Factors affecting the choice of non-deposit funding sources.
When deposits aren’t enough, banks knock on the doors of the money and capital markets. But choosing the right funding source is like picking the right topping: it depends on price, taste, shelf life, and how spicy it can get.
🧮 Key factors include:
- Cost: Cheapest is tempting, but not always best.
- Risk: Will this pepperoni make the pizza soggy later?
- Maturity: Do I need it for a quick meal or a banquet?
- Size: Can I handle jumbo-sized ingredients?
- Regulation: Are there rules on how much cheese I can use?
❓What’s the cheapest short-term source? Usually, Fed Funds — borrowed overnight from other banks.
But what if the cheese is cheap today and moldy tomorrow? That brings us to…
⚠️ II. RISKS OF EACH FUNDING SOURCE — THE PRICE OF PIZZA INSURANCE
Sure, Fed Funds are affordable, but their interest rate is like a teenager’s mood — changes every day. Commercial paper and CDs are less moody but cost more.
Banks also worry about:
- Credit Availability Risk: What if their usual vendor suddenly says, “No dough for you!”?
- Volatility: Like anchovies on pizza — some days spicy, other days meh.
❓How do banks sleep at night? They diversify — a bit of this, a bit of that, and they avoid indigestion.
⏳ III. MATURITY AND TIMING — DO YOU NEED A SNACK OR A FEAST?
Banks match the maturity of funds with the reason they need them.
- Need to cover daily expenses? Use Fed Funds.
- Planning to buy a building? Look for longer-term CDs or commercial paper.
Just like you wouldn’t buy a gallon of sauce for a midnight snack, banks don’t take 5-year loans for 5-day needs.
❓Is every bank eligible for all options? Not really. That leads us to…
🏦 IV. SIZE AND REGULATORY LIMITS — CAN SMALL BANKS HANDLE THE BIG TOYS?
Small banks may not be welcome at the big boy table:
- Negotiable CDs often come in \$1 million denominations.
- Secondary markets prefer prime-rated banks.
Also, regulators act like strict kitchen managers:
- Minimum CD maturity: 7 days.
- Reserve requirements: Surprise! You need to save sauce before spending it.
📊 V. COST OF FUNDS — THE BIG CALCULATION PARTY
Overall cost of funds uses both the historical average cost and the pooled-funds approach.
Let’s go full nerd with two methods:
🧮 Method 1: Historical Average Cost Approach
This is the looking-in-the-rearview mirror method.
Steps:
- Weighted average interest expense = total interest paid / total funds raised
$=$ $($24.75M$/$900M$)$ $=$ 2.75% - Breakeven Cost Rate
$=$ $($24.75M $+$ 11M$)$ $/$ 800M $=$ 4.47% - WACC — Weighted Average Cost of Capital
$=$ $4.47\% + \dfrac{12\%}{(1 – 0.2)} \times \dfrac{100}{800} = 6.35\%$
So, Orange Tree Bank must earn at least 6.35% on its assets just to break even after paying everyone — including shareholders who demand their slice of the pie.
🧮 Method 2: Pooled Funds Approach
This one’s forward-looking. The bank asks: “How much must I earn on every new dollar I raise?”
Example:
- Total raised: \$270M
- Investable: \$221M
- Expenses: \$22.6M
- Pooled Cost Rate = \$22.6M / \$270M = 8.37%
- Hurdle Rate = \$22.6M / \$221M = 10.23%
So Orange Tree Bank needs to earn 10.23% on each new dollar to cover future costs. If it earns less, it’s like burning the pizza.
🍕 Final Slice of Logic
We began by saying banks need extra toppings $($nondeposit funds$)$ when deposit dough runs thin.
We learned how choosing the right topping depends on price, expiry, portion size, and kitchen rules. Then we added math sauce — historical and pooled cost of funds — to measure if it’s worth the investment.
🧠 So what next?
Well, if costs rise and customer deposits shrink, how do banks protect themselves?
👉 That’s where liquidity buffers and funding diversification come into play.
And as always, in banking — just like cooking — the secret is balancing taste $($returns$)$ with caution $($risk$)$.