As bank failures rattle investors and test regulators, it’s time to rethink America’s financial system. One old solution, despised by regulators, might be just what the doctor ordered.
Nestled on the second floor of a suburban office building in Fairfield, New Jersey, not far from Interstate 80 and just down the hall from an opthalmology center, are the offices of Financial Northeastern. Its chief executive, Jeff Zage, 60, could be one of the saviors of the troubled $23 trillion U.S. banking industry. Zage is a money broker, and for the past 38 years, his firm has specialized in underwriting certificates of deposits for needy banks. These deposits are generally bank-run-proof—they are not redeemable prior to maturity unless the deposit holder dies or becomes mentally incapacitated. Over the last 12 years, Zage’s small firm has quietly raised some $150 billion for banks small and large, connecting them with business owners, municipal treasurers and wealthy individuals eager to park sums of $250,000 or less in FDIC-insured accounts around the nation. Thanks to the Federal Reserve, interest rates on CDs maturing from three months to ten years are now above 5%. That means business is good for Financial Northeastern, which makes a small fee on each CD it brokers. But Zage repeatedly demurs when Forbes asks him for a photograph or even just a face-to-face meeting.
“I am a very unassuming individual,” he says. “I try to do my best to stay under the radar.”
Thirty-five years ago, it was a different story. Zage—then just 24 years old—his older brother Steven and their team of young cold-calling brokers were making millions providing funding to the nation’s ailing $1.2 trillion savings-and-loan industry in the form of high-rate CDs. A 1987 Forbes article headlined “WE’RE THE LIFEBLOOD” pictured Zage popping out of the sunroof of his new car, his brother reclining on the hood. The story chronicled how regulators at regional Federal Home Loan Banks were calling brokers such as Financial Northeastern and Merrill Lynch to funnel billions to prop up zombie thrifts, mostly in Texas. Those S&Ls had gotten into deep trouble after newly deregulated deposit rates soared by investing in commercial real estate, junk bonds and other risky assets.
When the dust settled, 747 savings-and-loans were shuttered and FSLIC, the insolvent government insurance fund backstopping the industry, was absorbed into the FDIC. The debacle cost U.S. taxpayers $124 billion, about $300 billion in current terms, or the equivalent of 2% of America’s 1989 GDP. Money brokers were blamed for worsening the S&L crisis. Pundits called them a “cancer” afflicting the system because they peddled “hot money” that surged in and out of banks chasing the highest yield. In 1991, new regulations enacted by the FDIC made Zage’s bread-and-butter product, so-called brokered deposits, practically toxic to banks. Regulators warned against using them and increased FDIC insurance premiums for those who did. Today few of the nation’s 4,700 banks hold significant amounts of them.
But perhaps they should.
Savings Savior: CD brokers like Jeff Zage (above right, in 1987) got cash to troubled thrifts during the S&L crisis. He’s still at it: “It’s a powerful tool for the banks.”
Forbes
Silicon Valley Bank didn’t have a single brokered deposit on its books on March 9, the day depositors withdrew $42 billion in just 10 hours. Hot money? Sure—but it’s all hot these days. SVB’s $1 million-per-second deposit run was sparked by a handful of tweets. Dozens of fintechs, including Chime, Mercury and Robinhood, are more than happy to assist you with fast, frictionless money transfers. When Apple, backed by Goldman Sachs, announced in mid-April that it was offering an FDIC-insured savings account yielding 4.15%, it sucked in nearly $1 billion in four days. Non-banks, in the form of money market mutual funds like those offered by Vanguard and Fidelity, love hot money too. According to the Federal Reserve, over the last 13 months, $1 trillion in deposits has fled commercial banks for higher-yielding uninsured accounts.
Despite their pejorative “hot money” nickname, Zage’s FDIC-insured brokered CDs are far stickier than any of these bank savings accounts. Plus, there is strong evidence from a niche group of so-called industrial banks, which are in stellar financial condition while relying heavily on this funding, suggesting that this sort of heat is a stabilizing force. But brokered CDs alone won’t cure what’s ailing our nation’s banking system. The fact that after 40 years they continue to be stigmatized by regulators—and consequently shunned by banks—points to a larger problem. Bank regulation, with its multiple state regulators and three primary federal watchdogs—the Federal Reserve, the FDIC and the Office of Comptroller of the Currency—is stunningly inefficient, laden with political baggage and miles behind a quickly changing marketplace.
Part of the problem comes from clinging to old-fashioned banking ideals like “core” deposits, thought to be foundational to community banking and the soundness of our system. SVB and First Republic were far from the only banks caught flat-footed when the Fed hiked rates 10 times in the last year. According to FDIC call report data compiled by Roanoke, Virginia–based bank analytics firm KlariVis, 31 FDIC-insured banks with total assets of $30 billion are sitting on losses in their securities portfolios in excess of their tier 1 capital (see “Underwater on Main Street,” below). And that’s just the ugliest tip of the iceberg. Nearly 400 banks with combined assets of more than $3.7 trillion have losses amounting to more than half of their tier 1 capital. Virtually all these institutions are local community banks, most with assets of less than $300 million. Fortunately, few of these sick minnows are likely to have lots of uninsured deposits exceeding $250,000—or the external pressure of being publicly traded like Silicon Valley Bank and First Republic.
“In light of recent bank failures, the question is really not whether we need to rethink what a brokered deposit is or what hot money is, but what is a core deposit anymore?” says Jelena McWilliams, former chair of the FDIC and now a managing partner at Washington, D.C., law firm Cravath Swaine & Moore. “Long-term, the community banking model will have to change. These small banks basically cannot survive unless they engage in fintech partnerships because it’s an easier and less costly business model to attract customers. But for whatever reason, the regulators in Washington are very averse to fintech.”
Underwater On Main Street
These 31 community banks recently reported they were holding bonds and other securities with losses exceeding their capital. Luckily, the Federal Reserve announced it would advance loans to any bank for the full par value of these securities. These are the worst, but hundreds more are sitting on large losses.
Support for community or “Main Street” banking dates to the founding of the republic, when populist Thomas Jefferson squared off against federalist Treasury Secretary Alexander Hamilton, an elitist who wanted to create a national bank. Jefferson believed it was unconstitutional and a threat to the young democracy, in part because it would concentrate funding in the big cities and away from small, developing agrarian communities. Hamilton prevailed in 1791 with the establishment of the first central bank, but in 1811, Congress failed to renew its charter. It wasn’t until 1863, when the Union needed to finance the Civil War, that the national banking system was created.
This historic bias enabled small-town banks to proliferate, and by 1929 there were nearly 26,000 banks in the U.S., one for every 5,000 Americans. The stock market crash and Great Depression sparked a blizzard of bank runs on these often-undercapitalized institutions: In the four years before the FDIC was established in 1933, nearly 6,000 U.S. banks and savings institutions failed, costing depositors $1.3 billion, about $31 billion in today’s dollars.
Ever since, the number of community or “Main Street” banks has been shrinking. There are currently 4,676 FDIC-insured banks, but on average 200 of them are merged out of existence each year. Dwindling numbers have done little, though, to weaken the strength and resolve of small banks’ primary lobbying group, the Independent Community Bankers of America (ICBA), which spent nearly $4.8 million lobbying in 2022, according to Open Secrets, including about $1.3 million in donations spread around Congress, the largest chunk to the House Financial Services Committee. The ICBA’s stated goal is to “keep money local and invest in communities.”
“They’re politically powerful because they’re on every single corner,” says bank consultant Mayra Rodríguez Valladares. “There’s actually rare bipartisan support for community banking.”
Adds former FDIC chairwoman McWilliams, “There is a strong sense in Washington that these small banks matter. Large banks don’t understand local conditions where a loan may have originated in the past based on ‘I’ve known your grandfather. He was a man of his word, and I trust that you’re going be the man of your word.’ [The ideal] is Norman Rockwell–esque.”
The ICBA asserts that big Wall Street banks are transactional, making decisions based on “predetermined credit boxes,” while community banking boils down to relationships. Of course, this is largely nonsense. Small banks use—or should use—precisely the same metrics in evaluating creditworthiness that larger ones do. There is no evidence of any bank of any size in the year 2023 making a loan because it “knew your grandfather.” On the flip side, in many ways, Silicon Valley Bank, with its $212 billion in assets, was practicing community banking.
“SVB was built exactly the way the regulators say a bank should be built: customer by customer, relationship by relationship. No hot money,” says bank regulatory expert Paul Clark of Seward & Kissell. “Everything was ‘You want a line of credit from me, you keep your deposits here.’ Those are so-called core deposits.”
Moreover, because regulators were never especially precise in their definition of core deposits, except for the fact that brokered deposits should mostly be avoided, clever entrepreneurs and financial institutions over the years have figured out ways around the prohibitions and FDIC insurance limits.
In 2003 an Arlington, Virginia, company called IntraFi launched a deposit swapping service called CDAR (Certificate of Deposit Account Registry), which allowed banks to offer wealthy customers and businesses the ability to deposit up to $50 million. The big deposits are chopped up into $250,000 increments and placed at various FDIC-insured banks in IntraFi’s network. Banks that accept the deposits are then able to place their own over-the-limit deposits through the network.
“For me it’s being able to retain multigenerational customers that have accounts that will exceed the $250,000 limit,” says Jill Castilla, president of Citizens Bank of Edmond, Oklahoma, which has deposits of about $330 million, 18% of which are “reciprocal” thanks to IntraFi. “So now they don’t have to manually place those funds in different institutions to ensure they have coverage.”
Citizens’ $58 million in reciprocal deposits is not considered brokered by the FDIC but instead fall under the “core” deposit designation. Likewise, if you’re a bank that advertises your CD rates online using services like Bankrate, NerdWallet or Forbes Advisor, the high-rate deposits you bring in from across the nation typically qualify as “core.”
In Toyota We Trust: Says Toyota Financial Savings CEO Mara McNeill, “We want to be the bank that acts like a hospitality company. There is a word in Japanese: omotenashi.”
Ethan Pines for Forbes
Then there are the multiple, and often confusing, brokered deposit “exemptions” granted by the FDIC to various banks, including those working exclusively with fintechs. FDIC-insured $1.8 billion (assets) Evolve Bank & Trust of Memphis, Tennessee, provides banking services for large fintechs like Dave, Affirm and Mercury, but shows only 0.3% of its deposits are brokered.
Sourcing deposits outside your home market is apparently okay with regulators so long as you avoid broker-dealers like Zage, or UBS, Bank of America or Wells Fargo. Iowa’s Luana Savings Bank, a 115-year-old family-owned bank located in a town of 300 people amid thousands of acres of cornfields, found this out the hard way.
From 2016 to 2020, Luana’s assets more than doubled to $1.7 billion as its ambitious president, David Schultz, became one of Iowa’s biggest agricultural lenders. Luana and its six small branches were unable to attract enough local deposits to fuel its growing business, so Schultz connected with brokers that allowed him to fund his loans with out-of-market CDs with similar maturities. As assets climbed toward $2 billion, brokered deposits accounted for 60% of the total.
Luana’s operating stats have been exemplary, its return on equity averages 19% and it was a perennial winner of Des Moines–area “best bank” awards. Still, alarm bells sounded at the FDIC regional office, and in 2021, it and the Iowa Superintendent of Banks issued a cease-and-desist order claiming Luana was taking “excessive” risks and operating in an “unsafe and unsound” way. It also fined the bank $14.5 million and cut off its access to Federal Home Loan Bank loans. Schultz, who declined to speak to Forbes, told the Des Moines Register at the time that the charges were manufactured, and sued the FHLB.
Ultimately Schultz decided fighting regulators wasn’t worth it, so without admitting or denying the charges, Luana signed a consent order in 2022 and agreed to add independent directors to its board and reduce its reliance on non-core deposits.
Among banks, the biggest users of brokered deposits are a small group of FDIC-insured institutions known as industrial banks. There are 24 of them, representing only $250 billion in total assets, but they are extremely well capitalized and profitable (see “Industrial Strength,” below). They are also despised by the ICBA and the Federal Reserve, and barely tolerated by their regulator, the FDIC.
Sometimes referred to as industrial loan companies (ILCs), these banks are FDIC-insured and -regulated, but their parent companies are typically commercial or financial institutions. The first ILC was formed in 1910 to make loans to industrial workers who couldn’t obtain credit elsewhere. Over the years companies like General Electric, Target and Goldman Sachs have owned ILCs. Today their owners include Harley-Davidson, Pitney Bowes, UnitedHealth Group, BMW, Square and USAA. Only a few states, including Utah, Nevada and California, can authorize their charters, and though they’re subject to the same rigorous FDIC application process and examinations as other banks, they’re exempt from Federal Reserve oversight because their parent companies, which are required to support their ILC with capital, aren’t bank holding companies.
Industrial banks can offer savings accounts, credit cards, loans and mortgages, but are prohibited from offering checking accounts or financing their parent company’s products. Pitney Bowes Bank, for example, doesn’t make loans to purchase its postage meter machines, but it can finance and manage shipping payments for its thousands of small-business customers. Industrial banks tend to be specialized and branchless, which is why many rely heavily on brokered certificates of deposit for funding, which they use to match asset maturities.
Industrial Strength
Below are FDIC-insured industrial banks that are also the biggest users of non-core brokered deposits. Virtually all have impressive capital and return-on-assets stats.
One of the most profitable and well-capitalized banks in the nation, Nevada-chartered Beal Bank USA, is an industrial bank owned by Texas billionaire Andy Beal. It has $32 billion in assets and, as of March 31, 93% of its deposits were brokered. It’s currently offering one-year CDs yielding 4.65%.
Toyota Financial Savings Bank is another well-capitalized Nevada ILC, set up to provide savings accounts, mortgages and commercial loans to the company’s 35,000 U.S.-based Toyota and Lexus employees. Under its new chief executive, Mara McNeill, a former JPMorgan Chase auto finance executive—she graduated from the Air Force Academy in 1993 but also has a JD from Georgetown and a master’s in public policy from Harvard—its assets have grown from $1 billion in 2020 to nearly $6 billion, funded to a great extent by broker deposits, which currently stand at 58% of the total.
“It can be economically advantageous to have core deposits. You don’t have as much in fees from the FDIC,” McNeill says. “But at the same time, you’ve gotta pay for the salespeople to go out there and get those accounts. And so, you know, there’s a fee here and a cost there.”
Other successful but little-known industrial banks, all based in Utah, include Comenity, an $12 billion credit card lender; Nelnet, a $1 billion specialist in student loans; and Wex, a $6.5 billion bank offering gasoline charge cards to small and midsize fleets with discounts from refiners like Chevron and Exxon. Until a few years ago, $2 billion Medallion Bank specialized in financing taxicab medallions. But Uber and Lyft forced a hard pivot to lending for recreational vehicles and boats, and financing home contractors. Virtually all its funding comes from brokered deposits. “Our Deposits Don’t Run,” reads a headline on its website.
Industrial banks currently represent about 1% of all bank assets, but the ICBA apparently views them as a dire threat to community banking. In July 2005, when Walmart applied for an industrial bank charter, the ICBA helped orchestrate a tidal wave of thousands of alarming letters to the FDIC and Congress. Their message: Just as Walmart killed mom-and-pop retailing, an industrial bank charter would help it eliminate Main Street banks. In fact, efficiency-minded Walmart merely wanted to streamline credit card processing, saving money on bank fees, and would have been precluded from offering banking services directly to its customers.
The FDIC, under chairman Martin Gruenberg, ignored Walmart’s application. Then, a full year after the retailing giant submitted its forms, the FDIC announced a six-month moratorium on approving all ILC applications, ostensibly to “determine if any emerging safety and soundness or policy issues exist.” Walmart withdrew its application in March 2007, and that six-month moratorium wound up lasting 14 years, until Jelena McWilliams took over as FDIC chairperson and approved Nelnet and Square’s application.
“Martin Gruenberg does not like nontraditional banks. And so they just slow-walked the applications when they hit Washington,” says George Sutton, general counsel for the National Association of Industrial Bankers and Utah’s former commissioner of financial institutions. “Eventually it just goes into a black hole.” (The FDIC declined Forbes’ interview requests.)
Banking crises are always about trust and stability, something traditional banks no longer have a monopoly on. Most people now trust Apple and Toyota more than their community bank. The next generation of banking customers care little about charters or regulatory turf wars and are savvy enough to know that hot money offering higher returns, whether from their local bank, fintech or broker, is smart money.
