank capital as defined here represents the equity or-net

worth of the bank. Capital can be classified into primary or secondary types. Primary capital

results from issuing common or preferred stock or retaining earnings, while secondary capital

results from issuing subordinated notes and debentures.

A bank’s capital must be sufficient to absorb operating losses in the event that expenses or losses

have exceeded revenues, regardless of the reason for the losses. Although long-term bonds are

sometimes considered as secondary capital, they are a liability to the bank and therefore do not

appropriately cushion against operating losses.

When banks issue new stock, they dilute the ownership of the bank because the proportion of the

bank owned by existing shareholders decreases. In addition, the bank’s reported earnings per

share are reduced when additional shares of stock are issued, unless earnings increase by a

greater proportion than the increase in outstanding shares. For these reasons, banks generally

attempt to avoid issuing new stock unless absolutely necessary.

Bank regulators are concerned that banks may maintain a lower level of capital than they should

and have therefore imposed capital requirements on them. Because capital can absorb losses, a

higher level of capital is thought to enhance the bank’s safety and many increase the public’s

confidence in the banking system. In 1981 regulators imposed a minimum primary capital

requirement of 5.5 % of total assets and a minimum total capital requirement of 6 percent of total

assets. Because of regulatory pressure, banks have increased their capital ratios in recent years.
In 1988, regulators imposed risk-based new capital requirements that were completely phased in

by 1992, in which the required level of capital for each bank was dependent on its risk. Assets

with low risk were assigned relatively low weights, while assets with high risk were assigned

high weights. The capital level was set as a percentage of the risk-weighted assets. Therefore,

riskier banks were subject to higher capital requirements. The same risk-based capital guidelines

were imposed in several industrialized countries. Additional details are provided in the following

chapter.