Public banks: A viable, safe way to leverage public money

There is value and incentive for states, localities and other governmental entities to create a public bank to localize their financial incentives for investment in their communities and provide low-cost financing for those communities.

What is a public bank? It’s owned and controlled by a state, municipality or other governmental entity. There is one public bank in the United States that currently exists — the Bank of North Dakota. The state legislature created it to promote economic development and all the state’s and its instrumentalities’ money are deposited in the Bank.

Why don’t municipalities leverage their own funds the way that traditional banks do by creating their own public banks into which they would deposit all their funds? This is exactly what North Dakota has done by creating its bank. The Bank is a member of the Federal Reserve System and able to leverage these funds like any other bank.

However, since the Bank was created to serve a public purpose and not to maximize profits, it functions differently than private banks and is not designed to compete with private banks. This is the case in a number of respects.

There is also a public bank in the territory of American Samoa, the Territorial Bank of American Samoa, which became a member of the Federal Reserve System in 2018.

Some believe that public banks are too risky for taxpayers while others advocate that any funds of a municipality deposited in a public bank must be fully collateralized to protect public funds. This means that if a municipality deposits $50 million of its funds in a public bank, the bank would have to secure those monies with $50 million of safe investments, such as U.S. Treasury bonds.

While some have concerns, properly designed public banks would be safer than private banks and collateralization of deposits of public monies in a public bank does not make sense from a financial or policy perspective.

Let’s start with why a public bank makes financial sense. A public bank allows a governmental entity to leverage its own monies for public purposes as opposed to a private bank leveraging public deposits for its private profit-making purposes. To understand why this makes sense we will first discuss how private banks leverage public deposits.

Municipalities collect taxes and other revenue to provide public services and before these monies are spent, the funds are deposited into bank accounts or liquid investments. Public funds deposited in banks are leveraged by the banks as are all funds deposited with banks.

Banks pay very low interest rates on deposits and then use the funds to make long-term loans at higher interest rates — the source of bank profits. But if banks lend deposits to make long-term loans, where do banks get the funds if a depositor such as a municipality withdraws monies from its bank account?

The answer is from liquid funds, from loans between banks or from loans from the Federal Reserve Bank. Loans made between banks are typically made at very low interest rates called the federal funds rate. Members of the Federal Reserve System can also borrow directly from the Federal Reserve Bank discount window at low rates. Being a member of the Federal Reserve System provides a bank with steady liquidity at low interest rates.

The Bank of North Dakota leverages public funds. It works closely with and partners with local community banks and credit unions to support economic development. Loans are made to farmers, small businesses, students and homeowners. The Bank does not engage in retail activities like credit cards and other consumer products and it does not engage in any investment banking or speculative investments or products such as derivatives. It keeps its reserves and liquid funds in Treasuries.

As a result, the Bank has been very stable and has grown its assets steadily to about $8 billion. As needed in some years it has transferred monies to North Dakota when the state has had budget shortfalls. In other words, it has not only enhanced economic development in North Dakota but it has also enhanced and stabilized the state’s financial condition.

Virtually all states have laws requiring banks to fully collateralize public funds with securities or other assets. The Bank of North Dakota does not collateralize its public deposits. This is the case for two reasons.

One reason is that the Bank is managed in a fiscally conservative manner so it has not suffered losses but rather has been profitable.

The second reason is that doing so would defeat the purpose of the Bank which is to leverage public funds to promote economic development. If the Bank were required to 100% collateralize public deposits, it would not be able to leverage its funds and would have no reason to exist. This is because the Bank almost exclusively has as deposits public deposits. Therefore if the State and its instrumentalities deposited $100 million in the Bank, the Bank would have to invest these monies in safe investments like Treasuries to secure the deposits. This would leave no monies for making loans and fulfilling the purpose of the Bank.

If public banks were authorized in municipalities around the country they could also be structured to be very safe so as to negate any need to collateralize public deposits. This is the case for a number of reasons.

For one, newly created public banks would also become members of the Federal Reserve System thereby having access to consistent liquidity. This would allow for the leveraging of monies like any other bank.

But more importantly, since a public bank would not be established to maximize profits it would be materially safer than private banks. A public bank’s financial activities and investment options would be significantly limited. Loans would be made to foster the public good, serve underserved historically redlined communities and promote equitable economic development including affordable housing, renewable energy and small businesses. Risky financial activities such as speculative investments, derivative products like default swaps and investment banking would be prohibited.

In addition, public banks would function in a manner similar to Community Development Financial Institutions (CDFIs). Since maximizing profit is not the driving motivation of a public bank, its main goal would be the preservation of principal. The history of CDFIs is very instructive in this regard.

CDFIs are certified by the CDFI Fund of the Treasury Department. Once certified a CDFI may receive funds from the CDFI Fund, foundations, local governments or other sources. CDFIs are credit unions, local banks or lending entities which are mission driven. They seek to serve communities that are generally not served by commercial banks. They seek to build community wealth through loans to small businesses and financing for affordable housing and home ownership.

Since maximization of profit is not the goal of CDFIs, these institutions work with their borrowers to facilitate repayment of loans. This means they provide extensions of maturity dates or will lower interest rates as needed to facilitate repayment and to avoid defaults. Consequently CDFIs have been extremely successful at preserving the repayment of principal.

This is best illustrated by how CDFIs performed during the Great Recession. No CDFI failed or went out of business as compared to, for example, 157 banks in 2010. In addition during the Great Recession CDFIs suffered losses on average of only 1% or less. While CDFIs make less profit than commercial banks, defaulted loans and consequent losses are extraordinarily low.

Because public banks would be designed to function like CDFIs they too would be expected to suffer very low losses. For these reasons policymakers should oppose any laws that would require public banks to collateralize public deposits.

There is a bill in the New York legislature called the New York Public Banking Act that authorizes municipalities in New York to form public banks. The bill is backed by more than 150 labor and community institutions and many state legislators. New York public banks formed pursuant to this bill would: (1) focus on making loans to underserved communities to promote small businesses, affordable housing and renewable energy; (2) not be required to collateralize public funds with securities; (3) be governed by a diverse Board chosen by each branch of local government and comprised of a majority of members who are independent community based representatives (4) be required to function in accordance with strict ethical principles; and (5) be structured to function in a safe and sound financial manner.

Similar bills exist in State legislatures throughout the country. It is only a matter of time that public banks will exist at the municipal level to leverage public funds to promote equitable economic development.

David Dubrow is a partner at ArentFox Schiff who specializes in public finance.