Community Bank Forum: Community Banks Search for Ways to Fund Loans

RMA Journal, The, Feb, 2001 by Kathleen M. Beans

Pressure on net margins mounts as community banks struggle to make up for the loss of core deposits with more expensive sources of funds. While there is no simple solution to the problem, it can be addressed by attracting more deposits and by seeking alternative sources of funding.

When a merchant runs out of a hot item early in the buying season, he laments the lost opportunity for additional sales. Community banks today are in a similar situation. In this sizzling economy, the hot item is cash.

Banks could increase their margins if they had the funds to make more loans, but as every banker knows, there is a funding drought. Core deposits have been eroding while loan demand has been intensifying. The reason, of course, is that American families continue to shift assets to the stock market. A Federal Reserve study of trends among more than 4,000 households published last year showed that from 1989 to 1998, transaction accounts as a percentage of household assets decreased from 19% to 11% and certificates of deposit decreased from 10% to 4%. During the same time period, mutual funds as a percentage of household assets climbed from 5% to more than 12%. Stocks jumped from 15% to nearly 23%.

As a result, community banks have been forced to look elsewhere for cash to fund loans. And elsewhere--whether it be the Federal Home Loan Bank or brokered deposits--is always more expensive than a bank's own deposit base. Pressure on net interest margins is the inevitable byproduct of this liquidity crunch. Although there has been much written about this subject, there doesn't appear to be any one single approach that solves banks' funding woes.

Late last year, the American Bankers Association formed a steering group to help community bankers find more funding sources. In an interview with the Journal, steering group co-chair Earl D. McVicker, CEO, Central Bank & Trust, Hutchinson, Kansas, acknowledged the magnitude of the problem. "There are a variety of solutions, but there are no easy ones," says McVicker. "The problem is widespread and it is a problem for many, if not most, of the community banks around the country."

His co-chair on the steering group, Robert F. Lowe, president, Lexington State Bank, Lexington, North Carolina, agrees. While loan funding is an ongoing challenge for community banks, it must also be viewed as an opportunity to look at other funding sources, says Lowe. "The challenge is to match the available funding sources with the bank's strategy.

The most traditional and reliable source of funding is, of course, the Federal Home Loan Bank System. According to Grant Thornton's Seventh Annual Survey of Community Bank Executives, published in March 2000, the number of banks that plan to borrow more from the FHLB continues to grow. Of the banks that belong to the FHLB, 57% said they expected to increase their advances in 2000, as compared to 52% in 1999.

Looking ahead three years, the number of surveyed banks that expect FHLB to be a very important funding source is 55%, as compared to 34% currently. The survey also indicated that 94% of community banks say insured deposits are a very important source of funding. Almost as many (88%) say that insured deposits will continue to be a very important source of funding in three years.

While FHLB advances are the most convenient source of alternative funding, 21% of banks surveyed are looking for "other sources" of funding, such as federal funds and bankers acceptances, to become more important in the next few years.

Although some bankers have said that regulators frown when a bank relies too heavily on funds borrowed from the Federal Home Loan Bank System, Mark S. Schmidt, associate director in the division of supervision at the FDIC, says that's not so. "Federal Home Loan Bank funds are a legitimate source of funds and are perfectly acceptable as long as they are used properly in a well-thought-out asset and liability management policy." Unfortunately, he says, some banks don't match the maturities on their assets and liabilities. "If you take short-term advances from the FI-ILB or anywhere else and you invest in long-term loans like mortgages, the mismatched maturities can cause interest-rate risk problems."

Schmidt likes the approach of selling securitizations that many banks are employing today. "Securitizations are a legitimate, time-tested way of removing assets from the balance sheet to make more funds available for new loans," he says. "But we have had problems when the banks keep the riskiest piece in the form of residuals and sell the rest and when they don't keep enough capital to compensate for the risk. There have been a couple of bank failures where the residuals owned by the bank proved to be worth much less than book value, adding significantly to the FDIC's losses. That is one of the reasons behind the banking agencies' recent proposal to raise capital requirements on residual assets."

Attracting Core Deposits

One way to obtain sufficient funding is to attract more core deposits and to maintain those that are already in the bank. L. William Seidman, FDIC chair from 1985 until 1991, suggests a number of things banks could do to increase core deposits.