Certificate of Deposit
A certificate of deposit is a time deposit offered by banks and other financial institutions, with a specified maturity and typically a fixed interest rate. It is a savings instrument that pays interest in exchange for the depositor's agreement to leave funds on deposit for a specified period.
Characteristics
A certificate of deposit has a stated maturity, ranging from a few months to several years, and a stated interest rate. Early withdrawal typically incurs a penalty, reflecting the bank's reliance on the funds for a known period. Certificates may be issued in large denominations for institutional investors or in smaller amounts for individuals.
Interest may be paid periodically or at maturity, and the rate may be fixed or variable. The terms vary across institutions and markets, and the rates offered reflect market conditions, the maturity, and the characteristics of the depositor.
Negotiable Certificates
Negotiable certificates of deposit are large-denomination instruments that can be traded in secondary markets. They are issued by banks to institutional investors and are used as a source of short-term funding. The negotiability of these instruments makes them liquid, and they are traded at prices that reflect current interest rates.
The market for negotiable certificates is a component of the money market, providing banks with access to short-term wholesale funding. The rates on these instruments are closely related to other money market rates, and they respond to changes in monetary policy.
Role in Banking
Certificates of deposit are a source of funding for banks, providing stable funds for a known period. Because early withdrawal is penalised, certificates are less prone to runs than demand deposits, and they contribute to the stability of bank funding.
The rates paid on certificates affect the cost of funds and the net interest margin of banks. Banks adjust the rates they offer in response to market conditions and to their funding needs, and the terms of certificates are part of the management of the balance sheet.
Regulation
Certificates of deposit are subject to regulation, including deposit insurance, which covers eligible deposits up to specified limits. The insurance protects depositors and contributes to stability, though it also creates moral hazard that is addressed through supervision and capital requirements.
The disclosure of terms, including interest rates and penalties for early withdrawal, is regulated to protect depositors. The design of regulation must balance the protection of depositors against the costs it imposes on institutions and the risk of distorting their funding decisions.
Money Market Instruments
Certificates of deposit are one of a range of money market instruments, which are short-term debt securities traded in the money market. Other instruments include treasury bills, commercial paper, and repurchase agreements.
Money market instruments are characterised by their short maturities, their liquidity, and their low credit risk. They are used by institutions to manage their short-term funding and by investors to hold liquid assets, and the rates on them are closely related and respond to changes in monetary policy.
Interest Rate Determination
The interest rate on a certificate of deposit reflects several factors, including the current level of short-term rates, the maturity of the instrument, the creditworthiness of the issuer, and the conditions in the market. The rate is typically higher than the rate on demand deposits, reflecting the depositor's commitment to leave funds on deposit.
The rates on certificates of deposit respond to changes in monetary policy, and they are closely related to other money market rates. The relationships among rates, including the spread between the certificate rate and the policy rate, provide information about conditions in the funding market.
Large and Small Denominations
Certificates of deposit are issued in a range of denominations. Large-denomination certificates, typically issued to institutional investors, are negotiable and traded in secondary markets. Small-denomination certificates, issued to individuals, are typically non-negotiable and are held to maturity.
The characteristics of the instruments differ, reflecting the needs of the investors. Large-denomination certificates provide liquidity and are used for short-term funding, while small-denomination certificates provide a savings instrument for individuals.
Deposit Insurance
Certificates of deposit are typically covered by deposit insurance up to specified limits, providing protection for depositors. The coverage limits vary across jurisdictions, and the terms of the insurance affect the attractiveness of the instruments and the behaviour of depositors.
The design of deposit insurance involves trade-offs between the protection of depositors and the moral hazard that arises from the reduction of market discipline. The calibration of coverage and the design of premiums are central to the framework, and they affect the stability of the banking system.