Bank issues | Corporate debt

Bank issues

While bank products are part of the finance world, many banking products aren’t considered securities and therefore aren’t tested on the exam. Still, a few overlap with the securities markets. This chapter covers:

Certificates of deposit (CDs)
Jumbo (negotiable) CDs
Banker’s acceptances

Certificates of deposit (CDs)

Certificates of deposit (CDs) are similar to bonds, but they’re issued by banks. A CD pays a fixed rate of return based on the principal deposited (similar to a bond’s par value). You deposit money with the bank for a set period, the bank pays interest, and then returns the principal at maturity.

CDs can be short-term or long-term, and they may pay interest on different schedules (quarterly, semi-annually, annually, or at maturity). Traditional bank CDs don’t trade in the market; you generally buy them from the issuing bank and redeem them through that same bank.

Jumbo (negotiable) CDs

Jumbo CDs, also called negotiable CDs, are large-denomination CDs that trade in the secondary market. They have a minimum denomination of $100,000, and denominations of $1 million or more are common. That size puts them out of reach for many retail investors, although some financial institutions buy jumbo CDs and repackage them into smaller products for retail sale.

Because the minimum investment is larger, banks often offer higher rates on jumbo CDs than on traditional CDs.

Jumbo CDs are typically short-term. Many mature within one year of issuance, and some mature in as little as a week. This short-term structure makes them useful for institutions that want to park large amounts of cash for brief periods. Typical institutional buyers include pension plans, mutual funds, and large corporations.

Sidenote

FDIC insurance

Regular and jumbo CDs, along with general customer deposits at banks, are covered by FDIC insurance. Banks are required to obtain FDIC insurance for their customers, which protects depositors against loss of funds due to bank failure. To see why this matters, it helps to understand how a bank can fail.

Banks take deposits from customers, agree to safeguard those funds, and pay interest. To earn a profit, the bank invests most of the deposited money. Those investments might include making loans to customers (e.g., small business or personal loans) or purchasing securities.

Here’s a simplified example with small numbers. Suppose ten customers deposit $100 each, for total deposits of $1,000. You promise to keep their money safe and pay 2% annual interest*.

To make money, you invest most of the deposits, but you also keep some cash available in case customers want withdrawals.

*For sake of simplicity, let’s assume the interest is paid directly to the customer and is not reinvested or compounded.

Assume you invest $600 of the $1,000 in deposits. That means you’re holding back $400 in cash, which is a 40% reserve requirement* (you’re not investing 40% of customer deposits). You invest the $600 in “safe” long-term bonds.

*A 40% reserve requirement is quite conservative. Most banks today maintain a 10% reserve requirement.

In the first year, things go well. You owe customers $20 in annual interest (2% × $1,000). Assume your bonds pay you $50 of interest in that year. This shows how banks can earn profits: they make the spread between what they pay on deposits and what they earn on investments ($30 in this example). Also, none of the ten customers has requested a withdrawal yet.

In the second year, conditions worsen. Interest rates rise, and the value of your bonds falls from $600 to $400. At the same time, three of the ten customers request withdrawals totaling $300. You pay them, but you appear anxious and hesitant. That reaction makes other customers nervous.

The next day, six of the remaining seven customers request full withdrawals totaling $600. Now we can total up what you have available.

+$1,000 in original deposits
+$30 in first-year profits
-$200 loss on government bonds
-$300 in withdrawals (first three customers)

Total assets = +$530

Your remaining customers want $600, but you only have $530. Worse, $400 of that $530 is tied up in long-term bonds. To raise cash, you have to sell the bonds and lock in the loss ($600 original value vs. $400 sales proceeds). Even after selling, you still can’t meet all withdrawal requests. Here’s the final accounting:

+$1,000 in original deposits
+$30 in first-year profits
-$200 loss on government bonds
-$900 in customer withdrawals ($300 + $600)

Total = -$70

A bank failure occurs when customers request withdrawals that exceed the liquid cash the bank has available. This example is a simplified version of that situation. In the real world, bank failures can involve billions in losses (e.g., the Silicon Valley Bank failure in 2023). The two leading factors are usually the same: poor bank investments and a “run on the bank” (many customers requesting withdrawals at once).

FDIC insurance protects bank customers in these situations. Without it, depositors could lose some or all of their money if the bank failed. FDIC insurance covers customer deposits up to $250,000 per bank on a per-customer / per-ownership-category basis. For example, assume an individual has:

Individual savings account with $250,000
Individual checking account with $250,000
Joint savings account held with spouse with $500,000

If the bank failed, the total FDIC coverage would be $750,000: one $250,000 limit for the individual accounts (combined because they’re the same ownership category for the same depositor) and 2 × $250,000 = $500,000 for the joint account (each co-owner gets a $250,000 limit in that ownership category). FDIC coverage is applied per depositor, per bank, and per ownership category, so the spouse’s $250,000 of coverage is separate from the individual’s $500,000 total coverage.

Although jumbo CDs are issued in large denominations, FDIC insurance only covers up to $250,000.

Banker’s acceptances

A banker’s acceptance helps facilitate trade between international companies. Suppose an American importer wants to buy $50 million of TVs from a Chinese exporter. The exporter may want assurance of payment before shipping, since shipping costs are significant. At the same time, the importer may not want to pay before the TVs arrive. A banker’s acceptance can bridge that gap.

A bank acts as an intermediary between the exporter and importer. In this example, the American importer sends $50 million to the bank when the deal is made. The bank then sends a post-dated check to the Chinese exporter that becomes payable on the day the TVs are delivered.

The exporter can either:

Hold the check until delivery and then collect the full $50 million, or
Sell the check in the market at a slight discount to get cash sooner

For example, another organization might buy the check for $49.8 million, effectively advancing funds to the exporter. When the check becomes payable, that organization receives $50 million from the bank, earning a $200,000 profit. The exporter gets cash earlier, and the buyer earns a return for providing the funds.

The post-dated check that can be sold in the market is the banker’s acceptance. Investors use these short-term investments to earn a quick, generally safe return. They’re considered money markets because of their short-term nature. Banker’s acceptances are issued with 270 days or less until maturity to avoid Securities and Exchange Commission (SEC) registration requirements.

Key points

Certificates of deposit (CDs)

Pay a fixed amount of interest based on principal
The “bank version” of a bond

Jumbo CDs

Large bank deposits made for short periods
$100k minimum denominations
$1 million denominations are common
Trade in the secondary market

FDIC insurance

Covers up to $250k of bank deposits
Coverage provided per bank, per customer, and per ownership category (e.g., individual vs. joint accounts)

Banker’s acceptances

Used to facilitate international trade
Considered money markets
270 days or less to maturity