Will the real Core Deposits please stand up?

The FDIC and other regulators had a favorite phrase in this era of excessive bank growth leading to explosive bank failure: CORE DEPOSITS. The idea is as old as the hills. Banks have three types of funding sources -- capital, core funds and non-core funds. Nothing wrong with that statement, right?

The problem shows its face when you try to define Core Deposits. The FDIC created its definition decades ago, when the FDIC insurance limit was $100,000 and there were no material non-deposit sources of funding other than capital. This decrepit definition of core deposits includes all nonmaturity deposits (regardless of balance) and certificates of deposit under $100,000. [$100,000 in 1980 dollars (the year the FDIC insurance limit was raised to $100K) = over $250,000 in 2008 dollars.]

Fast forward to the 21st century, where $100,000 just doesn't buy as much as it used to. I walk into my local Bank A with $150,000 and open one certificate of deposit, which is not counted as a core deposit due to its size. If, however, I open two CDs for $75,000 each, they are both counted as core deposits. Or, if I open a Money Market account with the $150K, the whole balance is treated as a core deposit. Whichever account type I choose, all of my $150K is covered by FDIC insurance at its new $250K level.

If I am a retiree on a budget, who relies on interest income to buy groceries, I may watch rates like a hawk, moving my money often to get the best rates in town. In that case, my $150K is not really a core deposit, as it will stay at Bank A only as long as it offers the best rate. On the other hand, if I am a small business owner, the $150K may be a small portion of a bigger financial picture, and my relationship with Bank A may include personal and business deposit and loan accounts. I may even be an investor in Bank A or sit on its board of directors. All of this suggests that my $150K may be a very solid core deposit, regardless of balance.

Why does all this matter? It matters because the FDIC uses Core Deposit data (and a variety of ratios that include Core Deposits) as benchmarks when examining banks. A bank that has too many non-core funding sources (jumbo CDs, FHLB borrowings, brokered deposits, etc.) will be criticized harshly, even if the bank exhibits a well-developed ability to operate safely with its particular funding mix. With expanded deposit insurance in place, there have been many calls for the FDIC to revise its definitions of Core Deposits. The agency has, so far, been unwilling to do so, partly because it uses the current definition to its advantage when it needs leverage against a bank that it doesn't like.

I don't have a Pulitzer-winning close to this post, and I do have to get back to the paying work. Let's just close with the thought that the FDIC is in many ways a dinosaur that is unable or unwilling to keep up with changing banking structures. Of course, this should be obvious to anyone who has been watching the bank failure count grow every Friday. The scary part is that the FDIC is spending much of its energy these days fighting for more regulatory authority, instead of addressing some of the fundamental weaknesses in its existing regulatory framework.

Appropriate Measurement of Earnings at Risk in Community Banks

Recent regulatory thought on interest rate risk has been divided into two primary areas of concern: Earnings at Risk (EaR) and Economic Value of Equity (EVE). EaR addresses the short term IRR concern, while EVE addresses the long term aspects of IRR. For the rest of this discussion, let us focus on Earnings at Risk.

Recently, we have had several clients report negative exam comments surrounding the lack of RSA / RSL(rate sensitive assets / rate sensitive liabilities) parameters in the banks’ interest rate risk policies. The comments read something like:

The bank’s IRR policy establishes adequate parameters for post-shock changes in ROA but does not establish parameters for the RSA / RSL position or changes to the Net Interest Margin. Management should update the IRR policy to provide operating parameters for RSA / RSL and the Net Interest Margin.

These examiner comments about RSA / RSL expose a lack of understanding about how interest rate risk measurement works and incorrectly imply a regulatory requirement to measure by antiquated standards.

An example of the weakness of RSA / RSL relative to Change in ROA: Consider two banks (A and B), each with total assets of $100 million. Bank A has $30 million of loans that adjust immediately with a change in NY Prime. Bank B has $30 million of loans that reprice annually, with repricing dates spread evenly across the coming year. The two banks are identical in all other respects.

The RSA / RSL ratio at the one year horizon is identical for the two banks, as each bank’s $30 million in loans will reprice within the first year. The banks’ changes in ROA are very different, however, due to the timing of the repricing. If Bank A’s interest rate risk position as measured by Change in ROA is completely neutral, Bank B would be very liability sensitive due to the slower repricing of its loan portfolio in a rising rate environment.

If you are feeling the heat from examiners who seem unable to break free from antiquated measurement systems, send me an email (jfair@americanplanning.com) and let's talk about how we can help.