FDIC’s interest rate restrictions need a rewrite

Bankers are wise to prudently manage liquidity and funding as they attempt to reprice their deposits and stay competitive amid rising interest rates. As the Federal Reserve gradually raises benchmark rates and financial institutions compete for deposits, banks should ensure they will always have sufficient funds to meet both their short-term and long-term obligations. However, the Federal Deposit Insurance Corp.’s interest rate restrictions on institutions that are less than well capitalized are not helping with the liquidity challenges that community banks are currently facing.

Under the FDIC’s “national rate cap,” less-than-well-capitalized banks may not pay interest rates that significantly exceed the prevailing rate in the institution’s market area or the prevailing rate in the market area from which the deposit is accepted. For out-of-area deposits, the rate cannot exceed the national rate caps. Recognizing that competition for deposit pricing has become increasingly national in scope, the FDIC established in 2009 a presumption that the prevailing rate in all market areas is the FDIC national rate cap.

Also in 2009, the FDIC decided that pegging the national rate cap to 120% of the current yield on U.S. Treasury obligations with similar maturities was not working. Treasury yields were so low that year that they fell well short of the national average rates that banks were paying on their certificates of deposits. The FDIC decided to address the problem by redefining the national rate caps, for deposits of similar size and maturity, to be “a simple average of rates paid by all insured depository institutions and branches for which data is available.”

Currently, the FDIC uses a private firm to survey all insured depository institutions and their branches on the interest rates they pay. It adds 75 basis points to that average to determine the national rates caps. The FDIC has a rate cap for certificates of deposit of differing maturities, interest checking accounts, money market accounts and savings accounts. These are published weekly on the FDIC website.

There are many problems with the current process the FDIC uses for determining the national rate caps. However, the worst problem of all is the result. During the past two years, the caps have not been close to current Treasury yields nor to what community banks must pay to obtain deposits through a listing service or third-party broker. For example, the current one-year Treasury yield is 2.67%, whereas the current national rate cap for a one-year non-jumbo CD is 1.32%, nearly a 135-basis-point difference. Furthermore, community banks must pay close to 2.5% to obtain a one-year certificate of deposit through a listing service.

Another problem with the rate caps is they are based on deposit products at all bank branches. Because the nation’s largest banks have nationwide branch networks with identical deposit products and prices, they tilt the scales on the FDIC’s calculation heavily in their favor. Meanwhile, branchless and rapidly growing web-based banks such as Ally and Goldman Sachs are underrepresented, contributing as much to the calculation as the smallest community banks.

The rate cap also misses promotional rates for non-standard products, such as 13- or 19-month CDs. The rates on these products can be 150 to 200 basis points higher than standard rate offerings, yet they are excluded from the FDIC’s calculation. The same goes for deposit rates at credit unions, which are a primary competitor for many community banks, and non-interest accommodations such as discounts on bank services.

This faulty methodology could lead to a liquidity crisis of its own making for many banks. When the economic upswing eventually comes to an end—for whatever reason—regulators will likely react with CAMELS rating downgrades and even regulatory orders for some community banks, leading to de facto less-than-well-capitalized designations. These actions will in turn restrict the rates affected banks can pay on deposits, likely resulting in a shedding of depositors, a true liquidity crisis for many institutions, and failures that could have a ripple effect and pose a needless drain on the Deposit Insurance Fund. Ultimately, the rate cap’s procyclical impact on FDIC-insured institutions could create a self-fulfilling prophecy.

While some have encouraged community banks to calculate and use locally based rate caps as FDIC rules allow, the national rate cap could itself be improved by the FDIC with some relatively simple fixes. First, policymakers should calculate the rate cap using one entry per bank, rather than the current per-branch system, and should include credit union rates. This would address the distortions created by megabank branch networks and non-traditional deposit incentives while offering a fairer assessment of the deposit rates that financial services competitors offer.

And rather than relying on standard CD maturity terms, the cap could incorporate a series of maturity ranges to include both traditional and promotional products to provide a more accurate assessment. Finally, when banks become subject to an enforcement order, they should not necessarily also be subject to the onerous national rate caps.

Meanwhile, the FDIC should at least stick to enforcing the cap on less-than-well-capitalized institutions. Regulators are reportedly bringing up the national rate caps during exams of well-capitalized banks, insisting in many cases that they explain what would happen to their deposits if they were suddenly downgraded. This is a misuse of the policy.

Regulators are justified in monitoring liquidity risks in an environment of rising interest rates, but their methodologies should be as sound as possible to avoid marketplace distortions. While well intentioned, the national rate cap has flaws that should be addressed.