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Community Banks Tap into "Cedars" to Grow Deposits

CDARS debuted in January 2003 and is the newest funding tool community banks can use to attract local—and otherwise uninsured—funds.1 With CDARS, large deposits can be spread across other institutions in chunks under the $100,000 threshold, thereby securing complete FDIC coverage. The ability to offer 100 percent coverage could benefit community banks by helping them attract and retain funds from customers who demand complete insulation from losses, such as retirees and local governments.

CDARS is the sole service of Promontory Interfinancial Network, a bank consulting firm based in Washington, D.C. The network is led by Eugene Ludwig, former comptroller of the currency, and Alan Blinder, former vice chairman of the Federal Reserve System's Board of Governors. About 350 banks currently belong to the Promontory network, and about half of them actively use CDARS.

At first glance, CDARS might raise some regulatory eyebrows. Funds placed in the Promontory network are immediately classified as brokered deposits on the reports banks must file quarterly with their supervisory agency. Traditionally, the term "brokered deposits" has been applied to blocks of funds pooled by securities broker/dealers and then placed in depository institutions offering the highest yield. During the thrift crisis of the 1980s, many failing institutions used brokered deposits to "gamble on resurrection." As a result, supervisors now closely monitor institutions that rely heavily on this type of funding.

But CDARS are not likely to cause the problems that brokered deposits did during the thrift crisis. As noted, bank supervisors have procedures in place to monitor brokered deposits and prevent their misuse. Even more important, the CDARS deposit swap generally is initiated by a desire to retain local deposits, not to cover potentially unsafe-and-unsound loan growth. Moreover, any bank bent on acquiring funds to cover imprudent growth would find it much easier to tap the wholesale-funding market directly rather than using CDARS.

In theory, CDARS also could exacerbate the moral hazard in deposit insurance because it allows otherwise uninsured depositors to get full insurance coverage. Fully insured depositors are less likely to withdraw funding or demand higher interest rates as bank risk increases; so, CDARS could implicitly encourage risk-taking.

Recent research, however, suggests that jumbo-CD holders are not particularly sensitive to bank risk. Because of deposit-preference laws—which give domestic jumbo-CD holders priority over foreign depositors in failure resolutions—and high bank-capital levels, expected losses on jumbo CDs are small. Therefore, little monitoring or disciplining by uninsured depositors is going on. Put simply, weakening already weak depositor discipline by transforming jumbo CDs into fully insured CDs should not encourage risk taking—at least in the current institutional and economic environment.

However, CDARS could cause short-run problems in off-site surveillance. As previously noted, heavy dependence on brokered deposits traditionally has been a supervisory red flag, and funds placed in the Promontory network are reclassified automatically as brokered deposits on bank financial statements. Therefore, CDARS users could end up looking suspicious—on paper, at least—to examiners who monitor bank condition between exams. These examiners will have to stay in close contact with their bank to make sure that "blips" in brokered-deposit-dependence ratios are not misinterpreted.

Of course, the full supervisory implications of CDARS will not be clear until we have evidence about how banks have reshaped their balance sheets in response to the product. Also, community-bank depositors may not respond as enthusiastically as expected to the deposit protection afforded by CDARS—so this may be much ado about nothing. Regardless, community bankers face a continuing challenge to secure the funding they need to compete effectively, and CDARS could become an important new tool for meeting this challenge.2

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