Banking

To have funds to lend, banks must attract investors in a competitive interest rate environment. They compete against other banks and financial institutions and also against companies that offer other investment products ranging from bonds to common stocks. A bank’s success relies primarily on its ability to generate returns in excess of its funding costs. A bank tries to maintain a positive difference between its cost of funds and its returns on assets. If banks anticipate falling interest rates, they will try to invest in longer-term assets to lock in the returns while seeking short-term deposits, whose interest cost is expected to fall over time. When banks expect rising rates, they will try to lock in longer-term deposits with fixed-interest costs, while investing funds short term to capture rising interest rates. The risk of such strategies is that losses may occur should a bank incorrectly forecast the direction of interest rates. The aggressiveness of a bank’s strategy will be related to the size of its capital ratio and the oversight of regulators.

Banks need substantial liquidity to meet withdrawals and loan demand by its customers. A bank has two forms of liquidity. Internal liquidity is provided by a bank’s investment portfolio that includes highly liquid assets that can be sold to raise cash. A bank has external liquidity if it can borrow funds in the central bank's funds from central bank’s discount window, or by selling certificates of deposit at attractive rates who have excess money to invest such kinds of lucrative investment products.