In a recent blog discussion, I made the comment that banks have to compete for funds with non-bank financial institutions (NBFIs). Somebody questioned this by pointing to the fact that when investors transfer funds to NBFIs, this doesn't actually remove funding from banks, it merely transfers bank deposits around. I think the person who made the comment understands the distinction but it does highlight a common confusion, so I thought I'd say something on it.
First of all, we can note that in a very simple model, banks create their own funding and do not need to worry about having to compete with anyone else. In this model, banks have only one liability - bank deposits. There is also no cash, so funds cannot be withdrawn. The only way that bank deposits can change is therefore if their loans or investments change. Banks compete with other banks of course, but in the simple model we can ignore this. In this world therefore, banks do not need to worry about the liability side of their balance sheet - it looks after itself. Once deposits are created by lending, they are always there.
If households wanted to switch out of bank deposits into NBFI investments, they would transfer funds to the NBFIs, but this wouldn't reduce the overall amount of bank deposits. It simply transfers them from one person to another.
In the real world, banks have complex balance sheets. In particular, their assets are funded by a range of liabilities. These included transactions accounts, term deposits, wholesale deposits and repo, and capital market instruments. They also have equity. The balance between these different types of funding is important. Whether for regulatory or business reasons, banks need to manage the mix.
Unlike in the simple mode, this means that banks cannot just forget about the liability side of their balance sheet.
Again, I want to ignore the fact that banks compete with each other and look at the impact of NBFIs. Let's imagine, for some reason, that NBFIs start to offer higher returns on certain types of savings bonds (perhaps they have found a way to get round regulatory restrictions on holding certain types of higher yield assets). Investors now might decide to run down their term deposits with banks and place more money into NBFIs.
This does not of course reduce the overall amount of bank funding. However, it does involve a change in the composition of bank balance sheets away from longer term funding and into demand deposits. This matters to banks and if the switch is material and persistent, banks will be forced into raising the rates on their term deposits, in order to attract in more term money.
Therefore, even though the totality of bank liabilities is determined primarily by what happens on the asset side of their balance sheet, banks do not avoid having to compete for funds with NBFIs and other borrowers.
For more on this, see my earlier post: Banks, Non-Banks and the Interest Rate Effect