WASHINGTON — The Federal Deposit Insurance Corp. is set to make a massive change to the way it calculates premiums, releasing a proposal Tuesday that would force banks to pay assessments based on total liabilities rather than domestic deposits.
Many community bankers are already celebrating the plan, which was required as a part of the Dodd-Frank Act, but at the same time some say it could cause some large banks to rethink their funding strategies. Some analysts said that because banks will no longer get a premium discount for relying on alternative forms of funding, more institutions could compete for domestic deposits.
"To the degree that over the long term the Dodd-Frank changes could hurt the flexibility of banks to resort to alternative funding sources … that could potentially be setting banks up to put stress on their ability to profit," said Tim O'Brien, a managing director with Sandler O'Neill & Partners LP.
Small banks have long argued that charging assessments based on deposits was unfair. While larger institutions can impose risk on the FDIC by using foreign deposits or instruments like subordinated debts, the FDIC never charged premiums based on those liabilities. As a result, banks that relied most heavily on core funding — deposits — were charged relatively more than institutions that relied more on Federal Home Loan bank advances and other alternative funding strategies.
The FDIC has proposed a new system that would charge rates based on a bank's average assets over the assessment period, minus average tangible equity during that period. (The figure is roughly equal to total liabilities.) The proposal will also set new assessment rates for the industry to reflect changes to the base, as well as include certain exemptions for trust banks and bankers' banks that have a very small proportion of deposits to assets.
"This is an attempt to close a loophole," Edward Kane, a Boston College finance professor and a fellow at the FDIC's Center for Financial Research, said of the new system. "In a sense this redefinition of the base is something that is required to more fairly support the deposit insurance part of the safety net."
The new base is just a piece of the face-lift that Dodd-Frank gave the deposit insurance system, including other victories for small banks. The law also removed a cap on the size of the Deposit Insurance Fund, which in October allowed the agency to set an unprecedented target ratio of 2% of federal reserves to insured deposits by 2027.
A further proposal expected next year would outline how under Dodd-Frank the agency will ensure community banks are not affected by a required rise in the fund's mandatory minimum ratio to 1.35% from 1.15%.
While community banks generally have cheered the new assessment base, not all small institutions will be unscathed. For instance, those that carry a large amount of Federal Home Loan bank advances could see their premiums rise. Likewise, certain large institutions relying on retail deposits may welcome the change.
Experts said many institutions will likely re-evaluate their funding methods, and many have already done so.
"It's obviously going to increase the cost and reduce the desirability of [FHLB] borrowings," said Randy Dennis, the president of DD&F Consulting in Little Rock, Ark. "Banks will have to go back and relook at their liability structure — the cost of deposits and the cost of borrowings — and reallocate the new FDIC costs and then make a decision."
But Dennis said the largest banks will face the biggest costs as a result of the proposal.
"For community banks, the ones using advances would be the hardest hit. But all in all, it's going to hit large banks much more than community banks," Dennis said. "In some sense, the large banks will be subsidizing the overall fund because of their non-deposit-based liability structure. Generally, the community banks will come out ahead on this one."
O'Brien said although core deposits are already popular in the low interest rate environment, competition for deposits could intensify as large banks see a smaller cost advantage in other types of liabilities resulting from the FDIC change. "It is a good thing for banks to have some options with respect to the funding side of their balance sheet," he said. "To the degree that the new rules put some of those options out of reach and make alternative funding sources too costly for banks to utilize, that could be detrimental to the industry. It's something for the regulators to take into consideration."
One result could be that banks will use funding instruments that they do not have to report.
"In the long run, it certainly encourages off-balance-sheet financing," Kane said. "But it's hard to predict the precise instruments and corporate structure they will use."
Michael Bleier, a partner at Reed Smith, said large banks worried about higher FDIC costs may focus more on noninterest income, including from businesses such as asset management and asset servicing.
"What it really means is a lot of people are going to be looking for fee-based revenues as opposed to asset-based revenues," Bleier said. "If you can generate revenue from fee-based businesses that don't add assets to your balance sheet, then that's certainly an area to focus on."
Jeff Marsico, an executive vice president at Kafafian Group in Parsippany, N.J., said second-tier companies such as U.S. Bancorp may substitute their nondeposit funding with more deposits, but he added that deposits involve other costs besides premiums.
"It may motivate them to be more competitive for retail deposits, but the cost of the deposit is not just the interest expense plus the FDIC insurance assessment," Marsico said. "It's the interest expense, the FDIC insurance assessment and the operating expense to get the deposit in the door."
Dennis agreed the impact could be limited. He said there will be more competition for deposits only when there is more loan demand.
"It certainly can increase competition" for deposits, "if people want to grow," he said. "But right now, there's no loan demand. Everybody is flush with cash. They're dying for loans. What you'll see is a reallocation with deposit and borrowing costs."