Community banks are finding it increasingly tough to meet deposit and withdrawal demands as customers shift their deposits into higher-yielding investments like mutual funds.

"I think it could become a crisis," said C. William Landefeld, president of Citizens Savings Bank in Bloomington, Ill., and chairman of America's Community Bankers. "It's one of our biggest concerns."

Over the last three years, loans at banks with assets between $100 million and $1 billion have grown nearly 11% while deposits only increased 3.27%, according to the Federal Deposit Insurance Corp.

At June 30, loans at these banks averaged 74% of deposits-an all-time high.

"We're clearly seeing some community banks struggle with liquidity," said Keith Leggett, an economist at the American Bankers Association. Loan- to-deposit ratios above 70% force these institutions to seek alternative sources of funds to meet loan demand-a move that can squeeze profit margins.

"Banks may give up liquidity to meet loan demand and that raises a safety question," he added.

While deposits are leaving banks of all sizes, the problem is worst at small banks because they have fewer funding sources.

"The big banks can issue debt securities, but we can't really do that," said Arthur C. Johnson, president of United Bank of Michigan, a $165 million-asset bank in Grand Rapids. "Smaller banks don't have the same access to the capital markets."

Many of these banks also are in towns with dwindling populations or slumping economies.

Dennis Utter, president of $45 million-asset Adams County Bank, said it's difficult to keep deposits in the bank's hometown of Kenesaw, Neb. Baby boomers have moved much of their savings to alternative investments, and younger depositors are even tougher to attract, he said.

"When an old, loyal customer passes away, those funds don't stay in Adams County Bank," he said. "The heirs don't live here anymore."

To increase liquidity, community bankers are turning to the Federal Home Loan Bank System, seeking out deposit brokers, nudging up interest rates, or selling off assets.

The 12 Federal Home Loan banks, which lend money to member institutions, are a popular source of funds for community banks nationwide. Membership in the system has doubled in the last six years to roughly 6,300, and through August total loans were up 10.3%, to $177.8 billion.

Mr. Johnson said United Bank of Michigan has borrowed $5 million from the Federal Home Loan Bank of Indianapolis to fund loan growth.

But the Federal Home Loan Bank System is not the answer for all community banks. Membership is limited to banks and thrifts with mortgages making up at least 10% of their total loan portfolios. What's more, only mortgage loans may be used as collateral, further limiting what some institutions may borrow.

William L. McQuillan, president of City National Bank in Greely, Neb., said his bank went out and bought enough mortgages to meet the 10% test so it could start borrowing. "We couldn't continue to go out in the local market and pay up for deposits," he said.

The membership and collateral requirements soon may be relaxed throughrule changes and pending legislation.

For example, banks may be able to reclassify some agricultural loans as mortgages under a proposed rule, and pending legislation would waive the 10% mortgage rule for banks with assets under $500 million-making 800 more banks eligible for membership.

In the meantime, banks may buy deposits from brokers. Mr. Utter said he buys about $5 million of deposits to get Adams County Bank through the peak agricultural lending season of April through October.

"Brokered deposits used to be really frowned upon by regulators, but we're not funding long-term investments," he said.

Banks also sell older loans in their portfolios, branches, or other investments to boost liquidity.

Gary Scott, president of Cheatam State Bank in Kingston Springs, Tenn., said his bank occasionally bundles 15- to 20-year mortgages and then sells them to raise cash.

Citizens Savings Bank recently sold one of its under-performing branches to bring in new funds. The bank sacrificed the branch's $7 million of deposits, but Citizens was able to use cash from the sale to pay off some Federal Home Loan bank advances, Mr. Landefeld said.

First Dakota National Bank in Yankton, S.D., has sold off municipal bond securities in recent years to increase its loan capacity, according to its president, James Ahrendt.

Lew Stone, president of Goleta (Calif.) National Bank, said his bank is using the Internet to solve liquidity problems.

Goleta sells certificates of deposit through an electronic bulletin board, raising and lowering the rates depending on how much money the bank needs. "We could raise $10 million overnight if we had to," Mr. Stone said.

Industry experts say they expect the current trend of declining deposit growth and increasing loan demand to continue.

"I don't see any real relief for community banks," said Charles N. Cranmer, head of equity research at M.A. Schapiro & Co. in New York. "You've got a banking population that's been educated that they can do better things with their money than put it in a bank."

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