Absolute wholesale funding

What Is Absolute Wholesale Funding?

Absolute wholesale funding refers to a method used by financial institutions, primarily banks, to acquire large sums of money from non-retail sources to finance their operations, make lending, and manage overall liquidity risk. This approach falls under the broader category of Banking and Financial Markets. Unlike funds sourced from individual customer deposit accounts, absolute wholesale funding is obtained from other financial institutions, corporations, or through capital markets via various debt instruments. It is a critical component of a bank's balance sheet and a significant source of liabilities, enabling institutions to meet funding needs that cannot be satisfied by traditional retail deposits alone.²⁰

History and Origin

The reliance on wholesale funding by banks has evolved significantly over time, becoming particularly prominent in the latter half of the 20th century as financial markets became more integrated and sophisticated. Historically, banks primarily relied on customer deposits as their main funding source. However, with increased demand for credit and the expansion of financial activities, banks increasingly sought out alternative and larger-scale funding avenues. The role and risks associated with absolute wholesale funding gained significant attention during the 2007–2008 Global Financial Crisis. Many institutions, such as Northern Rock, Bear Stearns, and Lehman Brothers, experienced severe liquidity crises due to an overreliance on short-term wholesale funding, particularly from the interbank lending market. This highlighted the inherent fragility of such funding when market confidence eroded, leading to a sudden withdrawal of funds.

¹⁹## Key Takeaways

• Absolute wholesale funding involves large-scale borrowing by financial institutions from non-retail sources.
• It serves as a crucial supplement to retail deposits for financing operations and managing liquidity.
• Sources include interbank loans, brokered deposits, and debt securities issued in capital markets.
• While offering flexibility and scale, it can be more volatile and sensitive to market conditions than retail deposits.
• Regulatory frameworks like Basel III were introduced to mitigate the risks associated with excessive reliance on certain types of wholesale funding.

Interpreting Absolute Wholesale Funding

Absolute wholesale funding is interpreted as a measure of a financial institution's reliance on non-deposit, often market-based, sources for its liquidity and operational needs. A higher proportion of absolute wholesale funding in a bank's funding mix can indicate greater exposure to market fluctuations and potentially higher funding costs, especially when interest rates are rising or credit markets tighten. C¹⁸onversely, a balanced and diversified funding structure, including a prudent amount of absolute wholesale funding, can allow a bank to efficiently manage its Asset Liability Management (ALM) and respond to market opportunities without solely relying on potentially slower-growing retail deposits. Regulators often scrutinize the composition and maturity profile of a bank's absolute wholesale funding to assess its overall stability and resilience to financial shocks.

¹⁷## Hypothetical Example

Consider "Horizon Bank," a medium-sized commercial bank. Horizon Bank has a strong base of retail deposits, but it needs additional funds to support its growing commercial real estate lending portfolio. To meet this demand, Horizon Bank decides to access the wholesale funding market.

It issues $500 million in short-term commercial paper to institutional investors and borrows $200 million in federal funds from other banks through the money markets. Additionally, it obtains $300 million in brokered deposits from deposit brokers. The sum of these large-scale, non-retail sources—$500 million (commercial paper) + $200 million (federal funds) + $300 million (brokered deposits) = $1 billion—represents Horizon Bank's absolute wholesale funding acquired for this specific purpose. This funding allows Horizon Bank to originate new loans, but it also means the bank must carefully monitor the maturity dates and renewal costs of these wholesale liabilities to avoid liquidity shortfalls.

Practical Applications

Absolute wholesale funding is widely used across the financial industry for several key purposes:

• Liquidity Management: Banks use wholesale funding to quickly raise large amounts of capital to manage their day-to-day liquidity needs, cover unexpected outflows, or seize lending opportunities that exceed their traditional deposit base.
• Asset Growth: It allows financial institutions to fund the expansion of their loan portfolios and other income-generating assets without being constrained by the slower growth of retail deposits.
• Diversification of Funding Sources: Relying solely on retail deposits can concentrate funding risk. Absolute wholesale funding provides a diversified set of sources, including secured funding (e.g., repurchase agreements, covered bonds) and unsecured funding (e.g., commercial paper, interbank loans), which can enhance a bank's funding resilience.
• ¹⁵, ¹⁶Regulatory Compliance: Post-crisis regulations like Basel III's Net Stable Funding Ratio (NSFR) and Liquidity Coverage Ratio (LCR) mandate that banks maintain certain levels of stable funding and liquid assets. Banks often utilize wholesale funding instruments, particularly those with longer maturities, to meet these regulatory capital requirements and ensure a robust funding profile. Accor¹⁴ding to a report from the Federal Reserve Board in May 2023, some banks increased their reliance on wholesale funding sources as interest rates rose and deposit outflows picked up.

L¹³imitations and Criticisms

Despite its practical applications, absolute wholesale funding carries significant limitations and criticisms, primarily concerning its stability and cost. A major concern is its sensitivity to market sentiment and the potential for rapid withdrawal during periods of financial stress. Providers of wholesale funding, such as institutional investors, are generally more reactive to changes in an institution's credit risk profile or broader market conditions compared to retail depositors. This sensitivity can lead to abrupt funding shortfalls, as evidenced during the 2008 financial crisis, where an over-reliance on short-term wholesale funding was a significant determinant of bank vulnerability.

Furt¹²hermore, the cost of absolute wholesale funding can be more volatile than that of retail deposits. While it offers flexibility, banks may face higher interest rates when borrowing in wholesale markets, especially if their creditworthiness is perceived to decline or if the yield curve inverts. Excessive dependence on wholesale funding can also increase systemic risk, as a contagion effect can spread quickly across financial institutions if a major player faces funding difficulties. Regulators have responded to these limitations by implementing stricter liquidity regulations under frameworks like Basel III, aiming to encourage banks to diversify their funding sources and reduce their reliance on less stable, short-term wholesale markets.

A¹¹bsolute Wholesale Funding vs. Retail Deposits

The key distinction between absolute wholesale funding and retail deposits lies in their source, stability, and cost characteristics.

While retail deposits are often considered a bank's core and most stable funding source, they may not grow fast enough to support an institution's asset growth or specific lending initiatives. Absolute wholesale funding fills this gap, providing flexibility and scale. However, relying too heavily on wholesale funding can expose a bank to greater liquidity risk if market conditions deteriorate, making the balance between these two funding types crucial for sound financial management.

F⁴AQs

What are common types of absolute wholesale funding?

Common types of absolute wholesale funding include federal funds (overnight borrowing between banks), brokered deposits (large deposits obtained through intermediaries), commercial paper, certificates of deposit issued to institutional investors, and various forms of secured funding like repurchase agreements (repos) and covered bonds.

Why do banks use absolute wholesale funding?

Banks use absolute wholesale funding to supplement their retail deposit base, allowing them to finance larger loan portfolios, manage short-term liquidity risk, meet regulatory requirements, and diversify their overall funding sources. It provides quick access to significant capital amounts.

², ³Is absolute wholesale funding risky for banks?

Yes, absolute wholesale funding can be risky. Its providers are often highly sensitive to a bank's financial health and market conditions, making it less stable than retail deposits. A sudden loss of access to wholesale markets can lead to severe liquidity risk, as seen during past financial crises.

How do regulators monitor absolute wholesale funding?

Regulators, such as those implementing Basel III standards, closely monitor banks' absolute wholesale funding through metrics like the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). These ratios aim to ensure banks hold sufficient high-quality liquid assets and maintain a stable funding profile to withstand stress periods.¹