Uncertainty about the rules for brokered deposits has undermined FDIC sweep deposits, a major source of liquidity for the U.S. banking industry.
A lack of clear guidance from banking regulators about the accounting and liquidity treatment of FDIC sweeps, both generally and under Basel III liquidity coverage ratio and capital guidelines, has added to the uncertainty.
By some estimates this lesser-known source of bank funding totals more than $1 trillion. Broker-dealers bundle their clients' uninvested cash balances into large money market deposit account deposits and place them with banks. The banks pay interest on the deposit, part of which is passed on to the broker-dealer's customer. The customer receives FDIC protection on the cash balance kept in the broker-dealer's program under "pass-through" provisions of federal banking regulations.
The FDIC sweep deposit market between broker-dealers and unaffiliated banks has slowed drastically over the past year, according to industry participants. The broker-dealers that participate in the FDIC sweep market report a much more difficult time finding banks to take their deposits for two reasons. First, banks have massive amounts of short-term liquidity due in part to slow loan demand, but also an increase in core deposits. Such deposits grew more than $700 billion between June 2011 and June 2012. While it is difficult to track the causes and sources of this growth, it is in part due to the continued unlimited FDIC protection on transaction accounts through the Transaction Account Guarantee program. Thus, banks' need for deposits from broker-dealers with overnight deposit maturities has gone down dramatically.
Second, and more importantly, banks are unsure if deposit contracts with broker-dealers that have longer-term rate and contract maturities will be treated as such under Basel III.
Basel III liquidity coverage ratio provisions require a bank to classify all deposits into categories of projected run-off risk, and to hold reserves in the form of liquid assets equal to the projected deposit runoff under the required stress scenarios.
For example, because it has no contractual maturity date, a retail MMDA account is assumed to have a 10% runoff if a bank were under stress. The bank must hold an amount equal to the 10% in liquid securities at a far lower yield than the average of loans and other assets. By some estimates the equivalent cost of the 10% requirement is 35 to 50 basis points more in interest cost on the deposit. Certificates of deposit of a year or longer, on the other hand, are assumed to have no runoff under the same stress scenario. So other things being equal, the bank's net revenue is higher when funded by a CD than an MMDA.
Assume a broker-dealer and a bank enter into an agreement for a large deposit with a contractual maturity of more than one year, and an equivalent penalty for early return of the deposit to the broker-dealer. On the surface the bank is in the same position as it would be in a retail CD. Given how the draft of Basel III Liquidity Coverage Ratio stands now, some banks believe such a contract would be treated as a CD wouldand there would be no yield-diluting short-term liquid asset requirement.
Other banks, however, believe such contracts will be treated by regulators as short-term despite the contractual maturity and early termination penalties, because in this case they are brokered, not core, deposits.
These banks believe they cannot enter into longer term contracts with broker-dealers until the uncertainty is resolved. Unfortunately , the guidelines issued so far for Basel III do not even mention brokered deposits in general, or FDIC sweep variations in particular. It is unclear when (or even if) Basel III will be implemented in the U.S., even for the much more refined capital provisions, and its LCR provisions are not even under serious discussion, so resolution may be years away
Even without the complications of Basel III, banks already differ in their interpretation of accounting and regulatory treatment of FDIC sweep deposits.
Some banks believe that because these deposits are always classified as brokered they are inherently less valuable than the equivalent maturity core deposit, given the regulatory bias.
Prior to 2008, banks that held brokered deposits had to pay higher FDIC insurance premiums on those balances. In addition, a bank's reported liquidity ratios were hurt. In 2011 the Federal Reserve, in response to a Dodd-Frank requirement, re- examined the role of brokered deposits with the following outcomes:
- Well capitalized banks would no longer pay a higher FDIC premium for brokered deposits
- FDIC field examiners were instructed to view brokered deposits the same way as any other deposit source with respect to bank liquidity reporting
- Banks that have obtained deposits from an affiliated broker dealer were allowed to classify such deposits as core rather than brokered.
While it would seem that a bank should now be indifferent to brokered versus core deposits for regulatory and accounting purposes, their actual behavior is all over the board. Banks need medium term liquidity now, and their appetites for funding will increase as loan demand picks up, hopefully driven by an accelerating economy.
Basel III may also greatly increase FDIC sweep deposit demand if the CD-like favorable treatment mentioned above is given to longer-term FDIC sweep contracts, because MMDAs, which account for roughly 50% of bank deposits, will be so much less favored under currently drafted Liquidity Coverage Ratio guidelines
The time to resolve these issues is now before circumstances drive a hasty response. Broker-dealers need to get these deposits deployed and continue providing protection to their customers at rates that the customers can live with and that generate reasonable revenue for the broker-dealer. It would be very helpful if the FDIC and other regulators could provide some specific guidance regarding these issues.
Richard Heitman is the president of Heitman Financial Services Consulting, which helps broker dealers find partner banks for their FDIC Sweep programs. He can be reached at richardhheitman (at) gmail.com.