Short-Term Funding for Banks

Short-Term Funding for Banks: A Comprehensive Guide | CFA Level I Fixed Income

In this lesson, we will discuss the various short-term funding alternatives available to banks. We’ll cover retail deposits, certificates of deposit, reserve funds, interbank funds, and repurchase agreements (repos).

Retail Deposits

As you might know from personal experience, banks hold deposits from individuals and commercial depositors. These are known as retail deposits. There are several types of retail deposit accounts:

  • Checking accounts offer high transactional convenience and immediate availability of funds but typically pay no interest.
  • Savings accounts provide lower transactional convenience but do pay interest.
  • Money market accounts were designed to compete with money market mutual funds. They offer an intermediate level of transactional convenience and money market rates of return.

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.

Reserve Funds

Many countries require banks to place a reserve balance with the national central bank to ensure sufficient liquidity for depositors’ withdrawals. Banks can borrow from the central bank’s reserve funds or other banks’ reserve balances if they fall short. These borrowed funds, known as central bank funds, can have maturities up to one year. They are called “overnight funds” for one-day maturities and “term funds” for maturities between two days and one year.

The interest rates at which central bank funds are bought and sold are called central bank funds rates, which are determined by the market but influenced by the central bank’s open market operations. In the United States, this rate is called the Fed funds rate.

Interbank Funds

Funds loaned between banks for periods of one day to a year are called interbank funds. These loans are unsecured, and their liquidity may decrease severely during times of systemic financial distress.

Repurchase Agreements (Repos)

Repurchase agreements, or repos, are important funding sources for banks and other market participants. A repo is an arrangement in which one party sells a security to a counterparty with a commitment to buy it back at a later date at a specified price. In effect, the buyer is lending funds to the seller with the security as collateral.

On the repurchase date, the borrower (the seller) pays the lender the repurchase price to get back the collateral security. Repos can be classified as:

  • Overnight repos – for one-day maturities.
  • Term repos – for maturities longer than one day.

The interest rate implied in a repo is called the repo rate, which is the annualized percentage difference between the repurchase and selling prices.

Repo rate = Repurchase price / Selling price – 1

Repos are popular because their interest cost is usually lower than the rate on bank loans or other short-term borrowing.


A firm named Borrower enters into a repo agreement to sell a 5%, 10-year bond with a par value of $1 million. The bond has a current market value of $950,000. The bond is sold at $920,000 and repurchased 180 days later for $932,000. The holding period yield for the 180-day loan period is 1.3%, and the repo rate would be expressed as the equivalent annual rate, which is 2.63%.

Repo Margin (Haircut)

Repos carry credit risk for the lender, as the borrower may default by failing to repurchase the collateral. The lender can take possession of the collateral, but its market value may have fallen, resulting in a loss. To mitigate this risk, a repo margin (haircut) is applied to the collateral, providing the lender with a margin of safety.

Factors Affecting Repo Rate and Repo Margin

Some factors that affect the repo rate and repo margin include:

  • Length of the repurchase agreement – longer terms have higher rates and margins.
  • Credit quality of the collateral – higher quality leads to lower rates and margins.
  • Delivery of collateral – if collateral is delivered, the repo rate is lower.
  • Alternative interest rates – if alternative rates are high, the repo rate is likely to be high as well.
  • Creditworthiness of the counterparty – higher creditworthiness leads to lower repo margins.

Reverse Repurchase Agreement

A reverse repurchase agreement is essentially the same as a repurchase agreement but viewed from the lender’s standpoint. The lender lends cash by buying the collateral security and then sells it back on the repurchase date, earning interest in the process. Whether a transaction is labeled as a repurchase agreement or a reverse repurchase agreement depends on one’s point of view.

In conclusion, short-term funding options for banks include retail deposits, certificates of deposit, reserve funds, interbank funds, and repurchase agreements. These funding sources help banks maintain liquidity and meet their financing needs. In the next topic, we will move on to the valuation of fixed income securities.

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