Overview
When a bank takes in a deposit, it will invest the funds in an asset, either a loan to one of its customers, or a security that it purchases on the secondary market. In this example, we assume that the bank invests the deposit in a US Treasuty Security. (we do this for simplicity, so that we can ignore credit risk) In addition, we assume that the deposit is a term deposit, (certificate of deposit) that is locked up for a given term, and the treasury security is of the same term.
Assuming that the bank receive $100 in deposits, its balance sheet will look like:
Following the principles detailed in the funds transfer pricing mechanism, the bank will set up two departments, the deposit group, and the treasury.
The deposit team is not responsible for investing the deposits, the treasury is. As such, the mechanism by which this is accomplished is through a loan that the deposit group makes to the treasury.
Deposit View
Once the deposit group takes in $100, it then lends it to the treasury. The treasury pays the deposit group a rate for the funds (typically equal to the rate that the bank would be charged by the market if it raised the funds from the market)
The result would be the following balance sheet attributed to the deposit group.
Setting up the deposit groups balance sheet this way, creates a natural way to attribute a portion of the bank's profits to the deposit group. Here, the deposit groups PnL would come from the spread of the banks funding rate and the rate that the bank pays for deposits.
Treasury View
The flip side of the above process is that the treasury group borrows the deposit money from the deposit group, and then invests that money in some other asset. (In this case, a US treasury security. See simple loan for an example using a simple loan.)
The treasury should pay a rate for the deposits that is reflective of the rate that the bank would have to pay to raise the money in the open markets. This makes the treasury indifferent between raising funds from the deposit group or through open market funding.
In addition, the treasury should take the following in consideration when formulating the rate it pays the deposit group:
- Matched Maturity - the rate paid to the deposit group should take into consideration the term of the deposit. That is, a five year certificate of deposit should be charged a rate that the bank would be charged to raise money from the market for a five year term.
- Stable Funding Rate
- many deposits are withdrawable on demand. This may indicate (according to the matched maturity principle above)
that the rate paid for these deposits should
be an overnight rate.
This can be adopted, but it ignores a single fact. While each deposit may be withdrawable on demand, the whole group of deposits create a fairly stable base of money that can be reasonably relied upon. Some banks choose to value their deposit base as a core of stable funds, which can be priced at long term rates, and a portion that represents overnight funds. (see deposit modeling for various statistical models of bank deposits )