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The Decline in Core Deposits:
What Can Banks Do?

Introduction
Growth in traditional deposit funding sources has stagnated at many banks in recent years and has largely failed to keep up with the growth in bank assets. In response to these trends, banks have had to supplement traditional funding sources with a variety of new, but potentially less stable and more expensive, funding instruments. In addition, banks have had to take other significant steps, including cutting back on their holdings of cash and securities and selling or securitizing parts of their loan portfolio. All of these steps are increasing the challenges that banks face in maintaining sound and profitable operations. From the public's standpoint, an even more pressing concern may be whether funding problems will keep banks from meeting the credit needs of their customers and communities. This article, consequently, will examine recent bank funding trends and their effect on community banks in the Kansas City Federal Reserve District.

A number of community bankers, in particular, have described recent funding shortfalls as a "crisis" in the making.1 These concerns may have eased somewhat over the past few months in response to weaker loan demand, falling interest rates, and increased liquidity in the financial system. However, many community bankers believe that funding will be a persistent, long-term problem. In fact, a major fear of these bankers is that funding difficulties will eventually force them to curtail lending to small businesses, farmers, and other local customers— many of whom may have few other places to turn to for their borrowing needs.

A notable portion of the bankers responding to our 2001 Tenth District Bankers' Survey further voiced such concerns.2 Among their specific comments were: "The deposit base is shifting away from community banks," "The biggest problem for our bank is how we will fund ourselves in the future," and "Core deposit growth is not possible in small communities." Furthermore, in a survey question about the challenges bankers might face over the next five years, over 50 percent of the bankers thought that "maintaining and attracting retail deposits" would be a "significant problem," and another 35 percent felt that it would be a "moderate problem."

Not all signs, though, indicate that funding is such an intractable problem, and many banks may be able to find ways to acquire the funds they need. In fact, with the record profitability in banking over the last five years, banks may have sufficient room to make adjustments and implement new funding strategies. Recent deposit trends, moreover, may be a sign of the changing financial environment, which is not only increasing competition among banks, other financial institutions, and the capital markets, but is also creating new funding instruments and bank delivery channels.

In examining funding problems at Tenth District banks, this article will first look at bank deposit trends and how they have affected community banks. Next, the article will examine several possible explanations for these trends and their implications for future funding patterns. The final section will explore the options banks have for dealing with funding shortfalls and how these choices might affect banks' operations and ability to serve customers.

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