Funding the Bank

On September 14, 2001, the four federal banking regulators issued a warning that, only a few days before, would have been unimaginable. The regulators essentially warned banks to brace themselves for unusually large deposit inflows.

In a joint interagency statement, the Federal Reserve Board, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and Office of Thrift Supervision told bankers that market responses in the aftermath of the tragic events of September 11 could lead to significant, temporary balance sheet growth at some banking organizations.

Besides predicting large deposit inflows, the agencies alerted bankers that corporate borrowers were likely to make unusual draws on their existing lines of credit or request new lines in response to a perceived need for extra liquidity.

Sure enough, the events of September 11 induced behavioral changes among investors, triggering the predicted increase in total assets at many financial institutions … and the stock market plunge. How the world changed in so many ways on that terrible day!

A time to prepare

As America heroically gets back on its feet, we are strongly reminded of the inevitability of change and the need for preparedness. For bankers and board members, it would be a mistake to think that today’s sudden flush of deposits means that we are going back permanently to the world before the 1980s, when growth in core deposits typically outpaced loan demand.

We appear to be revisiting that time, if only briefly. As the pendulum inevitably swings back, the economy cycles out of recession, and investors regain their confidence (as they have already tentatively begun to do), bankers will once again be challenged to complement their core deposits with alternative funding sources. Indeed, in the future, banks will encounter an increasing need for these alternative sources to fund their operations, maintain an appropriate balance in their asset/liability mix, and manage their net interest margins.

How do we know that? Most bankers have anecdotal evidence that core deposits have been steadily falling for years. The numbers confirm the story:

• In 1995, core deposits funded 88% of loans at commercial banks. In 2000, only 75% of commercial bank loans were funded by core deposits.
• Deposits in community banks declined by 2% between 1995 and 2000, while loan demand grew by 11%.
• Consumers are putting more of their money into uninsured investment products. Insured bank deposits, as a percentage of household assets, shrunk from 22% in 1990 to 12% in 2000.
• For community banks with under $1 billion in assets, core deposits now comprise only about 70% of their funding base.

Will world events reverse these trends? The regulators think not. They believe the balance sheet growth being seen at some banking organizations following the terrorist attacks is a temporary situation.

I strongly urge you to use this time to prepare your bank for the future, when your management team will doubtless be called upon to implement innovative funding strategies to supplement the institution’s core deposits. Now is the time to get a better understanding of your options.

Core deposits are your first line of defense

I know of a few community bankers who regularly tap alternative funding mechanisms, such as Federal Home Loan Bank advances. Alternative funding is an edgy topic for community banks, and many of those who employ these mechanisms delight in being on the frontier of community bank management. But be careful. Not all community bankers have the requisite knowledge to carry out a sound asset/liability strategy that employs alternative funding sources.

For most community banks, enhancements to existing products and services remain the focal point of their funding strategies. Community bankers know their own products and customers best, and growing core deposits through targeted marketing and product strategies may be less expensive and risky than wandering into the wholesale funds market. Consequently, core deposits will remain a primary funding tool for community banks in the near term.

Competition in the financial services industry, however, has undeniably made it much harder to generate core deposits, notwithstanding bankers’ efforts to innovate. Banks are losing a growing portion of their traditional insured deposit franchise to common stocks, mutual funds, and money market accounts at brokerage houses. As deposits decline and interest rate margins continue to tighten, greater pressure is being exerted on bank earnings.

Notwithstanding the recent (and probably temporary) influx of deposits, most community banks now realize that they must incorporate alternative funding strategies into their overall asset/liability strategies. Total reliance on core deposits to fund bank operations is no longer a viable management position.

Alternative funding sources: handle with care

As a starting point, I encourage you to familiarize yourself with the various alternative funding mechanisms available to banks. When your management team steps forward to seek approval to use one or more of these tools, you will be able to contribute to a productive discussion of the pros and cons and make informed decisions.

The descriptions of alternative funding mechanisms shown in the sidebar box on page 59 are very basic. Remember that many banks seek the advice of a correspondent banker or investment banker before wading into alternative funding strategies. These experts are able to evaluate the applicability and accessibility of specific funding mechanisms to a particular community bank, given its size and the nature of its ongoing asset/liability policies.

Experience with alternative funding strategies is crucial from a risk management perspective as well. Each of the funding mechanisms listed in the glossary on page 59 bear certain risks, the principal ones being:

• Liquidity risks arising from borrowing or purchasing funds and from offering rate-sensitive deposits.
• Interest rate risk, which is present when you shift to a short funding structure or use option-laden borrowings, such as some Federal Home Loan Bank advances.
• Credit risk, which comes from dealing with counterparties in repo transactions or securitizations.
• Operational risk, that can occur when executing transactions in the money markets.

The board of directors should be instrumental in making sure that management pursues alternative funding strategies within a sound policy framework. The board should approve the bank’s alternative funding strategies and set policies for managing liquidity, interest rate, credit, and operational risks.

A risk management policy should define how risk will be measured and specifically limit the relevant risk exposures. The policy should also incorporate contingency plans that specify the steps that will be taken if risk exposures reach certain levels. With respect to liquidity risk in particular, the policies and procedures should spell out the parameters and responsibilities for day-to-day liquidity and funding management.

The board should also demand that satisfactory controls be set in motion, including an ongoing internal auditing process to monitor alternative funding transactions. The board’s leadership in instituting control and audit mechanisms is crucial to minimizing the risks and maximizing the benefits of alternative funding strategies.

Finally, I urge directors to intensify their oversight activities with respect to alternative funding strategies. If there is any time your bank needs your thoughtful and steady involvement, it is when the bank goes outside to supplement its core deposits. Ask for regular briefings, the more the better. And insist that management stay within the letter of the bank’s policies, procedures, and risk management practices.

At left is a ten-step action plan for locating and tapping alternative sources of funding.

A different world in so many ways

For sure, your bank’s balance sheet will shift once you begin using purchased or borrowed funds and developing more complex and costly deposit products. Your bank will exist on thinner spreads and be exposed to new sources of risk. However, by gaining an understanding of those risks and mitigating them with prudent policies, written procedures, and a good dose of management scrutiny, your balance sheet will remain strong and your bank will continue to prosper into the future.

Your bank has an unexpected moment in time to prepare, and I encourage you to take advantage of it. |BD|

Banker’s banksu00e2u20ac”Banks can purchase fed funds and market CDs through commercial banks owned exclusively by other banks. Banks can also obtain ancillary services, such as cash letters, and public funds CD programs.

Brokered depositsu00e2u20ac”A third-party, often a securities broker/dealer, arranges brokered deposits by collecting funds from groups of small investors, pooling them, and marketing them to banks in blocks of $100,000 or less so that the deposits retain FDIC insurance coverage. Under recent federal regulatory guidance, brokered deposits are not considered stable sources of funds and may be very expensive. However, they are useful when a bank needs to quickly raise a certain amount of funds at a specific maturity.

Commercial paperu00e2u20ac”This is a short-term, unsecured promissory note issued to investors. Banks cannot issue commercial paper directly, but their bank holding company or nonbank subsidiary may do so. Commercial paper represents a way of raising funds without undertaking the complicated process of issuing corporate bonds. This is a short-term, volatile source of funds.

Eurodollar depositsu00e2u20ac”Denominated in U.S. dollars, these deposits are held outside the United States, often at international banking facilities (IBFs) of U.S. banks. Banks that have IBFs can offer Eurodollar time deposits and Eurodollar CDs. These deposits are not protected by FDIC insurance and are commonly sold to institutional investors and large corporations. Individuals who are not U.S. citizens may also buy them.

Fed discount windowu00e2u20ac”Discount window borrowings are short-term, collateralized loans made by the Federal Reserve to banks that maintain reserves. This is considered a last-resort source of funding, although the Fed allows small rural banks to use the discount window to fund seasonal fluctuations in their balance sheets.

Fed fundsu00e2u20ac”These are the reserve balances that every bank is required by law to hold on balance at a Federal Reserve Bank. Currently, 10% of transaction accounts must be held in reserve. These reserve funds, whose purpose is to maintain bank liquidity, may be borrowed and loaned among banks in the fed funds market. These borrowings are unsecured and are known as “purchases” and are identified on the liability portion of the balance sheet as “fed funds purchased.”

Federal Home Loan Bank borrowingsu00e2u20ac”The FHLB banks offer loans or “advances” at a variety of terms, prices, and maturities. This funding source was expanded by changes in collateral requirements made by the Gramm-Leach-Bliley Act. Banks must become members of their regional FHLB bank in order to borrow.

Internet listing servicesu00e2u20ac”Using the Internet, banks are marketing deposit instruments, such as CDs, outside their normal market areas through CD listing services or directly through a Web site. The Internet gives banks the ability to raise significant amounts of funds quickly, but the regulators consider listing services to be a volatile sources of funds.

Security repurchase agreementsu00e2u20ac”A repo is a simultaneous agreement for a bank to sell a security to a counterparty and then buy it back the next day or on maturity. The transaction is secured by the securities from the bank’s investment portfolio.

Subordinated debtu00e2u20ac”This is a source of long-term debt used to fund acquisitions, contribute capital to subsidiaries, refinance short-term debt, fund long-term assets, or raise supplemental capital. Subordinated debt is usually issued through the holding company, and, for small banks, is almost always privately placed with institutional or qualified private investors.

Treasury Tax and Loan Programu00e2u20ac”Businesses deposit their tax payments electronically to the Department of the Treasury, and these deposits are held by participating banks until needed by the government. Banks can participate as “remittance banks” by receiving the payments, or as “note banks” by holding the funds. These deposits are fully collateralized but are volatile because a bank cannot guarantee that it will have a given balance on a given day.

Trust-preferred securitiesu00e2u20ac”To raise funds, a bank holding company sets up a subsidiary trust in which it owns 100 percent of the common equity. The trust sells preferred securities to investors. The cash proceeds from the sales are received into the trust, and the trust lends the proceeds to the bank as subordinated debt. Trust-preferred securities enable a bank to increase its capital, receive a tax deduction, and avoid shareholder dilution. Community banks can participate in packaged TPS deals.