Community Banking Connections

Print Article

A Deposit Deep Dive: Liquidity Risk Management for Uninsured and Nontraditional Deposits
by Jywanza Robinson, Lead Examiner, Supervision and Regulation, Federal Reserve Bank of Atlanta

In the first half of 2023, three banks failed, in large part because customers rapidly withdrew deposits over just a few days. These bank failures illustrated how large totals of uninsured and nontraditional deposits can severely weaken a bank’s ability to navigate an economic storm affecting its customer base or balance sheet or both. The failures also served as a reminder to bankers and bank supervisors of just how crucial strong risk management is for a bank’s deposits. Bankers can view the 2023 bank failures as a catalyst to review funds management practices related to deposits and improve in any areas that are lacking. This article explains how supervisors evaluate the risks arising from the features of a bank’s deposit base. In particular, the article focuses on how supervisors assess liquidity risks related to a bank’s uninsured and nontraditional deposits.

The Importance of a Well-Managed Deposit Base

The benefits of a well-managed deposit base are clear. A stable, low-cost deposit base can increase equity value and support the profitability of a bank. Moreover, traditional core deposits can provide a stable source of funding that is less likely to strain a bank’s ability to deal with a funding crisis. Nontraditional deposits can assist banks in meeting funding needs, but they can potentially exhibit less stability and, as a result, require proper risk management practices. Examples of nontraditional deposits include brokered deposits, reciprocal deposits, internet deposits, listing service deposits, and public deposits, such as funds from the U.S. government, state governments, or local political subdivisions. Other nontraditional deposits include sweep deposits, deposits that are part of a concentration, and deposits related to fintech or novel banking activities.

When a liquidity stress event arises, certain nontraditional deposits can exhibit their most unstable qualities, leaving a bank with few options to stem cash outflows. Predicting the cause and timing of a funding stress event is exceedingly difficult. The pairing of a stable deposit base with a high-quality risk management framework acts as a safety net for challenges to a bank’s ability to forecast future events.

While some bankers have already begun to adjust their deposit mixes, risks remain. After seeing what happened to banks that heavily relied on uninsured deposits, some bankers began to lower their bank’s exposure to uninsured deposits while increasing their totals of brokered deposits and nonbrokered reciprocal deposits. Although these deposits are often insured by the Federal Deposit Insurance Corporation (FDIC), they have their own set of risks that bankers need to guard against, such as funding restrictions related to capital or volatile features that require proper risk management procedures. See the figure for more information.

The 2023 stress event highlighted the serious problems that can arise from large exposures to uninsured deposits or deposit concentrations. Concentrations of deposit balances that exceed the FDIC insurance coverage limit of $250,000 are more likely to expose a bank to the risk of deposit withdrawals during a stress event. Other types of deposit concentrations can also increase funding risks for a bank, such as deposits stemming from a bank’s fintech partners.

Risk Management

Supervisors have identified risk management weakness as a contributing factor to the 2023 bank failures. The Federal Reserve’s report on Silicon Valley Bank’s failure notes that senior management failed to effectively manage risks,¹ and the FDIC report on Signature Bank’s failure highlights weaknesses in corporate governance.² The cause and timing of these funding troubles would have been hard to predict. However, the risk management elements of Supervision and Regulation (SR) letter 10-6, “Interagency Policy Statement on Funding and Liquidity Risk Management,”³ address the problems arising from banks with risky deposit profiles, which are similar to the issues seen in the bank failures in the first half of 2023.

As bankers and supervisors review and assess risk management strategies related to deposits, they should consider the guidance in SR letter 10-6. There are eight critical elements of sound liquidity risk management from the SR letter that, taken together, provide a road map for preparing for risks related to deposits.

• Corporate Governance: A bank’s board of directors should oversee funding strategies related to deposit activity and understand any risks in the bank’s deposit makeup. The board should also make sure that senior bank management executes its duty to identify, measure, monitor, and control any risks related to the bank’s deposits.
• Strategies, Policies, Procedures, and Risk Tolerances: Funds management strategies should consider any notable adverse business effects that could be related to a bank’s deposits, and policies should address any short-, intermediate-, and long-term funding risks arising from the risk profile of the bank’s deposits. Effective risk limits for deposit exposures allow a bank to implement plans to navigate times of funding stress. Strategically, bankers should not expose their bank to an undue amount of risk from risk layering. The use of volatile or less stable deposits to fund earning assets that have a higher inherent risk, such as long-duration investments or commercial real estate loans, is an example of risk layering. Bankers can expect examiners to look closely at banks that take on excessive risk through various methods, including risk layering.
• Liquidity Risk Measurement, Monitoring, and Reporting: Stressed cash flow projections in the contingency funding plans of banks should reasonably consider the risks of a bank’s deposits. Reporting should give the board a clear view of the bank’s deposit activity and risk exposure.
• Intraday Liquidity: This section of the guidance is especially meaningful for banks with exposures to deposits from fintech and novel banking activities. Events in the first half of 2023 illustrate just how quickly these deposits can leave a bank during a cash crunch.
• Cushion of Liquid Assets: Banks with higher levels of liquid assets and minimal unrealized losses are in a better position to deal with risks that could result from a high level of volatile deposits.
• Diversity of Funding Sources: Any undue overreliance on a particular deposit concentration is an unsafe and unsound practice, and bankers can expect examiners to assess the effectiveness of a bank’s funds management practices to deal with meaningful exposures to a particular deposit type. Maintaining diverse primary and secondary funding sources aids bank management in protecting the bank from funding stress related to a subset of deposits. Examples of deposit concentrations include individual depositors with large balances, deposits from the same industry, and uninsured deposits. Bankers may also identify concentrations based on the source of deposits (i.e., the method a bank used to obtain the deposits). To illustrate, concentrations based on the source of funds could include deposits obtained from deposit brokers or listing services, or a noteworthy surge in deposit balances over a certain period.
• Contingency Funding Plan: Bankers can expect supervisors to assess whether the stressed cash flow projections in a bank’s contingency funding plan consider its deposit profile. In developing deposit inflow assumptions, a less than well-capitalized bank needs to consider brokered deposit limitations or restrictions on paying interest rates on deposits, or both.⁴ Moreover, banks that are less than well capitalized or in troubled condition would most likely have limited or no access to unsecured lines of credit, Federal Home Loan Bank borrowings, or the Federal Reserve’s discount window. For deposit outflow estimates, bankers should carefully study the stability of their deposits and reasonably account for the stickiness of their deposits (i.e., the likelihood that deposits will remain at the bank) in stressed cash flow projections. Banks that heavily rely on risky deposits should have more granular cash flow buckets to estimate activities during the early days or weeks of a stress scenario.
• Internal Controls: A bank’s procedures and approval processes should ensure that actions related to deposit activities are aligned with board-approved policies. A qualified independent party should perform a comprehensive review of the bank’s funds management practices, including risk management practices related to deposit activity. Smaller noncomplex banks may be able to rely on their audit function or a qualified independent party at the bank to perform the review.

Nontraditional Core Deposit Considerations

A strong liquidity risk management framework identifies risks in a bank’s deposit profile. Misperceptions related to core deposits could cause bankers to underestimate risks related to their banks’ funding exposures. To avoid this pitfall, it is important that bankers and supervisors identify and assess the stability of deposits regardless of their Call Report category. The Uniform Bank Performance Report (UBPR) User’s Guide has a definition of core deposits that includes funds that are typically stable and also funds that can be less stable.⁵ For example, deposits from outside a bank’s market that total $250,000 or less, uninsured deposits in transaction accounts, and listing service deposits are all defined as core deposits that are generally less stable than traditional core deposits. Bankers can expect supervisors to review core deposits to discern whether a bank has identified and managed material exposures to nontraditional, less stable funding sources that the Call Report and UBPR consider core deposits.

As discussed earlier, nonbrokered reciprocal deposits are an example of a nontraditional core deposit that banks are using as a funding source while reducing their reliance on uninsured deposits. Many community and regional banks participate in reciprocal deposit networks to expand the FDIC insurance coverage of their deposits. Using a reciprocal deposit network, a bank can split a $400,000 deposit into two deposits. The customer’s home bank retains a $250,000 deposit, while a $150,000 deposit is sent through the network and swapped with a different bank. This allows both banks to maintain their deposits at or below the FDIC deposit insurance limit of $250,000. Although the intent of these arrangements is to give banks — community banks, in particular — access to large, stable deposits, bankers should understand the risks associated with this funding source.

Reciprocal deposits can be reported as brokered or nonbrokered. However, depending on a bank’s total exposure to these deposits and financial condition, there is a risk that the bank may incorrectly categorize these deposits. This mistake could result in unrealistic stressed cash flow projections in the bank’s contingency funding plan. In such circumstances, a bank could experience challenges in its ability to manage through a cash crunch. While stressed cash flow projections can offer a window into what a funding stress event might look like, poor assumptions or miscategorized deposits in these projections could muddy the view. If a bank’s reciprocal deposits are also brokered deposits, the institution could be subject to funding restrictions if its capital position declines. Therefore, a brokered deposit in a cash flow projection would not fully reflect a stressed scenario and would mask the full extent of the bank’s risk exposure.

Even if a reciprocal deposit is not a brokered deposit, it may still have volatile qualities and expose a bank to heightened funding risks in a stress event. Much of this depends on the qualities of the depositors and their relationship with the bank. For example, a depositor at a bank may participate in a reciprocal program the bank offers and have such deposits considered as a nonbrokered deposit. At the same time, a bank may experience industry-specific cyclicality, causing its deposit balances to fluctuate. In this instance, the bank should group such accounts separately from more stable accounts in its stressed cash flow projections for its contingency funding plan.

Deposits related to primary purpose exceptions (PPEs) could present similar risks. First, some background information on PPEs: At the end of 2020, the FDIC enacted a consistent process for deposit providers to apply for a PPE, a designation that allows a deposit provider to issue deposits that do not fall into the brokered deposit category.⁶ The FDIC also issued a list of business types that automatically qualify for a PPE. In terms of risks related to PPEs, bankers need to correctly report these deposits as brokered or nonbrokered deposits because inaccurate reporting could result in weaker contingency funding plans. Furthermore, a deposit with a PPE could still have funding attributes that are volatile. Examples include a deposit with a PPE that a bank obtained by offering interest rates well above the prevailing local market rates or a deposit with a PPE from a fintech firm.

Reciprocal deposits and deposits with a PPE are just two deposit types that can carry volatile features and show up as core deposits in the UBPR. Other examples include listing service deposits, deposits related to fintech or novel banking activities, and public deposits. Listing services compile interest rate information related to deposit products at banks. Deposits from these services are brokered if the listing service places the deposits at banks instead of just providing information. Either way, deposits from listing services are prone to be less stable than traditional core deposits because these depositors tend to be highly rate-sensitive while having no other relationship with or loyalty to a bank.

Fintech or novel banking depositors may have less loyalty to a bank compared with community-based depositors and, therefore, may quickly move their funds based on adverse public information. Public deposits, meanwhile, can be more sensitive to a bank’s financial condition and are subject to balance fluctuations related to the time frame over which the public entity receives tax payments and withdraws such funds.

Assessment of the Stability of Deposits

Several attributes can affect the stability of a deposit and a bank’s funding picture. Facets that can impact the stickiness of a deposit include the fiduciary responsibility of the depositor, the deposit’s access to FDIC insurance coverage, the depositor’s reliance on public information, and the sort of relationship the depositor has with the bank. Deposits from money market funds, mutual funds, and trust funds have agents or managers that will make decisions based on a fiduciary obligation to locate the best option for the placement of the funds. This may cause deposits linked to an agent or manager to be less stable than deposits without a representative in place to manage the funds.

Deposit balances with full FDIC insurance coverage are most often a relatively stable funding source. Certain insured deposits can still be less stable, such as deposits from outside a bank’s branch footprint, brokered deposits, listing service deposits, and sweep deposits. Uninsured deposits — as we are now so keenly aware because of the bank failures in 2023 — are frequently connected to customers who are more likely to pay attention to public information and react based on the financial condition of a bank, especially if the bank has stock that trades publicly.

Interest rates can also have a profound impact on the stability of deposits regardless of their FDIC insurance coverage status, particularly for noninterest-bearing accounts. Typically, these demand deposits or checking accounts are often tied to depositors with strong relationships with a bank. Customers frequently use noninterest-bearing accounts to handle payment transactions, direct deposits, or automatic withdrawals. However, when interest rates exhibit an increase that is large enough, some depositors may be motivated to move their excess funds to interest-bearing accounts that offer higher yields, even if the deposit balances are less than $250,000 and receive FDIC insurance.

Relationship banking is fundamental to most community banks, and the relationship that a customer has with a bank strongly influences the stability of a deposit. A key part of understanding the stickiness of a deposit is the ease of use of the deposited funds by a customer. A customer with several accounts and services with a lender may be less inclined to move funds out of a bank because the customer values the convenience of dealing with fewer banks. Furthermore, if it is cumbersome to move funds, a customer is less likely to transfer money elsewhere. The longevity of a deposit may also suggest a customer’s loyalty to a bank. However, if the financial health of a bank begins to falter in a public, eye-catching way, even the most loyal customers may seek a safer place for their cash.

Conclusion

The liquidity stress event in the first half of 2023 heightened awareness about the important role that deposit stability plays in the financial health of a bank. Uninsured deposits present funding risks that can occur with little or no warning. Therefore, bankers need to closely monitor the level and concentration of their uninsured deposits. Both bankers and supervisors need to have an in-depth understanding of a bank’s risk exposure to nontraditional deposits and whether the bank can withstand a funding crisis if these nontraditional funds exit the bank. As always, strong deposit risk management practices play a key role in a bank’s ability to handle unforeseen liquidity challenges.

• ¹ See Federal Reserve Vice Chair for Supervision Michael Barr’s review of the supervision and regulation of Silicon Valley Bank, available at www.federalreserve.gov/publications/files/svb-review-20230428.pdf.
• ² See the report, FDIC’s Supervision of Signature Bank, available at www.fdic.gov/news/press-releases/2023/pr23033a.pdf.
• ³ SR letter 10-6 is available at www.federalreserve.gov/boarddocs/srletters/2010/sr1006.htm.
• ⁴ Refer to FDIC regulations 12 C.F.R. 337.6(b) and 12 C.F.R. 337.7(c), available at www.ecfr.gov/current/title-12/chapter-III/subchapter-B/part-337, as well as 12 U.S.C. 1831f(e), available at https://uscode.house.gov/view.xhtml?req=granuleid:USC-1999-title12-section1831f&num=0&edition=1999.
• ⁵ Refer to the guide, available at https://cdr.ffiec.gov/Public/DownloadUBPRUserGuide.aspx.
• ⁶ See 86 Federal Register 6742 (January 22, 2021), available at www.govinfo.gov/app/details/FR-2021-01-22/2020-28196.