10/29/2012 05:00 pm ET Updated Dec 29, 2012

Can the Private Sector's Large Depositors Revive the Economy?

This is a shortened version of an article in the October 29, 2012 issue of The Institutional Risk Analyst where I comment on the risk implications of the secular increase in the bank deposit market that has occurred over the past five years. The original article, "Placement Considerations for Large Deposits in Banks for Major Counterparties Including Brokerage Firms, Investment Funds, Insurance Companies, Corporations and Credit Unions," is on the IRA website this week.

Deposits increased by $61.6 billion (0.6 percent) during the quarter. Deposits in domestic offices rose by $88.1 billion (1.0 percent), while foreign office deposits fell by $26.5 billion (1.8 percent). Much of the growth in domestic deposits ($71.7 billion) consisted of noninterest-bearing transaction accounts with balances greater than $250,000 that are temporarily fully covered by the FDIC. The portion of these deposits that is above the $250,000 basic coverage limit increased by $65.7 billion (5.0 percent). In addition to the increase in large-denomination domestic deposits, insured institutions increased their nondeposit liabilities for the first time in seven quarters. Securities sold under repurchase agreements increased by $28 billion (6.7 percent), and Federal Home Loan Bank advances rose by $19.8 billion (6.5 percent). -- FDIC Quarterly Banking Profile,
Second Quarter 2012

The total sum of large, block deposits being placed by counterparties in U.S. banks have been on the rise for several years. Since 2008, these deposits in U.S. banks have grown by $2 trillion, representing a substantial amount of Main Street capital made idle in the economy. Of this amount, roughly $940 billion went into investments in U.S. treasury and agency securities, fueling the Federal Reserve's quantitative easing process now in its third wave.

This vast amount of capital that migrated into deposits between 2008 and 2012 flowed almost exclusively into a very small number of the largest U.S. banks (those with $65 billion or more in assets). Indeed, total deposits at smaller banks comprising the bulk of the more than 7,800 FDIC-certified banks remained largely unchanged. This occurred even as the too-big-to-fail banks suffered the turmoil and risk that necessitates their filing Large Complex Institution Resolution Plans to comply with the Dodd-Frank Act. Why?

Misapplied Methods

The money went to the largest banks mainly because internal controls at the major depositors were coming out of the early 2000's Sarbanes-Oxley era. Specifically, the risk management rules for brokerage firms, investment funds, insurance companies, corporations and even credit unions were written during a time when conventional wisdom believed in the infallibility of Nationally Recognized Statistical Ratings Organization (NRSRO) ratings agencies. Internal policies, emphasizing these ratings, required the companies to deposit funds in institutions that had an investment grade agency rating or where one could arrange private deposit insurance. Over-reliance on these (now known to be) faulty ratings at the expense of safety-and-soundness due diligence practices proved near fatal. As the insurance industry also relied on NRSRO ratings, major depositors' choices were even further limited.

As the recent near collapse of the banking system, systemic freezing of overnight funding markets/money markets and overall near economic depression of recent times has proven, reliance on these ratings was the wrong choice. NRSRO ratings are designed for debenture analysis. To be "investment grade" requires an assumption that the underlying entity is bankruptcy remote. These modeling assumption tenets caused the major ratings agencies to completely miss the 2008 financial crisis that required massive bailouts to prevent bankruptcies at the very banks to which they were issuing AAA debt ratings. This dichotomy of analysis methodologies between debenture tools and safety-and-soundness tools was eventually realized, albeit too late. By 2012, this misapplication had been recognized and the FDIC deposit insurance assessment process precluded the use of these NRSRO ratings for performing risk categorization analysis under the post Dodd-Frank 12 CFR rules.

What was needed was a safety-and-soundness risk regime capable of maintaining linear analysis and control, thereby triggering risk-management procedures, on banks as they degraded well past junk quality and deep into distressed, but not resolved, operating conditions. Such systems have indeed begun to appear.

At the onset of this crisis, Institutional Risk Analytics' (IRA's) four-year old regime -- which assesses operational stress and counterparty quality down to the institutional failure horizon -- was just beginning to undergo rigorous testing. In 2007, it was reporting this anomalous indication that all the largest banks were in life-threatening trouble in near opposite relief to the conventional ratings. No one wanted to believe it. History, of course, proved otherwise and it has since been proven to be highly capable of tracking bank stress with an almost perfect record of identifying banks that eventually failed since 2008.

Currently, the system is in use by governments and industries to monitor quarterly the safety and soundness of nearly 100 percent of U.S. banks and credit unions. It has helped provide decision support to determine which institutions (including the smallest banks) are eligible to take brokered deposits. It has not yet been applied to the process of actuarial risk for private deposit insurance analysis that could potentially improve opportunities for the almost 7,000 other banks in the U.S. to interact more meaningfully with major depositors.

While IRA is one of the leading edge makers of such tools, we are certainly not alone in recognizing the need for them. The bottom line is that there are better measurement systems to aid in navigating post-2008 era bank risk analysis as the financial system sheds the myopia of the old implied size-equals-safety rules of thumb. For the remainder of the decade, it seems rather clear that a major depositor's interests are now much better served viewing banks based on their safety and soundness and not from the limited perspective of an investor doing debenture analysis.

Strategic Power to Invigorate Economies

Why should major depositors, bankers and insurers pursue this? The natural cycle of finance is that of a phoenix. It must be continually be reborn from its ashes.

In 2010, at a time when anger and confusion best described the U.S. financial economy, IRA teamed with Arianna Huffington to apply our tools to assist in raising the financial acumen of consumer depositors, those millions of people and their $2,000.00 average balance checking accounts. We adapted analytics to educating ordinary people that broader choices are available to consumers to serve their banking needs. The process helped maintain the economic viability of smaller banks at a time when almost all government aid was directed at the largest banks as part of an effort to forestall a catastrophic systemic meltdown. When the "little people" were left to fend for themselves, we helped them learn about "Move Your Money."

There are indications that --- almost two business cycles into the process -- the mathematics may be beginning to leave major depositors and banks to fend as "survival" attention narrows to a new category of too big to fail institutions, the government apparatus itself. Roughly forty-seven percent (47 percent) of the money major depositors placed into the banks since 2008 was in turn placed into the government. It is not an insignificant drain on the vitality of the private sector, a condition that the private sector has so far not discovered it actually has the power to affect. But what if it did?

What if $2 trillion dollars of corporate, brokerage and fund money began to break out of the financial ZIRP cage and migrated back to Main Street using the full 7,800+ population of banks instead of hyper-concentrating in under 100 institutions? Institutions increasingly becoming unable to act independently because of greater and greater regulatory oversight designed to keep the rollover investment in a $940 billion dollar government hedge fund alive. What do you think the U.S. economy would look like at the end of the decade with or without such a private sector energized reinvestment in Main Street?