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Declining deposits ... Is it all bad news?

What happens when people quit depositing money into banks? Where do banks get the funding necessary to make loans?

July 1, 1998


Ron J. Feldman Senior Financial Specialist

Article Highlights

  • Insured deposits dip in Ninth District, nation

  • Demographics, alternative investments cause shift

  • Banks use more wholesale funds

Declining deposits ... Is it all bad news?

Reduced to its core, traditional banking is a simple business: A bank pays an interest rate to hold a consumer's deposits, usually insured by the federal government, and then lends those funds at a higher interest rate to borrowers.

But what happens when consumers decide to put their funds elsewhere, like into stocks and bonds? If raising deposits becomes more difficult for a bank, especially community banks and those in rural communities, what are the implications for the banking industry and for potential borrowers?

A majority of the bankers responding to the fedgazette's annual banking poll see a change in current funding strategies hurting their profitability. Over half of those responding expect profitability to decrease over the next two years if banks have to find alternative, and presumably more costly, sources of funding.

Chart: A Majority of Ninth District Bankers Expect a Change in Funding to Decrease Profitability

Source: Federal Reserve Bank of Minneapolis, 1998 banking poll

For some of these bankers the severity of the problem should not be underestimated. "We will have a crisis facing us in five years or less," says Terry Jorde, president of Towner County State Bank in Cando, N.D. Jorde said the recent sale of a prominent independent bank in North Dakota was driven, in part, by the persistent decline in insured deposit funding. John Franklin, president of First United Bank, Sidney, Mont., agrees: "Where are we going to get the hamburger to fry?"

But not all bankers are as convinced of the problem. Some, like Charles Blair of the United Bankers' Bank in Bloomington, Minn., point to the record profitability of the industry during the decline in deposits. He also notes that concerns about insured deposit funding are nothing new, and that banks have already developed means to, at least partially, mitigate the fall in traditional funding.

Moreover, the movement of funds largely represents a boon to consumers. After all, households now have more alternatives for investment available to them than ever before. And, for most borrowers, the decline in deposits should not lead to a reduced supply of loans. However, Franklin, among others, raises a concern about small firms and farmers in small towns and rural communities that depend on banks for credit: "The next crisis in community banking, without a correction in the stock market, will be the lack of funds necessary for community banks to lend to Main Street and to farmers." The effect on these small firms and farmers, however, could also be mitigated.

This fedgazette investigates the issue of decreased deposit funding—especially insured deposits—for banks and considers some of its potential effects on the industry and borrowers.

Household and bank use of deposits

Banks issue a unique type of debt: deposits insured by the federal government. (While exact figures are unavailable, a rough estimate suggests that 75 percent of all bank deposits are insured. Thus even references in this article to deposits in general largely focus on insured deposits.) No other financial instrument allows a saver to retrieve their funds on demand without any fear that they will receive less than what they put in their account.

The absence of both default risk and restrictions on access allows banks to borrow money at low rates unavailable to almost all other financial institutions. Indeed, banks themselves pay more to raise funds when they tap nondeposit sources (often called "wholesale funds"). Because the government charges banks a price below the market rate to receive the benefits of its insurance—about 95 percent of banks do not pay insurance premiums—insured deposits are a subsidized source of funds (although the size of the subsidy has been subject to much debate recently).

Not only are nondeposit funds more expensive, they are also considered more sensitive to a bank's financial condition and the financial returns offered on other investments. Consumers who put an extremely high value on the safety and accessibility of insured deposits may keep their money in the bank even when a stock mutual fund offers a higher return.

Moreover, insured depositors have virtually no concern about the financial condition of their bank because the government will make them whole when the bank fails. In contrast, the providers of other funds to a bank, such as uninsured certificates of deposits, hold much less unique investments. The bank must then offer rates that more closely match the higher rates available on the myriad of comparable alternatives. Furthermore, because the provider of uninsured funds could lose its money if the bank goes out of business, the provider of funds will be more likely to demand a higher return or pull some of its money when the bank's chance of failure increases.

Because insured deposits cost the bank less money and are more stable, analysts and bankers consider them to be the preferred, "core," funding for banks. Thus, it has not gone without notice that households have a declining preference for, and banks have reduced their use of, insured deposits.

Chart: Components of Household Financial Assets

Source: Federal Reserve Bank of Minneapolis

In 1980, households held about a third of their financial assets in each of the following groups: (1) deposits, (2) stocks, bonds and money market funds and (3) life insurance, pensions and trusts. By 1997, deposits represented only 14 percent of household financial assets while stocks, bonds and money market mutual funds had risen to 45 percent. Insured deposits have also declined when compared directly to mutual and money market funds. Mutual and money market funds equaled about 20 percent of insured bank deposits in 1980 and had risen to 100 percent or more of deposits by 1997.

Chart: Mutual Funds as a Percent of Bank Deposits

Source: Federal Reserve Bank of Minneapolis

Data on Ninth District commercial banks also suggest a gradual movement away from insured deposit funding. The graph below provides the most direct measure of core deposit use in the Ninth District. Since 1987, small banks have increased their use of wholesale funds by 60 percent. Bank borrowing of funds requiring higher interest rates than insured deposits such as large CDs and Fed Funds (short-term loans banks make to each other) went from 10 percent of total funding to 16 percent.

Chart: Sources of Funding Ninth District Small Banks

The greatest percent increase in wholesale funding has come from the Federal Home Loan Bank (FHLB) system. Congress originally created the FHLB system to fund home mortgages made by savings and loans. Congress expanded the FHLB system's authority to make loans to commercial banks in 1991. The federal government provides implicit backing to the debt issued by the FHLB, which lowers the FHLB's cost of raising money. This allows the FHLBs to provide funds to banks at subsidized rates, creating the opportunity for banks to still receive below market cost funding even if insured deposits dry up.*

Another measure shows a relative decline in the use of deposits. Regulators and analysts traditionally evaluate commercial bank funding of loans by examining the ratio of banks' outstanding loans to their deposits (the loan-to-deposit or LTD ratio). A trend toward higher ratios may signal the need to fund lending through nondeposit sources.

Chart: Average Loan to Deposit Ratios of Ninth District Small and Large Banks

And, the LTD ratio has soared to the highest level in 20 years for the district's large and smaller banks. The annual growth rates of bank loans relative to those of bank deposits suggests that Ninth District banks have decided to fund increases in loans with money from sources outside of deposits. In almost each of the last 10 years, the growth in loans made by small banks has outstripped the growth rates in deposits. Over the whole 10-year period, small bank loans grew about 50 percent while deposits grew around 20 percent. The same pattern is even more pronounced for larger banks.

Why the decline in deposits?

Like many complex phenomena, there is no single factor that explains the trend toward lower deposit use. But three reasonable explanations are changes in demographics, individual preferences and availability, and cost of alternative investments.

Demographics. Older individuals, for example, may rely on investment income and be loath to take on much risk or tie their money up for a long period of time. Young couples getting started may have similar concerns. Both groups would have reason to put a high value on insured deposits.

In contrast, the middle-aged population may seek higher returns when saving for retirement and have more flexibility to invest for the long term. In fact, the percent of household assets held as deposits decreased over the last 20 years as the percent of the population between the ages of 35 and 65 increased. The graph below suggests that a similar negative correlation exists between deposits and middle aged households in the Ninth District.

Chart: Trend in Ninth District Deposits and Percent of Population From 35-65

Source: Federal Reserve Bank of Minneapolis

The demographic trend of falling population will also make it hard for banks relying on local populations to fund through insured deposits. The table below provides information on the population declines in rural counties in four states in the district. The U.S. Department of Agriculture found the greatest drop in bank deposits during the 1990s in rural counties that were losing total population or had death rates exceeding birth rates.

Population Change in Rural Counties
in Four Ninth District States
  Population for
Rural Counties
  1980             1997
Rural Population Change, 1980-1997 Rural Counties with Population Decline,
State Population in Rural Counties
North Dakota
South Dakota

Source: Federal Reserve Bank of Minneapolis

Changes in preferences. Household ownership of insured deposits could fall even without changes in demographics if households begin to place a lower value on the unique attributes of insured deposits and/or put a higher value on the characteristics of other financial assets.

Data suggest that the reallocation of assets from deposits to stocks and bonds by the middle-aged cohort is an important factor in explaining the fall of deposits. These data support the huge number of reports from bankers that depositors favor the higher returns possible on money market funds, stocks and bonds, and downplay the security and access of insured deposits.

Terry Jorde of Towner County National Bank doesn't think that's going to change. A number of bankers interviewed for this story look to a drop in the stock market to drive people back to banks, but Jorde thinks such an event would not fix the problem. She says that even a stock market crash would only encourage consumers to go to cash for a short time, and then they would be back in the market. "People think bank deposits are temporary and convenient and not for the long run, and that's not going to change," she says. "That was not true over the past 50 years." In reaction to this trend, a trade association of community banks recently began advertising the risks of stocks and bonds and the virtues of insured deposits.

Lower cost and greater access to alternative products. Developments in information processing and telecommunications technology, in addition to advances in financial engineering, have lowered the costs that households face in channeling their funds into nondeposit assets. Households, for example, can receive information on and service for their assets in mutual funds 24 hours a day via the telephone and computer. And, new types of financial instruments have allowed households to invest in a wider range of choices. These changes have provided cost-effective alternatives to the insured deposit that were not available several years, let alone two decades, ago.


Questions have been raised about how the decline in insured deposits will affect banks and their borrowers. The decline in cheaper insured deposits will likely raise costs for banks, especially community banks, which must rely on more expensive funding. The shift to nondeposit funding should also require banks to engage in more active, complex and costly management of their funding base to ensure that they can meet their repayment commitments. In the longer term, banks can take steps to manage, but not avoid, these cost increases and ventures into what may be unfamiliar territory.

The decline in insured deposits should have no effect for most borrowers. However, the trend away from insured deposits could potentially reduce the availability of credit for some small firms. More generally, households are better off by their ability to invest in options that they consider superior to insured deposits.

Bank profitability and fund stability. Increased availability of substitutes or changes in demographics need not inevitably lead to a reduction in banks' use of insured deposits. Banks could always decide to pay a higher rate on deposits to retain money which otherwise might switch to other investments. For example, Charles Blair of the United Bankers' Bank bemoans the loss of the passbook savings account that paid beyond the current 1 percent to 2 percent rate. He thinks banks should be willing to raise rates to the 4 percent to 5 percent range that was common years ago. Bankers tell him he's crazy to suggest that they double the cost of their passbook accounts, but Blair maintains it would be money well spent.

While most bankers might not agree with Blair's passbook idea, R. Scott Jones, chairman of the Goodhue County National Bank in Red Wing, Minn., and the incoming president of the American Bankers Association, says that bankers do need to be more creative when offering products to consumers. "It might cost more, but you can draw in liquidity," he says.

Thus, for many bankers, the move from lower-cost insured deposits to higher-cost uninsured sources could very well reduce bank profitability (although banks in less competitive markets should be able to pass on some of their higher costs). Because community banks have traditionally relied more heavily on insured deposits than larger banks, the smaller banks may face a bigger hit to the bottom line. But, the choice by many banks to replace local deposits with nondeposit or so-called "wholesale" funds indicates that an additional dollar of nondeposit funds costs less than an additional dollar of insured deposits.

There are at least two reasons why wholesale funds may be cheaper at the margin than insured deposits, even if the rates paid on nondeposit funds are actually higher. First, the noninterest costs required to raise insured deposits, such as the expense of branches, staff and technology, could be higher than the noninterest costs of wholesale funds which banks can often raise with a phone call. Second, raising an additional dollar of wholesale funds does not alter the bank's cost for its existing deposits. But if a bank raises rates to attract new deposits, it would also increase the cost of its existing deposit base.

Going forward, banks will continue to alter their behavior in the face of the declining value that many individuals put on insured funds so that they remain profitable. Banks with less reliance on deposits may suddenly find it economical to reduce their branch structure or to carry out new techniques for raising money, such as selling their small business loans, which seemed too expensive when deposits could be raised at relatively low cost. Some of the most cost-effective competitors to banks that do not have access to insured deposits already fund themselves via an increasingly developed loan sale market.

But cost represents only one factor in a bank's funding decision. Deposits have also had an advantage in their stability. Banks transitioning to wholesale funding from a fairly immobile deposit base must develop the capability to quickly and cheaply repay wholesalers and others providing funds. For example, these banks may have to establish additional sources of emergency backup funds, set up the capacity to sell assets or hold more assets, such as Treasury securities, that are very easy to sell. These steps should raise costs for banks by, for example, forcing them to hold lower-yielding securities in the place of higher-return loans. Banks may even have to invest in staff to gain the expertise to manage this new environment.

Not taking these steps, however, could prove dangerous for a bank. A bank with significant loans and mobile funding could find itself having to sell loans at "fire sale" prices to repay its funders. Regulators monitor banks' LTD ratio, among other measures, and routinely exam banks' funding sources to ensure they are operating in a safe and sound manner. A review of the LTD ratio and regulatory concerns about bank funding is found in the accompanying article.

Here too it may not make sense for banks to stick with insured deposits simply because they had in the past. Indeed, banks may have had to take some of these same costly steps described above even if they retained their deposit base. After all, the need to raise wholesale funds in the first place resulted from an increasingly jittery deposit base. In addition, wholesale funds offer attributes that can make funds management easier for banks. Some providers of wholesale funds, for example, will structure their advances so that the repayments the bank must make to the wholesaler mirrors the bank's incoming cash from a loan. Deposits do not offer the same level of tailoring to the bank's needs. In total, the movement away from insured deposits represents the most profitable decision for banks, even as it entails an increase in funding costs. Suggesting, as some have done, that banks try to retain insured deposits offers nostalgic value but may not be a cost-effective strategy.

Availability of credit. Banks will either make less money on each loan or raise the prices they charge for a loan if they have to spend more to fund their lending. Investors, as a result, would provide less of their capital to banks or borrowers would have a lower demand for bank loans. The outcome in either case is reduced bank lending.

Yet, this is not equivalent to reducing the total amount of credit available in the United States. Households will now directly invest some of the cash they used to provide banks in the stock and bond markets, more generally called the capital markets. Alternatively, households will send the money to mutual funds, insurance companies or pension managers who will make capital market investments on their behalf. In either case, reductions in deposits do not shrink the pool of investable funds and actually reflect an improvement for households who now have more options for investing.

Even if the total amount of credit does not change, the switch from bank loans to capital market investments could lead to a shift in who receives credit. This shift would result if borrowers from banks do not receive credit from lenders who fund themselves directly or indirectly through the issuance of stock or debt on capital markets. In the case of consumer credit, however, many of the banks and other lenders that provide mortgages, and auto and credit card loans already raise funds through capital market securities. Likewise, larger firms have direct access to capital market funding or receive credit through lenders, including large banks that can easily tap the stock or bond market.

In contrast, some analysts have argued that small businesses could face higher costs or even a lack of readily available credit if deposit reductions lead to fewer bank loans. Economic research suggests that banks, especially small banks, which rely the most on insured deposits, are especially suited to provide credit to smaller firms. Data indicate that small firms tend to depend more on local banks for financing than other borrowers.

Robert Laird would agree. Laird is the executive vice president of the Hand County State Bank in Miller, S.D., and the president-elect of the Independent Community Banks of South Dakota, and he says a continuing decline in deposit funding will ultimately hurt the community. If a bank's lending ability is affected by the decline in deposits, then a bank will have to find funds from other sources and will eventually become a sort of loan broker rather than a loan maker, Laird says. In the end, the bank will likely be sold or will leave town, he warns. And a small town without a community bank doesn't have a bright future, Laird says.

The degree to which higher-cost deposits and reduced bank lending reduces small business credit, however, is not clear. The increase in capital market funds could end up supporting finance companies, some of which also specialize in lending to small firms. Likewise, many larger banks with access to capital markets have recently begun targeting small business as an avenue for new lending.

More generally, the decoupling of local deposit markets from local lending need not always represent a setback for local borrowers. The growing ability of community banks to fund themselves through state or nationally based wholesale funding markets allows them to continue lending even when local funds dry up. Analysts viewed the similar elimination of local credit market segmentation in mortgage markets, for example, as greatly increasing the efficiency of lending.

Thus, while higher-cost deposits could leave some small businesses depending on higher-cost bank loans or even more expensive alternatives such as an owner's credit card, other small firms will still be able to receive competitive rates from lenders relying on nondeposit funds.

Heidi Taylor Aggeler, financial analyst, contributed to this story.

* FHLBs are an example of a Government-sponsored enterprise (GSE). Because the GSE is a very oblique method for providing subsidies, policy-makers have very little control over the size of subsidy and face serious challenges in ensuring that the intended recipients of the subsidy actually benefit from it. Concerns about GSEs were examined in detail in "Uncertainty in Federal Intervention," The Region, Federal Reserve Bank of Minneapolis [September 1996]. The growth of FHLB lending to banks suggests that now is an opportune time to re-examine the use of this GSE to support bank funding. As Chairman Greenspan recently suggested to policy-makers in response to questions about the FHLBs: "Congress needs to occasionally review the role of FHLBs, just as it should periodically review all forms of subsidized credit and of credit allocation mechanisms created by Congress, to determine if the role is still needed and justified."

Other related stories:
Community banking adapts to changing industry,
, July 1997
Uncertainty in Federal Intervention, The Region, September 1996