Is a State Bank a Useful Economic Development Tool?

• Author: Chirinko, Robert S.
• Position: STATE BANKS

Healthy banks and a robust economy tend to go hand in hand. Banks perform three basic tasks--creating money, facilitating transactions, and allocating credit--that are essential for a well-functioning economy. But there has been a longstanding concern as to whether private banks operating in private markets are serving the public interest. So far in 2021, four states have introduced legislation to create a state bank, and in 2019, similar legislation was enacted in the State of California for municipal banks. This concern has been amplified by the disproportionate economic impact the COVID-19 pandemic has had on small businesses.

LESSONS FROM PRIOR PUBLIC BANKING EXPERIENCES

The Bank of North Dakota is a public bank that has been in existence for more than 100 years, and it is held by many as the prototype of a successful state bank. The states of Massachusetts and Illinois explored starting a state bank in 2010, and five states very recently introduced public bank legislative initiatives. Furthermore, public banks have been active in many countries outside the United States. Three states that had examined the merits of introducing a state bank--Vermont (2010), Maine (2011), and Hawaii (2012)--are not included in this review. Oregon (2010) is left out because the initiatives are somewhat dated and not as consequential as the others. Lastly, American Samoa has a state/territorial bank, but the island's size and unique location suggest that its experience will not be instructive for, say, the State of Illinois.

* Bank of North Dakota, 1919

The Bank of North Dakota (BND), the only state bank in the United States, was founded in 1919. At this time, agriculture was the dominant sector in North Dakota's economy, and there was concern that the farmers were being exploited by out-of-state grain dealers, farm suppliers, and Chicago, Minneapolis, and New York banks. The BND was created to protect the farmers from these exploitive practices, caused by a lack of competition.

The bank's risk is borne by the State of North Dakota, "doing business as" the BND. Should the bank become financially distressed, all state assets would be vulnerable for providing financial support, especially since the deposits are not FDIC insured. But the bank's funding model is one of the reasons for its success: the BND is the depository for all state tax collections and fees. "And I would bet that that would be one of the most difficult things to wrestle away from the private sector--those opportunities to bid on public funds," said former president and chief executive officer Eric Hardmeyer. In light of this, along with the concern that it would compete with private banks, the BND has maintained only one office (in the City of Bismarck), It also now has satellite lending offices in three North Dakota cities.

The other key element of success is the bank's lending policy, which has changed focus over time: farms and municipalities (in the 1930s), managing state investments and servicing local banks (in the 1940s and '50s), and economic development and commercial loans (beginning in the 1960s). Again, Hardmeyer says: "But that's only one portion of it. We take those funds and then, really, what separates us is that we plow those deposits back into the State of North Dakota in the form of loans. We invest back into the state in economic development-type activities. We have specifically designed programs to spur certain elements of the economy."

The BND does not originate most loans (except for student loans). Instead, it frequently partners with North Dakota banks, serving as a "bankers' bank." Its major role seems to be more as a supplier of capital rather than a lead lender, finding lending opportunities based on its knowledge of local conditions. It supports local banks with participation loans and access to the federal funds market and the discount window. The BND lends to borrowers viewed as key to spurring economic growth, a strategy akin to an industrial policy in which a government agency attempts to pick winners--which is difficult to sustain on an ongoing basis. For example, in 2009, the BND favored investments in the energy sector. Over the past two decades this has been difficult to sustain, as the price of crude oil peaked in May 2008; in January 2020, it had fallen by more than 60 percent.

Still, BND's profitability has been notably robust for many years. Based on its total assets, the bank is about the 200th largest bank in the United States. The return on assets is 2.1 percent, substantially higher than the 1.6 percent for federally chartered banks and 1.3 percent for state-chartered banks. Similar differences exist for the return on equity.

Let's explore two possible reasons for this impressive performance: the low cost of funds, or lending acuity. The first explanation is a prime suspect, as virtually all state funds must be deposited with the BND--but this conjecture doesn't bear up under scrutiny. The bank's interest expenses as a percentage of total liabilities are relatively higher than that of other banks. This is surprising, since 12 percent of the BND's deposits do not earn interest--although this effect may be counterbalanced by the absence of FDIC insurance and an added risk premium embedded in BND deposit rates. Moreover, the BND relies relatively less on deposits than commercial banks do. Low funding costs do not appear to be the reason for BND's high profitability.

The second reason for the favorable outcome relative to other banks may be prudent lending. An examination of the asset side of the balance sheets shows that the BND does not extend more loans than other banks. It is striking, however, that the funds set aside for loan losses are much larger for the BND. This may imply an aggressive approach to lending and the holding of a high-risk portfolio of loans. Consequently, the higher profits, net of expected loan losses, compensate for extra risk-taking. This interpretation, however, would be contrary to the conservative approach to banking mentioned in BND documents. An alternative interpretation is that the relatively high loan loss provision is consistent with the BND's conservative banking policies. However, this perspective would not explain its high profitability, instead implying that profitability should be relatively low.

A third possibility is that funds are set aside to cover expected losses in energy-sector loans. This interpretation is consistent with loan losses provisions becoming greater for the BND relative to commercial banks beginning in 2015. The BND was setting aside fewer resources for loan losses before that.

The BND also holds very little cash--two percent of total assets--compared to five percent for national banks and 6.2 percent to 16.5 percent for state banks. The BND is a very large net purchaser of federal funds; these purchases are netted against the reported cash/assets ratio. In contrast, national banks are net buyers of federal funds. The difference seems to be traceable to the BND's role as a "bankers' bank" for North Dakota. According to its founding charter, the BND shall be "helpful to and to assist in the development of state and national banks and other financial institutions and public corporations within the state ..." (Additional services provided to North Dakota banks include check clearing, liquidity management, and bond...