The FINANCIAL -- Like any business, a bank needs to finance its commercial activities – most notably making loans to households and firms – with some source of funding. This article sets out the range of funding sources available to banks – such as savers’ retail deposits and wholesale borrowing from investors – and explains why the cost of banks’ funding is of central importance to both monetary and financial stability.
Using an analogy of two buckets balanced on a set of scales, the article explores the dynamic nature of bank funding and bank lending. This simplified depiction of a bank’s balance sheet is used to illustrate some possible implications of an increase in banks’ funding costs for both individual firm profitability and broader macroeconomic and financial conditions.
Banks’ funding costs are integral to the transmission of monetary policy and hence the outlook for growth and inflation. Following the onset of the 2007-08 financial crisis, for example, many sources of funding evaporated rapidly and funding costs rose sharply relative to risk-free rates. This, in turn, put upward pressure on the lending rates faced by households and firms.
Funding costs also matter for financial stability. The article explains how a rise in funding costs is likely to reduce a bank’s profitability, even if it chooses to pass on higher funding costs to customers (by charging higher interest rates on any new lending). Over time, a reduction in profitability could erode a bank’s capital buffer, threatening its solvency and posing risks to broader financial stability.