Home > Industry Analysis > Research & Analysis > FDIC: Atlanta Regional Outlook, Third Quarter 1999

FDIC: Atlanta Regional Outlook, Third Quarter 1999

Regional Perspectives Funding Issues Affect Commercial Banks in the Atlanta Region Bank funding has changed considerably in the 1990s (see Shifting Funding Trends Pose Challenges for Community Banks ). Change has been driven, in part, by cyclical factors since the current economic expansion began in 1992, but there are differences in the way the industry is funded when compared with previous expansions. Most notably, loan growth has increased relative to deposit growth more than in past cycles. This situation has contributed to a shift away from traditional core2 deposits toward alternative funding sources such as noncore3 deposits and borrowings.4 This analysis examines funding changes at banks in the Atlanta Region, the factors driving those changes, and potential risks. 2 Core deposits include all transaction, savings, and money market deposits, as well as time deposits less than $100,000. Core deposits typically are viewed as a stable source of funding for insured institutions. 3 Noncore deposits include time deposits over $100,000, foreign deposits, and deposits placed through a broker. These are considered more volatile than core deposits. 4 Borrowings include federal funds purchased, securities sold under agreements to repurchase, demand notes issued to the U.S. Treasury, mortgages and capitalized lease obligations, and any other borrowed money. Deposits have declined steadily as a percentage of assets at commercial banks in the Atlanta Region since the current economic expansion began in 1992 (see Chart 5). This trend has been consistent across large and small banks. It is not uncommon for loan demand to outstrip deposit growth during cyclical expansions, but, as Chart 5 shows, such a sharp and sustained decline in deposits relative to assets did not occur during the previous expansion in the 1980s. This shift suggests that factors other than the business cycle are influencing bank funding decisions. As discussed below, the move from deposits to borrowings appears to be occurring both from necessity, as competition from nonbank financial services providers has slowed bank deposit growth, and opportunity, as funding alternatives available to banks have increased. Chart 5 Competition from Nonbank Financial Services Providers Is Affecting Insured Institution Deposit Growth The slowdown in bank deposit growth has resulted, in part, from increased competition from nonbank financial services providers, such as mutual funds and, to a lesser extent, credit unions. Unquestionably, high returns in the financial markets have helped the mutual fund industry garner a substantial and growing share of each household dollar in the 1990s. Fund flow data suggest that there has been a demographic shift from a "saver" to an "investor" focus in recent years, as individuals are placing a larger share of their financial assets in the capital markets rather than in insured bank deposits. The Investment Company Institute5 (ICI) reports that net new cash flow into mutual funds (equity, bond, and money market funds) reached a record $477 billion in 1998, surpassing the previous record of $374 billion set in 1997. Moreover, during the five-year period from 1994 to 1998, nearly $1.5 trillion of new money flowed into mutual funds, compared with only $300 billion a decade earlier from 1984 to 1988 (a 400 percent increase). Mutual fund penetration also has grown steadily, as 44 percent of all U.S. households held mutual fund investments in 1998 compared with 24 percent 10 years earlier. It is likely that growth in the mutual fund sector, to some extent, is coming at the expense of the banking industry. Banks in the Atlanta Region may face even stronger competition with mutual funds relative to their out-of-region peers, as ICI demographic statistics show the nation's highest concentration of mutual fund ownership to be in the southern states. 5 The Investment Company Institute, based in Washington, D.C., is the national association of the mutual fund investment industry. Nonbank financial services providers have been successful in capturing market share during the 1990s. Chart 6 shows, at the national level, the growth in total funds held by various financial services providers (banks and thrifts, mutual funds, and credit unions) from 1991 to 1998, as reported in the Federal Reserve Board's Flow of Funds data. The chart illustrates how successful insured institution competitors have been in increasing their share of the nation's financial assets. Equity and bond mutual funds have been the big winners; their asset volume has grown nearly fivefold since 1991. Meanwhile, money market mutual fund assets (perhaps the closest substitute to insured institution core deposits) have risen by 150 percent since 1991. In fact, money market funds took in more new investment dollars ($235 billion) than bond and equity funds combined in 1998. (The increased flow into money market mutual funds in 1998 may have been a "flight to quality" surrounding the equity and bond market declines that occurred in the third quarter.) Chart 6 Credit union deposits also have grown at a faster rate than bank deposits in the 1990s. Chart 6 shows that credit union deposits grew nearly 60 percent from 1991 to 1998, compared with only 14 percent for bank and thrift deposits. As indicated by the bold line on Chart 6, slow deposit growth has led insured institutions to rely increasingly on borrowings to meet funding needs since 1992. Regional Flow of Funds data are not available, but Call Report data suggest that deposit and borrowing trends at insured institutions in the Atlanta Region are similar to the national trends. The mutual fund industry now holds the largest share of financial assets. Chart 7 presents the Federal Reserve Board's Flow of Funds data in dollars rather than as an index. As seen in the chart, insured institutions were losing deposit volume to competitors from 1991 until about 1994 (consistent with the 14 percent increase in total deposits from 1991 to 1998 shown in the previous chart). That equates to an average annual growth of 1.85 percent, which was less than the average interest being credited on deposits over that period. Chart 7 also shows that dollars held by the mutual fund industry actually eclipsed total bank and thrift deposits in 1996 and that the gap has continued to widen. Finally, it is important to note that credit union deposits, despite their strong growth in recent years, remain nominal relative to total deposits held by banks and thrifts. Chart 7 Bank Funding Has Diversified as More Alternatives Have Become Available Consistent with the national trend, banks in the Atlanta Region are relying more on borrowings to meet their funding needs. Chart 8 breaks down each new dollar of funding raised by commercial banks in the Region in 1998 into its components—core deposits, noncore deposits, borrowings, and equity—and compares that to the composition of new funds in 1988. Borrowings represented a much larger share of new funds in 1998 than in 1988 at both large and small banks in the Region. The increase in borrowings primarily offset a decline in large time deposits at both groups of banks, although large time deposits still make up the bulk of community bank noncore funding in the Region. Both groups, meanwhile, funded a larger portion of their asset growth with equity rather than interest-bearing liabilities in 1998 than in 1988, which is consistent with generally higher equity levels across the industry in the 1990s. It is important to note that, while core deposits were essentially unchanged as a percent of new funding in 1998 compared with 1988, core deposits have declined relative to assets at both large and small banks in the Region over the past 10 years. Chart 8 The shift from large time deposits to borrowings seen in Chart 8 may be related to an increase in the relative cost of large time deposits over the past few years. Chart 9 shows that, at the national level, the spread between negotiable (over $100,000) bank certificates of deposit and a benchmark six-month U.S. Treasury bill has increased since 1994. This is notable in that, according to a 1990 report by Citicorp entitled Interest Rate Spreads Analysis: Managing and Reducing Rate Exposures, this spread normally narrows during periods of recovery and economic stability. As seen in the chart, the spread has widened as expected during periods of economic uncertainty, such as the recession in 1990 and the Russian bond market collapse last year. But the fact that the spread has been increasing despite stable economic growth may signal that banks relying on this type of noncore funding must pay higher rates in response to increased competition from within the banking industry and from nonbank financial services providers. Chart 9 In addition to competitive factors, the industry's shift from deposits to borrowings may be a result of greater access to borrowed funds. The increase in borrowings by both large and small banks in the Atlanta Region has coincided with commercial banks gaining access to the Federal Home Loan Bank (FHLB) system with the passage of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989. As shown in Chart 10, membership in and advances from the FHLB system have been popular among Atlanta Region banks. From 1993 (earliest available data) to 1998, the number of commercial banks in the Atlanta Region that were members of the FHLB system more than doubled, from 310 to 725. Moreover, outstanding advances increased more than tenfold, from $2 billion to $23 billion, over that period. FHLB penetration within the Region has grown steadily as well, as membership has increased from one in five banks (21 percent) in 1993 to nearly two of every three banks (63 percent) in 1998. As of year-end 1998, 72 percent of banks in the Region with assets over $1 billion were FHLB members, with advances totaling $20 billion. Community bank membership stood at 63 percent at year-end, and advances totaled $3.3 billion. Community bank membership is likely to continue to grow, as the Federal Housing Finance Board amended its membership requirements in 1998 to allow rural banks with assets under $500 million to use combination business or farm properties on which a residence is located to qualify for FHLB membership. Chart 10 As the Region's overall funding mix has diversified to include more borrowings, the composition of core deposits also has changed. Chart 11 compares the composition of new core deposits raised by community banks in the Atlanta Region in 1998 with that of 1988. Small time deposits, normally a staple of community bank funding, fell sharply from 71 percent of new core funds in 1988 to 27 percent in 1998. This decrease is consistent with balance sheet data for community banks in the Region, which show that small time deposits have declined as a percentage of assets since the late 1980s. This decline may be related to strong growth in the mutual fund sector, as some consumers might view mutual funds and small time deposits as interchangeable products. Also, the fact that savings and money market deposit accounts represent a larger share of new core funds now than in 1988 may imply a "liquidity preference" on the part of depositors to hold nonmaturity deposits rather than time deposits, given today's low interest rate environment. Large banks exhibit trends similar to those shown in Chart 11, the only exception being that transaction accounts have declined at large banks while representing a higher percentage of small bank core funding. Transaction accounts, while free of interest costs, can be expensive to maintain depending on transaction frequency, average account balance, and the channel (electronic, automated teller machine, or teller window) customers use to make transactions. Chart 11 The Community Bank Funding Challenge Community banks may face greater funding challenges than their larger counterparts. A 1998 survey conducted by the American Bankers Association found that 4 of 10 community bankers reported core deposit growth lagging loan demand. In addition, a 1999 Grant Thornton survey showed that three of four community bankers believe core funding will be a greater challenge three years from now. Factors that could constrain community bank funding relative to large banks include limited access to the capital markets, a smaller geographic presence from which to solicit deposits, and slower rural population growth. According to an article in the June 7, 1999, American Banker, some small banks are soliciting out-of-market deposits to meet loan demand because core deposit growth is insufficient. This strategy could increase interest costs, however, and because many community banks have limited fee income opportunities, they are structurally more reliant than larger banks on spread income from taking deposits and making loans. Other factors that might affect community banks over the longer term include convergence toward national, rather than local, market pricing as a result of advances in technology. A number of community banks enjoy some pricing power in their local markets, but consumers' ability to shop markets nationally and move money more quickly at lower costs could pressure pricing spreads at certain institutions. Ultimately, this could lead to more volatility in core deposits, which currently fund 72 percent of the Region's community bank assets (compared with 54 percent for large banks). A less stable core deposit base would heighten the need for alternative funding sources, which are limited for many small banks. In a recent issue of SNL Securities' Bank Investor, L. Bud Baker, CEO of Wachovia Corporation, alluded to these concerns: "…there is no such thing any longer as a core deposit… you are going to be able to go on the Internet and find the best price for your money…and you can move your money with the punch of a button." Risk Implications of Funding Changes A more diverse funding mix can offer benefits with regard to pricing and balance sheet management, but a shift from core to noncore funding is not without new potential risks. With net interest margins already pressured by pricing competition and a flattened yield curve, there is some concern that the higher interest costs normally associated with noncore funding could lead to more risk taking (credit risk or interest rate risk) in search of higher asset yields. That risk may be tempered somewhat by the fact that the noninterest cost of gathering wholesale funds can be less than that of retail funds. The move from core to noncore funding also may have liability-side liquidity implications. As banks turn more attention to alternative funding, there may be less focus on retail deposit gathering. This raises the question of whether banks could recapture deposit share lost to competitors, such as mutual funds or credit unions, in the event that financial market turmoil or credit quality concerns unexpectedly diminish alternative funding. Many industry observers believe that the funding challenges facing banks are long term rather than cyclical. Thus, the issues discussed here will only add to the complexity of asset and liability management going forward. Maintaining a cost structure consistent with the mix of retail and wholesale funding will be critical for banks to continue to grow without sacrificing profitability. Regardless of how funds are acquired in the future, insured institution managers must allocate those funds in a manner that can achieve earnings and growth objectives without subjecting institutions to undue credit, interest rate, or liquidity risks. Atlanta Region Staff Regional Outlook Information Return to Regional Outlook main page