Banking used to be a pretty simple game. Take in deposits from some customers and loan the same money to other customers. And earn your profit on the difference.
The last 30 years have changed the game. Deposit gathering is now divorced from smart investing. If your deposits aren’t enough to fund your loans and investment portfolio, you can make up the shortfall on the wholesale market.
Why is this such a big deal?
Extra investments let the bank increase its risk and returns. If you are following solid risk management strategies (diversification and careful analysis of the risks in your portfolio), the bank is far safer than during the old days. The extra boost in risk lets the bank make more money, but still prevent meltdowns.
More important from a pricing perspective, balance level no longer must be a goal in itself. The deposit pricing committee can focus on optimal rates (high enough to keep balances around, low enough to increase profit margin) and let the treasurer ensure the bank is fully funded.
The bank doesn’t have to pay up for local balances. Of course, the rest comes at higher, wholesale rates. But the bank can keep its total costs lower than if the bank raised all the deposits locally.
The FDIC Banking Review comes through again. The Liability Structure of FDIC-Insured Institutions: Changes and Implications:
The study gives terrific information about the wholesale market. It outlines the major funding strategies and shows how important wholesale funds have become.
I would only disagree with the authors on the impact of the structural changes. I think the increased reliance on wholesale funds has a lot more to do with rate strategy than risk.
Hat tip: Steve Janaszak
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