Banks traditionally built their franchises based upon having a lot of branches within a market where customers could open and use their accounts. That model still works, but how most banks obtain deposits has changed radically over the past 30 years. It is time for regulators to rethink their notion of what constitutes a quality deposit portfolio to keep pace with innovation.
Regulators have long viewed brokered and other types of wholesale deposits with suspicion, characterizing them as “hot money” that banks cannot rely on as a stable source of funding. More recently, regulators have falsely correlated the effects of using wholesale funding with aggressive growth and bad lending. Regulators need to deepen their understanding of what has become the “new normal” for funding and liquidity. Before disparaging the quality of wholesale funding, regulators should remember that correlation is not enough to prove cause and effect.
With check imaging, mobile banking and free ATMs, many consumers aren’t bothered with where they bank. They have quickly adapted to modern banking technologies. Branch traffic is down considerably as most banking needs can be met from a mobile device or an ATM.
As a result, it is more challenging for a bank to find traditional consumer and business depositors than it used to be. That challenge will likely intensify as the Federal Reserve starts winding down the $4.5 trillion securities portfolio it amassed to stabilize the banking system after the global financial crisis.
Fortunately, banks have other ways to attract wholesale deposits thanks to various services that allow them to tap funds from other markets, such as online deposit listing services.
These services enable banks to obtain a specific amount of funds exactly when needed and with a maturity that fits the bank’s risk profile. This makes wholesale funds a complement to conventional deposit gathering, in which customers decide when to make deposits and for how long to keep them in a bank account consistent with their needs, not those of the bank.
But in spite of sophisticated online delivery systems and proven markets, regulators still stigmatize wholesale deposits. This is an outdated view that regulators should rethink.
In the 1970s and 1980s, brokered deposits emerged as a way for large depositors to obtain FDIC insurance for funds that exceeded the federal deposit insurance limit. The depositors earned a yield on their deposits in line with published rates and brokers earned a placement fee. The other significant event during this time period was, at the end of 1980, the elimination of previously imposed interest rate ceilings on nonmaturing deposits contained within Regulation Q.
Regulators and the industry are loath to forget that prior to that rule change, community banks primarily focused on the asset side of the balance sheet, not the liability (deposit) side. But with the interest rate margin competition intensifying, bank lending became more aggressive and some banks became troubled. With bad news and rumors about “troubled banks” traveling fast, customers were compelled to start taking out their money.
In such cases, the troubled banks had no choice but to reach out to deposit brokers to source their deposits. Of course, deposit brokers knew that if the bank was seeking funds, it must have been having problems sourcing deposits from its own market. So up went the fees and deposit rates.
The regulators saw a causal correlation between brokered deposits and problem banks. The regulators started to monitor call report data for banks with concentrations in brokered deposits as a possible sign that a bank was in trouble.
In 1988, the Office of the Comptroller of the Currency shared the conclusions of a study about failed banks. The OCC noted that more banks failed during the 1980s than in the entire previous post-Depression period. Although many of the failures were initially perceived to be caused by local economic conditions, the OCC found that in fact the policies and procedures of a bank's management and board of directors had more influence on whether a bank would succeed or fail. In other words, bad management caused bad banks.
So to recap, bad management and weak corporate governance begot bad banks. Bad banks were ill-equipped to manage the liability (deposit) side of their balance sheets and bad banks turned to “brokered” deposits. Therefore, the logic went, brokered deposits were bad for banks.
But why is there still this stigma today?
In the 21st century, a bank can source deposits from listing services, FDIC insurance aggregators, public funds, school systems, local and national governments, wholesalers, and yes, deposit brokers, to name a few.
How does this differ from the 1980s? For starters, a bank must now be well capitalized to use these deposit sourcing services. Many of these services have stringent financial requirements to ensure participation is only among high-quality banks. What was once considered to be a depositor of “last resort” has moved to the top of the class. Wholesale deposits have matured rather like Samsung, whose products were sold at discount stores 30 years ago but which is now perceived as one of the best electronics brands. During the most recent financial crisis, regulators thought they found a correlation between the faster-growing banks that made bad loans and those that used wholesale deposits. However, this is correlation without causation and therefore is not relevant. Any bank would have made the same bad lending decisions if it had sourced local deposits instead of wholesale deposits.
The regulators were loath to prove a cause and effect that simply didn’t exist.
The fact is, what was once a solution for the worst of banks is now a solution for the best of banks. Yet regulators are still lost in a 1980s mindset.
Risk is relative and change is constant. Now, technology provides the means to drive change, enabling a variety of deposit-sourcing solutions that have been proven consistently to be available in strong and soft economic conditions. The commercial paper market was obliterated during the Great Recession, but wholesale funding has persevered.
A well-run bank needs a funding strategy that capitalizes on free market exchanges. The precision provided by new funding sources can help to maximize the return to investors while providing a safe and sound operating environment. Bankers will also need to raise their game to demonstrate proper liquidity management.
Meanwhile, regulators are still painting listed deposits, wholesale deposits, brokered deposits and so on all with the same broad brush — claiming they are not as reliable as funding provided by a customer walking through the door. An unbiased study would likely prove that the opposite is actually true.