When wholesale funding goes bad

The wholesale financing model is a viable basis for a business model under a specific interest rate and credit market environment. However, if the shape or slope of the yield curve changes, its profits may decrease. This can also cause problems if the credit market stagnates. If these two conditions change at the same time, please pay attention.

This article will describe the ideal interest rates and credit markets required to make profits using wholesale funds, who uses wholesale funds, and explore how long-term hypothetical collapses can hurt commercial finance companies and push them to the brink of bankruptcy.

Key points

  • Wholesale financing is a financing model that utilizes various commercial credit markets, including federal funds and lenders’ brokerage deposits.
  • Wholesale financing can expand the needs of financial companies beyond the use of core deposits.
  • Although helpful in many situations, wholesale financing can be more expensive than traditional routes and comes with unique risks and considerations.

What is wholesale funding?

Wholesale funds are different from the traditional sources of funds used by commercial banks. Traditionally, banks have used core demand deposits as a source of funding, which is a cheap source of financing. Deposits represent the liabilities of banks. These deposits are lent out and become income-generating assets.

Wholesale funding is an “all-encompassing” term, but mainly refers to federal funds, foreign deposits and brokerage deposits. Some also include public debt market borrowing in the definition.

Who uses wholesale funds?

Both traditional banks and commercial financial companies can become users of wholesale financing. Banks can use wholesale funding as an alternative, but commercial financial companies are particularly dependent on this source of funding. The two have different regulations and sometimes compete for the same business.

Commercial finance companies only provide commercial loans, not banks that provide both commercial and consumer loans. Therefore, the main customers are small and medium-sized enterprises that borrow from these commercial financial companies to purchase inventory and equipment. Commercial finance companies also provide value-added services such as consulting services and sales of accounts receivable.

Commercial finance companies are not banks. For small business owners, it is usually a higher-cost borrowing option. This is because they are not as conservative as traditional banks and are more willing to provide higher-risk loans. Since they are not banks, they are subject to less supervision and can take more risks. In times of economic turmoil, reducing regulation and increasing risk may be a double-edged sword.

Why use wholesale funds?

If core deposits are such a cheap source of financing, why would anyone use wholesale financing? For banks, wholesale financing represents a way to expand or meet financing needs. Sometimes, banks may struggle to attract new deposits. Maybe the interest rate is too low, and customers find the low interest rate unattractive.

Whatever the reason, sometimes banks will seek wholesale financing. This can take many forms, but a popular option for banks is to use brokerage deposits. These deposits are collected through brokers who collect money from their wealthy customers and find several different banks to deposit them, usually to allow these customers to obtain FDIC insurance (and hope for more attractive interest rates). If these wealthy customers deposit all their funds in a bank, their deposits may exceed the FDIC’s insurance limit. Basically, they distribute the cash they hold to different banks so that all their deposits are protected from bank failures.

Commercial financial companies do not have a depositor base from which they can withdraw funds. Therefore, they need to be able to use the public debt market to capitalize themselves. These funds are lent to small business customers at higher interest rates. Looking at this business model, it is obvious that it is important for commercial finance companies to have the highest possible credit rating so that they can obtain the lowest coupons on the debt they issue.

How to make a profit for wholesale funds

A positive spread is needed to make wholesale funds work and profitable. When wholesale funding sources are exhausted, commercial financial companies may encounter liquidity problems, or borrowing conditions may become so onerous that they cannot be profitable. Your cost of funds should be lower than your asset (loan) income. Any other situation is unprofitable and unsustainable.

To achieve a positive spread, an upward sloping yield curve is first required. An inverse yield curve—short-term interest rates are higher than long-term interest rates—is unprofitable and can cause problems for banks and commercial financial companies. A flat yield curve is also a problem, because it does not allow the above mentioned spreads to be positive.

As the shape of the yield curve changes throughout the business cycle, one can see the real impact on the net income of banks and financial companies. When the yield curve slopes upward, the profitability of banks and commercial finance is good. When it hangs upside down, profitability will suffer. When it is somewhere in between or flattening out, the profitability of the bank will weaken. For commercial financial companies, a flat yield curve may be unprofitable because the source of funds is not low-cost demand deposits available to banks, but higher-cost sources, such as borrowing in the unsecured debt market.

The wrong environment for wholesale financing

The use of wholesale funds is not necessarily a bad thing in itself. Under appropriate conditions, it provides banks with additional sources of operational financing and additional investment opportunities. Commercial finance companies can also use wholesale funds to make profits for many years in multiple business cycles.

But what happens when there is a credit crunch, the debt market is basically closed, or short-term borrowing rates (represented by benchmark interest rates such as the federal funds rate or LIBOR) soar due to uncertainty? This is a toxic combination that may put commercial financial companies on the verge of bankruptcy and cause trouble to banks.

We know that the main source of funds for banks is retail deposits. Deposits are insured by the FDIC and are usually long-term in nature. Banks can also use wholesale funds, although this source of funds has a shorter period. This means that if the bank is deemed to have credit risk, the faucet can be shut down quickly. If the bank is insufficiently capitalized, the banking supervisory agency can also prohibit brokerage deposits. In this case, the bank is faltering.

Bottom line

Commercial finance companies need to earn “spreads”. In this respect, they are like banks, benefiting from a steep yield curve. Unlike banks with a large depositor base, their perceived credit risk is an extremely important factor that affects the speed at which they can obtain funds.

If commercial finance companies are seen as deterioration and risk, then it doesn’t matter how steep the yield curve is; they will have to pay more for funds, which will squeeze profit margins. If they cannot resolve the crisis fast enough, other problems will also arise. Customers may start withdrawing credit lines, which further affects liquidity. In addition, the longer the negative news lasts, the more small business customers they may lose, thereby further compressing profitability.

If the economic tsunami strikes in the form of soaring short-term interest rates and credit crunch, it could be devastating for commercial financial companies-if this situation persists for a long time, it may even lead to eventual bankruptcy.


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