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 chris@cwhalen.com. 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

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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.

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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.

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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

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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.

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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

References

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curbs,” American Banker, November 6, 1985.

Cates, David and Stanley Silverberg, “The Retail Insured Brokered Deposit: Risks and

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Checki, Terrence J., “Beyond the Crisis: Reflections on the Challenges,” Remarks By

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