Reluctant Role Model: The Bank of North Dakota

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Consider this tale of two cities: Grand Forks, North Dakota, suffered massive flooding that left it economically crippled in April 1997. So did East Grand Forks, just across the river in Minnesota. Three years later, Grand Forks had lost 3 percent of its population, and East Grand Forks had lost 17 percent.

Those who are pushing for states like Illinois and Washington to create a publicly owned bank insist this difference in economic recovery is no coincidence. They give much of the credit for Grand Forks' resiliency — only one minute by car from its Minnesota counterpart — to the 92-year-old Bank of North Dakota, the country's only state-owned bank. Its help came in many forms, including a quickly established $25 million line of credit for the city itself.

Lawmakers in state capitals across the country are increasingly intrigued by such arguments. With the financial crisis fueling disdain for the banking industry in general, some view a public bank as an appealing alternative to a system they consider to be broken.

But Eric Hardmeyer, president and chief executive of the Bank of North Dakota, is not so sure.

"I am not an advocate for a state-owned bank model," Hardmeyer says. "I won't advocate that this is the model you should build in your state. It is up to the state and the constituency base to make that decision."

North Dakota and all state agencies are required by law to deposit their funds in the Bank of North Dakota — funds the bank uses, among other things, to support economic development, capitalize community banks, and make student loans.

In addition, the bank — where deposits are backed not by the full faith and credit of the United States, but by the full faith and credit of North Dakota — acts as a sort of miniature Federal Reserve for the 95 state-chartered banks.

Hardmeyer says he has been inundated with phone calls from policymakers across the country seeking his advice. They face huge budget shortfalls and want to know more about how the bank managed to return $340 million in profits to the state over the past 14 years. They complain about depositing state funds in large money center banks so far away, as local business owners complain about not being able to get loans. They all wonder whether it would make sense to try to replicate the Bank of North Dakota in their states.

Hardmeyer has a simple message for them: Good luck with that.

The Bank of North Dakota was formed in response to a set of very distinct challenges. In 1918, the country was reeling from a recession; poor weather had caused food shortages in parts of the country; and in North Dakota, farmers were finding it difficult to secure credit from lenders who were generally located in other states.

The bank was created specifically to give farmers in North Dakota a fighting chance in an adverse economic climate.

"North Dakota was an agrarian state, so this was about the ability to control our own destiny at a time when most of the big decision makers were out of state," Hardmeyer says.

He adds, wryly, "And you had just had the Bolshevik revolution in 1917, and socialism was somewhat in vogue, so the political atmosphere was completely different."

But where Hardmeyer sees unusually rare circumstances, others see similarities — including a deeply scarring recession, a widespread credit crunch, and frustration with big out-of-state lenders.

In Illinois, state Rep. Mary E. Flowers of Chicago has introduced a bill to create a bank with a structure similar to that of the Bank of North Dakota, including a requirement that the state's operating funds be deposited with the bank.

She says "a sense of helplessness" prompted her to draft the bill. "Last summer, when all the banks started going under, there were foreclosures, and the banks couldn't lend money," Flowers says.

She blames the banking crisis for stifling the kind of economic activity that Illinois needed to get its economy moving again. "Here, a person has an idea to create their own business but they cannot get the capital to start up," she says. "And we bailed out a lot of these banks with our tax dollars."

Considering the plight of local small businesses, Flowers began to see the North Dakota option as very appealing. She also envisions many other ways such a bank could make a difference. "We can help eliminate some of the deficit; we can help people stay in their homes," she says.

Mostly she just wants change. "If we keep on doing the same things we've been doing, we're going to get the same result," she says.

Flowers is far from alone. Her bill is one of more than half a dozen in states across the country, all aimed at either creating a state-owned bank or studying the feasibility of creating one. Others with pending legislation are Hawaii, Massachusetts, Maryland, Oregon, Virginia and Washington.

Such proposals are very unpopular with banking industry representatives. The Washington Bankers Association has been fighting a bill to create a state investment trust there that would receive and lend out all state funds. "Capital is readily available today within the banking system," making such an entity unnecessary, says James M. Pishue, president and CEO of the Washington Bankers Association. If a business is having trouble getting a loan, the issue is its creditworthiness, and if a state bank makes loans that other banks won't, then it would be putting public funds at risk, he says.

Hardmeyer says that should a state succeed in establishing a bank like his, there would still be roadblocks to success in the way: in particular, the temptation to run the business less as a bank than as an economic development institute.

"The one thing that truly is not understood very well is that if you are going to have a state-owned bank, you have to staff it with bankers," he says. "If you staff it with economic developers you are going to have a very short-lived, very expensive experiment. Economic developers have never seen a deal they didn't like. We deal with that every day."

Hardmeyer says that his bank balances a large portfolio of federally guaranteed student loans with relatively low net interest margin against a riskier portfolio of economic development loans to small and medium-sized businesses to create an overall risk portfolio comparable to that of other banks in the state.

"This is the public's money, so they demand that we do our fiduciary responsibility," he says. "But on the other hand, they expect us to go out there and help create something in their communities."

The bank, which is expected to report record earnings for 2010, has $4.1 billion in assets and more than $300 million in capital. Its net income has risen every year since 2003, with some of its largest percentage increases coming amid the banking crisis of the past several years.

The legislature dictates the amount the bank is expected to contribute to the state budget each year. Sometimes that money is deposited directly into the general fund. Other times it is earmarked to support particular programs.

Last year the bank gave nothing back because it needed to increase its capital base to support increased lending activity.

While Hardmeyer is an unabashed champion of his bank's success and its mission in North Dakota, he is brutally honest about political reality. In the age of Tea Parties and "government is the problem" rhetoric, he says, the possibility of starting a state-owned bank now seems wildly optimistic at best.

"We've been here for 92 years," he says. "Could we create this model here today? I don't think it could happen."

Advocates of public banking don't think selling people on the idea is such a stretch, especially with the memory of a massive taxpayer-funded bailout for Wall Street behemoths still fresh.

"States have to look out for themselves," says Ellen Brown, one of the founders of the Public Banking Institute, a nonprofit think tank created just last year to advance the cause of public banking.

She finds it hard to understand why states willingly surrender to "Wall Street" the opportunity to make use of their funds. Rather than letting bankers in far-away cities choose when and where to deploy that money, Brown asks, why not make sure it is put to work lending to local businesses, capitalizing local banks, and creating local jobs? "That's what the Bank of North Dakota does, and every state could have that same arrangement," she says.

In the decades after the Bank of North Dakota opened, its power waxed and waned, as opposition from banks and political opponents resulted in limits on what it could do.

Today, the bank is technically a full-service retail bank, with savings and checking accounts available to individuals, but it does not market those services, has no branches, and does not so much as issue ATM cards. Deposits from individuals account for less than 2 percent of the bank's total.

Its primary deposit base — funds from the state — earn a market interest rate set by the bank. It tracks a middle ground between the highest and lowest interest rates offered by other banks in the state.

Gary Petersen, president of Lakeside State Bank in New Town, says the state-owned bank "competes" with other banks in only the most theoretical sense. "They are the receptor of most state deposits and if the bank weren't there, those deposits would be going somewhere else," says Petersen, who serves as a member of the seven-person advisory board for Bank of North Dakota. "But they wouldn't necessarily be going to my bank. In fact, as I understand it, in most states those deposits are going to large regional or national banks anyway."

Unlike a typical retail institution, the state bank's primary mission is serving as a sort of central bank.

It provides correspondent banking services to virtually every financial institution in North Dakota and offers a Federal Funds program with daily volume of $330 million. It also provides check clearing, cash management services, automated clearing house services and other functions common to a banker's bank.

While the Bank of North Dakota makes relatively few direct loans, it is active in three specific categories. It makes farm loans and offers a guarantee program for those loans to other banks. It lends to residents and institutions to fund the acquisition of bank stock, because the state wants to promote local ownership of banks. And it makes student loans, a program that is in flux because of the recent federal changes.

Its other programs generally involve partnering with community banks to participate in commercial loans and development projects.

"We utilize a lot of their lending services," Petersen says. "Their guarantee program for entrepreneurs has helped us get some new companies off the ground. And their guarantees for agricultural lending have helped us allow farmers and commercial customers start or expand a business."

The Center for State Innovation at the University of Wisconsin-Madison has become one of the hotbeds of research on public banking. The foundation-funded, nonpartisan policy group originally began working on the issue after discussing the financial problems of many states with their treasurers' offices.

"In the wake of the recession, people started talking about the public banking idea," says Sam Munger, managing director of the center. "They are able to act counter-cyclically to ramp up lending at a time when banks cannot or will not."

Munger says that North Dakota's financial performance — it is one of the few states not struggling with potential deficits — helped spark even more interest in the possibility of imitating its banking anomaly.

In Washington, hearings have been held for a bill calling for a state-owned institution — called the Washington Investment Trust — to promote economic development as well as become the repository for state funds (currently housed with Bank of America). Backers have purposefully modeled it after the Bank of North Dakota.

According to an analysis done by the Center for State Innovation, Washington could be earning a profit from such a state-owned bank within four years. The center also contends the new institution could increase small-business lending more than 8 percent through participation loans and could help create or retain between 7,400 and 10,700 jobs.

To back its case, the center compares bank data for North Dakota with neighboring states, tying higher lending activity to the influence of having a public bank. Over the last five years, banks in North Dakota had loan-to-asset ratios that were 4.4 percent to 12.4 percent higher than banks in Montana, South Dakota and Wyoming.

Opponents argue that a state-owned institution would put public funds into higher-risk loans that private banks won't back.

They also argue that the solid performance of Bank of North Dakota, and the lending activity of banks there, has a lot to do with a relatively healthy economy, partly supported by a growing oil industry.

Steve Swiontek, the chairman, president and CEO of the $1.2 billion-asset Gate City Bank in Fargo, North Dakota, concedes that the state bank likely owes some of its success to the economy. "That's part of it," he says. "We have consistent, solid growth here. We have the lowest unemployment rate in the nation. And the banks in the state are conservative."

He also says banks across the state and the state itself worked together with the Bank of North Dakota on a massive relief effort after the Red River flooded in 1997. So he is reluctant to give too much credit to one entity.

Still, Swiontek, a former state legislator, is a fan of the state bank. He says he is unfamiliar with the proposals in other states, but if the aim is to copy the Bank of North Dakota exactly as it is, then he doesn't think bankers in those states need to worry.

Linda Navarro, president and CEO of the Oregon Bankers Association, says much of the opposition to the public banking model initially proposed in her state was over the potential to dismantle current deposit arrangements between community banks and local municipalities, as well as school and water districts.

She questions how the state would provide backup for uninsured public deposits; currently those deposits are collateralized by banks that agree to pledge securities against them in exchange for the right to hold the state and municipal deposits. "In Oregon we have a shared liability model," says Navarro. "When you're having to pledge collateral that's 75, 100 or 125 percent of deposits, those deposits become very, very expensive. I don't think most Oregonians nor most legislators would accept the idea those public deposits would be lent back out in form of higher-risk loans without being protected."

Now the Oregon proposal has morphed into a compromise "financing and credit authority," under which the state would mostly consolidate much of its existing economic development boards and small-business loan programs, without depository accounts.

To be sure, there are other methods of fostering economic development that don't require a state to charter its own bank. One example is the Connecticut Development Authority, which acts, according to President Marie C. O'Brien, as "the state's bank with a public purpose."

Connecticut set up the authority in 1973 so it could take advantage of federal tax laws and financing programs. It issues industrial development bonds and helps banks with development lending.

After being initially capitalized by the state, the CDA is now self-financing. However, its guarantees are backed by the state.

Because of its quasi-public status, the authority is able to help create financing opportunities for businesses that would not be available through the private market alone, says O'Brien. "We are able to operate with much more creativity," she says.

A loan guarantee program is one option it makes available to Connecticut banks. The authority deposits a percentage of the loan amount into a deposit account at the lending bank, creating a pool of reserves that the bank can use in the event of a loss on the loan. Bankers in the state say this credit enhancement allows them to make loans they might turn down otherwise because of marginal collateral.

But the creation of an economic development authority simply doesn't go far enough to satisfy lawmakers who see the Bank of North Dakota as a model for their own states, because it fails to ensure that all the state's funds are put to work locally.

"In our state, we never get the benefit of capturing all those dollars," says Rep. Flowers. "If we had the opportunity that North Dakota has, we wouldn't be in the situation we are in now. Right now we are borrowing from other entities and taxing the people, whereas in North Dakota, the bank is giving money back to the state."

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Ag lending Correspondent banking North Dakota