Short-Term Funding Alternatives | CFA Level I

Welcome to our deep dive into Short-Term Funding Alternatives. Today, we’re unpacking everything from lines of credit to commercial paper issuance, and the specific funding dynamics for financial institutions. Let’s make complex concepts simple and approachable.

Understanding Internal vs. External Funding

At the heart of finance, every company faces the question: How do we fund our operations? There are two main avenues:

• Internal Funding: This includes generating cash from operations and managing assets efficiently—think optimizing receivables, payables, and inventory.
• External Funding: Here, we’re talking about borrowing from banks or tapping into the capital markets through instruments like commercial paper.

Zooming In on Short-Term External Financing

For today’s lesson, we’ll focus on the external short-term side of things. Businesses often rely on financial intermediaries (mainly banks) or issue commercial paper for quick funds. Let’s break down the key players:

Lines of Credit: The Business Lifeline

Think of lines of credit (LOC) as a financial safety net for companies, especially the large and financially stable ones. Banks offer various LOC types, each with its perks and considerations:

• Uncommitted Lines of Credit: They’re flexible but somewhat unreliable. Banks can withdraw the offer when you most need it.
• Committed Lines of Credit: Here, the bank promises to lend up to a specific amount. It’s more reliable but comes with a commitment fee.
• Revolving Lines of Credit: These are the gold standard—long-term, flexible, and for the financially elite. They come with commitment fees and sometimes, covenants.

Commercial Paper: An Alternative to Bank Loans

For large, creditworthy companies, issuing commercial paper is a cost-effective way to raise funds. It’s less expensive than bank loans and can be a strategic tool for managing longer-term financing needs through a series of rollovers. However, there’s always a rollover risk, mitigated by having a backup line of credit.

Funding Strategies for Financial Institutions

Banks and financial institutions have a unique set of tools at their disposal, including customer deposits, interbank funds, and certificates of deposit (CDs). Each serves a distinct purpose and offers varying levels of stability and flexibility:

• Customer Deposits: These are considered stable funding sources and include checking accounts and savings deposits.
• Certificates of Deposit: CDs can be either negotiable or non-negotiable, with maturities ranging from short to long-term. They play a critical role in a bank’s funding strategy.

Certificates of Deposit (CDs)

Banks also obtain funds from the wholesale market by issuing certificates of deposit (CDs). CDs are interest-bearing securities that mature on specific dates and are available in a range of short-term maturities. Most CDs have maturities shorter than one year and pay interest at maturity, while CDs with longer maturities are called “term CDs.” They can be issued in varying denominations, with large denomination CDs (typically $1 million or more) being an important funding source for banks. CDs can be either non-negotiable or negotiable:

• Non-negotiable CDs pay the deposit plus interest only to the initial depositor at maturity, with a withdrawal penalty for early withdrawal.
• Negotiable CDs can be sold, typically have maturities of one year or less, and are traded in domestic bond markets and the Eurobond market.

Yields on CDs are primarily driven by the credit risk of the issuing bank and, to a lesser extent, the term to maturity. Spreads widen during times of financial turmoil as a result of increased risk aversion.

Understanding Bank Regulations and Reserve Requirements

First off, it’s essential to grasp the foundational role of bank regulations and reserve requirements. Countries around the globe mandate banks to maintain a reserve balance with their national central bank. Why? This practice is a safety net designed to ensure that banks remain liquid enough to meet depositor withdrawals when demanded. It’s a financial buffer of sorts, guarding against unexpected cash outflows.

But what happens if a bank’s reserve falls short? Here’s where it gets interesting. Banks have two primary safety valves:

• Borrowing directly from the central bank: When reserves dwindle, banks can tap into the central bank’s funds to replenish their coffers.
• Borrowing from other banks: Alternatively, banks can borrow from peers with surplus reserves, ensuring they meet the minimum required threshold.

Central Bank Funds Market: A Closer Look

Moving onto the central bank funds market, a fascinating ecosystem where banks with excess liquidity lend to those in need. This market facilitates loans for durations up to one year, classified into:

• Overnight funds: Loans with a one-day maturity.
• Term funds: Loans extending from two days up to a year.

The interest rates for these loans, known as the central bank funds rates, play a pivotal role in the financial markets. These rates are market-driven but heavily influenced by central bank policies, such as open market operations. In the U.S., this rate is famously known as the Fed funds rate, a key benchmark that influences numerous short-term interest rates.

Interbank Funds: Bridging Banks Together

Shifting our focus to interbank funds, these are essentially loans made from one bank to another without collateral, spanning from one day to a year. The interbank market is crucial for maintaining liquidity and stability within the banking sector. However, it’s worth noting that liquidity can dry up during financial crises, showcasing the market’s vulnerability to systemic shocks.

Commercial Paper: Short-Term Financing Unveiled

Commercial paper (CP) represents another cornerstone of short-term bank financing. Predominantly issued by large financial institutions, CP caters to short-term funding needs, constituting around 60% of the annual CP issuance volume. Despite its benefits, it’s important to be aware of the rollover risk associated with CP, where the issuer faces challenges in refinancing the paper at maturity.

Furthermore, banks often issue Asset-backed Commercial Paper (ABCP), a secured variant of CP. In this arrangement, banks sell short-term assets to a Special Purpose Entity (SPE), which then issues ABCP to investors. This method provides off-balance-sheet financing, offering mutual benefits: banks enjoy liquidity and reduced capital costs, while investors access liquid, short-term notes backed by a diverse loan portfolio.

ABCP stands out by offering a secure investment option, where the SPE issues notes backed by a credit line from the issuing bank, ensuring that investors receive interest and principal payments funded by the asset cash flows.

Wrapping Up Short-Term Funding

As we conclude our exploration of short-term funding mechanisms within the banking sector, it’s clear that these strategies are vital for maintaining liquidity, ensuring operational continuity, and managing financial risks. From the intricate workings of the central bank funds market to the strategic issuance of commercial paper, banks employ a variety of tools to navigate the complex financial landscape.