When Wholesale Funding Goes Wrong

Wholesale funding is a viable base for a business model in certain interest rate and credit market environments.

However, it can become risky if the slope of the yield curve changes. And if credit markets seize up, meaning credit becomes less available and borrowing costs rise, problems can also arise for institutions. If both conditions change at the same time, watch out.

This article reviews some basics of wholesale funding, the ideal interest rate and credit markets necessary to use wholesale funding profitably, and the dangers that can result from changes in interest rates and a credit crunch.

Key Takeaways

• Wholesale funding is a financing model that uses a variety of commercial credit markets, including federal funds and brokered deposits by lenders.
• It can expand a bank’s funding sources beyond the use of its core deposits.
• While helpful in many cases, wholesale funding can be more expensive than traditional funding sources and has risks.
• Successful wholesale funding depends on a positive spread between borrowing and lending rates.
• An inverted yield curve can mean trouble for those engaged in wholesale funding.

What Is Wholesale Funding?

Wholesale funding refers to alternate funding sources for institutional borrowers. It is a catch-all term that mainly refers to federal funds, foreign deposits, and brokered deposits. Some people also include borrowings in the public debt market in the wholesale funding definition.

Wholesale funding differs from the customary source of funding that, say, a commercial bank uses. Traditionally, banks use core demand deposits for funds due to their availability and the fact that they are an inexpensive source of financing.

Deposits represent a liability for the banks. Those deposits are lent out and become income-producing assets.

Reasons for Wholesale Funding

Financial institutions may turn to wholesale funding because:

• They need more funding to support their business activities, such as lending.
• They seek to diversify beyond bank deposits to avoid the risks of deposit withdrawals during times of economic volatility or crisis.
• Additional money from wholesale funding can help them manage liquidity risks.
• Quick access to extra funds can help them meet regulatory rules relating to capital reserves.
• Wholesale funding offers flexibility when managing lending risks.

Users of Wholesale Funding

Banks and commercial finance companies are users of wholesale funding.

Such funding can be an alternative source of funds for banks, but commercial finance companies especially rely on this kind of funding. 

Both of these types of financial institutions are regulated differently and sometimes compete for the same business.

Commercial Finance Companies vs. Banks

Commercial finance companies provide only business loans, as opposed to banks which provide both business and consumer loans.

Therefore, their primary customers are small- to medium-sized businesses that borrow to purchase inventory and equipment.

Commercial finance companies also provide value-added services, such as consulting options and sales of receivables.

They are not banks and can be a higher-cost borrowing choice for the small business owner. This is because they are less conservative than traditional banks and more willing to make riskier loans.

And as they are not banks, they are subject to less regulation and can assume more risk, which can be a double-edged sword in times of economic turbulence.

Important

Federal Home Loan Bank (FHLB) advances are a common wholesale funding option. They’re used if a bank is undercapitalized and therefore barred from accepting brokered deposits. In addition, they aren’t regulated and funding can be available immediately.

Forms of Wholesale Funding

If core deposits are such a cheap source of financing, why would anyone use wholesale funding?

As noted above for banks, wholesale funding represents a way to expand or to satisfy funding needs. Furthermore, banks at times may have trouble attracting new deposits due to interest rates that are too low.

Whatever the reason, banks may look to wholesale funding. Such funding can take different forms, but a popular option for banks is brokered deposits.

Brokered Deposits

These deposits are made by a broker who takes their wealthy clients’ money and finds several different banks in which to deposit it. This is usually done so that those clients receive FDIC insurance (and hopefully a more attractive rate of return).

If these wealthy clients deposited all of their money into one bank, it might exceed FDIC insurance limits. So brokers break up their cash holdings among different banks so that all of their deposits are insured against a bank failure.

Public Debt Markets

Commercial finance companies don’t have the depositor base from which to draw funds. Therefore, they need to tap the public debt markets to capitalize themselves. Then, these funds are lent out to small business clients at a higher rate.

Looking at this business model, it becomes apparent that it’s important for a commercial finance company to have the highest credit rating possible, so it can issue debt at the lowest coupon rate possible.

How Wholesale Funding Can Be Profitable

A positive spread between rates for borrowing funds and rates for lending them out is needed in order for wholesale funding to work and be profitable.

A commercial finance company may experience liquidity problems when sources of wholesale funding dry up, or the borrowing terms may become so onerous they are not profitable.

Your cost of funds should be lower than the yield you earn on your assets (loans). Any other scenario is unprofitable and not sustainable.

To achieve a positive spread, it is first necessary to have an upward sloping yield curve, on which yields run from low to high, short-term to long-term.

An inverted yield curve—one on which short-term rates are higher than long-term rates—means a company borrows at a higher rate than it earns. That’s a negative spread. This is not profitable and leads to problems for banks and commercial finance companies.

A flat yield curve is also a problem because, again, it does not allow for the aforementioned positive spread scenario.

As the shape of the yield curve changes during the full business cycle, one can see the tangible impacts on net income for banks and finance companies.

When the yield curve is upward sloping, bank and commercial finance profitability is good. When it is inverted, profitability suffers. When it is in between or flattening, profitability is muted for banks.

For commercial finance companies, a flat yield curve can be unprofitable, because their source of funding is not the low-cost demand deposits that banks have access to, but higher cost sources of borrowed funds such as those from the unsecured debt markets.

How Wholesale Funding Can Go Wrong

Under the right conditions, wholesale funding provides banks and finance companies additional sources of financing for operations and investment opportunities.

Commercial finance companies can be profitable for many years and through several business cycles using wholesale funding.

But what happens when there is a credit crunch, and the debt markets essentially shut-down? Or when short-term borrowing rates (as represented by a benchmark such as the fed funds rate or SOFR) soar due to financial uncertainty?

Each situation is troublesome. Both create a toxic combination that can bring a commercial finance company to the brink of bankruptcy and cause problems for banks.

If an institution’s wholesale funding slows or ends, it could face liquidity problems. Short-term creditors could refuse to extend its debt. It might be forced to liquidate assets.

Depending on how interest rates fluctuate, these borrowers may find themselves paying more for their short-term funding than they earn on their lending.

The funding spigot can turn off quickly if an institution is perceived to be a credit risk. That can be a severe problem when it needs that funding for its ongoing operations and financial management.

Bank regulators can also prohibit brokered deposits if a bank is undercapitalized. A bank in this situation is teetering on the edge.

What Is Wholesale Funding?

It is business funding that comes from large institutions and sometimes well-to-do individual investors. Sources of wholesale funding differ from traditional sources of funding such as a bank’s core deposits and equity.

Is Credit Risk a Greater Factor for Finance Companies Than for Banks?

Credit risk is a factor taken into account for any borrower. However, finance companies don’t have the large depositor base that banks usually have. So, credit risk can play a prominent role in higher borrowing costs.

How Does the Federal Reserve Define Wholesale Funding for Banks?

According to the Fed, wholesale funding is “the sum of brokered deposits under $250,000, federal funds purchased, securities sold under agreement to repurchase, subordinated notes and debentures, and other borrowed money.”

The Bottom Line

Wholesale funding is useful for banks and finance companies that seek sources of funds beyond those they traditionally turn to.

However, wholesale funding has its risks. Banks can face severe liquidity risks if short-term funding dries up. They may be forced to sell assets.

Finance companies seen as deteriorating and risky will have to pay more for funding, and this will squeeze margins.

If an economic tsunami hits and skyrocketing short-term rates and a credit crunch last for an extended period of time, banks and finance companies may suffer greatly and even face the prospect of bankruptcy.