Many more community banks used structured notes and mortgage-backed derivatives last year than said they would - a trend that is expected to continue.
In a 1995 survey by Grant Thornton, only 17% of community bankers said they would invest in the financial instruments. This year's survey shows that 42% actually invested in them.
According to Diane Casey, national director of the financial services firm, 24% of the bankers surveyed by the firm said they would use structured notes in 1996, but that percentage is probably too low as well.
The accounting firm surveyed 752 community bank chief executives from across the nation in December. Of these banks, which averaged $82 million in assets, 90% said their main regulator was either the Federal Deposit Insurance Corp. or the Office of the Comptroller of the Currency.
"I think regulatory scrutiny leads these bankers to predict lower usage of these products" than they actually expect, said Ms. Casey, the former executive director of the Independent Bankers Association of America.
Derivatives are complex financial instruments whose value is based on an underlying security or index. Investors experienced large losses on structured notes when interest rates started rising in February 1994.
The securities, which are issued by government-sponsored entities like the Federal Home Loan Banks and Federal National Mortgage Association, enable banks to increase the yield of their portfolios and can help a bank overcome an increase in deposit costs.
Now that regulators have specified some of their concerns about derivatives, there is less uncertainty in the market, and that has helped lure community bankers back into ordinary structured and derivative products.
"As bankers begin to get a better feel for how regulators will view derivatives, I think the use of derivatives will go back up again," said C.J. Pickering, president and chief executive of IBAA Securities Corp., a wholly owned securities subsidiary of the Independent Bankers Association of America.
While some banks are already returning to the market for plain vanilla products, Mr. Pickering said most will wait until the latter half of the year. Even then, he predicts, bankers will stick to less exotic, on-balance instruments.
Meanwhile, as use of derivatives is expected to rise, community bankers are also expected to consider alternative funding methods.
According to the survey, 41% of community bankers say they plan to use the secured funding lines offered by the Federal Home Loan Bank to alleviate funding pressures. In the past year, 27% of the banks surveyed said they had tapped this liquidity source.
Ms. Casey said the increased interest in the Home Loan Bank's advances stems from enduring credit demand combined with growing competition for deposits. In fact, 26% of community bankers surveyed reported a loss of core deposits during the past year.
"This is a new experience for community banks," said Ms. Casey. "The nice thing about Federal Home Loan Bank advances is that the banks can just go to the window and get (the money)."
