25556 Chap.6 Intermediation and Bank Funding
Intermediation and Bank Funding
Topic 3 turns to the indirect route, where authorised deposit-taking institutions collect savings and relend them. The chapter explains what a bank does for both sides of that arrangement: it turns small, short, low-risk deposits into large, long, riskier loans, and it is paid through its interest margin and fees.
You will also meet APRA's five subgroups of ADIs, from the big four to purchased payment facility providers.
The second half reads the liability side of a bank balance sheet. Retail deposits became the dominant source after the global financial crisis, so the chapter covers why they are trusted, how compound interest and effective rates work on them, and how to compare products that compound at different frequencies.
It then covers wholesale funding through negotiable certificates of deposit, offshore commercial paper and bonds, and why equity matters to depositors.
What this chapter covers
- 01
Intermediation and the four transformations
- 02
APRA's subgroups of authorised deposit-taking institutions
- 03
Maturity mismatch, liquidity risk and funding risk
- 04
Net interest income and the interest margin
- 05
Retail deposits, compounding and effective rates
- 06
NCDs, bonds and equity as bank funding
Worked example · free
Read a credit union's balance sheet for funding mix and maturity mismatch
- 1Totals: assets are 40 + 300 + 60 = $400m, matching funding of 250 + 70 + 30 + 20 + 30 = $400m.
- 1Funding mix: retail deposits (250 + 70) ÷ 400 = 80%; financial markets, NCDs plus bonds, (30 + 20) ÷ 400 = 12.5%; equity 30 ÷ 400 = 7.5%.
- 1Liquidity buffer: liquid securities are 40 ÷ 400 = 10% of assets, against $360m of loans lent for long terms.
- 1Risks: $250m can be withdrawn on demand while loans run for years, which is liquidity risk; the $50m of NCDs and bonds must be rolled over, which is funding risk.
Key terms
- Authorised deposit-taking institution
- A financial institution licensed by APRA to carry on banking business, including banks, credit unions and building societies.
- Net interest income
- Interest earned on a bank's assets minus interest paid on its liabilities.
- Liquidity risk
- The danger that a bank lacks the cash to meet depositors' withdrawals when they fall due.
- Funding risk
- Exposure to being unable to replace maturing borrowings with new funds.
- Effective interest rate
- The annual growth rate actually earned once compounding within the year is taken into account.
Intermediation and Bank Funding FAQ
What does a bank transform when it intermediates?
It pools many small deposits into a few large loans, lends money that savers can reclaim quickly for long periods, the credit risk of borrowers into a risk depositors will accept, and the returns depositors want into borrowing costs borrowers will pay. These four transformations are the benefit of intermediation; the interest margin and fees are its cost.
Why did banks rely more on deposits after the global financial crisis?
The crisis began in the financial markets that banks had relied on before it, so those markets proved unreliable. Banks shifted towards domestic retail deposits, which were seen as a steadier source, and paid higher rates to attract them. By mid 2022 deposits supplied about 60% of bank funding and markets about 28%.
How do you compare deposit rates with different compounding?
Convert each quoted nominal rate to an effective annual rate using one plus the rate per period, raised to the number of periods in a year, minus one. The product with the higher effective rate earns more, even if its quoted rate is lower, because more frequent compounding adds interest on interest.
What is a negotiable certificate of deposit?
It is a wholesale deposit, usually five million dollars or more, placed with a bank for a fixed term at an agreed rate. It works like a promissory note: the deposit cannot be withdrawn early, but the holder can sell it in the money market, and the bank pays its face value to whoever holds it at maturity.
Why do major banks find offshore borrowing easier than smaller banks?
They carry higher credit ratings, may be regarded as too big to fail, and borrow in large amounts that spread the fixed costs of issuing. Together these give them cheaper and more reliable access to overseas markets, a funding advantage over smaller domestic competitors.
Exam move
Sketch a bank balance sheet from memory with funding on one side and uses of funds on the other, then mark which items are short-term and which long-term so the maturity mismatch is visible. Practise converting nominal rates to effective rates for monthly, quarterly and daily compounding, and the reverse step of finding a nominal rate from an effective one. Compute an NCD face value at least twice with the 365-day convention.
Finally, explain in two sentences each why deposits became the main funding source after the crisis and why the major banks hold a funding edge offshore.
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