Pension funds, endowments, and insurance firms obtain virtually free funds for investment purposes. Not so with banks. To have funds to lend, they must attract investors in a competitive interest rate environment.
They compete against other banks and also against companies that offer other investment vehicles, from bonds to common stocks. A bank’s success relies primarily on its ability to generate returns in excess of its funding costs.
A bank tries to maintain a positive difference between its cost of funds and its returns on assets. If banks anticipate falling interest rates, they will try to invest in longer-term assets to lock in the returns while seeking short-term deposits, whose interest cost is expected to fall over time.
When banks expect rising rates, they will try to lock in longer-term deposits with fixed-interest costs, while investing funds short term to capture rising interest rates. The risk of such strategies is that losses may occur should a bank incorrectly forecast the direction of interest rates.
The aggressiveness of a bank’s strategy will be related to the size of its capital ratio and the oversight of regulators.
Banks need substantial liquidity to meet withdrawals and loan demand. A bank has two forms of liquidity. Internal liquidity is provided by a bank’s investment portfolio that includes highly liquid assets that can be sold to raise cash.
A bank has external liquidity if it can borrow funds in the federal funds markets (where banks lend reserves to other banks), from the Federal Reserve Bank’s discount window, or by selling certificates of deposit at attractive rates.
Banks have a short time horizon for several reasons.
First, they have a strong need for liquidity.
Second, because they want to maintain an adequate interest revenue–interest expense spread, they generally focus on shorter-term investments to avoid interest rate risk and to avoid getting “locked in” to a long-term revenue source.
Third, because banks typically offer short-term deposit accounts (demand deposits, NOW accounts, and such), they need to match the maturity of their assets and liabilities to avoid taking undue risks.
Banks are heavily regulated by numerous state and federal agencies. The Federal Reserve Board, the Comptroller of the Currency, and the Federal Deposit Insurance Corporation all oversee various components of bank operations.
The Glass-Steagall Act restricts the equity investments that banks can make. Unique situations that affect each bank’s investment policy depend on their size, market, and management skills in matching asset and liability sensitivity to interest rates.
For example, a bank in a small community may have many customers who deposit their money with it for the sake of convenience. A bank in a more populated area will find its deposit flows are more sensitive to interest rates and competition from nearby banks.
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