White Paper: The New Value of Public Funds

By Joe Hooker

Shifting factors in the banking industry are making public fund deposits more available to community banks. Now is a time when many government finance officers are considering shifting investments out of money market funds into bank deposits. It is also a time when many of the nation’s largest banks do not want public fund deposits, as new regulations raise the cost of public unit deposits to large banks (but not to smaller and mid-sized banks).

Here’s what’s happening:

  • The Liquidity Coverage Ratio (LCR) is making public funds more expensive for large banks – The largest banks (banks with assets of $50 billion or more) hold more than half of the country’s public deposits. Basel III’s introduction of the LCR applies a 40% run-off rate to public funds at these largest banks, making them more likely to forego public fund deposits. With less competition from the nation’s largest players, these deposits may become more accessible and more affordable for community banks looking for inexpensive funding.
  • Changes to money market fund (MMF) rules are limiting where public funds can go – By the middle of 2016, changes to the rules that determine how prime MMFs calculate net asset value (NAV) will make it impossible for public funds to invest in prime MMFs. The general consensus is that this ruling will also apply to local government investment pools (LGIPs), either forcing LGIPs to invest in fully secure investments (e.g., Treasuries) or operate with a floating NAV. The change is likely to either reduce the yield from LGIPs or eliminate them as an investment option for public funds, giving community banks a better chance to compete for these funds – possibly without rate competition from large banks if they sit on the sidelines, as many expect.

Increased availability of public deposits, reduced price competition for these funds from large banks, and fewer alternatives for government finance officers may provide an opportunity to community banks – many of whom, according to Promontory Interfinancial Network’s Bank Executive Business Outlook Survey  for the first quarter of 2015, say that they plan to rely on deposits as the chief source for meeting their institution’s funding goals over the next year.

The new value of public funds could have benefits for communities as well as community banks. Community banks have typically been the leading source of small business lending in the U.S., and 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. What has often been looked at as a mixed blessing may be a key to community banks thriving.