Brokered Deposits Don't Deserve Their Bad Rap

Despite the fact that brokered deposits have developed into an abundant, reliable and cost-effective source of stable funding, efforts to inhibit their use continue. It is as if nothing has changed since the days when brokered deposits first appeared and had the reputation for being hot money and volatile.

These efforts can be seen in the Federal Deposit Insurance Corp.'s new proposed deposit insurance premium formula. The plan will increase premiums when a bank holds ample brokered deposits even if the bank is otherwise safe and sound. Opposition to brokered deposits is also seen in regulators' emphasis on the "stickiness" of deposits — that is how reliably the funds will stay in an institution — in a bank's funding strategy.

A bias in support of "core" deposits has morphed into a misguided belief that brokered deposits are often used recklessly. Core deposits are preferred because they involve a direct relationship between the bank and depositor, which brings loyalty and makes those deposits sticky. This is true and is obviously an important consideration when a bank relies on its relationship with depositors to originate loans.

But the conventional wisdom is wrong when it assumes, as many regulators do, that only sticky deposits are stable. This myth of stickiness sees deposits on a continuum with core deposits on the stable end of the scale and brokered deposits on the volatile end. Brokered deposits are assumed to be more volatile because depositors holding them give no consideration to where their funds are deposited as long as the funds are federally insured. They are perceived ready to move their funds whenever another bank offers better terms.

The reality is quite different. Brokered deposits, especially certificates of deposit, have become some of the most stable and cost-effective deposits currently available. Customers who place their funds through a broker may lack loyalty, but how relevant is that when brokered deposits have proven to be a reliable source of funding in all economic conditions and highly stable even during runs?

Over the past few decades, the supply of brokered deposits has consistently been abundant. Once deposited, brokered CDs tend to stay put in an institution until they mature. The depositors usually don't know which bank holds their money so there is no "headline risk" to start a run. The brokers know where the funds are deposited but they also know the FDIC is diligent about paying depositors after a bank fails. And all brokered deposits typically fall under the federal insurance limit.

Additionally, CD contracts prohibit withdrawal before maturity unless the depositor dies. In the now-well-established market for brokered CDs, no evidence has emerged showing any correlation between brokered deposit withdrawals and developing problems at a bank. Indeed, about the only time a brokered CD is paid before maturity is if the bank fails and is liquidated. Prior to failure, brokered CDs have proven to be virtually run-proof.

A good example is Barnes Bank, which failed in Utah in 2010 due to a run that began when rumors about its failing condition were reported in local newspapers. The bank had served a suburban area for nearly 120 years and had a strong loyal customer base. When the run began, about 30% of the bank's deposits were brokered. During the run, the bank lost about 15% of its total deposits over 10 days and eventually exhausted its liquidity. All of the deposits withdrawn were core deposits. Not a penny of brokered deposits left the bank.

The stability and cost effectiveness of brokered CDs have improved over time mostly because the typical depositor has changed. Depositors tended to chase yield when brokered CDs first entered the markets. They were a new product and banks needed to offer high rates to entice people to try them out. Now brokered deposits are well-established as an alternative option to government securities. Depositors tend to be investors seeking safety, not yield.

Transactional brokered deposit programs have also begun to emerge, often involving health savings accounts and other kinds of NOW accounts placed by a program sponsor or plan administrator. These accounts are also stable in the same way a core deposit is. The program administrators work closely with the bank holding their deposits and that typically helps form strong relationships. A plan sponsor will rarely move money to a new bank on a whim or to gain a small increase in yield. Only major problems in the program or big advantages offered by another bank warrant the effort and inconvenience to move large amounts of money while hoping the program will work as well or better than it did before.

Brokered deposits have also proven to be very stable in bad economic times. The supply of brokered deposits actually increased during the Great Recession as people fled to safety. In the history of brokered deposits, there has never been a time when a bank could not obtain all of the brokered deposits it wanted.

Brokered deposits were considered "hot" when they were first offered in the 1970s and 1980s, but that has changed almost completely as the market matured. Today, brokered deposits typically offer a small increase in yield over similar core deposits. But they also offer savings in not needing branches or other infrastructure to support the deposits. CDs also provide institutions with "match funding" options enabling the bank to correlate deposit flows with loan demand. In comparison, core transactional and savings deposits do not correlate to loan activity and require a bank to hold more cash and lower yielding liquid assets.

The FDIC raises a fair point about brokered deposits' low "franchise value." In a failure, an acquiring bank frequently takes just the failed institution's retail deposits to get the customer relationship, leaving the FDIC to make brokered depositors, who are fully insured, whole again. Yet another FDIC criticism of brokered deposits — that they fund rapid, and sometimes overheated, growth in the loan portfolio — does not tell the full story. The agency cites studies showing how some community banks that failed in the Great Recession grew fast lending in the housing bubble using brokered deposits.

Yet all of those banks failed because they made bad real estate loans, not because they held brokered deposits. The loans would have been just as bad if they had been funded with core deposits. The FDIC fails to acknowledge that in the same period some of the safest banks held even higher percentages of brokered deposits than banks that failed. Some of the safest banks held only brokered deposits. Many of these banks also grew quickly but they were well-capitalized and profitable and could take new business when other banks stopped lending.

Another point the FDIC does not acknowledge is that the growth of brokered deposits has happened in tandem with the development of branchless banks. The healthy banks that relied heavily on brokered deposits during the recession were mostly branchless. Those banks don't pursue core deposits because they do not rely on depositors for loans and other business. As a group those banks have tended to be better capitalized and more profitable than banks with branch networks that mostly hold core deposits. The difference is apparent when comparing efficiency ratios. In general, branchless banks are more than twice as efficient as banks with branches. Nevertheless, the FDIC's proposed new premium formula would increase the deposit insurance premium for some branchless banks by as much as 172%. Most of these branchless banks are well above regulatory minimums and industry medians for every measure of financial strength.

In general, the concept of "core" versus "noncore" deposits is seriously outdated in today's markets. It used to be that core deposits consisted of classic savings and checking accounts opened at a branch. But the term now includes deposits raised directly from depositors over the Internet. Internet deposits qualify as core because there is no intermediary between the bank and the customer. But such deposits are also similar to brokered deposits in that the customer has no real physical connection to the bank. Classifications such as "core" and "brokered" will become even more outdated as the financial markets continue to evolve. The future of banking will include an explosion of new products through different delivery channels to attract younger tech-savvy customers. Brokered deposits, perhaps in a form unlike they are today, will be a major part of that future.

Suppressing the development of new products and services and delivery channels to slow or stop growth would be a serious mistake. If regulators freeze the industry into a model that funds only with core deposits, banking may have no long-term future or will become insignificant.

George Sutton is an attorney at Jones Waldo Holbrook & McDonough. From 1987 to 1993, he was the Utah commissioner of financial institutions.