Hey there, my banking besties! Today, let’s delve into the world of banking and explore the fascinating topic of funding for different types of financial institutions. Whether you’re a small community bank or a big Wall Street player, how you fund yourself makes a big difference. So, grab your favorite cup of coffee and let’s get started!
Small Banks: Deposits and Home Loan Banks
For little banks with total assets below a billion dollars (which happens to be the majority of the industry), the main source of funding comes from deposits. Think checking accounts and small business deposits. These banks also have the option to finance their mortgages through the Federal Home Loan Banks. This arrangement works like a repurchase agreement: the bank sells the mortgage to the Home Loan Bank and gets funding in return. They can then use that money to issue more mortgages or sell them to other entities like Fannie Mae or Freddie Mac. It’s all about production and manufacturing assets in this case.
Big Banks: Wall Street Funding
Now, let’s shift our attention to the bigger banks like JP Morgan and Goldman Sachs. These heavy hitters have a much more diverse range of funding sources. Surprisingly, most of their funding doesn’t come from deposits. For example, JP Morgan’s funding is about 50% deposits while Goldman Sachs relies on deposits for only around 15% of its funding. Why the difference? Well, Goldman Sachs is primarily an investment bank and they’re trying to build up their banking side. On the other hand, banks like Key or US Bank still rely heavily on deposits for about 70% to 80% of their funding. These “universal banks” have to rely on the street for their funding needs every day.
Smaller Banks: Slow and Steady
Smaller banks, with total assets below 100 billion, have a different funding dynamic. They primarily rely on deposits and don’t have the Wall Street operations that bigger banks do. These banks focus on lending and taking deposits, with perhaps an off-balance sheet trust department thrown into the mix. Since their rates are determined by Main Street, they tend to move slower when it comes to rising funding costs compared to the larger banks. Growth for these banks is based on their recurring funding from customers, like mortgage payments and payrolls.
Preferred Bank Funding: The Chain of Borrowing
For non-banks that need to borrow money, they often turn to big banks as their primary source of funding. Smaller community banks also play a role, but big banks dominate the money market side of the game. While smaller banks may lend to non-banks, they typically lend to customers they know and trust. Limited sources other than big banks pose a challenge for non-banks in search of funding.
The Fed’s Influence and Funding Costs
Let’s take a trip down memory lane to the aftermath of the Financial Crisis. To protect banks during that difficult time, the Federal Reserve significantly reduced the cost of funding for the banking industry. They did this to help banks finance their losses from bad loans. This deliberate reduction in funding costs had a profound impact: the cost of funds for the industry dropped by about 90%. Instead of the usual $100 billion per quarter, it cost around $11 billion to finance $15 trillion in assets. However, this approach effectively transferred money from savers to equity holders of banks. Nowadays, banks allocate more cash flow to equity holders instead of depositors and bondholders.
The Cost of Funds and the Competitive Market
Fast forward to today, and we find banks facing challenges in terms of funding costs and the highly competitive market. While funding costs have been on the rise in recent years, banks are also competing with other financial entities for both funding and lending opportunities. Pension funds, private equity funds, and other institutions are all vying for the same assets, putting pressure on banks to remain competitive. This competition, coupled with increasing funding costs, makes it difficult for banks to generate additional revenue from lending. Pricing power becomes a critical issue, especially for larger banks, as they struggle to differentiate themselves from other players in the market.
The Changing Landscape and Profitability
Commercial lending, particularly in specific areas like real estate, has become highly competitive for banks. Larger banks face stiff competition from insurance companies, pension funds, and private equity firms for the most profitable commercial lending opportunities. Citibank and Capital One, on the other hand, have found success in consumer-focused businesses like credit cards. However, as non-banks and investors venture into areas like auto lending, banks are more cautious about taking on residential mortgages due to the associated risks. Profitability for banks depends heavily on focusing on their most lucrative categories, with commercial lending often bringing in the highest returns.
The Fed’s Balancing Act
Interest rates and the yield curve often create speculation about market trends and the possibility of a looming recession. However, the dynamics have shifted, especially with the global demand for US Treasuries. While interest rate movements may indicate certain market behaviors, such as a recession, it’s essential to understand that the factors affecting the economy and financial institutions have changed. The interconnectedness of global markets and the demand for US debt can distort the traditional signals derived from interest rates.
Regulation and the Banking Landscape
Regulation plays a crucial role in shaping the banking industry, but sometimes there can be too much of a good thing. Inconsistent regulations from different agencies can create blockages and hinder overall growth. To foster growth, there needs to be better coordination and a holistic perspective among regulators. For example, restrictions on construction lending have impacted the housing market despite the demand for more homes. It’s crucial to strike a balance and tune regulations so that they don’t unnecessarily impede economic progress.
The Future of Banking: Slow Growth and Pricing Concerns
Looking ahead, we can expect slow growth in terms of top-line revenue for banks. Funding costs will remain a concern, gradually increasing but not skyrocketing. The capital markets side, especially for big banks like Goldman Sachs and Morgan Stanley, will likely be choppy with limited visibility and deal flow. On the other hand, consumer-focused banks such as Citi and Capital One have a higher chance of outperforming their peers due to their profitability in consumer-oriented businesses. Smaller banks also present opportunities, but investors must consider their tolerance for potential liquidity challenges.
Phew! That was quite a journey through the world of banking and funding. Remember, my dear besties, the banking landscape is ever-evolving, and understanding the nuances of funding is crucial for both financial institutions and savvy investors like yourselves. Stay curious, stay informed, and keep rocking the banking world!
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