Brokered deposit

From CEOpedia | Management online

Brokered deposit is a part of a larger deposit certificate or deposit that was sold to a deposit broker and then divided into smaller parts for individual investors[1]. The term "brokered deposits" are of key importance for banks subject to restrictions on accepting brokerage deposits.

Characteristics

Broker deposits are characteristic of deposit brokers (it is an individual or a company that facilitates the placement of deposits in deposit institutions that are insured), who transfer these deposits to the hands of investors. Deposits or certificates of deposit of high value are sold by banks to brokers, and they divide large amounts into parts that are much smaller and easier to manage. The intermediaries then sell the smaller parts of these deposits or certificates of deposit to customers or smaller banks.

These deposits offer higher than typical interest rates, which makes them very attractive to both individuals and banks[2].

The amount of brokered deposits can affect the following components of its deposit insurance assessment rate[3]:

  • for a large or highly complex institution, its core deposits ratio
  • or a small institution (in the US generally under $10 billion in assets), its brokered deposit ratio.

Individual and corporate clients should carefully and thoroughly examine the bank of origin of brokered deposits, it is particularly important to check whether these brokered deposits are insured by the National Credit Union Administration. This should be checked well because the broker cannot offer deposit insurance, which means that even if the investment is insured in amount determined by the given country (e.g. US - US$250,000), its owner will lose all future and unpaid interest[4].

Core vs. Brokered Deposits

Core deposits, as not only an analytical but also a supervisory tool, should include those deposits that are stable and have the lowest possible cost, and those that price more slowly than other deposits when interest rates rise sharply. These deposits are the funds of usually local clients who also have loans or other relationships with a particular bank. Core deposits are not specified in the statue or in specific regulations, and yet they form the basis of all banks, they are stable, cheap deposits that grow slowly and are usually not sensitive to interest rates. An example would be a traditional savings account[5].

Unlike core deposits, brokered deposits are defined by statue. On the other hand, brokered deposits are larger, often variable and very sensitive to interest rates, which makes them much more risky than core deposits.

Examples of Brokered deposit

  • Certificate of Deposit (CD): A CD is a deposit certificate issued by a bank that pays a fixed interest rate over a set period of time. An investor can purchase a CD from a bank or a deposit broker. The broker acts as an intermediary between the investor and the bank, and the broker may offer a higher interest rate than the bank.
  • Money Market Deposit Account (MMDA): A MMDA is a deposit account that pays a higher interest rate than a traditional savings account. A MMDA can be purchased through a deposit broker, who will purchase the account from a bank and then divide it into smaller accounts for individual investors.
  • Preferred Deposit Account (PDA): A PDA is a deposit account that pays a higher interest rate than a traditional savings or money market account. A PDA can be purchased through a deposit broker, who will purchase the account from a bank and then divide it into smaller accounts for individual investors.
  • Zero-Coupon Bonds: A zero-coupon bond is a bond that does not pay interest until maturity. Zero-coupon bonds can be purchased through a deposit broker, who will purchase the bond from a bank and then divide it into smaller bonds for individual investors.

Advantages of Brokered deposit

Brokered deposits offer a number of advantages to investors, including:

  • Higher yields than traditional deposits: Brokered deposits generally offer higher interest rates than traditional deposits, allowing investors to earn more on their investments.
  • Flexibility: Brokered deposits can be customized to meet the needs of the investor and can offer a variety of maturities and terms, allowing investors to choose the best fit for their financial goals.
  • Diversification: Brokered deposits can be used to diversify an investment portfolio, providing investors with a variety of different types of investments to choose from.
  • Liquidity: Brokered deposits are typically more liquid than other investments, allowing investors to access their money quickly if needed.
  • Professional advice: Brokered deposits are typically offered through financial professionals who can provide investors with personalized advice and guidance.

Limitations of Brokered deposit

Brokered deposits have several limitations that should be considered before investing:

  • They are generally more costly than other types of deposits. Since the broker is paid a commission for arranging the deposit, the cost of the deposit is passed on to the investor.
  • Brokered deposits are usually not insured by the FDIC, so investors may face the risk of losing their money if the bank becomes insolvent.
  • Brokered deposits often have more restrictive withdrawal terms than traditional deposits, making it difficult for investors to access their money when needed.
  • Brokered deposits may also be subject to greater liquidity risks than other deposits, as the broker may not be able to quickly find a buyer for the deposit if the investor needs to cash out.
  • Finally, since brokered deposits are often sold by brokers who are not regulated by the FDIC, there is a risk that the broker may be providing inaccurate or misleading information about the deposit.

Other approaches related to Brokered deposit

One approach to dealing with brokered deposits is to limit the amount of deposits a bank can accept from a single broker. This can help to reduce the amount of risk associated with a single broker's deposits and ensure that a bank remains in compliance with applicable regulations. Other approaches include:

  • Screening prospective brokered deposits to ensure they are of high quality and pose minimal risk to the bank
  • Establishing a limit on the total amount of brokered deposits accepted by a bank
  • Imposing a minimum loan-to-deposit ratio to limit the risk of over-concentration in brokered deposits
  • Reallocating a portion of the bank’s interest rate spread to cover the cost of brokered deposits
  • Requiring the bank to hold additional capital to cover the risk of accepting brokered deposits

In summary, banks can use a variety of methods to manage and mitigate the risk associated with accepting brokered deposits, ranging from screening and limiting the amount of deposits accepted to setting loan-to-deposit ratios and requiring additional capital to cover the risk of accepting brokered deposits.

Footnotes

  1. Bovenzi J. F., (2015), p. 2-3
  2. Rossi C., (2014), p. 314-316
  3. Kolb R. W., (2010), p. 38
  4. Bologna P., (2011), p. 22
  5. Simpson T. D., (2014), p. 118-121

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References

Author: Monika Sojka