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How Bank Certificates of Deposit Work
by Carmelo J. Montalbano
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How Bank Certificates of Deposit Work
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Definition of a Bank Certificate of Deposit
Bank certificates of deposit, or CDs, are short and intermediate maturity notes that are purchased by the investing public. CDs are offered with insurance guarantees by the Federal Deposit Insurance Corporation for up to $100,000 and, under times of financial duress, up to $250,000. Certificates of deposit are popular because they are liquid, easy to purchase, have strong credit backing, and yield more than bank savings accounts.
Certificates of deposit represent an important source of bank funding for all their loan and business activities. Banks profit by the spread between the cost of the certificates of deposit and the rate at which the bank lends the money.
Jumbo certificates of deposit are large CDs written to large institutions. Jumbo CDs are over $100,000 in value and often denominated in the millions or tens of million of dollars. They are usually purchased by money market funds and large institutions seeking a place to deposit large sums of cash on a temporary basis. Jumbo certificates of deposit usually have maturities of months rather than years.
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How Banks Use Certificates of Deposit
Certificates of deposit are issued by banks mainly for lending operations. Because certificates of deposit are stable sources of bank funding, bank regulators look at CD issuance as a high-quality source of capital. Thus, the regulatory "haircut," or amount of deposit required to be kept as a reserve, is low, making CDs an even lower cost of lending compared to other debt offerings. Certificates of deposit are usually issued with maturities of several months to 10 years with most certificates of deposit due in 2 years or less. Certificates of deposit are more reliable sources of funds than savings accounts or checking account deposits. Bank certificates of deposits are the main source of bank Tier 1, or highest quality, level assets. Banks, in turn, use the deposit base to make loans to customers in which they can extract higher rates of interest, such as mortgages, corporate lending or other bank funding activities such as corporate lines of credit and foreign loans.
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Terms of the Certificate of Deposit
Certificate of deposits carry some special requirements in order for customers to receive a higher rate. Certificates of deposit carry penalties if the customer decides to redeem the proceeds early. Customers usually receive a much lower default rate equal to the lowest yielding instrument the bank offers for the period of time. Some certificates of deposit have call features so high interest rate certificates of deposit can be redeemed by the bank if rates drop. This leaves the customer in a position of looking at lower rates of interest in which to invest the redeemed proceeds. In addition, some banks will automatically invest a matured certificate of deposit at a lower, short-term rate if the proceeds are not withdrawn after a certain period of time.
