Regulators should reexamine their assumptions about brokered deposits

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The banks that failed in 2023 shared one key similarity: high concentrations of uninsured deposits. Yet regulators like the Federal Deposits Insurance Corp. remain convinced that the real cause was "poor management" — and that the solution lies in more bank supervision and maintenance.

While this may be useful, regulators should also consider another strategy if they want to address the nagging problem of uninsured deposits and improve bank stability in 2024 and beyond. Principally, they should reconsider their assumptions and definitions governing core and brokered deposits.

It's important to first understand why uninsured deposit concentrations played such a critical role in last year's bank failures.

The problem is primarily one of competition. The top ten banks in the country control over half of all assets in commercial banking. To compete, then, others must differentiate themselves by going deep in sectors that have unique needs. In the case of Silicon Valley Bank, it was venture backed startups; for Signature Bank, it was cryptocurrency.

As their loan portfolios in those sectors grow, however, so too does the need for deposits. The ratio between loans and deposits is highly regulated, and as a result, lenders often make it a condition of the loan that the borrower holds deposits at their bank — which in turn creates uninsured deposits. By the end of 2022, for instance, 93.8% of SVB's deposits were above the insurance threshold, and 89.3% of Signature's deposits were uninsured.  

The story with the smaller banks is not that different. Nearly all of Silvergate Bank's deposits were uninsured, and the bank was highly concentrated with cryptocurrency clients. Heartland Tri-State Bank was tied to cryptocurrency investment as well, while Citizens Bank of Iowa was heavily concentrated in the trucking industry and had about 50% of its deposits uninsured.

While their strategies might be to continue to diversify into different segments, it can take years for this to develop to the point where it can be diversified enough. In the interim, these and other banks like them continue to pose greater risks than depositors and regulators may realize.

In today's banking environment, depositors should be paying attention to where their cash sits and focus on safety. Regulators, meanwhile, should consider revisiting Section 29 of the Federal Deposit Insurance Act, which covers rules related to brokered deposits. This rule is relatively recent, having come into effect in April 2021, and providing much needed clarity for banks through the primary purpose exception that third-party agents could seek. While a helpful step forward, the rule falls short of achieving this goal because it focuses on the nature of the business of the third party and not the nature of the deposits themselves.

The FDIC has historically asserted that such deposits can be less stable than deposits gathered directly by the bank. The FDIC argues that these deposits weaken the customer-bank relationship, which could lead depositors to jump ship should a better deal present itself.

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In the absence of a clear primary purpose exception, many banks feel forced to classify a significant number of deposits as brokered, despite the fact that they have been proven to be very stable, long-term and consistently replaced when withdrawn. A recent analysis, for instance, found that brokered deposits were more stable than core deposits during the collapse of First Republic. Even Travis Hill, FDIC vice chairman, admitted in a 2023 speech that, "…because the depositors have no relationship with the bank, earn high rates, are fully insured, and generally cannot withdraw before maturity, the deposits are extremely sticky. … Far from being 'hot money,' these deposits are so cold they are virtually frozen in place."

This stickiness is particularly true when it comes to third-party agents who provide a highly specialized service to certain industry verticals, where the byproduct is deposits. Imagine, for instance, a third-party fund administrator specializing in Opportunity Zone funds. These funds are typically used for large construction projects that last several years, with recurring and new funds coming in all the time. Overall, these deposits are stable, as it would be very hard to move them given the risks associated with Opportunity Zone reporting requirements. Yet if the fund administrator was the third party, the bank might be tempted to classify them as brokered deposits to avoid any risk. The same would be true of a company that helps law firms manage their client trust accounts, or a firm that may do impact measurement and reporting based on where deposits are held.

Such specialization helps the client meet their needs and the bank administer an operationally complex offering. Classifying these stable, incremental deposits as core might also enable banks to be less dependent on driving deposits from their borrowers in return for loans — behavior which significantly contributes to the concentration risk that creates uninsured deposits.

Surely, reexamining these rules will cause added complexity. Right now, it's easy for the regulator to simply see a third-party agent and give the deposit a red flag. Additional tests would need to be added — for example, evaluating how the third party is paid — but doing so would ultimately make it easier for banks, and improve stability of the system as a whole.