Municipal bank feasibility study says “theoretically yes, but realistically no”

At the beginning of 2018 the City of Seattle commissioned a study to look at the feasibility of creating a municipal bank. Those study results were released yesterday.  It says that in theory the city could create its own bank, but there are significant legal, logistical, regulatory and financial challenges to doing so.

A bit of history: early last year, the City Council passed a resolution stating that it was cutting ties with Wells Fargo Bank, its banking services provider, over its well-publicized corrupt practices and its ties to environmentally unsound projects such as the Dakota Access Pipeline. The city then issued an RFP to replace Wells Fargo with another bank, but it received no responses to the RFP despite breaking it up into several modules to try to attract more bidders. So the city then crawled back to Wells Fargo and asked to stay on as a customer of the bank. That is also when it commissioned the study of forming its own municipal bank.

HR&A Advisors, the company that did the municipal bank study, spoke to local bankers to understand why the city’s RFP generated no responses:

Conversations with local bankers suggest that the lack of responses
resulted from the demands of the City’s banking activity, the challenge of responding to each module separately, and stringent requirements such as an “Outstanding” Community Reinvestment Act (CRA) rating.

HR&A notes that only two banks in Washington state currently have “outstanding” CRA ratings: Community First Bank in Kennewick and Farmington State Bank in Farmington, both based in rural eastern Washington.

The city has two goals for forming its own municipal bank:

1. Independence from the questionable business practices of Wells Fargo and other large financial corporations in how it manages its own money;
2. The ability to provide retail banking services, including deposits and loans, to the public in order to help the city meet its racial and social justice goals.

HR&A broke these goals apart, establishing a “baseline” model that accomplishes the first goal, and a second model that adds in retail activities.

Banks — even publicly-owned ones –are highly regulated, as they should be to protect taxpayers’ and depositors’ money. Public banks are not exempted from banking regulations, and indeed have some additional hurdles they need to jump. Nothing in state law either explicitly allows for or exempts cities from creating a bank to provide itself banking service, so under “home rule”  the city has the authority to do so. However, the City Charter would need to be amended to add a public bank as an authorized function of city government; that requires City Council approval and a vote of the people.

There are several other state requirements that must be followed. State law specifies that all public funds must be deposited in a certified public depositary, so a municipal bank would need to be certified by the state Public Deposit Protection Commission (PDPC). Doing so would require it to pledge collateral equivalent to the uninsured public assets that it intended to hold, or to obtain insurance for its assets in holding (a topic we’ll come back to later). That means the city would have to pledge as collateral the maximum amount of money it would have on deposit at any given time (which ranges from $28 million to over $300 million). The collateral — which needs to be liquid assets that can be converted to cash quickly — would either need to be separate assets in another financial institution, or the deposits themselves. If the collateral is the deposits, then none of it could be loaned out or invested in anything other than liquid assets.

Then the city would need to obtain a banking charter from the state DFI, in the process establishing the bank’s board, management and governance structure, capital structure,  premises and fixed assets, information systems, business plan, an ability to achieve financial feasibility, a commitment to maintain capital levels above the regulatory minimums, and an ability to meet community needs. An important part of obtaining DFI’s approval will be demonstrating how the bank’s governance will be shielded from political influence by city government; most of the bank’s directors will need to be independent from city government, and personnel decisions will need to be apolitical. Further, the bank will need to have a clear legal division from the city to protect depositors (even if the city is the only one), so it will need to be a separate entity such as a public authority. And despite the independence, the city will need to make a binding commitment to support the bank’s financial health, particularly in the first ten years when it is likely to lose money for several of them.

Once the DFI charter is obtained, the bank can then seek access to the Federal Reserve payment system, through which all U.S. banks clear transactions. The HR&A study notes that in the past the Federal Reserve has only granted access to public banks after “lengthy scrutiny.”

All of that is indeed possible, but it creates an enormous amount of bureaucracy and overhead, and will be expensive. We’d better make sure it’s worth it before we go down this path, and that leads us to take a closer look at the nature of the banking services that the city needs and how that fits into the financial soundness of a municipal bank.

Proponents of a municipal bank throw around $3 billion as the size of Seattle’s business, which conjures up images of that much money sitting in a bank account, drawing a low interest rate and allowing the bank to make loans and other investments. But the reality is much different. $3 billion is approximately the total amount of deposit transactions that the city makes in one year. At the end of any given day, the city’s bank account may hold a balance of somewhere between $28 million and $325 million, with an average of $173 million. But — and this is very important — every day all but $3 million is “swept” into the city’s “investment account” (basically a money market account that gets a slightly better interest rate than a generic savings account). So there are billions of dollars moving through the bank account over the course of a year, but very little stays there for more than a day. Banks make money two ways: from transaction fees, and from the “spread” between what it pays depositors in interest and what it earns from lending and investing depositors’ money.  According to the HR&A study, the average spread for a bank is 1.31%. In case you’re curious, 1.31% of $3 million is $39,300. Wells Fargo’s banking services contract with the City of Seattle isn’t about access to deposits; it’s about transaction fees, for which the city pays the bank $150,000 to $200,000 annually. Wells Fargo handles a wide variety of transactions for the city, including electronic funds transfers; cash, check and ATM deposits; cash vault deposits; account information and reporting; merchant banking services; commercial card services; and cash management. At Wells Fargo’s scale, it’s easy to make the fixed overhead investment in building the capability to do all of that because it will be heavily utilized across its entire customer base, and even if it isn’t making money from the city’s deposits, it can make a profit from its transactions. But a municipal bank with only one customer (the city) would have great difficulty covering the overhead costs for all of those transaction services, and without the ability to profit from a large pool of deposits, it won’t be able to keep the business in the black. It would certainly cost much more than $200,000 annually for a municipal bank to serve the city’s transactions if that was its only customer.

You may be thinking: wait, the city can just move its investment account over to the municipal bank too! Or even just a part of it. True, but investment accounts are expected to deliver a higher interest rate on deposits, which would cut into the bank’s return on investment — and its flexibility to invest in higher-risk, lower-return projects for social good. And it would also need to be collateralized. It’s not at all clear that hosting the investment account would improve the financial picture for a municipal bank. Alternatively, the city could accept a lower interest rate on its investment account. But in 2017 it earned $32.9 million for the city in interest from that account; I doubt the City Council will want to give up a sizable chunk of that. Or the city could decide to overpay for financial transaction services.

To recap thus far:

• change the city charter;
• pledge collateral to get the PDPC approval;
• establish an enormous bureaucracy separate from city government in order to get a banking charter from the state DFI;
• get access to the Federal Reserve banking transaction clearance system;
• set up the systems and overhead to process $3 billion in annual transactions;
• lose money.

The financial picture changes significantly if the municipal bank branches out to handling retail deposits and loans. Businesses often tend to run heavy on transactions and low on accumulated balances, but individual consumers are just the opposite. That makes for a nice complement to the city’s account.

BUT — retail banking is a completely different world, with its own requirements, restrictions, and legal barriers.

First, the Washington State Constitution, Article VII Section 7, says:

“No county, city, town or other municipal corporation shall hereafter give any money, or property, or loan its money, or credit to or in aid of any individual, association, company or corporation, except for the necessary support of the poor and infirm, or become directly or indirectly the owner of any stock in or bonds of any association, company or corporation.”

That means barring a change to the state Constitution (requiring legislative action and a vote of the people), a municipal bank can probably only loan money to low-income individuals. And that’s a great public service, but without a larger, more diverse population to balance out the risk and return, it’s not financially viable. This is directly akin to the ACA’s health insurance pools: if you take all the healthy people out of the pool, the system falls apart.

Second, in order to get a state banking charter,  again it would need to provide liquid collateral equivalent to somewhere between 50% and 100% of the total deposits it accepts. The better the bank is “capitalized” (meaning it has its own money too, either from initial investment or from business profits) the lower the collateral requirement. So in order for a municipal bank to lend money to anyone, the city would need to make a substantial initial investment of equity into the bank to cover both startup costs and to “capitalize” it.

Third: in order to obtain a banking charter from the state DFI that allows it to accept retail deposits, a municipal bank will probably need to get FDIC insurance. The FDIC has never granted insurance coverage to a public bank. Here is its guidance on the topic:

“An application for deposit insurance from a depository institution which would be owned or controlled by a domestic governmental entity (such as, for example, a state, county or a municipality) will be reviewed very closely. The FDIC is of the opinion that due to their public ownership, such depository institutions present unique supervisory concerns that do not exist with privately owned depository institutions. For example, because of the ultimate control by the political process, such institutions could raise special concerns relating to management stability, their business purpose, and their ability and willingness to raise capital. On the other hand, such institutions may be particularly likely to meet the convenience and need of their local community, particularly if the local community is currently un- or under- served by depository institutions.”

The HR&A study points out that the FDIC considers “management quality” to be the single most important factor in determining whether to insure a bank’s deposits. The city would need to prove that the bank has full political independence (meaning that the City Council and Mayor can’t influence loan decisions), while at the same time proving that the city is committed to financial support of the bank for as long as it takes to reach self-sufficiency. The study also suggests that the city might have a difficult time making the case that Seattle is underserved by its existing banks.

The city might try to do an end-run around the FDIC insurance requirement by self-insuring deposits with the “full faith and credit of the city.” Other public banks have taken this approach, but those banks don’t accept retail deposits. Also, doing so financially burdens the city’s assets and may lower the city’s top-notch bond rating. If that happened, then the city would get less favorable interest rates when it issues bonds, costing it money in the long run. The bank could also try to get private insurance for deposits, but no banks in the U.S. currently do that so it would be setting a precedent.

Finally: there are hopes that a municipal bank would be able to provide banking services to the cannabis industry, as existing banks refuse to do so. However, a municipal bank would face the same problem: since selling marijuana is against federal law, the Federal Reserve will not grant access to its banking transaction clearance system to any institution that provides service to the cannabis industry.

To recap the second part:

• can’t loan money to anyone other than “the poor and infirm” without a change to the state Constitution;
• huge collateral requirements;
• significant equity investment requirements;
• can’t get a state banking charter without FDIC insurance, and the FDIC is unlikely to grant it;
• can’t serve the cannabis industry.

So while technically there are no insurmountable steps to starting a municipal bank to handle only the city’s own deposits, it will be costly, it will take years, and it won’t provide money to invest back in the community without large-scale changes to the way the city manages its investments and the return it expects to get from them. And there are barriers to a municipal bank providing retail banking services that are probably insurmountable; even if they aren’t, it would take even more years to run the gauntlet and the resulting business would be so constrained as to be financially infeasible.

Further, it places the Mayor, the City Council, and the city at risk of being sued for breach of their fiscal responsibilities by taking a large financial risk and accepting lower investment returns on city resources.

Council members Sawant and O’Brien put their best positive spin on the release of the study:

“Last year, my Council colleagues and I voted to fund this study to see how we can move forward and align the City’s banking with our values and goals. What we’ve learned from this study is while the path to a public bank may not be easy due to regulatory hurdles, it’s possible. I am excited for the possibility of the city banking with an institution that is consistent with our city’s values. One step identified is relaunching the financial services RFP that can allow for more appropriate banking services,” said Councilmember O’Brien.

“From their financial backing of environmentally devastating projects like the Dakota Access Pipeline to their brazen discriminatory and gouging practices against communities of color and low-income people, for-profit mega-banks like Wells Fargo are clearly not the bank for the City of Seattle. My office and community activists are committed to taking the next steps outlined in this thorough feasibility study to create a public bank for our city,” said Councilmember Sawant.

The study does suggest some alternative paths. One that O’Brien mentions above is re-issuing the RFP for banking services, using learnings from HR&A’s discussions with local bankers to make it more attractive. However, the RFP would need to lower the bar for CRA rating, a bitter pill for the City Council to swallow.

Another option is to wait to see what the State of Washington does. It is developing a business plan (page 53) for its own public bank, that would be open to participation from local jurisdictions. One assumes that a state public bank would have an easier time pushing through the necessary changes to laws and regulations to make it feasible.

Meanwhile, Council member Sawant has introduced an item into the budget development process for 2019 to request the development of a business plan for a municipal bank by June 1, 2019.