Why Banks Still Need Funding Even When They Can Create Deposits

Begin where the previous article ended

Suppose Bank A lends $100,000 to a borrower and credits the borrower’s account. The bank now has a $100,000 loan asset and a $100,000 deposit liability.

At that instant, the balance sheet is matched in an accounting sense. But the borrower did not take the loan in order to admire the account balance. The borrower is likely to spend it.

If the borrower pays a supplier who banks at Bank B, the deposit created by Bank A may leave Bank A. Bank A still owns the loan asset—the borrower still owes $100,000—but the matching deposit liability has migrated into the wider banking system. Bank A must settle the payment and then decide how it wants to finance the asset it still holds.

That one movement explains why the sentence “loans create deposits” never abolishes treasury management.

Funding asks a different question from liquidity

Funding and liquidity are closely related, but they are not identical.

Concept	Main question
Funding	What liabilities and equity support the bank’s assets, at what cost, maturity and stability?
Liquidity	Can the bank meet payments, withdrawals and other cash obligations when they fall due?

A bank may have a reasonable long-term funding structure and still face a short-term liquidity shock. Or it may have enough cash today while depending on funding that becomes prohibitively expensive next month. Good bank management has to see both the stock of financing and the timing of cash flows.

What actually funds a bank?

A bank can fund itself through several broad channels. The exact mix varies by institution and jurisdiction, but the underlying logic is general.

• Customer deposits. Transaction, savings and term deposits can provide a large and often relatively diversified source of funding.
• Wholesale borrowing. Banks can borrow from other financial institutions or issue market instruments to professional investors.
• Secured funding. The bank can borrow against eligible collateral, depending on the market and facility.
• Longer-term debt. Bonds and other debt instruments can extend the maturity profile of funding.
• Capital and equity. Capital is not a substitute for ordinary funding, but it is a permanent or loss-absorbing source supporting the balance sheet and protecting creditors from losses.
• Central-bank facilities. Eligible institutions may obtain liquidity through monetary-authority facilities under the applicable rules and collateral arrangements. This is a funding route, but not one that makes normal funding strategy irrelevant.

The important word is mix. Dependence on one source can make an otherwise sound bank fragile. Diversification matters because different funding providers react differently to interest rates, reputation, market stress and changing opportunities.

Why deposits are valuable funding

Retail and business deposits can be attractive because they may come from many separate customers rather than a small number of market counterparties. A diversified deposit base can be more stable than funding that depends on a handful of institutions renewing large contracts every few days.

But “deposits are stable” is not a law of nature. Deposit behaviour depends on account type, customer concentration, insurance arrangements, interest rates, digital transfer speed, customer sophistication, confidence and the presence of attractive alternatives.

A bank with one million modest household deposits does not face the same behavioural profile as a bank funded by a small number of very large uninsured corporate balances. Both are called deposits. Their stability under stress can be very different.

The price of deposits can change

Deposit funding is not automatically cheap forever. When market interest rates rise, customers may demand better rates, move into term deposits, shift to competing banks or choose other financial instruments. A bank that refuses to reprice may lose balances. A bank that reprices aggressively may keep the funding but pay much more for it.

This creates one of banking’s central tensions: the yield on existing assets may adjust slowly while the cost of funding adjusts quickly. A loan written two years ago at one rate can remain on the balance sheet while deposit customers expect today’s higher rate. The bank’s margin compresses even if no borrower defaults.

Funding is therefore not merely about having enough liabilities. It is about cost, maturity, concentration and behavioural stability.

Maturity is hidden inside the funding problem

Banks often hold assets that mature over long periods: mortgages, business loans and other credit exposures can last years. Many liabilities can leave much sooner. A current account may be legally withdrawable on demand. Wholesale borrowing may mature in days or months.

This mismatch is not an accidental defect. Maturity transformation is one of the economic services banks provide. Savers may want liquid claims while borrowers need long-lived financing. The bank sits between those preferences.

But transforming maturity creates risk. If too much short-term funding has to be replaced while long-term assets cannot be sold or repaid quickly, the institution can become vulnerable even when many of its borrowers remain perfectly solvent.

A bank cannot force funding providers to stay

This is the part of banking that becomes visible during stress. Management controls many internal decisions, but it does not control every creditor’s behaviour.

• A depositor can transfer funds to another bank.
• A wholesale lender can decline to renew a maturing facility.
• A bond investor can demand a much higher yield in the next issuance.
• A secured lender can demand better collateral terms as market conditions change.
• A counterparty can reduce exposures if it becomes uncomfortable with the institution.

Funding resilience therefore depends partly on maintaining options before they are needed. A bank that waits until every cheap funding route has disappeared before developing alternatives has discovered the problem too late.

Why a bank may compete for deposits even though it can create them

This is no contradiction. Creating a deposit through lending creates a liability to the borrower. Attracting deposits from the market changes the composition and distribution of the bank’s funding. The bank may want stable customer balances because they reduce dependence on more expensive or volatile sources.

Think of a restaurant that can write an IOU for ingredients. The ability to issue the IOU does not guarantee suppliers will accept it indefinitely, nor does it remove the need for sustainable cash flow. In banking, the institutional mechanisms are more sophisticated, but the discipline is similar: claims must remain acceptable to the people who hold them.

Funding costs enter the price of a loan

A bank cannot price a loan intelligently by looking only at the borrower’s promised interest rate. The bank has its own cost structure.

A simplified lending decision has to consider at least:

• expected interest and fee income;
• expected credit losses;
• the cost of funding;
• the capital allocated to the exposure;
• operating and servicing costs;
• liquidity implications;
• the value of collateral or guarantees where relevant;
• and the return the bank requires for taking the risk.

This is why a bank can reject a loan that looks profitable if one only compares the customer rate with zero. The bank does not fund itself at zero, operate at zero cost or absorb risk with zero capital.

Internal transfer pricing: making funding visible inside the bank

Large banks often need a way to prevent each business line from pretending funding is free. One conceptual solution is internal funds-transfer pricing: treasury assigns an internal funding value or cost to assets and liabilities so that business units are evaluated more realistically.

A lending team may see a customer willing to pay 5 per cent. Treasury may see that the relevant maturity, liquidity and funding profile costs much more than the lending team assumes. Internal pricing forces the two views into the same decision.

This is a useful example of why bank profitability is an engineered system. The customer sees one loan rate. Inside the institution, that rate has to support many invisible layers.

Funding can be plentiful and still be dangerous

A rapidly growing bank can attract enormous funding during good times. That does not prove the funding is durable. Cheap wholesale money can encourage rapid asset growth. Concentrated corporate deposits can make a balance sheet look liquid. Short-term markets can remain open for years.

The weakness appears when conditions rotate. What happens if market lenders stop rolling? What happens if a few large depositors move together? What happens if collateral values fall? What happens if funding costs rise before asset yields reprice?

A serious funding strategy is therefore designed for the day when yesterday’s easiest assumption stops being true.

The four layers should now be separated

Layer	What can go wrong
Loan creation	The bank can originate poor-quality assets
Funding	The bank can rely on funding that is expensive, concentrated or short-lived
Liquidity	The bank can lack immediately usable resources when payments leave
Capital	The bank can lack sufficient loss-absorbing capacity when assets deteriorate

A bank can fail at any one of these layers. That is why no single ratio and no single slogan can describe bank resilience.

A miniature funding story

1. Bank A creates a $1 million loan and matching deposit.
2. The borrower pays suppliers at several other banks.
3. The created deposit largely leaves Bank A, but the $1 million loan asset remains.
4. Bank A settles the outgoing payments using settlement liquidity.
5. Treasury replaces or offsets the outflow through incoming deposits, market funding, asset management or other available sources.
6. Over the following years, the loan produces scheduled repayments while its funding mix changes repeatedly.
7. If the bank can fund the asset at an acceptable cost and the borrower performs, the loan can contribute positively.
8. If funding becomes unstable or expensive, the economics of the same unchanged loan can deteriorate.

The lesson is subtle but powerful: the loan is created once; the funding problem is managed continuously.

What funding does not do

Funding does not guarantee solvency. A bank can borrow enough money to postpone a problem while its assets are losing value. Funding also does not substitute for capital. Borrowed money creates another obligation; capital is the layer expected to absorb losses before ordinary creditors do, subject to the bank’s capital structure.

This distinction becomes essential when a loan goes bad. The bank may have plenty of funding and enough cash to operate today, but a credit loss still reduces the economic value of its assets. Something has to absorb that loss. That is the job of capital.

Five questions that reveal whether you understand bank funding

1. If a bank can create a deposit when it lends, why can the borrower’s spending still create a funding problem?
2. Why are funding and liquidity related but not identical?
3. Why can a large deposit base be unstable even when the total number looks impressive?
4. Why does the maturity of funding matter for a long-term loan book?
5. Why can higher funding costs damage profitability even when borrowers continue paying on time?

If the answers are clear, banking begins to look less like money sitting in boxes and more like what it really is: a managed structure of claims across time.

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