Don't get caught between demands of regulators, depositors
The U.S. economy is changing, forcing banks to examine how they operate.
With strengthening GDP growth, falling unemployment and recent increases in the Federal Reserve’s target range for federal funds, competition for deposit pricing is heating up among financial institutions. It is now common to see community banks and credit unions increasing rates paid on core deposits and offering CD specials — something they haven’t had to do since before the financial crisis of 2008.
Because of the changing environment, bank regulators currently see liquidity as a top priority regulatory concern. Many of the banks that failed in the financial crisis did so with large amounts of high-yielding deposits that were used to fund risky loans. In response, the Federal Deposit Insurance Corp. imposed national rate caps in 2009 that set maximum rates that less than well-capitalized banks could pay on deposits. In short, regulators see high-yielding deposits as riskier than traditional core deposits — when combined with high loan-to-deposit ratios, they can represent a potential “canary in the coal mine.” In this light, community banks must understand how their institution’s liquidity is being evaluated with regard to deposit pricing.
It is our observation that national rate caps do not reflect realistic market conditions for most community banks. Recognize that the national rate cap for deposit products is simply the national average of interest rates listed for all FDIC-insured depository institutions and branches, plus 75 basis points. This measurement is problematic for community banks in three ways. First, the national average is heavily weighted by the largest banks in the U.S., as large multinational and regional banks make up two-thirds of the sample. Second, these large institutions are generally not in need of additional funding today and thus are not increasing rates as one would expect in line with the recent increases in the federal funds rate. Third, the average national rate does not include rates paid by credit unions, which are significant funding competitors for most community banks.
As an illustration of this problem, FDIC data for July 9, 2018, indicate the following national rate cap: six-month jumbo CDs (1.02%), 12-month jumbo CDs (1.20%), two-year jumbo CDs (1.395) and five-year jumbo CDs (1.83%). Community banks currently offering CD rates above these national caps could be restricted from doing so in the event of future regulatory problems, as such deposits could be viewed as "hot money." At a minimum they will find that their deposit pricing is being evaluated by regulators using national rate caps, unless they establish a local rate cap.
As the FDIC’s 2009 rule governing interest rates restrictions for institutions that are less than well-capitalized states: “An institution not choosing to use the national rate can define its market area and support its position to the FDIC that prevailing rates in that area exceed the national average.”
Thus, if approved, the effective national rate cap for an organization will equal the approved local prevailing rates plus 75 basis points, which is why community banks should determine their own local rate cap. That would require a bank to identify the local geographic area and local competitors, calculating an average of local rates paid on each of the different deposit types and adding 75 basis points above these local averages. All commercial banks should consider determining their own relevant local caps even well capitalized as regulators require a liquidity assessment in contingency funding of stressed environments where banks fall below being well-capitalized.
The objective of establishing local rate caps is to more realistically assess whether a bank is trying to aggressively pay deposits, or not, thus better establishing whether the funding source can be considered core deposits, or not.
In addition to more accurately determining high-cost deposits, there are two additional benefits to establishing a local rate cap. First, as mentioned, it will assist in contingency funding planning in the event the bank falls below the “well-capitalized” rating for its capital requirements. Second, under recent regulatory guidance, reciprocal deposits may not be designated as brokered deposits if they are from the local market and the rates do not exceed the local rate cap.
It is beneficial to develop a systematic routine for assembling and analyzing market rate data in order to improve deposit pricing and better control funding costs. The analysis should also alert bank managers to pricing shifts in a market as well as the sources of pricing pressures. Such analyses help banks make better-informed decisions about responding to rate moves or being aggressive in setting local market rates. Multiple-market banks may further benefit from observing differentials in pricing moves and momentums. Finally, in today’s environment, unless a community bank determines its local rate cap, the default is that the national rate cap will be used to determine whether a bank has core deposits, or not. The national rate cap, which is a relatively new regulatory constraint, does not represent reality for most community banks.