Question

How are commercial banks are funded?

Answer 1

Short answer: commercial banks are funded mainly by customer deposits and by borrowing in wholesale markets, with equity/retained earnings providing the capital cushion. They also use secured funding, securitisation and central‑bank facilities. Below is a concise breakdown.

Main funding sources
- Customer deposits (the largest and most stable source)
- Demand/checking accounts, savings accounts, and time deposits (CDs). Retail and small‑business deposits tend to be the cheapest and most stable funding.
- Wholesale/market funding
- Interbank loans and deposits (overnight and short term).
- Repurchase agreements (repos) — collateralised short‑term borrowing.
- Commercial paper and certificates of deposit (short‑term unsecured instruments).
- Senior unsecured bonds and long‑term debt issued to investors.
- Covered bonds (bond secured by a pool of mortgages or loans).
- Securitisation and asset sales
- Banks package loans (e.g., mortgages) into securities and sell them to investors, converting loans into immediate funding.
- Equity and retained earnings (capital)
- Shareholder equity and accumulated profits provide the loss-absorbing buffer; not a funding source for day‑to‑day lending but essential for regulatory capital ratios.
- Central bank and official facilities
- Discount window or other central‑bank lending (often collateralised) — lender of last resort.
- Other sources
- Subordinated debt (counts toward regulatory capital components like Tier 2).
- Lines of credit from other financial institutions and parent company funding (for bank groups).

Key concepts and risks
- Funding vs capital: “Funding” is borrowed money used to run the bank; “capital” (equity/retained earnings) absorbs losses and supports lending capacity.
- Maturity transformation: banks borrow short (deposits, overnight markets) and lend long (mortgages, corporate loans), creating liquidity and interest‑rate risk.
- Liquidity and funding risk: reliance on short‑term or concentrated wholesale funding can cause runs or stress (seen in 2007–09 crisis). Regulators require liquidity buffers and stable funding (LCR, NSFR).
- Diversification and management: banks diversify instruments, maturities and investor bases; maintain high‑quality liquid assets and contingency lines to handle stress.

Proportions and practice
- Retail deposits often remain the core funding for most commercial banks; large banks also make extensive use of capital markets and securitisation. Exact mixes vary by size, business model and jurisdiction.

If you want, I can show a simplified funding mix for a typical retail bank versus an investment bank, or explain how regulatory ratios (CET1, LCR, NSFR) affect funding choices.