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Electronic copy available at: http://ssrn.com/abstract=1857121
1
Working Paper
2011-WP-14 June 2011 What is a Core Deposit and Why Does It Matter? Legislative and Regulatory Actions Regarding FDIC-insured Bank Deposits Pursuant to the Dodd-Frank Act R. Christopher Whalen
Abstract: The paper looks at the changes in the Federal Deposit Insurance Corporation assessment process since the passage of the Dodd-Frank legislation. It outlines some of the
changes made to the insurance premium rates as well as the calculation of the deposit
assessment base, and examines how the burden of payment is now more equitably distributed between large and small banks. The paper also examines the issue of core vs. brokered
deposits. The author discusses the rule making process regarding brokered deposits in 2010 and 2011 from a firsthand perspective and also comments on the public information gathering
process mandated by the Dodd-Frank law with respect to brokered deposits.
About the Author: R. Christopher Whalen is co-founder and managing director of
Institutional Risk Analytics, with responsibility for sales, marketing and business development. He has worked as an investment banker, research analyst and journalist for more
than two decades. Whalen contributes regularly to publications such as Barron's, The International Economy and American Banker. He has appeared before the U.S. Congress and the Securities and Exchange Commission to testify on a variety of financial issues and speaks on
topics such as XBRL, investing and corporate governance. Mr. Whalen volunteers as a member of the New York and Washington Steering Committees of Professional Risk Managers
International Association and edits a blog on regulation and risk management. After graduating from Villanova University in 1981, Mr. Whalen worked for the U.S. House of Representatives and
then as a management trainee and in the bank supervision and foreign exchange departments at
the Federal Reserve Bank of New York. He then worked in the fixed income department of Bear, Stearns & Co, in London. After returning to the United States in 1988, he spent a decade
providing risk management and loan workout services to multinational companies and government agencies operating in Latin America. In 1997, he returned to Wall Street, working as
an investment banker in the mergers and acquisitions group of Bear, Stearns & Co. and later
Prudential Securities. He then served as the managing director of The Free Internet Group Ltd., one of the largest independent Internet service providers in the United Kingdom. In 2001, Mr.
Whalen returned to investment banking, working as a banker at Fechtor, Detwiler & Co. and an equity research analyst at Ramberg, Whalen & Co.
Keywords: FDIC, Dodd-Frank, deposit insurance, brokered deposits.
The views expressed are those of the individual author and do not necessarily reflect official positions of Networks Financial Institute. Please address questions regarding content to Chris Whalen at [email protected]. Any errors or omissions are the responsibility of the author. NFI policy briefs and other publications are available on NFI’s website (www.networksfinancialinstitute.org). Click “Thought Leadership” and then “Publications/Papers.”
Electronic copy available at: http://ssrn.com/abstract=1857121
2
What is a Core Deposit and Why Does It Matter? Legislative and Regulatory Actions Regarding FDIC-insured Bank Deposits Pursuant to the Dodd-Frank Act
Introduction
The Federal Deposit Insurance Corporation (FDIC) was created by Congress in the 1930s
to act as receiver of failed banks and to provide temporary federal deposit insurance for
American consumers. Though opposed by President Franklin D. Roosevelt, the industry
and members of both parties, FDIC insurance eventually became permanent and has
since become one of the most important government enterprises created under the
socialist New Deal reforms. Essentially an industry-funded mutual insurance scheme
with powerful regulatory and receivership powers, and backed by the full faith and credit
of the U.S. Treasury, the FDIC is among the most formidable independent agencies ever
created by Congress.
The FDIC‟s revenues and outlays are included in the federal budget, but the banking
industry effectively pays for its operations and absorbs the cost of bank resolutions. All
FDIC members are, in effect, joint and severally liable for their respective liabilities.
Under the leadership of Chairman Sheila Bair, Vice Chairman Marty Gruenberg and the
other board members, the FDIC has resolved hundreds of failed banks without drawing
on the Treasury credit line. Through a combination of asset sales, loss sharing
agreements and higher assessments on larger banks, the FDIC and its member banks have
shouldered the cost of most of the significant bank failures since the start of the subprime
crisis.
Since 2007, the FDIC has acted as receiver and sold hundreds of failed banks and
hundreds of billions of dollars in assets from failed depository institutions. Under the
Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), the FDIC
now acts as receiver with respect to the largest depositories and their parent companies
under the dubious rubric of preventing systemic risk. But the basic role it plays in
providing deposit insurance coverage remains its most important function and has
profound effects on the behavior of consumers, depositories and financial markets.
The changes to the deposit insurance assessment base for insurance premiums, which is
one of the subjects of this paper, has already drawn criticism. For example, in an April
2011 commentary, David Kotok of Cumberland Advisors accused the FDIC of canceling
out the impact of the Federal Reserve‟s (Fed) quantitative easing effort by raising deposit
insurance premiums at the start of 2010. He writes:
In making monetary policy decisions, the Fed did not have to contend with this
cost prior to April 1. Now the FDIC has interfered in a way that adds a cost to the
banking system at the very time the Fed is engaged in easing. The mechanics of
the FDIC fee act as a form of a tightening. We estimate that the impact is nearly
the same as if the Fed were to have raised interest rates about 15 basis points. By
3
some “guess”timates, the FDIC has taken back all the easing provided by all of
QE2. 1
This paper provides an overview of recent regulatory developments at the FDIC with
respect to (1) the method for calculating deposit insurance assessments for insured banks
and (2) the changes mandated by Dodd-Frank with respect to “core” and non-core
deposits. This paper also examines some areas for future investigation by the FDIC as
part of a study mandated by Dodd-Frank that will be delivered to Congress later this year.
As this paper is published, Republicans in Congress and the banking industry are
threatening to repeal part or all of Dodd-Frank. The reaction to the sweeping changes
made by the FDIC to deposit insurance in 2011 and the recommendations to Congress
contained in the upcoming FDIC study may well lead to active opposition to the new
rules on deposit insurance assessments, but so far none has materialized. The Dodd-
Frank legislation empowered the FDIC to:
modify the definition of an institution‟s deposit insurance assessment base;
change the assessment rate adjustments;
revise the deposit insurance assessment rate schedules in light of the new
assessment base and altered adjustments;
implement Dodd-Frank‟s dividend provisions; and
revise the large insured depository institution assessment system to better
differentiate for risk and better take into account losses from large institution
failures that the FDIC may incur.2
Revised Assessment Base: Equity for Small Banks
Prior to the passage of Dodd-Frank, the calculation of the assessment base for FDIC
deposit insurance purposes involved putting banks into one of four risk categories each
quarter, determined primarily by the institution‟s capital levels and supervisory
evaluation as expressed in the CAMELS rating for the depository.3
The annual rates of
assessment ranged between 12 and 45 basis points (bp) per year, a premium levied
against domestic deposits only. In the wake of Dodd-Frank, all deposits are now
explicitly part of the assessment base calculation. Of note, the FDIC has never
distinguished between U.S. residents and foreign depositors for the purposes of deposit
insurance coverage, which extends to any natural person.
1 Kotok, David, “Scylla and Charybdis, The FDIC and the Federal Reserve,” Market Commentary, April
19, 2011, http://www.cumber.com/commentary.aspx?file=041911.asp. 2 “Assessments, Large Bank Pricing,” Federal Register Vol. 76, No. 38, February 25, 2011, p. 10672. .
3 The regulatory acronym “CAMELS” stands for Capital adequacy, Asset quality, Management, Earnings,
Liquidity and Market Risk.
4
Initial base assessment rates for FDIC insurance were subject to adjustment based on a
number of balance sheet and other factors. An insured depository institution‟s total base
assessment rate could vary from its initial base assessment rate as the result of an
unsecured debt adjustment and a secured liability adjustment. The unsecured debt
adjustment lowered an insured depository institution‟s initial base assessment rate using
its ratio of long-term unsecured debt (and, for small insured depository institutions,
certain amounts of Tier 1 capital) to domestic deposits. Under the regime prior to Dodd-
Frank, the effective rate for FDIC deposit insurance could reach as high as 77.5 bp for
institutions in Risk Category IV.4
In 2009, the FDIC imposed a special assessment on the banking industry to replenish the
Depository Insurance Fund (DIF) in lieu of an actual change in the insurance assessment
formula. The FDIC also increased the insured limit on deposits from $100,000 per
account to $250,000 per account and also extended blanket coverage to transactions
accounts on an emergency basis, two changes which increased the assessment base
substantially. Not only the changes in the rate charged to banks but also the secular
increase in bank deposits has contributed to the increase in the assessment base since
2007. Today many larger U.S. banks are awash in deposits. Many of the banks covered
by the author showed dramatic increase in their interest bearing and non-interest bearing
funding in Q1 2011, even as loan portfolios showed net runoff.
Since the FDIC put its emergency assessment in place, using the increased discretion to
manage the DIF granted by Dodd-Frank, the agency developed a comprehensive, long
range management plan for the DIF which essentially seeks to create a larger reserve
buffer in the DIF by increasing the total amount of money raised through deposit
insurance assessment. On October 19, 2010, the FDIC proposed a rule “with the goals of
maintaining a positive fund balance, even during a period of large fund losses, and
steady, predictable assessment rates throughout economic and credit cycles.” The FDIC
adopted a Notice of Proposed Rulemaking (NPR) on Assessment Dividends, Assessment
Rates and the Designated Reserve Ratio (the October NPR) setting out the plan, which is
designed to:
(1) Reduce the pro-cyclicality in the existing risk-based assessment system by allowing
moderate, steady assessment rates throughout economic and credit cycles; and
(2) Maintain a positive balance in the DIF even during a banking crisis by setting an
appropriate target fund size and a strategy for assessment rates and dividends.5
Further to this goal, Dodd-Frank requires that the FDIC amend its regulations to redefine
the assessment base used for calculating deposit insurance assessments in a way similar
to that adopted by the agency earlier as part of special assessments to replenish the DIF.
4 “Initial and Total Base Assessment Rates,” Federal Register Vol. 76, No. 38, February 25, 2011, p.
10673. 5 “Assessment Dividends, Assessment Rates and Designated Reserve Ratio,” Federal Register Vol. 75 ,
No. 207, October 27, 2010, p. 66272. Pursuant to the comprehensive plan, the FDIC also adopted a new
Restoration Plan to ensure that the DIF reserve ratio reaches 1.35 percent by September 30, 2020, as
required by Dodd-Frank.
5
Dodd-Frank directs the FDIC:
To define the term „„assessment base‟‟ with respect to an insured depository
institution as an amount equal to—
(1) the average consolidated total assets of the insured depository institution
during the assessment period; minus
(2) the sum of—
(A) the average tangible equity of the insured depository institution during
the assessment period, and
(B) in the case of an insured depository institution that is a custodial bank
(as defined by the Corporation, based on factors including the percentage
of total revenues generated by custodial businesses and the level of assets
under custody) or a banker‟s bank as that term is used in ... (12 USC 24)),
an amount that the Corporation determines is necessary to establish
assessments consistent with the definition under... the Federal Deposit
Insurance Act for a custodial bank or a banker's bank.
While the amount of money raised post Dodd-Frank via FDIC insurance assessments is
only slightly larger than the aggregate premiums paid by the U.S. banking industry before
the legislation, the distribution of the insurance assessments is now spread far more
equitably between large and small banks. The highest premium charged to the most risky
and largest banks is now just 45 bp or 30 bp below the previous maximum premium rate
of 75 bp. This is possible because of the dramatic increase in the size of the assessment
base.
The bias of Dodd-Frank when it comes to deposit insurance is against the largest banks, a
significant change from the previous regime. During the political negotiations over
Dodd-Frank, the community bankers managed to use their considerable political clout to
effectively push more of the cost of the DIF onto the large banks. Whereas prior to
Dodd-Frank the large money center banks paid FDIC premiums only on domestic
deposits and then also received a favorable adjustment for debt funding, now the
assessment base looks at all tangible liabilities less capital and only provides limited
dispensation for debt funding that does not have explicit FDIC insurance. 6
In terms of risk-based measures, the new assessment regime incorporates the existing
methodology of CAMELS based factors for applying higher premiums to a given
institution based on risk. As before Dodd-Frank, the different ratings taken from the non-
public CAMELS ratings are used to determine the risk category for a given depository.
6 The FDIC believes that the change to a new, expanded assessment base should not change the overall
amount of assessment revenue that the FDIC would otherwise have collected using the assessment rate
schedule under the Restoration Plan adopted by the FDIC Board on October 19, 2010. At that time, the
FDIC changed the assessment base from domestic deposits alone to tangible assets less capital.
6
The bank may then seek mitigation of the score based upon special factors. The figure
below shows an example of the analytical framework applied to banks under the new
regime taken from the April 15, 2011 Federal Register notice by the FDIC with respect to
“Proposed Assessment Rate Adjustment Guidelines for Large and Highly Complex
Institutions.”
Source: Federal Register.
Of all of the top Wall Street investment banks, Goldman Sachs (GS) saw the largest
percentage increase in its FDIC deposit insurance premium assessment base as a result of
the new FDIC assessment rule, more than 200%. According to Institutional Risk
Analytic‟s (IRA) internal calculations, the assessment base for the FDIC insured GS bank
unit will increase from $32 billion before Dodd-Frank to $90 billion under the new
calculation rule, based upon data from the FDIC call reports. The insured bank, Goldman
Sachs Bank USA, is currently rated “A+” and has a CAMELS equivalent of “1” based on
data from the FDIC and calculations by The IRA Bank Monitor. This means that GS
would pay the lowest premiums for FDIC insurance given its riskiness, but will pay these
premiums on an assessment base almost three times larger than before the enactment of
Dodd Frank. Therefore, GS will see a threefold increase in the actual premiums paid.
Below is the before and after comparison for the top-ten U.S. commercial banks by
assets, some of which had even larger changes in assessment base than did Goldman
Sachs:
Table 1
Change in FDIC Assessment Base 2010-2011
($000)
7
2010 Base 2011 Base $ Change % Change CAMELS
JP Morgan Chase 670,052,983 1,785,476,778 1,115,423,795 166.5% 2.1
Citigroup 335,530,975 1,311,861,918 976,330,943 291.0% 2.5
Wells Fargo & Co. 786,162,921 1,155,252,023 369,089,102 46.9% 1.7
Bank of America 943,235,523 1,736,652,402 793,416,879 84.1% 2.1
US Bancorp 177,504,855 308,471,261 130,966,406 73.8% 1.6
PNC Financial 182,160,160 272,424,404 90,264,244 49.6% 1.5
CapitalOne Financial 121,604,715 199,104,344 77,499,629 63.7% 2.0
Bank of New York Mellon 76,785,471 196,302,418 119,516,947 155.7% 2.2
SunTrust Banks 122,483,706 162,509,568 40,025,862 32.7% 2.0
State Street Corp 23,007,287 155,568,533 132,561,246 576.2% 2.0
Source: FDIC (RIS)/The IRA Bank Monitor. Public data CAMELS ratings by IRA.
Assuming that the banks shown above remain in the CAMELS 1-2 range, they will
continue to pay assessment rates at the low end of the assessment schedule but will see
their actual premiums measured in cash terms rise by at least the rate of increase in the
assessment base. Should the ratings of these institutions deteriorate, then the increased in
premiums would be larger than the percentage increase in the assessment base.
So whereas JP Morgan (JPM) paid a bit over $400 million in FDIC deposit insurance
assessments in 2008, in 2011 their assessments paid to the FDIC will be closer to $1.4
billion, according to The IRA Bank Monitor. A copy of the JPM assessment calculation
summary is included in Appendix A. It is important to bear in mind that the combination
of (1) the increase in FDIC insurance coverage and growth in JPM‟s deposit base and (2)
the increase in the assessment base for JPM.
Core vs. Brokered Deposits
In December 2010, the FDIC closed the period for comments on a key aspect of these
changes mandated by Dodd-Frank, namely the rule regarding “Assessments, Assessment
Base and Rates,” which was adopted in final form by the FDIC in early 2011. In
February of 2010, the FDIC issued a final rule to implement some of the revisions to the
Federal Deposit Insurance Act mandated under Dodd-Frank. These rule changes mostly
affect the largest U.S. banks in terms of increased assessments, while as discussed above,
smaller institutions are now taxed less with respect to insurance levies. Based on the fact
that larger banks tend to have elevated risk profiles compared with smaller banks, this
policy outcome seems to be consistent with the congressional mandate for a risk-based
approach to pricing deposit insurance.
But the FDIC‟s approach to regulation of different types of deposits in some important
respects remains idiosyncratic. In public comments on the rule, the banking industry, this
author and others raised questions with respect to the characterization of both core and
brokered deposits in the rule and, particularly, how the FDIC differentiates between
institutions using ostensibly “risky” non-core deposits for funding vs. core deposits and
other types of “safe” funding. In comments on the large bank pricing rule and at the
8
subsequent industry round table held at the FDIC on March 18, 2011, the author focused
on the fact that the proposed rule pursuant to Dodd-Frank did not seem to have a risk-
based component for pricing deposit insurance assessments on non-core brokered
deposits.7
The FDIC modified the final rule to meet some of the concerns that were raised regarding
the pricing of assessments on non-core deposits as well as the definition of “core” and
brokered deposits. It is important to note that the FDIC moved on the large bank deposit
insurance assessment regulation before it completed the Dodd-Frank mandated study, a
seemingly illogical ordering of diligence and rule making activity. Section 1506 of the
Dodd-Frank Wall Street and Reform Consumer Protection Act requires that the FDIC
conduct a study to evaluate:
The definition of core deposits for the purpose of calculating insurance premiums.
The potential impact on the DIF of revising the definitions of brokered deposits
and core deposits to better distinguish between them.
Differences between core deposits and brokered deposits and their role in the
economy and U.S. banking sector.
The potential stimulative effect on local economies of redefining core deposits.
The competitive parity between large institutions and community banks resulting
from redefining core deposits and brokered deposits.
The rule-making process and the comments received by the FDIC on the several
comment periods conducted over the last year illustrate a number of issues still facing the
FDIC and Congress as the banking industry manages the new assessment base and rules
for different categories of bank deposit liabilities. Among these, perhaps the chief issue
and challenge facing the FDIC and ultimately Congress is whether the use of labels such
as “core” and “brokered” are still accurate and useful for making public policy.
The Evolution of the Funding Market
In the market for deposits today, competitive pressures, the continuing impact of the
subprime crisis and the collapse of several large financial institutions, and technological
innovations have made and are forcing enormous changes in the banking industry. How
these events affect the changes in the behavior of bank customers and financial
institutions, in turn, affects the effectiveness of current law and regulation, as well as the
adequacy of public disclosure by insured depositories with respect to their operations.8
7 See “Core and Brokered Deposits,” March 18, 2011, FDIC, http://www.fdic.gov/regulations/reform/c-n-
b-deposit.html. 8 Following the collapse of Lehman Brothers and other institutions, the FDIC extended extraordinary
guarantees on deposits and debt to help stabilize the funding of insured depositories and non-financial
industrial companies cut off from traditional markets.
9
Congress has long mandated that the FDIC have a risk-based deposit insurance system, a
legal requirement often ignored in practice since implementing a workable risk
assessment system is not a trivial task. Such a system must be based on empirical data,
not speculation, bias, or conjecture. Both the FDIC and other regulators have often been
reluctant to craft and impose their own methodologies for rating bank risk, instead relying
on the rating agencies and even the banks themselves.
One of the top level concerns that proponents of a risk-based approach to deposit
insurance pricing bring to the public policy discussion is whether the FDIC has sufficient
data to address the concerns of Congress, the industry and the banking public regarding
new deposit products now available in the marketplace. A first order task is that the
FDIC needs to step back and first create a new business case description of the data
required for insured banks, regulators and the public to understand and benchmark the
different types of funding in the industry.
In the period prior to the passage of Dodd-Frank, the FDIC employed a combination of
regulations and price controls to limit the perceived risk from brokered deposits and to
focus banks on primary reliance upon core deposits and other “safe” funding sources
such as the Federal Home Loan Banks. With the deregulation of the 1980s, the FDIC and
other agencies became concerned by the use of early types of brokered funds to finance
rapid growth in banks and thrifts. The failures of Penn Square Bank and Continental
Illinois, among others, confirmed the view among many regulators that rapid growth of
brokered deposits was a red flag in terms of safety and soundness.9
The institutional view among regulators is that brokered deposits as an asset class was the
chief cause of the Penn Square, Continental Illinois and other failures, but the reality is
more complex. First, Penn Square started losing core deposits because investors could
see that the bank had asset quality problems. Second, only when it was already in trouble
did Penn Square start ramping up brokered funds. Markets could smell that the bank was
in trouble, refuting the idea that franchise value in terms of core deposits survives in a
bank with poor management and impaired asset quality. Some researchers have even
concluded that brokered funds played little significant role in the bank and thrift failures
of the 1980s.10
In using Penn Square or the other failures of the 1980s as inputs in today‟s analysis, we
need to recall the nature of brokered deposits 30 year ago. In the mid-1980s, what we
call a “brokered deposit” was almost certainly uninsured institutional money taking
advantage of the new $100,000 FDIC insurance limit. Moreover, there was no retail
brokered market in the 1980s as exists today.
9 The FDIC case study on the failure of Penn Square Bank N.A. describes how brokered funds at the
institution rose by an order of magnitude in just six months during 1982. The resulting deposit payout and
FDIC bridge bank at resolution was one of the worst losses to the deposit insurance fund up to that time.
See http://www.fdic.gov/bank/historical/managing/history2-03.pdf. 10
See Cates, David and Stanley Silverberg, “The Retail Insured Brokered Deposit: Risks and Benefits,”
Cates Consulting Analysis, May 1, 1991. Then-Fed Chairman Paul Volcker attempted to convince then-
FDIC Chairman Isaac to bail out Penn Square because of the bank‟s asset quality and funding problems.
10
Yet the reaction from regulators to events such as Penn Square has been to brand all
“brokered deposits” as being akin to acts of Satan. Some thrifts and banks did use early
examples of brokered funds to create unsafe and unsound situations. But most of these
institutions actually met the net worth requirements for use of brokered funds until long
after they got into trouble.11
What Penn Square and the savings and loan crisis show is that mere capital hurdles were
inadequate tools to manage asset quality and funding risk. This same pattern was
repeated in the financial crisis of 2007. Large lenders and RMBS dealers such as
Countywide, Bear Stearns and Washington Mutual had already reached the point of no
return by 2005 but financed their expansion with a variety of agency and private funding
sources.12
Under the leadership of former Chairman William Isaac (1981-1985), the FDIC led a
holy crusade to effectively eliminate the use of brokered funds by denying deposit
insurance coverage. Wall Street firms led by the likes of Merrill Lynch openly sparred
with Isaac, who accused Merrill of having billions of dollars of hot money parked at bad
banks with no diligence by the investment bank.13
Isaac‟s effort to prohibit the use of brokered funds was ultimately struck down by the
courts, but prompted Congress to investigate and eventually legislate with respect to risk-
based pricing for regulating these funding sources. Under William Seidman, the FDIC
took a different approach, effectively taxing brokered deposits via the deposit insurance
assessment process and also limiting the use of brokered funds via the supervisory
process. "I'm not against brokered deposits per se," Mr. Seidman told reporters after a
1985 speech at the U.S. League of Savings Institutions' annual convention, but his arrival
brought with it a different approach to regulating brokered funds.14
With the 1991 FDIC Improvement Act, the FDIC began to use operational measures of
bank capital adequacy to determine whether an insured depository institution ought to be
permitted to use brokered deposits and only then under strict limits. The law also
required reporting by deposit brokers to the FDIC, an important requirement that was
later weakened during the later period of financial deregulation that was a proximate
cause of the 2007 financial crisis. To the agency‟s credit, under Chairman Sheila Bair the
FDIC again began to examine and monitor the large bank and non-bank aggregators of
deposits.
11
See Murphy, M. Maureen, “FIRREA: The Financial Institutions Reform, Recovery and Enforcement Act
of 1989,” Congressional Research Service, August 28, 1989. 12
At the end of 2005, WaMu was reporting strong financial performance and low losses, but in fact the
bank had already started to shrink its books. 13
Rosenstein, Jay “Merrill Lynch challenges Isaac's remarks; says brokered deposits were not placed in
troubled banks, American Banker, December 14, 1984. 14
Basch, Mark, “Seidman takes a conciliatory stance on brokered deposits, but plans curbs,” American
Banker, November 6, 1985.
11
The biggest asset a bank has is actually a liability, namely stable core funds. Other
intangible assets that are frequently considered by regulators to be problematic, such as
mortgage servicing rights, can also be very valuable tools in managing duration risk, for
example, assuming that the institution understands the risk. There are numerous
examples from recent history, starting with Washington Mutual and also smaller
situations such as Waterfield, Raymond James, and United Western, where a failure to
understand the true risk-based components of core funding led to losses to the DIF. But
in most cases, use of brokered and other non-core deposits was not the key factor in these
failures.
Part of the reason for the failure of contemporary risk management tools is that American
bank managers and regulators have made core deposit modeling a quantitative exercise
without building a legitimate and defensible business case. That is, it should not be
solely about deriving a duration, balance, and rate projection, but it should also ask how
the funds are employed. When asked about brokered deposits, FDIC Chairman Sheila
Bair said at the American Bankers Association government relations summit in March
2011 that “maybe we should look, not at the source of funds, but how they are used.”
Changes that have occurred in the marketplace for bank funding over more than two
decades call into question the efficacy of current regulation and even of our current
understanding of the market for bank funding. Past examples of the manifest evil of
brokered funds going back to Penn Square Bank and Continental Illinois, however, still
greatly influence the perception of the FDIC and Congress regarding the nature of
different types of bank funding. This is illustrated by the two key factors identified in the
FDIC outline for the March 2011 roundtable discussion:
1) Characteristics that Define Core and Brokered Deposits
· Customer relationship
· Insurance coverage
· Location of depositor
· Interest rate
2) Impact on Franchise Value
Clearly customer relationship is an important criteria for judging the nature of a funding
relationship, whether via a deposit or a debt instrument. Yet it must be recognized that in
the world of online financial services, deposits are effectively securities, with Committee
on Uniform Securities Identification Procedures identifiers and other attributes of a debt
instrument. Banks are now able to sell these instruments globally, 24/7, via various
automated electronic modalities such as the internet, telephones and handheld devices.
Banks have little ability to gather data about online customers and the value of the
relationship is debatable. In the world of online banking, the nature of the customer
relationship and thus the franchise value of a deposit becomes more complex, but also
offers benefits to banks and customers.
12
If you examine leading online banks such as ING Bank FSB, the value of the online
banking model in terms of the value of the customer relationship is questionable.
Through most of the past decade, ING Bank was one of the worst performing large thrifts
in the United States, in part because the parent company sought rapid asset growth as part
of a larger, now discredited strategy of expansion. The bank paid aggressively for
deposits and invested the funding mostly in mortgage backed securities. Since the bank
was restructured in 2009, however, ING Bank has been a good performer, with below-
peer levels of operational stress and better-than peer asset and equity returns, but a
shrinking balance sheet.
In the FDIC‟s regulations today, virtually all of ING Bank‟s deposits are considered
“core,” even though the depository has no physical branches. The blurring distinction
between traditional “core deposits” gathered by physical bank branches and deposits
gathered via various retail and institutional networks pose a crucial issue and challenge
for the FDIC and Congress. This same challenge, however, may help to inform and
improve the supervisory process and the public need for transparency when it comes to
the soundness of individual depositories. The diligence process being conducted by the
FDIC pursuant to Dodd-Frank is an opportunity to reexamine the definition of the various
types of funding used by banks. In many respects, this will mean bringing the world of
bank deposits into compliance with the norms of disclosure and transparency applicable
to all debt securities under Title 12 of the United States Code (USC). But a key part of
the exercise to which the FDIC and other regulators contribute, with respect to our
understanding of bank funding, is creating a new business case framework to guide both
bank supervision and analytics activities.
Core Deposits: Compliance/ALM Issue or Enterprise Risk?
As part of fulfilling its investigation under Dodd-Frank, the FDIC should address a long
standing concern relating to deposit modeling by FDIC insured banks. Banks have never
wanted to perform the task of properly assessing their deposits, nor have they had the
data for their own institutions and their peers to do so in an effective way. At best, banks
view modeling deposit behavior as a compliance/asset liability management (ALM) issue
rather than a true “enterprise value” task, an error encouraged by well-meaning
consultants, auditors and regulators. It is a serious mistake by regulators to accept this
view and one that arguably violates the internal controls guidelines set by Committee of
Sponsoring Organizations (COSO) and goes directly to the issue of managing risk to the
DIF.
Finding the approximate value of a deposit is important, as discussed below, but the
primary question/problem regulators, bankers and analysts are trying to solve is not best
described as an issue of internal rate of return (IRR) sensitivity. Rather, we need to
define the business case for the data, modeling, and information technology infrastructure
(i.e., the “use test”). Valuation should be a by-product of a well-specified business need
that justifies the costs involved. Account modeling should be done at the local and
account level and perhaps segmented by metropolitan statistical area or zip code, as is
now the standard in the loan data industry.
13
Analytics should employ behavioral analysis of account opening/closing probabilities,
segmentation of accounts by high-risk/low-risk of option exercise (with concomitant
marketing to the high-risk accounts), account level innovations allowed (i.e., analyzed
accounts wherein higher risk of account loss is able to be modified to make them
“stickier”), et cetera. Consider some possible questions regarding deposit analytics:
What is the problem we are trying to solve, and why? Deriving a value shouldn‟t be
the goal. Rather, the goal should be to determine how core deposit value is created
and destroyed, and thus measured dynamically through time. Once we make this
determination, the goal should be one of figuring out how to manage and optimize the
variables driving value and create a simple means of monitoring same.
Is this a neat exercise for IRR only, or are there other legitimate business reasons for
pursuing advanced core deposit analytics? Said differently, how do we ACT (how
CAN we act) on the results of our analysis? Again, the sources and uses of deposit
funds must drive the complete analysis.
How do you define “error” in a deposit model? Given that most model estimates are
wrong, how do you determine in a statistically valid manner whether the REASON
the estimate is wrong has anything to do with the parameters you use to produce a
“model” result?
Recommended Changes to Current Framework
One of the core lessons of the 2007 financial crisis is the distinction between an asset that
is funded with stable sources such as equity and stable deposits, and an asset that is
merely financed with commercial paper, debt and other types of unstable funding.15
Labels such as “core” and “brokered” are imprecise, subjective and are therefore
inadequate to describe the volatility of different types of funding. It is the volatility of
deposits, which is a function of liquidity and market risk factors, that ultimately poses the
threat to insured depositories and thus influences franchise value.
In order to gauge the volatility of a bank‟s liabilities, we need to focus on not only (1) the
relationship -- that is, the type of customer -- but also (2) the price of the liability
measured in a spread over a given market benchmark and (3) the maturity or duration of
the liability. The FDIC needs to create an objective, risk-based matrix for describing and
scoring the volatility of all of a bank‟s liabilities as the first step toward building a
business case framework for bank deposit analytics.
From a public disclosure and supervisory perspective, this matrix should capture both a
bank-only and consolidated parent level view of funding sources to capture the cost and
15
“Beyond the Crisis: Reflections on the Challenges,” Remarks by Terrence J. Checki, Executive Vice
President, Federal Reserve Bank of New York at the Foreign Policy Association Corporate Dinner in New
York, December 2, 2009.
14
duration of a given subject‟s liabilities. The FDIC should incorporate some of the
thinking embedded in market concepts such as the net stable funding ratio (NSFR), which
requires dramatic increases in capital if liabilities are mismatched with much longer
assets. The FDIC should also carry this NSFR concept further in negotiations to modify
H.R. 940 (Garrett/Maloney Covered Bond Bill) to reduce the risks to the DIF. If a DIF
perspective indicates that a securitization trust is a stand alone “bank,” then the trust
should be constructed in such a way as to satisfy NSFR criteria.
A matrix that the FDIC could consider incorporating in its report to Congress:
Funding Assessment and Disclosure Matrix
(1) Relationship: Customer type (individual, corporate, public)
(2) Pricing: Rate/spread (fixed or variable)
(3) Maturity/Duration: Stated vs. Effective (optionality)
Some of the information described above is already included in current disclosure
provided by banks and thrifts, but much of it is not. At a minimum, the FDIC should
mandate public disclosure of all of the basic elements in each of these three categories so
as to enable a true risk-based pricing regime for all bank level liabilities, including
institutional deposits, Federal Home Loan Bank (FHLB) advances and covered bonds.
Taken together, these additional factors will provide the FDIC and the public with a
better estimation of the franchise value of a bank, a perspective that is not merely relevant
to the resolution process. Better describing the assets and liabilities of a bank and thus
the franchise value in a liquidation not only satisfies the public disclosure obligations of
all federally insured depositories with respect to the Dodd-Frank “living will” resolution
standards, but aids the FDIC in maximizing recoveries in the event of a resolution.
Fortunately the leadership shown by the FDIC over the past several decades in terms of
gathering and disseminating bank financial statement data in a highly organized fashion
puts the agency in a strong position to meet this challenge.16
In terms of relationship, the type of customer is obviously of importance in terms of
selling a failed bank, but the attribute of relationship also informs the FDIC and other
regulators regarding the business model attributes of depositories. For example, the fact
of large public depositors/creditors such as the Treasury, FHLBs and other agencies
informs the analysis as to the bank‟s ability to fund its operations in the private markets.
Given the role played by the FHLB advances in terms of increasing the cost of resolution
at many failed banks since 2007, the fact of a large percentage of a bank‟s funding
16
The FDIC‟s implementation of extensible markup language (XML) and the related accounting taxonomy
associated with bank and thrift call reports allows fully automated data validation, transfer, analysis and
distribution by consumers of this information. The XML-based data collection architecture employed by
the FDIC enables the addition of new data variables with relatively little hardship and expense for insured
banks.
15
coming from public sources is an obvious red flag and a risk to the DIF that is at least as
urgent as that raised by brokered funds. FHLB funding capacity should be limited
equally with “hot money” as advances require huge haircuts against collateral.
Conversely, institutional funding sources such as sweep accounts, long-term certificates
of deposit) (CD) and reciprocal deposits now labeled as “risky” may, in fact, raise
relatively few supervisory concerns so long as the aggregators of these funds conduct
their business in a safe and sound manner. Indeed, to the FDIC‟s concern about
minimizing the cost of resolution and maximizing franchise value in the context of a
failed bank sale, it may be possible to convey some stable institutional and reciprocal
deposits instead of paying them out as is now agency practice. Based on the author‟s
conversations with FDIC personnel and bankers, I have yet to find any practical objection
to giving the FDIC acting as receiver the option to convey such liabilities if doing so
supports the goal of a least cost resolution to the DIF.
Also, based on the tripartite factor analysis proposed above, the FDIC ought to eliminate
the practice of treating principal and interest (P&I) and taxes and interest (T&I) escrow
balances at mortgage servicers as “core” deposits for regulatory purposes. These escrow
balances are essentially trust accounts and have variable seasonality and periodicity that
differs significantly from core deposits. These escrow flows are also directly impacted
by prepayments and losses on a monthly basis, adding further volatility to the funding
risk profile.
More importantly, the treatment of these balances as “core” by regulators gives the top
four banks the appearance of larger core deposits than is in fact the case. These deposits
fail the FDIC‟s own relationship test and reinforce the monopoly position of the large
bank loan servicers vis-a-vis smaller banks. In the event of a failure, much of a bank‟s
P&I and T&I business will go elsewhere, thus the franchise value of these transaction
balances seems questionable.
Because the Federal Reserve Board‟s ill-advised rules regarding mortgage servicing
rights force small banks to sell loans “servicing released,” the FDIC‟s treatment of P&I
and T&I balances as “core” actually reinforces the large banks‟ monopoly position in the
secondary market for mortgage loans. The inflated “core” deposits at large banks give
these lenders access to extra leverage and also more borrowing capacity at the FHLBs.
Even today, the largest banks still have the predominant balance of FHLB advances
which are used to support excessive credit and geographic concentrations in the largest
banks. One way to limit systemic risk is to reduce the “leveraged” size of the largest
banks.17
The Fed and FDIC are creating serious systemic risk and antitrust issues with these
policies on large bank core deposits and mortgage servicing rights (MSRs). The FDIC
ought to reach out to the Fed and other agencies to discuss whether these policies ought
17
See “Study & Recommendations Regarding Concentration Limits on Large Financial Companies,”
Financial Stability Oversight Council, Completed pursuant to section 622 of the Dodd-Frank Wall Street
Reform and Consumer Protection Act, January 2011.
16
to be modified in the name of enhanced competition and improved revenue and liquidity
for community and even regional banks. The fact that federal capital rules force smaller
lenders to sell their conforming loan production to the government-sponsored enterprises
(GSEs) via the top four banks is a national scandal and one that arguably violates U.S.
anti-trust laws.
But for the Fed‟s rules on MSRs, smaller community banks could sell loans into the GSE
market without releasing the servicing. This change would make the supposed “core
deposits” of the top four banks far smaller and would increase the market power of
smaller banks. More, allowing smaller banks to retain loan servicing could alleviate
many documentation issues regarding foreclosure since the originating bank would
remain the local agent in the state where the property was located.
Pricing is the next crucial area where the FDIC needs to enhance public reporting and
disclosure, both in terms of the public need and also supervisory requirements. It is not
possible for the FDIC and other agencies to properly supervise banks and also meet the
requirements of public disclosure without timely pricing information on deposits. As
stated earlier, requiring disclosure of deposit pricing will complement existing disclosure
of loan spreads and will thus enable a more informed analysis of the business model
attributes of a given depository. Enhanced price information also allows bank customers
and regulators to understand how aggressive or conservative an institution is vs. its peers
and allows an apples-to-apples analysis of deposit pricing vs. debt and other alternatives.
Along with relationship and pricing, the third key variable that the FDIC needs to collect
from all insured depositories is both the stated and effective maturity of deposit liabilities.
If a deposit has a no penalty for early withdrawal feature, this optionality should be
disclosed. Depositories should be required to track the stated and effective duration of
both assets and liabilities, especially given the proliferation of all types of derivatives and
other optionality in all financial products. The FDIC should give banks credit for issuing
non-callable liabilities compared with core deposits that have no penalty features.
A “good” liability structure, for example, has banks issuing matched liabilities to long
term assets, such as covered bonds with tight collateralization and ALM criteria or FHLB
advances. This illustrates how the nature of the deposit and the asset are tied together in
the overall business case analysis. A “bad” liability, on the other hand, is a five year CD
with no penalty for early withdrawal. This product is effectively an interest-bearing
demand deposit that creates a short duration position for the depository that must be
recognized and managed in the same way as the duration of assets. A five year CD,
sweep account or reciprocal deposit with standard industry terms is arguably a far more
stable type of funding than the “core,” no penalty for early withdrawal products now
advertised on national television by a variety of lenders.
Given the evolving competitive environment in the bank deposit market, the FDIC has a
duty to evolve the coverage of public disclosure to keep up with these changes. The
FDIC should regularly survey the banking industry and consumers of deposit services on
these issues. Once the FDIC has conducted additional diligence to better understand
17
relationship, pricing and maturity for all types of bank liabilities, then the agency will be
in a position to craft a new set of rules to score deposits based upon the true level of risk
to the DIF.
Using the deposit assessment methodology already adopted by the agency and
supplemented with additional data on price and maturity, Congress and the FDIC can
create an effective way to describe different types of bank funding accurately and fairly.
With this enhanced set of variables to observe and monitor the volatility of funding on an
ongoing basis, the FDIC will be in a position to better inform the public and supervisory
personnel in all relevant agencies on the safety and soundness of federally insured banks.
As this paper is finalized, it is unclear which way the FDIC will go on these issues.
Chairman Bair showed some sympathy with the risk-based approach to assessing the
volatility of bank liabilities. But the old guard at the FDIC‟s division of insurance and
research seem to continue to believe that brokered funds are fundamentally unsafe and
unsound. There seems to be good support among the industry, however, for a more
flexible approach that incorporates the three factors highlighted above, namely
relationship, pricing and duration. The author continues to believe that aligning the
regulatory treatment and disclosure regarding all deposits with the treatment of the assets
they fund is the logical and best public policy course for the United States to pursue.
18
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