Hey buddy, can you spare a dime?

A booming stock market has created unprecedented wealth for American investors at the expense of commercial banks, whose core deposit growth has stagnated as money has flowed into mutual funds and money market accounts sold by aggressive nonbanks.

From 1990 to 1999, according to the Federal Deposit Insurance Corp., assets in the banking system increased 41%, to $5.7 trillion, while core deposits - demand and savings accounts, as well as small certificates of deposit that don't reprice quickly - rose only 26.6%. At yearend 1999 core deposits were just 47% of assets, against 58% at yearend 1989.

Another worrisome trend is the corresponding growth in deposits of wholesale CDs of more than $100,000, foreign office deposits, and certain nondeposit sources of funds such as advances from Federal Home Loan banks, which rose 47% in the past decade. Clearly the growth in core deposits has failed to keep pace with asset growth.

The implications for commercial banks and thrifts should be as obvious as the nose on George Washington's face. Lenders are being forced to rely more on a variety of funding alternatives that are generally more expensive, and in some cases less reliable, than core deposits.

Think of deposits as the raw material of banking. As the cost of funds goes up, net interest margins compress, which forces the bank to increase loan volume to maintain the same level of profitability. The danger is that lenders will push more to do deals - and in the process will take on too much credit risk.

The funding problem is especially troublesome for small banks that have stubbornly looked to their local communities for funding, even while those same communities were depositing money at record levels into equity mutual funds at Fidelity Investments or opening cash management accounts at Merrill Lynch.

Large banks are quite practiced at tapping alternative sources of funding, including securitization, brokered deposits, and borrowed funds. Now the liquidity squeeze has become severe enough that community banks must examine many of these funding alternatives, such as:

  • Federal Home Loan banks: Most of the shortfall in core deposit growth in recent years has been made up through wholesale borrowings ("advances") from the Federal Home Loan Bank System.
    Institutions must join the Home Loan banks in their region and purchase capital stock in the bank to get access to the advances window. Banks may use one- to four-family mortgage loans, certain commercial loans, and government, agency, and mortgage-backed securities as collateral.
    The Home Loan bank advances are among the most cost-effective alternatives to core deposits, and have the added advantage of being extremely reliable, provided you have the right collateral.
  • Certificates of deposit: Community banks can attract CDs from around the country by subscribing to listing services that post rates nationwide. The advantage here is that such funding is not classified as brokered deposits, which must be listed separately on bank call reports.
    One disadvantage of listing CDs nationally is that demand has driven up the cost of these funds. Nor is this the most efficient funding mechanism: A bank would have to sell 50 CDs of $100,000 to raise $5 million, while a broker would sell you one wholesale CD for the whole amount.
  • Repurchase agreements: Banks can borrow from major investment firms by pledging government, agency, or mortgage-backed securities as collateral for a loan at short-term market rates that can extend from 30 to 180 days.
  • Securitization and loan sales: Many community banks have been reluctant to securitize their one- to four-family mortgage loans or sell them outright to another lender. Both securitization and loan sales free up funding, allowing the bank to make new loans and collect origination fees. But securitized loans are better because they can then be used as collateral either in repurchase agreements or to get higher-level advances from a Home Loan bank. With loan sales, the bank isn't building its asset base.
    Unfortunately there are no effective vehicles at the moment for the securitization of small-business loans on a large scale, and these loans constitute a significant percentage of the balance sheet at many small banks.
  • Brokered CDs: While some banking regulators still look suspiciously at these instruments because of their history, most understand that the funding situation is severe enough that brokered deposits can play an important role in an institution's liquidity management.

Because Home Loan bank advances are very reliable and accessible, community banks may want to maintain a minimum amount of borrowing availability at their local Home Loan bank. Once their borrowings reach a targeted level, the bank can use brokered CDs to pay down their Home Loan bank borrowings and maintain their desired level of liquidity.Institutions that are classified as "well capitalized" under federal regulatory guidelines, which requires 5% Tier 1 capital and 10% risk-based capital, may use brokered deposits without restrictions as part of a comprehensive funding plan.
A bank needs 10% asset growth a year to cover its overhead and give its shareholders a respectable return on equity. Unless its core deposits rise by the same amount, its growth and profitability will be compromised.

An intelligently designed and well-diversified funding strategy will give community banks the liquidity they need to grow and prosper.

Mr. Pieniazek is president of Darling Consulting Group Inc., which specializes in the financial services industry and is based in Newburyport, Mass.

Note to Readers

"Viewpoints" is a regular feature in American Banker, appearing every Friday. It serves as a forum for discussion and debate on a wide range of issues in the financial services industry, including management approaches and strategies, legislative and regulatory matters, and public policy in general.
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