Sources and Uses of Funds at Commercial Banks
Funds provided by commercial banks for a medium-term period.
line of credit
Access to a specified amount of bank funds over a specified period of time.
Commercial banks obtain most of their funds by accepting deposits from investors. These investors are usually individuals, but some are firms and government agencies that have excess cash. Some deposits are held at banks for very short periods, such as a month or less. Commercial banks also attract deposits for longer time periods by offering certificates of deposit, which specify a minimum deposit level (such as $1,000) and a particular maturity (such as 1 year). Because most commercial banks offer certificates of deposit with many different maturities, they essentially diversify the times at which the deposits are withdrawn by investors.
Deposits at commercial banks are insured up to a maximum of $100,000 per account by the Federal Deposit Insurance Corporation (FDIC). Deposit insurance tends to reduce the concern of depositors about the possibility of a bank failure, and therefore it reduces the possibility that all depositors will try to withdraw their deposits from banks simultaneously. Thus the U.S. banking system efficiently facilitates the flow of funds from savers to borrowers.
Commercial banks use most of their funds either to provide loans or to purchase debt securities. In both cases they serve as creditors, providing credit to those borrowers who need funds. They provide commercial loans to firms, make personal loans to individuals, and purchase debt securities issued by firms or government agencies. Most firms rely heavily on commercial banks as a source of funds.
Some of the more popular means by which commercial banks extend credit to firms are term loans, lines of credit, and investment in debt securities issued by firms. Term loans are provided by banks for a medium-term period to finance a firm's investment in machinery or buildings. For example, consider a manufacturer of toys that plans to produce toys and sell them to retail stores. It will need funds to purchase the machinery for producing toys, to make lease payments on the manufacturing facilities, and to pay its employees. As time passes, it will generate cash flows that can be used to cover these expenses. However, there is a time lag between when it must cover these expenses (cash outflows) and when it receives revenue (cash inflows). The term loan can enable the firm to cover its expenses until a sufficient amount of revenue is generated.
The term loan typically lasts for a medium-term period, such as 4 to 8 years. The interest rate charged by the bank to the firm for this type of loan depends on the prevailing interest rates at the time the loan is provided. The interest rate changed on term loans is usually adjusted periodically (such as annually) to reflect movements in market interest rates.
Commercial banks can also provide credit to a firm by offering a line of credit, which allows the firm access to a specified amount of bank funds over a specified period of time. This form of bank credit is especially useful when the firm is not certain how much it will need to borrow over the period. For example, if the toy manufacturer in the previous example was not sure of what its expenses would be in the near future, it could obtain a line of credit and borrow only the
amount that it needed. Once a line of credit is granted, it enables the firm to obtain funds quickly.
Commercial banks also invest in debt securities (bonds) that are issued by firms. When a commercial bank purchases securities, its arrangement with a firm is typically less personalized than when it extends a term loan or a line of credit. For example, it may be just one of thousands of investors who invest in a particular debt security the firm has issued. Nevertheless, recognize that a bank's credit provided to firms goes beyond the direct loans that it provides to firms, because it also includes all the securities purchased that were issued by firms.