Bank regulators are beginning to worry that small banks, intent on growing assets, are looking for funds in all the wrong places.

Recent reports by the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency found that as loan demand outstrips deposit growth, banks with assets of less than $1 billion are becoming increasingly reliant on high-cost funding, including subordinated debt, Federal Home Loan Bank advances, and purchased federal funds.

From 1992 to 1999, banks' average assets grew 6% a year on average, versus 4% for core deposits, the OCC said. As a result, the FDIC concluded, the industry's average deposit-to-asset ratio reached an all-time low of 67.33% in 1998, while the loan-to-deposit ratio hit an all-time high of 87.97%.

Small banks have always paid less for funds than large banks. But their advantage is shrinking it went from 0.58% in early 1994 to 0.09% early this year. And since 1993 the proportion of small banks with "noncore" deposit liabilities accounting for more than 10% of total liabilities has jumped from 42% to 75%.

Nancy Wentzler, the OCC's director of economic analysis, said small banks should be cautious.

"These tend to be much more liquid funds ... more sensitive to changes in economic conditions, and these banks could see an outflow of nondeposit funds that they are not prepared for," she said in an interview.

Regulators understand banks' need today to look beyond the highly competitive market for core deposits. "It's not like banks have much of a choice," Ms. Wentzler said.

She said relying too much on high-cost funds could eventually eat into banks' earnings. Among the most expensive of these high-cost funding alternatives is the subordinated debt issue. At yearend 1998, commercial banks paid an average 3.29% interest on their core deposits but paid 6.96% on subordinated debt. Home Loan bank advances and federal funds costs were also well above core deposits, at 5.60% and 4.82% respectively.The higher cost of funds has already taken a toll on net interest income.

In the two years that ended June 30, net interest income for all commercial banks fell 18 basis points to 3.51%. For those with less than $100 million of assets, it fell even harder -- 28 basis points, to 4.08%.

Outside factors including a slight rise in interest rates and a steeper yield curve masked the problem in the second quarter, FDIC financial analyst Ross Waldrop said. The Federal Reserve's August interest rate hike probably will produce another bump in smaller banks' net interest margins in the third quarter.

The OCC predicts net interest income will continue falling over the next several quarters. "This is not a turnaround," Mr. Waldrop cautioned.

Regulators are concerned that when the effect of rising interest rates wears off, banks unable to make up the difference through cost-cutting or noninterest income will move further into risky activities.

"As bank managers search for additional ways to offset the relative rise in funding costs, they may be tempted to increase asset yields by pursuing additional portfolio risk, in the form of credit or market risk," a separate FDIC report on economic trends concluded.

Steve Cunningham, a section chief at the FDIC's insurance division, said how banks offset their increased use of noncore funds is important. "The other issue is their expertise with and knowledge of the instruments they are using," he said. "They may want to look at their asset liability management function."

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