Understanding a Bank's Liabilities

A bank's financing sources are key to its success.

Emil Lee
Emil Lee
Jan 8, 2007 at 12:00AM

In a previous article, we took a look at the asset side of a bank's balance sheet. Now we take a look at the other side.

If a bank's yield-producing earning assets are its meal ticket, then its liabilities and shareholder equity are its lifeblood. Basically, a bank borrows at low interest rates from depositors, creditors, and other banks, and it lends at a higher interest rate to real estate developers, homeowners and small businesses (which is why banks are referred to as "spread lenders").

As a result, a bank's financing base is critical. The more financing it gets at a lower rate, the more money it can make by lending that money out and collecting the spread. The best way to judge the strength of a bank's financing base is to check out its "sources of funds" footnote.

Deposits are a bank's most important source of financing. Not only do most checking, demand, NOW, and savings deposits yield low or no interest rates, which means the bank is paying almost nothing for the use of this money, but they are often a stable and growing financing base.

If we take a look at the sources of funds footnote for Commerce Bancorp (NYSE:CBH) and PNC Financial (NYSE:PNC), we can see that the majority of their liabilities are from deposits. For Commerce Bancorp, out of its $40 billion funding base as of the latest quarter, 88% was from deposits. However, it's also important to note the makeup of the deposit base, because obviously interest-free deposits are more valuable than more expensive sources of funds, such as brokered high-yield certificate of deposits. Twenty percent of Commerce's funding base was from non-interest-bearing deposits, while 15% of PNC's average asset balance was funded by non-interest-bearing deposits. The tables below show each bank's deposit mix and the rates paid on each type of deposit.

Commerce Deposits

% of Avg. Assets











Time deposits



PNC Deposits

% of Avg. Assets











Money market



Retail time deposits



Banks tend to shun the use of other sources of borrowings, such as borrowings from other banks through federal funds purchases and repo agreements, bank notes, long-term debt, and commercial paper. Unlike core depositors, who for the most part are happy to receive any interest at all, these lenders demand and receive higher yield, so banks try not to use too much in the way of "other borrowings." Commerce, a bank renowned for its ability to attract deposits, used other borrowings for only 6.5% of its borrowing base. PNC, which has a more complicated mix of business requiring more diverse funding sources, had 15.1% of funds from other borrowings, with yields ranging from 3.9% to 6%.

Shareholder's equity
Shareholder's equity is the part that you, the shareholder (as opposed to depositors and other creditors), are financing. Because banks, after paying depositors and creditors, only earn a small return on their assets, often only 0.75% to 1.5%, they must leverage each dollar of equity into $10 to $15 worth of assets to achieve a satisfactory return on equity of 10% to 15%.

Bottom line
The larger a bank gets, the more complex its balance sheet. For a money-center bank like Citigroup (NYSE:C) or JPMorgan Chase (NYSE:JPM), whose tentacles reach beyond traditional spread-lending into investment banking, asset management, private equity, and securitization, you'll find a much more complicated financing base filled with a more complex mix of debt, derivatives such as mortgage-backed securities and leveraged loans, and other complicated borrowing arrangements. A small community bank like Bank of the Ozarks (NASDAQ:OZRK), however, will be more straightforward, with assets primarily funded by deposits and a small slice of other borrowings and shareholder equity.

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When investing with a bank, always make sure to take a glance at the sources of funds footnote. Check out what mix of its asset base is funded by non-interest-bearing deposits, as well as other low-cost sources, and check out the trend in the funding composition over time. A bank that can grow its low-cost deposit base over time should do well, but a bank that increasingly has to resort to offering high-yield CDs could see its margins squeezed.

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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates comments, concerns, and complaints. The Motley Fool has a disclosure policy.