Short-term Funding Alternatives

AnalystPrep Summary

Short-term funding allows corporations and financial institutions to meet immediate liquidity needs through bank borrowing, commercial paper issuance, deposits, interbank markets, and central bank funding.

Non-financial companies typically choose funding sources based on cost, flexibility, collateral requirements, reliability, and rollover risk. Financial institutions rely heavily on deposits, certificates of deposit, interbank borrowing, commercial paper, asset-backed commercial paper, and central bank funds to manage liquidity.

For CFA Level I candidates, the key is to understand how each funding source works, who uses it, and what risks or benefits it creates.

Key Takeaways

• Short-term funding supports day-to-day liquidity management.
• Companies use short-term financing to manage working capital, payroll, inventory, and temporary cash shortfalls.
• Bank credit facilities differ in commitment level, cost, and reliability.
• Commercial paper provides unsecured market financing for highly rated issuers.
• Eurocommercial paper allows issuers to access international short-term funding markets.
• Financial institutions rely heavily on deposits and interbank borrowing.
• Liquidity risk and rollover risk are major considerations when selecting funding sources.
• Different funding alternatives suit different borrower profiles.

Understanding Short-Term Funding Alternatives

Businesses frequently require short-term financing to manage working capital, meet payroll obligations, finance seasonal inventory, or bridge temporary cash flow shortages. Both non-financial corporations and financial institutions rely on a variety of funding sources, each with different costs, risks, maturities, and levels of flexibility.

Short-term funding alternatives include bank credit lines, revolving credit facilities, commercial paper, Eurocommercial paper, deposits, certificates of deposit, interbank borrowing, central bank funds, and asset-backed commercial paper.

In this study note, you’ll learn:

• Common short-term funding sources
• Differences between bank credit facilities
• Commercial paper and Eurocommercial paper
• Funding sources used by banks
• Advantages and risks of each financing method
• How these concepts are tested in CFA Level I

Short-term funding is key for corporations to meet immediate cash needs, maintain liquidity, and capitalize on supplier discounts.

Common Short-Term Funding Alternatives

Funding Source	Typical User	Secured?	Main Advantage
Uncommitted Line of Credit	Corporations	No	Flexible and low cost
Committed Line of Credit	Corporations	No	More reliable access to funding
Revolving Credit Facility	Corporations	No	Ongoing access to liquidity
Commercial Paper	Large corporations	No	Low-cost market financing
Eurocommercial Paper	Large corporations	No	Access to international funding
Asset-Backed Commercial Paper	Financial institutions	Yes	Secured short-term funding
Demand Deposits	Banks	N/A	Stable funding source
Certificates of Deposit	Banks	N/A	Wholesale funding source
Interbank Loans	Banks	Usually unsecured	Short-term liquidity management

How Do Banks and Financial Institutions Fund Themselves?

Financial institutions use several short-term funding sources to manage liquidity, meet customer withdrawals, satisfy regulatory requirements, and support lending activity.

Deposits are often one of the cheapest and most stable funding sources for banks because they come from customers who hold checking, savings, or time deposit accounts.

Banks may also use wholesale funding sources such as certificates of deposit, interbank borrowing, commercial paper, and asset-backed commercial paper. These sources can provide larger amounts of funding but may be more sensitive to market conditions.

Interbank markets allow banks with excess reserves to lend to banks that need short-term funds. When market funding becomes stressed, central bank funding may serve as an important source of liquidity.

For CFA candidates, the key is to understand that financial institutions rely on both customer deposits and market-based funding to manage liquidity.

How Do Non-Financial Companies Obtain Short-Term Funding?

Why Do Companies Need Short-Term Funding?

Companies use short-term funding to manage temporary cash flow needs. Even profitable businesses may need short-term financing when cash payments and cash receipts do not occur at the same time.

Common reasons include:

• Managing working capital
• Meeting payroll obligations
• Financing seasonal inventory
• Covering accounts payable before customer payments arrive
• Bridging temporary cash shortages
• Funding unexpected liquidity needs
• Supporting day-to-day operations

Short-term funding helps companies maintain liquidity without raising long-term debt or issuing equity.

What Are External Short-Term Financing Options?

Non-financial entities can acquire immediate liquidity through various banking avenues:

Uncommitted Lines of Credit

These are provisional credit arrangements where there’s no obligation for the bank to lend the specified amount. They are useful for immediate liquidity needs. Banks typically grant these lines to clients with stable cash deposits, which allows them to monitor the company’s financial activities closely. Uncommitted lines of credit are cost-efficient since there are no upfront fees, and companies are charged interest only on the utilized amount. However, given their ‘uncommitted’ nature, they are not always reliable, especially during financial downturns.

Regular (Committed) Lines of credit

Contrary to the uncommitted lines, these involve a formal contractual obligation by the bank to provide the funds up to the agreed limit. They are often utilized as backup credit sources, and they can be categorized as short-term liabilities when drawn. They are more reliable than uncommitted lines, but there might be upfront costs, such as a commitment fee. Renewal at maturity can become a challenge, especially for companies whose financial positions are deteriorating.

Revolvers (Revolving Credit Agreements)

Revolvers are long-term credit arrangements that can span several years. They may come with specific covenants or conditions the borrower needs to adhere to. They can also include medium-term loan options. Being a multi-year commitment, they provide a dependable source of liquidity. However, due to their extended nature, lenders often seek protections to safeguard their interests.

1. Secured Loans and Factoring. Secured Loans are those that demand collateral like company-owned assets or high-quality receivables, inventory, and securities. The lender secures a right on the collateral until the loan is cleared, reflecting on the borrower’s credit report. Companies with inadequate credit strength typically opt for these loans.Companies can utilize their accounts receivable in two main ways:
   1. Assignment of accounts receivable: Here, receivables act as collateral for loans, but the responsibility of collection remains with the company.
   2. Factoring: This involves selling receivables to a factor, usually at a discount. Here, the factor handles the credit granting and collection.
2. External, Security-Based Financing
   
   Commercial Paper (CP) is predominantly issued by big, high-credit corporations, CPs are short-term, unsecured notes which generally mature in under three months. They are used for working capital, bridging finance, or handling seasonal cash demands. A common practice is “rolling over” or paying off maturing CP with new issuances. This introduces “rollover risk” – the potential inability to issue new CP. To counteract this, investors typically seek a liquidity enhancement, like a backup credit line from banks. This acts as a protective measure, ensuring issuers can fully repay their obligations if new issuances aren’t viable. Given their brief maturity, CP markets are agile in adjusting to credit hiccups, making defaults infrequent. Beyond non-financial corporations, other CP issuers include governments, financial institutions, and international bodies.
   

   Eurocommercial Papers (ECPs)Eurocommercial Papers (ECPs) are CPs issued internationally. While they share many similarities with the U.S. Commercial Paper (USCP), they tend to involve smaller transaction sizes and are generally less liquid.

How Do Companies Choose a Short-Term Funding Source?

Companies choose short-term funding sources based on cost, reliability, speed, flexibility, and risk.

A company with strong credit quality may prefer commercial paper because it can be cheaper than bank borrowing. A company that needs guaranteed backup liquidity may prefer a committed credit line or revolving credit facility. A company with receivables may consider factoring or secured borrowing.

Important factors include:

• Borrowing cost
• Availability of funds
• Speed of funding
• Credit quality
• Collateral requirements
• Financial flexibility
• Maturity
• Rollover risk
• Market access

The best funding source depends on the borrower’s financial strength and liquidity needs.

Comparing Bank Credit Facilities

Bank credit facilities differ mainly in the level of commitment provided by the lender.

An uncommitted line of credit provides flexibility but does not guarantee that funds will be available when needed.

A committed line of credit gives the borrower more reliable access to funds because the bank formally commits to lending up to a specified amount.

A revolving credit facility provides ongoing access to funds over a longer period. Borrowers can draw, repay, and borrow again within the agreed limit.

Facility	Bank Commitment	Typical Cost	Reliability
Uncommitted Line of Credit	None	Lowest	Low
Committed Line of Credit	Formal commitment	Moderate	High
Revolver	Longer-term commitment	Higher	Very high

How Do Financial Institutions Obtain Short-Term Funding?

Financial institutions, such as banks, serve as intermediaries between depositors and borrowers. Their assets mainly comprise loans given or securities purchased, while liabilities include deposits, securities sold, and short-term borrowings. Here’s a closer look at their short-term funding sources:

Deposits Demand Deposits

Primarily from households and commercial entities, these deposits don’t have a stated maturity and often pay minimal interest. While they can be withdrawn anytime, banks count on them due to added stability. Operational deposits, generated through clearing, custody, and cash management activities, also offer a stable source of funding.

Saving Deposits

These are non-transactional and may have defined terms. Certificates of deposit (CDs) are an example where banks offer pre-set maturity and interest rates. CDs can be non-negotiable or negotiable, allowing for early withdrawal with penalties or market selling. CDs are also found in the Eurobond market.

Interbank Market Unsecured Loans

This market facilitates short-term lending and borrowing among financial institutions. Loans usually span from overnight to one year. The rate of interest on these loans is affected by credit risk, and banks often set counterparty limits to manage this risk.

Central Bank Funds Market

Banks are mandated to maintain reserves with the central bank. Banks with a surplus can lend to those short on reserves through this market. The rate of borrowing and lending in this space is known as the central bank funds rate. Banks struggling in the interbank market can borrow directly from the central bank, albeit at higher rates and with more scrutiny.

Commercial Paper (CP)

Predominantly, large financial institutions issue CPs to cater to their short-term borrowing needs. About 60% of the yearly issuance is from financial institutions and the rest from non-financial corporate entities. These institutions need to manage the rollover risk associated with CP.

Why Do Companies Use Commercial Paper?

Commercial paper is an unsecured short-term debt instrument issued by highly rated companies to meet temporary funding needs.

Only strong issuers typically access the commercial paper market because investors must be confident that the issuer can repay the debt at maturity. Commercial paper usually has short maturities and is often cheaper than bank borrowing for companies with strong credit ratings.

However, commercial paper creates rollover risk. If market conditions deteriorate or investor confidence declines, an issuer may not be able to issue new commercial paper to repay maturing paper. For this reason, many issuers maintain backup lines of credit with banks.

For CFA candidates, the key is to understand that commercial paper is generally low-cost but depends heavily on issuer credit quality and market access.

Asset-Backed Commercial Paper (ABCP)

This is a secured variant of CP. Loans or receivables are typically sold to a special-purpose entity (SPE) that issues debt. The bank trades short-term loans for cash with the SPE, which in turn issues ABCP to investors with a backup credit line from the bank. This off-balance-sheet financing benefits the bank and investors as it offers liquidity and access to loan portfolios. However, during the Global Financial Crisis, challenges in rolling ABCPs led to multiple SPE failures. Post-crisis, the ABCP market primarily funds short-term, high-quality loans and receivables.

What Is Rollover Risk?

Rollover risk is the risk that a borrower will not be able to replace maturing short-term debt with new financing.

This risk is especially important for commercial paper issuers. A company may issue commercial paper with the expectation that it can issue new paper when the old paper matures. If investor confidence falls or market conditions tighten, the issuer may be unable to refinance on favorable terms.

Backup lines of credit help reduce rollover risk by giving issuers access to bank funding if the commercial paper market becomes unavailable.

Rollover risk is a key reason why short-term funding can be cheaper but also more fragile than longer-term financing.

Example: Selecting a Short-Term Funding Source

Suppose a large manufacturing company experiences a temporary cash shortfall while waiting for customer payments.

Possible funding choices include:

• Drawing on an uncommitted credit line
• Using a committed line of credit
• Issuing commercial paper
• Factoring receivables

The optimal choice depends on the company’s credit quality, urgency, borrowing cost, collateral availability, and access to money markets.

If the company has a strong credit rating, commercial paper may be cheaper. If the company needs guaranteed access to funds, a committed line of credit or revolver may be more appropriate.

Question #1

Which of the following best describes a credit arrangement where the bank has no obligation to lend the specified amount and is typically granted to clients with stable cash deposits?

1. Revolvers (Revolving Credit Agreements)
2. Uncommitted Lines of Credit
3. Regular (Committed) Lines of Credit

Solution

The correct answer is B:

Uncommitted Lines of Credit are provisional credit arrangements where the bank has no obligation to lend the specified amount. They are granted to clients with stable cash deposits, allowing the bank to monitor the company’s financial activities closely.

A is incorrect: Revolvers (Revolving Credit Agreements) are long-term credit arrangements that span several years and often come with specific covenants.

C is incorrect: Regular (Committed) Lines of Credit involve a formal contractual obligation by the bank to provide funds up to an agreed limit.

Question #2

Which of the following is a type of commercial paper issued internationally most likely involves smaller transaction sizes, and is less liquid compared to its domestic counterpart?

1. Eurocommercial Papers (ECPs)
2. U.S. Commercial Paper (USCP)
3. Asset-Backed Commercial Paper (ABCP)

Solution

The correct answer is A.

Eurocommercial Papers (ECPs) are commercial papers issued internationally and tend to involve smaller transaction sizes and are generally less liquid compared to U.S. Commercial Papers.

B is incorrect: U.S. Commercial Paper (USCP) is domestically issued and does not fit the international criterion.

C is incorrect: Asset-Backed Commercial Paper (ABCP) is a secured variant of CP, and its definition does not match the given description.

Question #3

In the context of short-term funding for financial institutions, which deposit type least likely  have a stated maturity and is relied upon by banks due to its stability?

1. Saving Deposits
2. Demand Deposits
3. Certificates of Deposit (CDs)

Solution

The correct answer is B.

Demand Deposits primarily come from households and commercial entities and don’t have a stated maturity. Banks rely on them because of their added stability.

A is incorrect: Saving Deposits are non-transactional and may have defined terms but do not fit the described criteria.

C is incorrect: Certificates of Deposit (CDs) offer pre-set maturity and interest rates and do not match the given description

Glossary

Commercial Paper — An unsecured short-term debt instrument issued by corporations or financial institutions.

Eurocommercial Paper — Short-term commercial paper issued in international money markets.

Asset-Backed Commercial Paper — Short-term debt backed by financial assets such as receivables or loans.

Revolver — A credit facility that allows a borrower to draw, repay, and borrow again within an agreed limit.

Line of Credit — A borrowing arrangement that allows a company to access funds up to a specified limit.

Committed Line — A line of credit in which the lender formally agrees to provide funds up to a specified amount.

Uncommitted Line — A line of credit where the lender is not obligated to provide funds.

Factoring — Selling receivables to a third party to obtain immediate cash.

Interbank Market — A market where banks lend and borrow short-term funds from each other.

Demand Deposit — A bank deposit that can be withdrawn on demand.

Savings Deposit — A deposit account that earns interest and is typically used by retail customers.

Certificate of Deposit — A time deposit issued by a bank with a fixed maturity and interest rate.

Rollover Risk — The risk that maturing short-term debt cannot be refinanced on acceptable terms.

Liquidity — The ability to access cash or sell assets quickly without significant loss.

Frequently Asked Questions

What are short-term funding alternatives?

Short-term funding alternatives are financing sources used to meet immediate liquidity needs, such as lines of credit, commercial paper, deposits, interbank borrowing, and asset-backed commercial paper.

What is commercial paper?

Commercial paper is an unsecured short-term debt instrument issued by highly rated companies or financial institutions.

What is the difference between committed and uncommitted lines of credit?

A committed line of credit requires the lender to provide funds up to an agreed amount, while an uncommitted line does not guarantee funding availability.

What is a revolving credit agreement?

A revolving credit agreement allows a borrower to draw, repay, and borrow again within an agreed credit limit.

What is rollover risk?

Rollover risk is the risk that a borrower cannot refinance maturing short-term debt with new financing.

What is Eurocommercial paper?

Eurocommercial paper is short-term commercial paper issued in international money markets.

What is asset-backed commercial paper?

Asset-backed commercial paper is short-term debt backed by financial assets such as receivables, loans, or other collateral.

Why do banks rely on demand deposits?

Banks rely on demand deposits because they are generally a low-cost and stable funding source.

What is the interbank market?

The interbank market is a market where banks lend and borrow short-term funds from each other.

What is the difference between corporate and bank funding sources?

Corporations often use credit lines, commercial paper, and factoring. Banks rely more heavily on deposits, certificates of deposit, interbank borrowing, central bank funds, and asset-backed commercial paper.

Summary of Short-Term Funding Alternatives

Funding Source	Main Purpose	Typical User
Uncommitted Line of Credit	Temporary liquidity	Corporations
Committed Line of Credit	Guaranteed backup funding	Corporations
Revolver	Ongoing liquidity	Corporations
Commercial Paper	Low-cost unsecured borrowing	Large corporations
Eurocommercial Paper	International commercial paper issuance	Large corporations
Asset-Backed Commercial Paper	Secured market funding	Financial institutions
Demand Deposits	Stable funding	Banks
Certificates of Deposit	Wholesale funding	Banks
Interbank Loans	Liquidity management	Banks
Central Bank Funds	Reserve and liquidity management	Banks