Author: Avik Ray, Director Liquidity Risk Analytics 

The Risks of Relying on Expensive Funding Sources for Community Banks

Community banks play a vital role in fostering local economic growth and providing essential financial services to their communities. However, as these institutions navigate the complex financial landscape, it's crucial for them to be mindful of the risks associated with relying on expensive sources of funding, such as the Federal Home Loan Bank (FHLB) or brokered deposits. In this post, we will explore the potential pitfalls of such reliance, with a specific focus on the impact on liquidity.

Understanding the Landscape

Community banks often turn to external sources for funding to support their lending activities securities portfolios. While the FHLB and brokered deposits can be attractive options, they come with their own set of challenges that can affect a bank's overall financial health.

1. Costs and Dependence

While FHLB and brokered deposits can provide a quick influx of funds, they often come at a higher cost compared to traditional deposit channels. Relying too heavily on these expensive funding sources can lead to increased interest expense and therefore reduced net interest margins, impacting the bank's overall profitability.

2. Interest Rate Risks

External funding sources may expose community banks to interest rate risks. Changes in interest rates can impact the cost of funds, potentially further squeezing the bank's net interest margin making already expensive sources of funds more expensive.

   3. Volatility

Brokered deposits by their very nature are highly volatile, subject to rate competition and credit innuendos concerning the bank.  FHLB may become volatile and subject to political decisions.

  4. Regulatory Scrutiny

Regulatory bodies closely monitor a bank's funding composition. Excessive reliance on expensive and volatile sources might raise concerns among regulators, triggering additional scrutiny and potentially affecting the bank's ability to carry out its operations smoothly.

The Impact on Liquidity

Liquidity is the lifeblood of any financial institution, and community banks are no exception. Relying on costly funding sources can have a direct impact on a bank's liquidity position, potentially exposing it to heightened risks. Cost and availability of these external, non-organic sources of liquidity can make major impacts to liquidity.

1. Expense. Obviously, the cost is detrimental to the bank. These sources will almost always be more expensive than organic deposit sources.
2. Risk. Community banks are susceptible to many market and institutional issues, all of which can put pressure on these sources and thus liquidity.

Mitigating the Risks

Community banks can take proactive steps to mitigate the risks associated with relying on expensive funding sources:

1. Diversification

Diversify funding sources to include a mix of traditional deposits, core deposits, and other stable funding options. This helps spread the risk and reduces dependence on costly external sources.

2. Risk Management Policies

Develop and implement robust risk management policies that address interest rate risks, liquidity risks, and regulatory compliance. Regularly review and update these policies to adapt to changing market conditions.

3. Build Strong Relationships

Cultivate strong relationships with local communities and depositors. Building a loyal customer base can enhance the stability of core deposits and reduce the reliance on external, more expensive funding options.

Conclusion

While external funding sources like the FHLB and brokered deposits can offer community banks a quick infusion of capital, a heavy reliance on these options comes with inherent risks. Balancing the need for funding with prudent risk management practices is essential for ensuring the long-term sustainability and resilience of community banks. By diversifying funding sources, implementing robust risk management policies, and fostering strong community relationships, these institutions can navigate the financial landscape more effectively, safeguarding their liquidity and overall financial health.

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