The risks of bank wholesale funding
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The Risks of Bank Wholesale Funding. Rocco Huang Philadelphia Fed Lev Ratnovski Bank of England. FDIC/Cleveland Fed Conference, April 17, 2008. Asset. Liability. Bank Funding. capital. Deposit. Retail deposits Passive, insured Limited Supply Funded only by deposits?

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The risks of bank wholesale funding l.jpg

The Risks of Bank Wholesale Funding

Rocco HuangPhiladelphia Fed

Lev RatnovskiBank of England

FDIC/Cleveland Fed Conference, April 17, 2008

Bank funding l.jpg



Bank Funding



  • Retail deposits

    • Passive, insured

    • Limited Supply

    • Funded only by deposits?

      • Excess capital / Unused investment opportunities

  • Short-term wholesale funds

    • Need to be rolled over in the short-term; effectively more senior

    • Source: other financial institutions, non-financial corporations, state and local authorities, foreign entities, etc

    • Instruments: Fed Funds, Repo’s, Large Certificate of Deposits, Commercial Papers, etc.


Short term wholesale funds l.jpg



Short-Term Wholesale Funds



  • Bright side

    • Fully exploit investment opportunities

    • Market discipline (Calomiris, 1999)

    • Reduced liquidity risks (Goodfriend & King, 1998)

  • Dark side

    • Aggressive lending + compromised credit quality

    • Limited market discipline

    • Sudden stops + inefficient liquidations

  • How to reconcile?

    • When is wholesale funding beneficial?

    • Can banks opportunistically choose risky wholesale funds?


Wholesale funds in the past bank failures l.jpg
Wholesale funds in the past bank failures

  • What did short-term wholesale funds learn?

    • Run!

    • And you (almost always) get your money back in whole and when you want them

  • Example 1: Continental Illinois Bank

    • Noticing its energy sector exposure, wholesale depositors kept withdrawing

    • The Fed kept lending

    • Wholesale depositors who withdrew escaped unscathed

    • So they kept running (why not?)

    • Retail depositors held the bag

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Wholesale funds in the past bank failures

  • Example 2: Northern Rock

    • Frightened by U.S. crisis, short-term wholesale funds stopped rolling over financing

    • After sustaining it for a while, NR finally asked for emergency funding from BoE

    • …which allowed further exit by wholesale funds

    • THEN retail deposit run finally started

    • Short-term wholesale investors didn’t lose a cent

    • They ran faster than ordinary folks!

  • Message for wholesale funds

    • Sometimes they wrongfully liquidate the good guys (Northern Rock), but sometimes they hit the bad guys (Continental)

    • In any case, it was historically costless to run on a bank with insured depositors!!!

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How did short-term wholesale funds escape unscathed?

  • First-come-first-served gives short-term funds effective seniority

    • until the bank is taken over by the court / government / FDIC / FHLB

  • Central bank (and FHLB) by providing liquidity to a failing bank also helps finance their exit

    • and can potentially increase the FDIC loss

  • Retail depositors and taxpayers hold the bag

  • Wholesale funds run based on a noisy signal

    • Why not?

When is wholesale funding a good thing l.jpg
When is wholesale funding a good thing?

  • Good when they invest in information

  • Bad when uninformed

  • Why do they remain uninformed sometimes?

    • Monitoring costs not fully compensated when passive depositors freeride

    • Free, noisy signal reduces incentive for monitoring

    • Effective seniority allows them to shift the burden of liquidation to passive depositors

      • Making it more attractive to liquidate based on a noisy, negative signal.

The model setup l.jpg
The Model Setup

  • A bank with a long-term investment project

    • Date 0: Attract funding, and invest

    • Date 2: Return (per unit of investment)

      “Good”: X>>1 w.p. P

      “Bad”: L<1 w.p. (1-p)

    • Date 1: L<1 (in liquidation)

  • Wholesale depositors can

    • incur a cost and get a precise signal on project quality

      • Screen out bad banks

    • or rely on a noisy signal that is precise enough (threshold is endogenous)

      • Example of signals:

        • market-wide or sector-wide news; e.g. house price seems to contain a lot of information on banks holding a lot of mortgage-backed securities

        • Energy price on Penn Central, Continental, etc

Slide9 l.jpg


Depositors only

Attractwholesale funds

Date 0

Providers of wholesale funds

Screen, lend to good banks only

Do not screen, lend to all banks

Date 1

Upon a noisy negative signal, stay

Upon a negative signal, liquidate

What are they thinking l.jpg
What are they thinking?

  • Wholesale funds:

    • Get Informed? Depositors free-ride the benefits

    • Remain Uninformed? Costs of liquidation burdened by the depositors

    • Incentives distorted by:

      • Effective seniority over passive depositors

      • Availability of a free, noisy signal

  • Banks:

    • Deposits only? excess capital

    • Attract wholesale? Can have higher liquidity risk

    • Incentives distorted by limited liability

  • Society:

    • Lending to “bad” projects never optimal [market discipline]

    • Early liquidation never optimal[liquidity risk]

Results from the model l.jpg








Uninformed,but stay upon a negative signal

Uninformed,and liquidate upon a negative signal

Wholesale financiers




Uses wholesale funds

The bank uses wholesale funds, although it is not socially optimal

Results from the model

Distorted incentives l.jpg
Distorted incentives

  • Wholesale financiers

    • Low incentives to screen = Insufficient market disciplineDo not internalize benefits for depositors

    • High incentives to liquidate = Liquidity risk Withdraw before the depositors, enjoying effective seniority, and thus larger share of a smaller pie

  • Banks

    • Over-reliance on risky wholesale fundsLimited Liability; Do not internalize risks of depositors

Is wholesale funding bad l.jpg
Is wholesale funding bad?

  • Less risky if:

    • Predominantly wholesale

      • Wholesale not necessarily a problem per se

      • They seem to be more “reasonable” in financial institutions without much retail deposits

        • They sat down and bailed LTCM out

        • They maintained credit lines to Countrywide

        • Exception: Bear Stearns – people just hated BS for its LTCM role? ?

    • Predominantly deposits

      • But: no monitoring; and excess capital

  • More risky if:

    • Combination of deposits and wholesale

    • Use of wholesale funds in depository banks

      • Insufficient market discipline

      • Heightened liquidity risks

Model v 2 0 l.jpg
Model v.2.0.

  • New model

    • Endogenous (optimal) arrangement of seniority [0,1]

    • Endogenous choice of monitoring intensity [0,1]

  • Optimal seniority arrangement:

    • Unlike in Calomiris and Kahn (1991), seniority is not always good

    • Wholesale funds should be made more junior if:

      • Share of passive retail depositors is higher

      • The precision of the noisy signal is higher

        • e.g. For banks holding mainly mortgage-backed securities vs. loans

      • Liquidation cost is smaller

  • Inverse U-shaped relationship between monitoring and seniority

    • Monitoring efforts maximized in the middle

    • Lower seniority -> incentives not aligned

    • Higher seniority -> liquidate too often