When Wholesale Funding Goes Bad

The wholesale funding model is a viable base for a business model under certain interest rate and credit market environments. However, it can become less profitable if the shape or slope of the yield curve changes. If credit markets seize up, this can also cause problems. If both conditions change at the same time, watch out.

This article will describe the ideal interest rate and credit markets necessary to use wholesale funding profitably, who uses wholesale funding and explore how the breakdown of long-run assumptions can hurt commercial finance companies and bring them to the brink of bankruptcy.

Wholesale funding differs from the traditional source of funding that a commercial bank would use. Traditionally, banks used core demand deposits as a source of funds, and they are an inexpensive source of financing. Deposits represent a liability for the banks, and those deposits are lent out and become income-producing assets.

Wholesale funding is a "catch-all" term but mainly refers to federal funds, foreign deposits and brokered deposits. Some also include borrowings in the public debt market in the definition.

Traditional banks and commercial finance companies can both be users of wholesale funding. Banks can use wholesale funding as an alternative, but commercial finance companies are especially reliant on this source of funding. Both are regulated differently and sometimes compete for the same business.

Commercial finance companies solely provide business loans, as opposed to banks that provide both business and consumer loans. Therefore, the primary customers are small- to medium-sized businesses that borrow from these commercial finance companies to purchase inventory and equipment. Commercial finance companies also provide value-added services such as consulting services and sales of receivables.

Commercial finance companies are not banks and are often a higher-cost borrowing option for the small business owner. This is because they are less conservative than traditional banks and more willing to make riskier loans. As they are not banks, they are subject to less regulation and can assume more risk. Less regulation and more risk can be a double-edged sword in times of economic turbulence.

If core deposits are such a cheap source of financing, why would anyone use wholesale funding? For banks, wholesale funding represents a way to expand or to satisfy funding needs. Sometimes, banks may have trouble attracting new deposits. Maybe interest rates are so low that customers don't find the low rates attractive.

Whatever the reason, sometimes banks look to wholesale funding. This can take many forms, but a popular option for banks is to use brokered deposits. These deposits are received through a broker who takes their wealthy clients' money and finds several different banks in which to deposit it, usually in order for those clients to receive FDIC insurance (and hopefully a more attractive rate). If these wealthy clients deposited all of their money into one bank, their deposits might exceed FDIC insurance limits. Basically, they slice and dice their cash holdings among different banks so all of their deposits are insured against a bank failure.

Commercial finance companies don't have the depositor base from which to draw. Therefore, they need to be able to tap the public debt markets to capitalize themselves. These funds are lent out to small business clients at a higher rate. Looking at this business model, it becomes apparent that it would be important for a commercial finance company to have the highest credit rating possible, so the lowest coupon on the debt they issue can be received.

A positive spread is needed in order for wholesale funding to work and be profitable. A commercial finance company may experience liquidity problems when sources of wholesale funding dry up, or the borrowing terms may become so onerous they are not profitable. Your cost of funds should be lower than the yield you earn on your assets (loans). Any other scenario is unprofitable and not sustainable.

To achieve a positive spread, it is first necessary to have an upward sloping yield curve. An inverted yield curve – one in which short-term rates are higher than long-term rates – is not profitable and leads to problems for banks and commercial finance companies. A flat yield curve is also a problem because it does not allow for the aforementioned positive spread scenario.

As the shape of the yield curve changes during the full business cycle, one can see the tangible impacts to net income for banks and finance companies. When the yield curve is upward sloping, bank and commercial finance profitability is good. When it is inverted, profitability suffers. When it is in between or flattening, profitability is muted for banks. For commercial finance companies, a flat yield curve can be unprofitable, because the source of funding is not low-cost demand deposits like banks have access to, but higher cost sources such as borrowing funds in the unsecured debt markets.

(Learn about what happens when there is an inverted yield curve in "The Impact of an Inverted Yield Curve.")

The use of wholesale funding in and of itself is not necessarily a bad thing. Under the right conditions, it allows banks an additional source of financing for operations and additional investment opportunities. Commercial finance companies can also be profitable for many years and through several business cycles using wholesale funding.

But what happens when there is a credit crunch, when the debt markets are essentially shut-down, or when short-term borrowing rates (as represented by LIBOR) skyrocket due to uncertainty? This is a toxic combination that can bring a commercial finance company to the brink of bankruptcy and cause problems for banks.

We know that a bank's main source of funding is retail deposits. Deposits are insured by the FDIC, and are generally longer-term in nature. Banks can also employ wholesale funding, although this source of funding is shorter term. This means the spigot can turn off very quickly if the bank is perceived to be a credit risk. Bank regulators can also prohibit brokered deposits if a bank is undercapitalized. A bank in this situation is teetering on the edge.

Commercial finance companies need to earn a "spread." In this respect, they are just like banks and benefit from a steep yield curve. Unlike banks that have a large depositor base, their perceived credit risk is an extremely important factor that affects the rate at which they can obtain funding.

If the commercial finance company is seen as deteriorating and risky, it doesn't matter how steep the yield curve is; they will have to pay more for funding, and this will squeeze margins. If they cannot resolve the crisis quickly enough, other problems will arise, as well. Customers could start to draw down lines of credit, further impacting liquidity. Also, the longer the bad press continues, the more small business customers they could lose, leading to further squeezes in profitability.

If an economic tsunami hits, in the form of skyrocketing short-term rates and a credit crunch, it can be devastating to a commercial finance company – and even cause eventual bankruptcy, if the conditions exist for an extended period.