Correspondent Banking: Demand for Funds Putting Bankers' Banks in a

With loan demand rising and deposit growth slow, community banks are scrambling for cash to lend, industry observers contend.

As a result, many community banks have become net borrowers for the first time in years by tapping sources for federal funds and other types of loans.

"In the last year, we've seen more banks borrowing overnight funds ... than we have in many a year," said Edward T. Baker, a vice president at CoreStates Financial Corp. in Philadelphia.

Mr. Baker said CoreStates had a 50% increase in overnight lending from September 1994 to January 1995, compared with the first nine months of 1994.

The demand has been so great bankers' banks, which provide excess funds to community banks, have faced their own cash shortfalls.

"There certainly has been an increase in loan demand that has caused some liquidity problems," said John D. Schneider Jr., president and chief executive of the Independent Bankers Bank of Illinois and chairman of the Bankers Bank Council. "I wouldn't classify them as severe, but certainly it's been an area that we've all needed to work on a bit."

In January 1994, for example, the Bankers' Bank in Wisconsin was administering about $400 million in overnight federal funds for its bank customers. One year later, overnight deposits were down to almost zero.

In Illinois, the Independent Bankers Bank had averaged selling $3.5 million to $4 million a day in federal funds to its customers during its first eight years of existence. But within a "sudden and dramatic" 30-day period last summer, the bank found itself lending $25 million to $30 million, Mr. Schneider said.

And at March 31, community banks throughout the Midwest had borrowings of $75 million in federal funds from Minneapolis' Norwest Corp. alone. That's up from only about $10 million at yearend 1993. Borrowings peaked at about $125 million in late April 1995.

"The banks that borrow (federal funds) from us are borrowing more, and the banks that sell to us are selling less," said John P. Sampson, senior vice president of Norwest Bank Minnesota, who handles correspondent banking in several Midwest states.

Windom State Investment Co., holding company for $115 million-asset Southwest State Bank in Windom, Minn., is normally a net seller of federal funds to correspondent banks. But in the second and third quarters of 1994, the bank borrowed between $4 million and $6 million in federal funds from First Bank System Inc., Minneapolis.

"There was a period when we were borrowing continuously, (and) borrowing for us a fair amount," said Jim Redding, president and chief executive of Windom. "It's more than we ever did before."

Observers don't see conditions improving much in the coming months.

"I think it'll probably get worse," said Sung Won Sohn, senior vice president and chief economist at Norwest. "I expect tighter liquidity at community banks, so their activities in accessing funds from outside would increase."

And that increased borrowing isn't good for the banks if the loan demand and liquidity problems continue to grow, Mr. Sohn said.

The inadequate funding that many community banks have experienced stems primarily from the adoption of an accounting rule that restricts banks to selling only those securities classified as available for sale. But any declines in that portfolio before a sale are considered unrealized losses that must be recorded as reductions in a bank's capital levels.

To avoid potential capital losses, many community banks have conservatively placed their securities in held-to-maturity portfolios, locking up their money and eliminating a traditional source of liquidity.

"That has exacerbated the situation," said Camden R. Fine, president and chief executive of Midwest Independent Bank in Jefferson City, Mo., a bankers' bank. "A great many community banks don't have the flexibility in their investment portfolios to meet their funding demands."

Also, record loan growth in some parts of the country is putting extra pressure on lenders to find ways to help their borrowing customers. But many institutions have already used up their available deposits.

That's reflected in the ratios of loans to deposits reported for March 31. Community banks with less than $5 billion in assets already have an average loan-to-deposit ratio of about 75.55%, according to the Federal Deposit Insurance Corp. That's up from only 68.64% two years earlier.

The industrywide figure of 84.88% at March 31 was the highest in at least 15 years, easily surpassing the previous record of 80.7% in December 1989, according to the FDIC.

As a result, "that's changed the character a great deal of community banks, who typically have not been borrowers," Mr. Christensen said.

The current situation is a reversal for many community banks, which normally find themselves depositing extra cash in overnight federal funds, Mr. Christensen said.

And the surge in borrowing of federal funds in late 1994 and early 1995 caught the correspondent lenders by surprise, especially the bankers' banks, which are dependent on federal funds deposits to lend money back out to other customers.

"Banks that have never borrowed fed funds have found themselves in that position," Mr. Schneider said. "And when that happens to the sudden degree that it happened last summer, it caught a few of us off guard and we had to scramble and raise the money from other sources."

But the bankers' banks don't have the large deposit bases of the regional correspondent banks or the government support of the Federal Home Loan banks.

And they couldn't turn to even their smaller deposits because their community bank customers reduced them during the last year. That's because the deposits are only used to generate a level of interest that will pay the bankers' banks' fees. Last year's interest rate hikes meant that a smaller deposit could pay the fixed fee.

"As banks have great needs for their own liquidity, they don't leave deposits with us and don't sell their fed funds to us, so that makes a smaller pot of funds that is available to us to manage," Mr. Christensen said.

Overnight borrowings by community banks from bankers' banks and correspondent banks have again dropped off in the past few months as the small banks have either raised deposits or found alternative sources, such as the Home Loan banks.

But the bankers' banks still aren't taking any chances. They've already secured new federal funds and repurchase lines of credit from each other, regional banks, and securities dealers. And the correspondent banks are turning to bond sales, offshore funds, or loans from the Federal Reserve discount window.

"I think all of us have looked at our own individual situations and taken steps necessary to (ensure) that liquidity will not be a problem for the year," Mr. Schneider said. "We're very comfortable in our position here, and it's not going to catch us off guard this year."

For reprint and licensing requests for this article, click here.
MORE FROM AMERICAN BANKER