Short-term Funding Alternatives

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

Short-term Funding Alternatives for Non-financial Institutions

External Financing

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 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, lenders often seek protections to safeguard their interests due to their extended nature.

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): Commercial Paper (CP) primarily comes from large, high-credit corporations. CPs are short-term, unsecured notes with a usual maturity of under three months. They serve purposes like funding working capital, bridging finance, or managing seasonal cash needs. A common practice is “rolling over,” where maturing CP is paid off with new issuances. This introduces “rollover risk,” the chance of being unable to issue new CP. To mitigate this, investors often seek liquidity enhancements, such as backup credit lines from banks, ensuring issuers can meet their obligations if new issuances aren’t possible. CP markets are flexible in responding to credit issues, leading to infrequent defaults. In addition to non-financial corporations, CP issuers include governments, financial institutions, and international bodies.
3. 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.

Short-term Funding Alternatives for Financial Institutions

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) General 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 is from non-financial corporate entities. These institutions need to manage the rollover risk associated with CP.

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.

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 closely monitor the company’s financial activities.

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 that 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  has 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.