Opportunity Knocks for Community Banks

By Steve Kinner

At first glance, it may appear that new regulations are making public fund deposits less attractive to banks. But as is often the case in the banking sector, what applies to some banks, doesn’t generally apply to all.  

In fact, recent regulatory changes, combined with other factors, have substantially altered the dynamic of bank funding for the nation’s largest banks, which has, in turn, decreased the attractiveness of public fund deposits to Wall Street and other banks with assets of $50 billion or more, resulting in greater availability of public funds for community banks.

A careful review of recent data from the Federal Deposit Insurance Corporation (FDIC) indicates that more and more government entities are shifting deposits out of the nation’s largest banks, thereby making deposits from governmental entities an increasingly important and accessible source of funding for community banks.

Public Fund Deposits Held at Banks

Source: Federal Deposit Insurance Corporation Statistics on Depository Institutions 2016 

According to data from the FDIC’s Statistics on Depository Institutions, as of the end of the first quarter of 2016, more than half of the deposits from federal, state, and local government entities were placed at banks with less than $50 billion in assets. The amount of public deposits at these smaller institutions increased nearly 10.4% from the first quarter of 2015, while public funds deposits at large institutions fell by 3.5%. This data confirms that large banks are slowly shedding public deposits and given the current regulatory environment, this decline should continue for the foreseeable future.

The Shifting Public Deposit Environment

Part of the answer for the drop in public funds held by large banks can be found in changes required as part of Basel III. In September of 2014, U.S. bank regulators implemented a final rule (as part of the Basel III agreement) that established a baseline liquidity requirement called the Liquidity Coverage Ratio (LCR). The LCR requires banks to maintain a buffer of high quality liquid assets (HQLA) to cover liability run-off that may occur during a 30-day period of stress.

One consequence of the new rule is that is has forced large banks to reconsider how they value different customer segments. Regarding public funds, when banks consider the up to 40% run-off rate with the requirement in almost every state to collateralize uninsured public fund deposits, it is not surprising that many large banks are lowering the returns they offer on public funds or, in some instances, informing public entities that they are not interested in their deposits. Simply put, public deposits have become far less attractive for large banks, and could become less expensive for community banks not affected by the LCR.

The Value of Public Funds for Community Banks

Community banks have traditionally met the majority of their funding needs through retail and corporate deposits, but those deposits are becoming more competitive and eventually that competition could make these deposits more costly.

The increase in competition is partially caused by growing loan demand, but that does not explain the whole picture. Regulatory changes are also a factor for greater competition. Not only do the LCR rules make public funds less desirable to large banks, they substantially increase the value of retail deposits, pushing big banks to value the latter more highly.

Even as competition for retail deposits increases, greater availability of public deposits and reduced price competition for these funds from large banks may provide an opportunity to community banks – many of which, according to Promontory’s Bank Executive Business Outlook Surveys, say that they plan to rely on retail deposits as the chief source for meeting their institution’s funding goals over the next year.

This public funds opportunity could have benefits for communities, as well as community banks. Community banks continue to be the biggest source of lending to small businesses in the United States. While banks under $10 billion in assets held only 17% of bank assets in Q1 of 2016, they made over 51% of all loans, including both CRE and C&I loans, to small businesses.1 As more deposits from federal, city, state, and local governments are funneled into community banks, this could substantially increase the funds available for local lending.

To grab hold of this potential opportunity, community banks may want to revise their vision of public deposits.

If your bank would like assistance crafting a marketing campaign targeting government finance officers or help making joint marketing calls, please contact your Regional Director. Also, feel free to check out the following infographic to see information on balances placed through CDARS and ICS by public fund managers in various states.