Wholesale funding gives bankers the liquidity to fund loans as demand materializes, but changes in regulatory acceptance of wholesale funding have limited this flexibility and worsened the credit crunch.

The changes also will lead to a significant increase in the number of bank failures. Though the regulatory preference for core deposits is understandable, it is worsening problems in the current environment.

Under "prompt corrective action" rules, regulatory sanctions increase as a bank's capital position deteriorates. The sanctions are most dire with regard to wholesale funding, including brokered deposits. A "well capitalized" bank is not subject to any written restriction regarding its funding. An "adequately capitalized" bank on this scale must obtain a waiver from the Federal Deposit Insurance Corp. before it can accept brokered deposits or pay a premium over market prices for deposits.

The FDIC, however, has been very hesitant to approve such waivers. A bank that is less than adequately capitalized is prohibited from obtaining brokered deposits at all. Significantly, the bank regulators can drop a financial institution down one level on the scale if it is in a "troubled condition." In other words, the regulators can treat a bank that is well-capitalized as if it were only adequately capitalized under the rules.

In prior downturns, several financial institutions were able to work through their credit issues and survive. A share of these same institutions would have failed in the current regulatory environment, however, because they would not have been able to meet their liquidity needs.

In light of the regulatory intolerance for troubled financial institutions' rolling over brokered deposits, the time frame to fix a problem bank is dramatically shorter in this recession than in earlier ones.

It is not just problem banks that are suffering. The regulatory view regarding wholesale funding is a significant contributor to the unwillingness or inability of healthy banks to lend. Regulators view brokered deposits and advances as less stable than local customer deposits. In response, they have cracked down on all forms of wholesale funding. The regulators even tell banks not to offer deposit accounts at rates higher than the average in their markets.

The effect of such hypervigilance has been to distort the historical premium brokered deposits received. Now, in many markets, certificate of deposit rates for local money are higher than for brokered deposits. This discrepancy can be considered the regulatory rate premium.

Regulators may say that they only require approval of brokered deposits when a bank is "troubled." Yet the examiners seem to criticize wholesale funding regardless of the financial institution being reviewed. Thus, if a bank has more than a certain level of its liabilities in wholesale funding or the trend is that such funding is on the rise, it gets negative ratings. It is irrelevant whether the bank is well-operated and has avoided recent years' excesses. The mere fact of too much wholesale funding may tar that management as poor.

Healthy institutions need liquidity to fund new loans. If they cannot increase the level of wholesale funding or the rates paid in the market to attract deposits without potential regulatory sanction, then they can only expand lending to the extent they can add core deposits. Bolstering core deposits is an extraordinarily slow process. Yet the country needs immediate growth in lending capacity. From a macroeconomic standpoint, the regulators are preventing the movement of liquidity to where it would do the most good. Thus, banks in strong financial condition are limited in what they can do to obtain funds for lending.

What the country needs from regulators is to counter the business cycle. Unfortunately, if history is our guide, this will not happen.

So what is to be done? Bankers should be allowed to fund "lumpy" growth with wholesale funding. The FDIC already charges higher premiums to financial institutions that use wholesale funding to spur growth. Bank regulators have ample opportunity to impose higher capital requirements and allowances for aggressive business plans. Of course, this requires examination on a case-by-case basis.

In the current economic environment, the United States needs more than regulatory pronouncements that bankers are being encouraged to lend. Likewise, congressional questioning into the use of Tarp funds betrays a fundamental lack of understanding of economic forces. On no issue do we need a fundamental reassessment of policy more than in the approach to wholesale funding.

This funding would help address the resource misallocations that beset lenders able and willing to fill credit demand. Regulators should not evaluate all financial institutions as if they had the same management teams, boards, capital and balance sheets.

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