Many financial product innovations sound brilliant, but are prone to blow up after 5 or 15 years of increasing emulation and bloat, as discipline declines. Then, after the horses are long gone, Washington thinks about painting the barn. Some of that happened with inventive mortgages and their securitization, with collateral default swaps, with overinvestment in commercial real estate, and — some would allege — with money market funds.
How about internet banking?
Decades ago, regulators drew a sharp distinction between "core" deposits on one extreme and "brokered" deposits on the other. A core depositor was thought of as a household or business located near a branch. This was assumed to be a loyal, stable and less rate-sensitive customer.
The brokered deposits, contrariwise, were obtained by price competition — from depositors who had no personal relationship with or proximity to the bank. Prior to the Internet, these deposits were often placed through brokers, who claimed to know which institutions offered the highest rates; to facilitate account opening and transactions; and to give advice about soundness.
The regulators stigmatized dependence on brokered deposits in examinations and also placed various restrictions on them. Their reasoning was that brokered deposits were much more likely than core deposits to become unduly expensive or to melt away if funding tightened or a bank came under stress. Hence reliance on brokered deposits implied greater risk to both liquidity and solvency. Indeed, examiners criticized banks that paid significantly above market for deposits.
With the Internet replacing brokers as a more convenient and reliable source of extensive current information on rates and also of transaction capability, the place of brokered deposit accounts has largely been taken by Internet deposit accounts. A few banks are primarily or entirely dependent on Internet deposits. Some of the largest of these grew rapidly by paying significantly above market for these deposits. I’m not aware that this has given rise to regulatory concerns.
On a recent day, 6 of the 8 banks paying more than double the average national rate on 3-month CDs at bankrate.com were Internet banks.
Large Internet banks are owned by institutions that already have big consumer lending businesses. Even paying 100 or 150 basis points above the prevailing market rates can be cheaper than obtaining the funds by borrowing or securitizing. Particularly after wholesale markets froze in the recent crisis, these deposits may also be perceived as less subject to liquidity risk.
But the fact remains that it is something new under the sun for a bank's deposits to consist of non-core, highly rate-sensitive accounts — invested predominantly in portfolios of credit card, auto or other vulnerable loans. If the Transaction Account Guarantee program is extended without limitations, this will increase the number of banks competing effectively for 0% deposits, hence impel the needier banks to offer interest. That's what legislators sought to avoid after the Great Depression, when Reg. Q, which prohibited interest on commercial demand deposits, was originally mandated.
What is the risk here? When we are no longer drowning in liquidity, funds scarcity could result in a substantial escalation of the premium that Internet banks have to pay for deposits. Even if they make loans with floating rates, those rates will not adjust to disproportionate increases in funding costs.
Second, this trend to non-core deposit financing of lending concentrates consumer credit portfolio risks in the FDIC--whereas the alternatives, credit card and auto securitizations for example, tend to spread these risks across outside investors, many of which are not financial institutions. Would it be excessively risky for a bank to have primarily credit card loans as assets and Internet deposits as liabilities? I think so.
Furthermore, the operational investment and cost for a bank to start competing for Internet deposits is very low. The web site and processing can be rented. Even small banks can, when they need funds, up the ante to open up this tap. Thus, they have access to a new, large, uncritical and not necessarily healthy source of liquidity. That's a far cry from the situation that has prevailed up to now, which featured dependence on the heavily regulated discount window.
If I were a bank's chief risk officer and if the regulations permit me to do so, I'd want to have this capability in operation if only in order to use it as a non-government funding source of last resort.
This seems to merit regulatory attention. Banks that pay substantially above market for deposits need closer supervision. Banks that invest Internet deposits in illiquid assets face greater liquidity risk. Undue concentrations either in liabilities or assets increase vulnerability to failure.
Andrew Kahr is a principal in Credit Builders LLC, a financial product development company, and was the founding chief executive of First Deposit, later known as Providian.
