June 2001

Top of the Ninth

Bank Funding
Challenges ahead but no crisis

Gary H. Stern
President
Federal Reserve Bank of Minneapolis

Banking associations, the financial press and many policymakers have declared that banks face a funding "crisis." As evidence for this proposition, they note that the relative use of deposits is declining (to be more precise, the total amount of insured deposits that banks raise each year is rising but at a slower rate than in the past). Observers also point out that bank lending has grown faster than deposits. At some point in the future, it is argued, banks will have to turn down loan applications or at least raise the prices charged for a loan because of a lack of available, cheap deposits. Worst-case forecasts posit a funding crisis threatening the survival of small towns as local businesses cannot access "affordable" bank credit.

To gain insight into banks' use of insured deposits, I asked several Ninth District bankers to discuss their experiences in the current funding environment. The bankers came from large, medium and small banks, primarily in Minnesota. We have solicited bankers' views in the past and, like those previous meetings, I found the give and take of the funding meeting quite helpful, although this column may not reflect the views of the attendees. By the end of the meeting, I was convinced that recent funding trends do not support the crisis designation, even though bankers certainly face challenges. Moreover, I left the discussion concerned that the more ambitious policy reforms to fix the crisis would have costs that exceed whatever benefits they provide.

Deposit insurance, technological change and
higher-cost funds for banks

Changes in the bank funding environment appear related to a combination of factors, including a reduced value that society puts on deposits insured by the federal government, new technologies and regulatory changes that led to more, close substitutes to bank deposits and new technologies that reduced the cost of investing in alternatives to bank deposits. Consider the first point. Government insurance of certain bank deposits eliminates risk of loss on these funds. Depositors covered by such protection will accept a lower interest rate because of the safety of the investment. But, depositors will not accept such low rates if they reduce the value they put on deposit insurance. If banks do not raise rates in response to changing preferences, bank customers will shift funds out of deposits. Indeed, depositors have options offered by nonbanks, such as money market funds, that provide some of the features of deposits. Moreover, the transaction and administrative costs of investing in equities and fixed-income instruments have also fallen.

The bankers gave us many examples of how the changes facing depositors have manifested themselves. In some communities, deposits have left the banking system as older depositors die and their younger heirs put the money in uninsured investments. In other cases, depositors have left some of their money in insured bank deposits but have put an increasing share of new funds into other investments. This last trend could also reflect the fact that households and firms need only so much money in low-risk, highly liquid deposits. As a result, an increase in wealth above some level will not translate into more insured deposits but will instead increase investments in equities, for example.

Banks meet the funding challenge

In the new regime, bankers cannot count on low-cost, stable funds or the strategies that such funding made possible. The challenge for bankers is retaining profits when the cost of a major input, in this case funds, becomes more expensive. Like the many industries that have faced a similar challenge, the bankers at our meeting described a wide array of responses they have undertaken to maintain profitability. Some banks have tried to offset their higher cost of funds by focusing on activities where they have a comparative advantage and shedding operations that, upon close scrutiny, do not generate sufficient returns. Other banks have been more aggressive in raising funds from nontraditional sources to dampen the effect of higher-cost deposits. In some cases, this strategy entails raising money over the Internet or through the subsidized Federal Home Loan Bank system (FHLB). In other cases, bankers argued that insured deposits at a low cost still exist if a bank can tap into previously overlooked consumers who may not have a long track record with banks. Still other banks have created a "customer friendly" culture, which they believe increases their ability to raise low-cost, insured deposits.

This list of bank responses gives only a hint for the myriad ways that banks have responded to the new environment. While I was very impressed with the innovative nature of the banks' responses, I am not surprised about the general trend. Price signals are powerful means for altering behavior. Banks subject to higher input costs will devise and test strategies to maintain profitability that observers could not have predicted. As Chairman Greenspan noted when speaking about the new funding environment, "... community banks will, I am sure, adjust to the changing realities of the deposit market." (See the speech, via the Board of Governors.)

More government intervention is unwarranted

My description so far makes clear why I view the current situation as manageable, but it also suggests why others wave the crisis banner. Certainly not all banks will meet the challenges of the new environment successfully. Because of lower future returns, these banks may end up shrinking in size and even ceasing to exist. As I noted earlier, borrowers that rely exclusively on banks for credit could also face more expensive borrowing as banks pass on the higher costs of funds. Advocates on behalf of these banks and borrowers have a natural inclination to describe their situation in bleak terms.

However, I do not see a strong justification for new government intervention in response to the current funding environment, given the apparent ability of many banks to innovate in response to higher-cost deposits. Indeed, many borrowers subject to higher-cost credit already have access to government support through loan guarantees and government-backed lenders such as the Farm Credit System. And, of course, banks still benefit from deposit insurance even if to a lesser degree than in the past.

More importantly, many of the proposals that seek to reduce the prices banks pay for funds could themselves have significant costs for society in the future. For example, bank trade associations have called for an increase in the amount of insurance the government provides depositors as a response to the alleged funding crisis. But the mechanism by which deposit insurance lowers the cost of funds—namely by divorcing the rates depositors charge a bank from the activities of the bank—can lead to excessive risk taking. Indeed, our previous meeting with bankers focused on plans to reform explicit and implicit government guarantees for bank creditors. We believe policymakers must rein in expectations of future government protection for bank creditors to prevent a repeat of previous banking crises (see my column in the September 1997 Region for a summary of this earlier meeting).

For similar reasons I see the expansion of the mission, membership and lending of the FHLB as a potentially costly method for providing lower-cost funds to banks. Like a bank backed by government insurance, government sponsorship shields the FHLB from the full effect of market discipline. Thus, the FHLB can take on additional risk without paying the market rate for such activities. Such separation between risk taking and market pricing of funding has been linked to widespread failures of financial institutions in the United States and abroad. We would be wise to avoid fixing a problem whose societal effect has been overstated with a solution whose potential costs have been repeatedly underestimated.

In contrast, there may be less ambitious reforms that could help banks without exposing taxpayers to significant risk. Congress could allow bankers to pay interest on business accounts and allow the Federal Reserve to pay interest on the reserves that banks hold with Federal Reserve banks. These steps could allow banks to better rationalize their funding programs and more efficiently compete for deposits.

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