Asset Growth Continues to Outpace Core Deposit Growth at Community Banks
During the past decade, greater competition for traditional deposits among FDIC-insured institutions and other financial intermediaries has contributed to an increased reliance on noncore funding by community banks.² This long-term trend of declining levels of core deposits in relation to total assets appears likely to persist (see Chart 1).³

In recent years, the banking industry has experienced relatively healthy core deposit trends, with community bank core deposit growth exceeding 7 percent in three of the past four years. Factors that may have contributed to higher core deposit and certificate of deposit (CD) growth include higher growth in gross domestic product, changes in interest rates, growth in corporate profits, growth in disposable income, the total return of the S&P 500, and growth in median housing prices.⁴ Interestingly, although deposit growth has been relatively strong, assets have grown faster still, thereby putting pressure on FDIC-insured institutions to increase their use of noncore funding sources. With the recent rebound in equity market performance, core deposit growth has begun to slow, which could contribute to increased use of alternative funding.⁵

With the increasing reliance on noncore funding by the industry, community banks have been trending toward liability structures that more closely resemble those of larger institutions—that is, funding a larger percentage of assets through noncore funding. In the past decade, the difference between large and small institutions has narrowed. Ten years ago, noncore funding represented only 13 percent of total community bank assets. As of September 30, 2004, that figure had almost doubled to 24 percent of assets. Nevertheless, the ratio of noncore funding to assets at large banks remains significantly higher at 41 percent of assets.

Community Banks Are Increasing Their Use of Alternative Funding Sources
For community banks, the most noteworthy funding trends have been increased use of Federal Home Loan Bank (FHLB) borrowings and brokered deposits. Although the banking industry overall has not reported an increase in FHLB borrowings relative to total assets during the past three years, more community banks have turned to this funding source. As of September 30, 2004, 61 percent of community banks reported the use of FHLB borrowings, up from 52 percent three years earlier. The availability of FHLB credit has generally been positive for FDIC-insured institutions, as many small banks without easy access to capital markets can tap into this source of funds.

The use of brokered deposits also has increased among FDIC-insured institutions, even though this form of funding is typically of higher cost and more sensitive to interest rate movements than core deposits. In 2004, 25 percent of community banks reported the use of brokered deposits, up from only 8 percent ten years ago and 16 percent three years ago. Although more institutions are using this funding source, the percentage of brokered deposits to assets remains relatively low; only 4.5 percent of large bank assets and 2.3 percent of community bank assets are funded this way.

If properly administered, such diversification of funding sources can benefit FDIC-insured institutions. The increased use of noncore funds can also enable a more precise structuring of liabilities than can be obtained primarily through changes in core deposit pricing. For instance, many institutions have found that brokered deposits can be a more cost-effective deposit-gathering mechanism than building new branches.

Community Banks Continue to Experience Changing Depositor Preferences
Since 2001 community banks have seen a shift in deposit maturities, a trend likely to continue as interest rates climb. As the percentage of time deposits maturing in more than one year increased from 22 percent of all time deposits in 2001 to 33 percent in 2004, all time deposits fell from 40 percent to 35 percent of assets. During the same period nonmaturity deposits increased by an equal amount, from 42 percent of assets to 47 percent of assets.⁶ These shifts highlight how depositor preference can fluctuate during periods of changes in interest rates or other market factors. Part of the shift toward nonmaturity deposits could reflect a flight to quality, as some customers may have sought to avoid turbulent equity markets and also perceived low opportunity costs associated with short-term deposits given historically low inflation as well as low interest rates.

As bankers well know, managing depositor preference is a dynamic process. If depositors expect recent interest rate increases to continue, they will have less incentive to lock up funds for a longer duration, which may lead bank managers to alter deposit pricing or reposition the maturity structure of their noncore funding sources.

Funding Costs Remain Sensitive to Interest Rate Movements
Typically, there is some lag time between changes in market interest rates and rates offered on bank deposits. This pricing lag is a function of the repricing schedule of deposits, management's deposit pricing strategy, and customer preferences. Part of the time lag arises from the fact that core deposit customers often consider factors other than interest rates when choosing where to bank, including the convenience of banking services and the extent and satisfaction of their current banking relationship.

Early indications suggest, however, that banks may be finding it difficult to hold deposit rates steady in this rising rate environment. Given that retail deposit customers have endured a lengthy period of very low interest rates and short-term interest rates have risen quickly of late, these customers may now be more yield-conscious. For instance, a nationwide index of CD rates suggests that short-term CD rates began moving upward even before the initial rise in the federal funds rate (see Chart 2). Although deposit rates will vary across geographic markets and reflect the intensity of competition for local deposits, it appears that core deposit competition will remain strong and that funding costs will be sensitive to higher interest rates. Bank Call Report data suggest that the cost of funding is beginning to rise in response to rising short-term rates. The target federal funds rate first moved upward by 25 basis points at the end of June 2004, with further 25 basis point increases in both August and September. Community banks' cost of funding earning assets rose slightly, from 1.55 percent in second quarter 2004 to 1.60 percent in the third quarter.

Funds Management Assumptions May Need Revisiting
The assumptions banks make about the rate sensitivity of their deposits, which are crucial inputs in interest rate risk management, may need to be revised in this interest rate cycle. Special consideration to the interest rate sensitivity of core deposits is warranted, as these assumptions are critical in the interest rate risk monitoring systems of most banks. Furthermore, heightened use of noncore funding, while often beneficial, can come at a cost. Often, this kind of funding will exhibit increased interest rate sensitivity or contain embedded options that can be difficult to value.

In addition, continued strong growth in loans outstanding and unfunded commitments have the potential to generate significantly increased funding needs for FDIC-insured institutions. During the past ten years, the ratio of unfunded commitments to assets nearly doubled, with the median level reaching 9 percent of assets in 2004. As banks and thrifts may not always be able to accurately anticipate the amount of loan draws that will take place, large unexpected draws over a short period of time could pressure bank funding needs.

The remainder of this article highlights some of the most significant funding issues and trends occurring regionally, with commentary from analysts in each of the eight FDIC regional and area offices.

Mike Anas, Senior Financial Analyst

The Fastest-Growing Institutions in the Southeast Are Also the Biggest Users of Noncore Funding
The decline in the ratio of core deposits to total funding has been most pronounced in Atlanta Region community banks that have displayed high rates of asset growth. In fact, during the first nine months of 2004, some 29 percent of community banks headquartered in the Region reported particularly strong asset growth. These "fast-growing" banks had asset growth exceeding 20 percent year-over-year (see Map 1).⁷ To accommodate this growth, these banks have turned to alternative sources of funding, especially in active real estate markets where competition for core deposits has heightened because of new market entrants. While the increased availability of noncore funding has enabled many institutions to fund robust asset growth, the use of noncore funding does come at a cost, typically in the form of higher interest expenses.

In third quarter 2004, combined borrowings and noncore deposits represented 36 percent of the total funding of fast-growing banks, compared with 31 percent for other community banks. Fast-growing banks also reported higher funding costs, which contributed to narrowing net interest margins (NIMs). A diminished reliance on core deposits also may reflect the fact that 20 percent of the fast-growing banks are new institutions that face the high overhead costs typically associated with penetrating competitive deposit markets.

Although fast-growing banks can be found throughout the Region, the largest clusters are in the three key market areas of Atlanta, Southwest Florida, and South Florida (see Map 1). Though less concentrated than the key markets, Central and Northeast Florida, the Alabama coast/Florida Panhandle, and Northern Virginia also are home to pockets of fast-growing community banks. During a period of rising rates, greater reliance on more interest-rate-sensitive funding sources, combined with the competitive nature of these markets, may continue to pressure funding costs.

Scott Hughes, Regional Economist
Ronald Sims II, Senior Financial Analyst

Large and Small Banks in the Mid-Atlantic States Differ in Their Funding Strategies
Some of the world's largest FDIC-insured institutions are headquartered in the Mid-Atlantic states. In fact, 18 percent of the FDIC-insured institutions headquartered there have more than $1 billion in assets, while only 6 percent of institutions elsewhere meet that threshold. As a result, large institution funding trends significantly affect both the regional landscape and national trends.

Larger institutions historically have relied more on noncore funding than have smaller institutions. The largest institutions in the Mid-Atlantic, those with assets greater than $10 billion, have noncore funding levels considerably greater than that of institutions with assets less than $1 billion (see Table 1). Over the past three years, the ratios of noncore funding to assets reported by institutions with assets of $1 billion to $10 billion have been more than 10 percentage points higher than those of Mid-Atlantic community banks, while institutions with assets of $10 billion or more reported ratios of noncore funding to assets almost 30 percentage points higher. The biggest difference between the funding profiles of large versus smaller banks is their use of FHLB advances, purchased federal funds, and foreign deposits.⁸

The Mid-Atlantic's larger institutions have reported funding costs slightly less than or roughly equivalent to those of community banks during the past three years, despite significantly higher noncore funding levels.⁹ This may suggest that the largest institutions have some competitive advantage over smaller banks in gathering noncore funding. Larger institutions typically have greater access to capital markets and generally may be perceived as a lower-risk premium among investors when borrowing uninsured funds.¹⁰ Of course, many factors can affect a bank's overall cost of funds, such as the maturity composition of liabilities and the perceived credit risk associated with borrowings. Nevertheless, higher levels of noncore funding do not necessarily equate to higher funding costs, particularly among larger institutions.

For community banks, however, the incremental costs of adding noncore funding may be higher than for large banks. Community banks that have a significant reliance on noncore funding (greater than 30 percent of assets) typically have much higher funding costs than other community banks. In the Mid-Atlantic states, community banks below this threshold have a cost of funds of only 1.88 percent, compared with 2.23 percent for those with a larger amount of noncore funds. A similar relationship holds nationwide and has existed for many years.

Looking ahead, should core deposit competition intensify along with rising interest rates, Mid-Atlantic institutions are likely to continue to see noncore funding levels grow, particularly among smaller institutions. Moreover, while core deposit rates typically lag changes in market interest rates, rates on noncore funding are more sensitive to interest rate changes. For smaller institutions, rising rates, coupled with a shift to generally higher-cost noncore funds, will potentially mean a more rapid increase in funding costs than during the past year. In the Mid-Atlantic, higher NIMs reported by smaller institutions as compared with larger banks should help absorb some incremental increases in funding costs.¹¹ Also, smaller institutions have had slightly higher levels of noninterest-bearing deposits and greater success in growing these deposits; if the trend continues, these noninterest-bearing deposits will help offset the costs associated with growing noncore funding.

Mike Anas, Senior Financial Analyst
Kathy R. Kalser, Regional Manager

New England Institutions Use Noncore Funding to Support Longer-Term Asset Portfolios
The composition of funding among New England community banks has changed markedly since the end of the 2001 recession. The dollar volume of borrowings grew almost 22 percent from third quarter 2001 to third quarter 2004, compared with total deposit growth of only 3.0 percent. Borrowings are largely composed of FHLB advances, which have grown 30.2 percent since third quarter 2001. Community banks in New England, many of which are similar to thrifts by their specialization in mortgage lending, have long participated in the FHLB system. Almost 79 percent of New England community banks have outstanding FHLB advances, the highest percentage of any FDIC region in the country and well above the national average of 60.7 percent (see Chart 3).

Nonmaturity deposits have also increased more than 15 percent in dollar terms during the past three years, offsetting a similar decline in time deposits.¹² Community banks generally have enjoyed an increase in nonmaturity deposits since the stock market decline of 2000, as investors pulled money out of the stock market and placed those funds in secure, liquid bank deposits. In addition, while brokered deposits support only 1.2 percent of total assets, the percentage of New England community banks using brokered deposits has grown substantially, from 5.2 percent in 2000 to 19.3 percent in 2004.

During the past five years, New England's savings institutions have held portfolios with a historically high level of long-term assets, primarily mortgage loans.¹³ With the low interest rates and a relatively steep yield curve that persisted through much of 2004, banks have retained a large portion of long-term assets on their books to help augment a narrowing NIM.¹⁴ However, the market value of these long-term assets may decline in value should interest rates rise. In addition, as longer-term interest rates have increased since mid-2004, refinancing activity has declined, thereby scaling back an important stream of income for New England institutions.

Paul M. Driscoll, Regional Manager

Chicago Region Banks Use a Variety of Noncore Products to Address Their Funding Needs
Consistent with the national trend, community banks in the Chicago Region are becoming more reliant on noncore funding sources (see Chart 4). Increasing competition among banks, thrifts, and nonbanks as well as higher-yielding investment alternatives have made it more difficult for many community banks in the Region to attract core deposits.¹⁵

Trends in noncore funding vary throughout the Region. Ohio, for example, is a very competitive banking market with a relatively high number of banking branches dominated by large regional banks. In the past two years, core deposits slowed for Ohio community banks as competition heated up. In response to weak core deposit growth, banks and thrifts in Ohio increased their reliance on noncore funding more than any other state in the Region—their ratio of noncore funding to total assets rose by 315 basis points to 25.8 percent in the year ending September 30, 2004. Ohio institutions also reported the Region's largest 12-month increase in the ratio of FHLB borrowings to assets, which grew by 140 basis points to 8.8 percent as of third quarter 2004.

Although most banks in the Region saw an increase in noncore funding, the type of noncore funding used predominantly by banks in the different states varied. For instance, Wisconsin banks and thrifts funded 5.2 percent of their assets with brokered deposits in third quarter 2004, up from 3.7 percent a year earlier. Although the share of large time deposits to assets increased across all community banks in the Region, community banks headquartered in Michigan reported the greatest shift, with the percentage of large time deposits to assets increasing by 225 basis points in the past year. And banks and thrifts based in Indiana and Kentucky are turning more frequently to FHLB borrowings—near the end of 2004, more than 80 percent of FDIC-insured community banks in these two states reported some level of FHLB borrowings, up from approximately 72 percent three years earlier.

Linda Lo, Financial Analyst

A Confluence of Factors Contribute to the Decline of Noncore Funding in the Kansas City Region
Before 1990, the Kansas City Region's small community banks consistently funded more than 80 percent of their total assets with core deposits.¹⁶ In the 1990s, however, the convergence of a number of factors has made it harder for these banks to continue to acquire core deposits. These factors include disintermediation caused by rapidly increasing stock markets, competition for deposits from large banks and credit unions, and depopulation in most of the Region's rural areas. As a result, core funding as a percentage of total assets dropped steadily in the 1990s (see Chart 5). By 2000, just over 71 percent of small community bank assets were funded by core deposits.

As core deposit levels declined in relation to total assets, institutions were forced to look to other sources of funds, including large time deposits, FHLB borrowings, and, in some instances, brokered deposits. The use of these funds reached a peak in third quarter 2000 as the Region's small community banks used noncore funds to finance 17.8 percent of total assets, compared with 7.9 percent eight years earlier. And, while large time deposits made up the bulk of small community bank noncore funding, alternative sources such as FHLB borrowings were commonly used as well. FHLB borrowings nearly tripled from just under $3.0 billion in 1992 to $8.6 billion in 2000.

Downward trends in core funding reversed temporarily at the beginning of this decade as declining stock markets led investors to seek the safety of FDIC-insured bank deposits (see Chart 5). From 2000 through 2003, the percentage of total assets funded by core deposits varied little (between 71.1 percent and 71.5 percent), marking the first period of stability in more than ten years. In part due to this stability in core funding, the median small community bank NIM improved by 14 basis points in 2002.

However, recent rebounds in the stock market may once again be luring funds away from the Region's small community banks, and the long-term downward trend in core funding appears to have resumed. As of September 30, 2004, core funds made up only 69.6 percent of bank assets, representing the first time that the ratio has fallen below 70 percent. Noncore funds, led by surges in FHLB borrowings (up by $1.2 billion, or 14.6 percent, during the 12 months ending September 30, 2004) and large time deposits (up $600 million, or 4.2 percent, over the same time period), funded a record 19 percent of total banking assets. As a result, the median NIM among the Region's small community banks as of third quarter 2004 was 4.05 percent, down slightly from 2003 and far below the level of 4.42 percent of a decade ago.

John M. Anderlik, Regional Manager

Rural Institutions in the Midsouth Area Have Significantly Increased Use of Noncore Funding
As a result of slow growth in core deposits, the ratio of noncore funding to assets for community banks based in the Midsouth Area reached an all-time high in third quarter 2004.¹⁷ A major contributor to this trend is the rapid increase in the number of commercial banks using FHLB advances (see Chart 6).

The shift from core deposits to generally more costly funding alternatives has been most pronounced among FDIC-insured institutions in rural areas, although there is a wide variance in usage among those areas. The growth in noncore funding sources varies significantly between institutions in rural areas highly dependent on manufacturing employment and those in areas less dependent on manufacturing.¹⁸ During the year ending September 2004, the median ratio of noncore funding to total assets increased 90 basis points to 22 percent of assets among rural-based FDIC-insured institutions in areas highly dependent on manufacturing employment. Although rural-based FDIC-insured institutions that are less dependent on manufacturing also have begun to use alternative funding sources, the degree of change has been much less dramatic at 6 basis points during the same period. Employment in rural areas traditionally has been centered in the manufacturing sector, which suffered severe job losses even before the national recession in 2001.

The increasing reliance on noncore funding sources among banks and thrifts based in manufacturing-dependent rural areas likely contributed to the median NIM decline of 7 basis points in third quarter 2004 from one year ago. By contrast, the median NIM among FDIC-insured institutions less dependent on manufacturing was relatively unchanged in the same period. Should the use of noncore funding continue togrow among FDIC-insured institutions based in the Midsouth Area, it is reasonable to expect that pressures on NIMs could increase.

F. Miguel Hasty, Senior Financial Analyst

Smaller Metropolitan Areas in the Southwest Report Stronger Core Deposit Growth than Larger Metropolitan Areas
Community banks in the Southwest, especially those located in highly competitive banking markets, have increased their use of alternative funding sources.¹⁹ Reflecting the heightened competition for business and consumer deposits, community banks based in the Southwest are reporting a median core deposit ratio of 71.1 percent. Although this rate remains slightly above the national rate, it is the lowest level in two decades for Dallas Region institutions. As the Region's economy continues to improve, historical trends suggest loan demand should increase as well, prodding community banks to consider alternative sources of funding when evaluating new loan and investment opportunities.

Shifting funding strategies also can be observed by considering the kinds of markets where banks and thrifts operate—that is, metropolitan, micropolitan, or rural.²⁰ In contrast to the rest of the Region, FDIC-insured institutions in Southwest micropolitan counties have reported higher ratios of core deposits to assets during recent years (see Chart 7). The increase could be due, at least in part, to the significant growth in per capita income in these micropolitan areas, which was almost 18 percent during the four years ending December 31, 2003. This rate exceeds the 12 percent growth rate recorded in the Southwest's metropolitan areas. Similarly, employment growth in micropolitan counties increased 6.1 percent over the same four-year period, significantly above 1.9 percent reported in metropolitan counties. This comparatively strong job growth in the Region's micropolitan areas appears to be a positive factor for bank deposit growth. In addition, stronger job growth may allow banks headquartered in these micropolitan counties to be better positioned to attract core deposit funding. Alternatively, FDIC-insured institutions based in metropolitan counties may need to use alternative funding sources if the downward trend of the ratio of core deposits to assets continues.

Jeffrey A. Ayres, Senior Financial Analyst

Brokered Deposits Are Becoming a More Important Source of Funds in a Number of Western States
Community banks based in the West have experienced strong loan demand during the current economic expansion, particularly in construction loan portfolios. In turn, this loan demand has contributed to an increased need for funding. Although core deposits continue to comprise the bulk of funding, FDIC-insured institutions based in the San Francisco Region are reporting an increased reliance on noncore funding sources, consistent with national trends.

Brokered deposits have been an important component of the increase in noncore funding in the Region since 2001. As of September 30, 2004, 37 percent of all FDIC-insured financial institutions in the Region reported the use of brokered deposits, up from less than 25 percent three years ago. The use of brokered deposits was higher among institutions that have been in operation for less than nine years; 43 percent of these institutions reported brokered deposits. The percentage of FDIC-insured institutions reporting brokered deposits was particularly high among community banks based in Arizona, Nevada, and Idaho, where construction loan demand was propelled by strong housing construction activity, robust in-migration, and strong employment growth (see Chart 8). These markets also have had significant new bank chartering activity during the past nine years.

As of September 30, 2004, banks and thrifts headquartered in Arizona, Nevada, and Idaho ranked in the top five states nationwide for FDIC-insured institutions with construction and development loan exposure, employment growth, and population growth, and in the top ten for brokered deposit usage (see Table 2). Of banks reporting brokered deposits, community banks in Arizona reported more than twice the 3.9 percent national median level of brokered deposits to assets. In Nevada and Idaho, however, the median concentration of brokered deposits was similar to that of community banks across the nation.

Robert E. Basinger, Senior Financial Analyst

¹ According to the February 1, 2005, issue of Blue Chip Financial Forecasts, the consensus estimate for the average federal funds rate is 3.6 percent for fourth quarter 2005.

² Community banks are defined here as both banks and thrift institutions with less than $1 billion in assets, excluding new institutions (those established within the past three years) and specialty lenders such as credit card banks. Noncore funding generally consists of large time deposits (greater than $100,000), borrowings, brokered deposits, federal funds purchased, repurchase agreements, and foreign deposits.

³ Core deposits are defined as checking, savings, and money market accounts as well as certificates of deposit less than $100,000.

⁴ Michael Mayo, "Are Deposits Hitting an Inflection Point?" Prudential Equity Group, LLC, January 14, 2005.

⁵Merger-adjusted community bank loan growth spiked from 7 percent to 12 percent from third quarter 2003 to third quarter 2004. If sustained, this loan growth may foreshadow stronger asset growth, as institutions may initially fund loan growth through the liquidation of marketable assets.

⁶ Nonmaturity deposits include transaction, savings, and money market demand accounts.

⁷ For the purposes of the Atlanta Region analysis, community banks are defined as insured commercial institutions with assets of less than $1 billion. Also, this analysis excluded special-purpose entities, new banks, and banks that had been involved in any merger activity.

⁸ The larger amount of foreign deposits held by the Mid-Atlantic large banks reflects the presence of multinational operations.

⁹ The cost of funds calculations represent the ratio of annualized year-to-date interest expense to average interest-bearing liabilities through September 30.

¹⁰ Risk premiums differ by issuer based on individual credit risk and liquidity premiums.

¹¹ For more information on net interest margin performance across bank asset sizes, see "Does Net Interest Margin Matter to Banks?" by Jack Phelps, Scott Hughes, Ronald Sims II, and Robert L. Burns in FDIC Outlook, Summer 2004, http://www.fdic.gov/bank/analytical/ regional/ro20042q/na/index.html.

¹² Nonmaturity deposits are deposits with no set maturity date, such as demand accounts, savings accounts, NOW accounts, and money market accounts.

¹³ Long-term assets are defined as assets that mature or reprice after five years; see FDIC Call Report Instructions.

¹⁴ For further discussion on yield curves, see "Rate/Volume Analysis: An Off-Site Approach to Measuring Interest Rate Risk" by Ronald Sims II in this issue.

¹⁵ The increasing competition among banks as well as between banks and nonbank financial companies is discussed in "The Future of Banking in America: Summary and Conclusions" by George Hanc, FDIC Banking Review 16, no. 1 (2004), http://www.fdic.gov/bank/ analytical/banking/2004nov/index.html.

¹⁶ Small community banks in the Kansas City Region are defined as banks and thrifts with fewer than $250 million in total assets. These institutions currently represent 89 percent of the Region's total institutions.

¹⁷ The Midsouth Area includes Arkansas, Louisiana, Mississippi, and Tennessee. The ratio of noncore funding to total assets reached a historic median high of 22.7 percent in third quarter 2004.

¹⁸ Areas highly dependent on manufacturing employment are defined as those with 32 percent or more of total employment attributed to the industry (top quartile). Areas less dependent on manufacturing are those with 13 percent or less of total employment (bottom quartile).

¹⁹ The Southwest includes Colorado, New Mexico, Oklahoma, and Texas.

²⁰ According to the U.S. Census, a metropolitan statistical area must have at least one urbanized area of 50,000 or more inhabitants, a micropolitan statistical area must have at least one urban cluster of at least 10,000 but less than 50,000 in population, and a rural area does not contain an urban cluster of at least 10,000.