Skip to main content

Ehlers - Public Finance Advisors

  • Careers at Ehlers
  • Bond Sales
  • Locations
  • Disclosures
  • Investments Login
Get In Touch
Search
  • Our Approach
  • Our Services
  • Our Team
  • Our Work
  • News & Resources
  • About Us

Deposit Collateralization

E-Quarterly Newsletter - June 2023

Deposit Collateralization
It’s Not Personal, It’s Just Business.

By Brian Reilly, CFA
Senior Municipal Advisor | Managing Director

In our prior Newsletter, we showcased the failure of Silicon Valley Bank (SVB) and used it as a cautionary tale of why public funds depositors should ensure the funds they hold with depository institutions are not subject to the risks associated with such crises.  As we stated, the rapidity at which a bank’s financial condition can deteriorate won’t likely offer ample time to react, as depositors can withdraw funds at the speed of a mouse click or tap on a smartphone.  In the matter of a little more than a business week, SVB went from a headline to receivership administered through the Federal Deposit Insurance Corporation (FDIC), ultimately resulting in the second largest bank failure in U.S. history.

While the FDIC and its other federal partners seem to find ways to bend over backwards to shield depositors, it really isn’t practical to rely on these extraordinary measures to protect your funds.  It should be assumed that the standard insurance coverages of the FDIC and its counterpart in the credit union space, the National Credit Union Association (NCUA), will apply.  That’s essentially $250,000 per depositor, although there are some aspects of FDIC and NCUA coverage that may afford a single depositor up to $500,000 in total coverage.  Similarly, there are some states that provide deposit guaranty programs, but those funds are subject to appropriation and usually limited to a specific dollar amount, which may or may not be sufficient to make all public funds depositors whole.

The balances you hold with any one depository institution will likely exceed insured amounts at some point in any given fiscal year.  At these junctures, you are essentially an unsecured creditor of that institution, which places you in a precarious position. It’s important to remember that, in these situations, you’ve become a lender, so you should think like one.  What do lenders do when they are concerned about a borrower paying back a loan?  They secure their investment in the borrower by requiring a pledge of collateral that could be legally taken and liquidated in the event of non-payment or default.  Depository collateral substitutes for the credit of the bank and can make public funds depositors whole in the event of a bank failure.  While some states require collateralization of uninsured deposits, many do not.  Regardless, all governmental entities should consider it a best practice.

Of course, when it comes to collateralization, the devil is truly in the details.  A term of art often referred to in the industry is “perfecting” collateral.  This entails:

  • Establishing a legal right and enforceable security interest in the assets being pledged
  • Identifying what assets can be pledged as collateral and whether substitutions are allowed
  • Determining where the collateral will be custodied
  • Calculating the minimum amount of collateral and how those assets are periodically valued
  • Defining the means by which the depositor can take control of the collateral

There are four key questions depositors need to consider when collateralizing public funds deposits”

  • What’s your claim to the assets pledged as collateral? You should enter into a legal and binding pledge agreement with the pledging institution.  This can often be a boilerplate document but can also be uniquely drafted by counsel of either the depositor or financial institution.  The pledge agreement establishes a legal and enforceable claim to the assets pledged, including against the receiver of a failed financial institution.  If your bank sent you a letter stating they are pledging “XYZ security” as collateral for your uninsured account balance, it may not be worth the paper it was printed on.  The bank still holds the stated security, and you can’t be certain whether it pledged that same asset as collateral to another party or perhaps even sold it outright after the date of the letter.  Further, it’s unlikely the letter would be sufficient to substantiate your claim and stand up to the scrutiny of a receiver.

 

  • What assets are eligible to be pledged as collateral? First things first: Investment statutes dictate the specific investments governmental entities can own.  If what’s being pledged to you not on the list of approved investments, it’s not eligible as collateral, just because you can’t take possession of an asset you can’t legally own.  You also don’t want to be forced to immediately liquidate the collateral as soon as you take possession due to legal constraints.  Some states allow surety bonds or letters of credit as eligible collateral in lieu of securities, both of which are fine.  Federal Home Loan Bank letters of credit have been popular forms of collateral in recent years.  Be sure you receive documentation from the pledging institution that “perfects” your interest.  A confirmation from the issuing entity should state the beneficiary (your jurisdiction), the amount, the effective and expiration date, and the pledging institution.  You should only accept irrevocable letters of credit.

You should also consider whether to further limit eligible collateral beyond what is allowed under statute.  Municipal bonds tend to be a common pledged security as they tend to be of high credit quality, but there may not be an active secondary market for a nominally sized position of a small issuer.  You may need to take a concession on the price in order to convert it to cash.  The same can be said for some mortgage-backed securities.  You may want to limit allowable collateral to certain issuers, rating levels, and even specific types of obligations of a particular issuer.  Consult with your advisor if you want to better understand the pros and cons of limiting the universe of securities that are eligible to be pledged as collateral.  The depositor and the pledging institution will also need to determine under what circumstances collateral can be substituted.

  • Where is the collateral held and how do you get your hands on it? When a lender forecloses on a property to enforce its mortgage security interest, it’s a very involved process.  If you are the borrower, you’re in possession of the property and maybe even still occupy it.  The lender has to essentially take title from the borrower by exercising its legal remedies.  You don’t have months to access what you’re entitled to (which is essentially your cash), so want to be sure you understand the custody of the pledged assets.  Ideally, there should be what’s known as a “tri-party” agreement between the depositor, the pledging institution, and the custodian of the collateral.  A control agreement between these parties will define under what circumstances and by what means the depositor can take control of the pledged assets.  The custodian should be an entity legally distinct from and independent of the pledging institution.  This ensures the collateral is held only in the interest of the depositor and not commingled with the pledging institution’s other assets.

Under a control agreement, the depositor should have the right to give notice to the custodian of the bank’s failure, which then gives rise to the immediate transfer of the collateral.  Upon transfer, the depositor can sell the assets, thus turning the collateral into the cash it originally had on deposit.

  • How is the collateral valued and how frequently reported? There’s an important concept here called “margin.”  Margin is the difference between the amount of the uninsured deposit balance and the value of the pledged collateral.  You should accept no less than 100% margin, which means those two numbers are equal.  However, keep in mind that the value of financial assets changes daily.  What was $1 million of pledged collateral yesterday, could be $985,000 tomorrow.  Some states require as much as 10% margin, meaning the collateral must be valued at no less than 110% of the amount of the uninsured deposit.  Other states have no requirements, which means you’ll need to negotiate margin with your depository institution.  A good rule of thumb is 102% – 105% in the absence of a statutory requirement, but that should be viewed in the context of what you allow as eligible collateral and how often you receive a collateral register that states the assets and their reported market value.  You should have the collateral marked-to-market no less than monthly.  If the value falls below the stated margin, the pledging institution must put up additional collateral.  If the value is higher than the stated margin, collateral can be removed accordingly.  The value should be provided by an independent institution or pricing service.  Also understand that you may not be able to sell the pledged assets at their reported market value, since those values are only indications based on modeling rather than actual trading values.  There may be times each year when you wish to mandate a more frequent level of reporting, such as tax settlement time.

It’s imperative that finance staff have proper insight into the treasury management practices of their organization.  Safeguarding public deposits should carry the highest consideration, but that’s not without some level of administrative procedure and diligence on your part.  The funds for which you maintain stewardship have accumulated over the entire life of your jurisdiction, and your goal is to ensure they are there for the next generation and beyond.

Ehlers investment and treasury professionals have extensive experience analyzing depository relationships and perfecting collateral, as well as establishing written policies and procedures that will provide the foundation of stability for your organization now and into the future.  We would be happy to visit with your team about this important aspect of your finance function.


Required Disclosures: Please Read

Ehlers is the joint marketing name of the following affiliated businesses (collectively, the “Affiliates”): Ehlers & Associates, Inc. (“EA”), a municipal advisor registered with the Municipal Securities Rulemaking Board (“MSRB”) and the Securities and Exchange Commission (“SEC”); Ehlers Investment Partners, LLC (“EIP”), an investment adviser registered with the SEC; and Bond Trust Services Corporation (“BTS”), holder of a limited banking charter issued by the State of Minnesota.

This communication does not constitute an offer or solicitation for the purchase or sale of any investment (including without limitation, any municipal financial product, municipal security, or other security) or agreement with respect to any investment strategy or program. This communication is offered without charge to clients, friends, and prospective clients of the Affiliates as a source of general information about the services Ehlers provides. This communication is neither advice nor a recommendation by any Affiliate to any person with respect to any municipal financial product, municipal security, or other security, as such terms are defined pursuant to Section 15B of the Exchange Act of 1934 and rules of the MSRB. This communication does not constitute investment advice by any Affiliate that purports to meet the objectives or needs of any person pursuant to the Investment Advisers Act of 1940 or applicable state law. In providing this information, The Affiliates are not acting as an advisor to you and do not owe you a fiduciary duty pursuant to Section 15B of the Securities Exchange Act of 1934. You should discuss the information contained herein with any and all internal or external advisors and experts you deem appropriate before acting on the information.

Read More From This Newsletter

E-Quarterly Newsletter - June 2023 VIEW
Minnesota Legislative Update

Housing Update & Potential Impacts

Housing, primarily affordable housing, has been a focal point at both the state and local level in Minnesota for many years. Rising interest rates, inflationary pressures on construction costs, perpetually high rents, and a general lack of housing availability have made it increasingly difficult for Minnesota communities to deliver critical housing resources to their constituents. However, this year’s sweeping legislative session resulted in a comprehensive suite of programs intended to address the production and preservation of affordable housing, rental assistance, and down payment assistance for first-time homebuyers, just to name a few. This year’s package of housing legislation will have wide-ranging and direct impacts on local resources – some for better, and likely some for worse.

Long-Term Facilities Maintenance Planning

Guidance for Minnesota School Districts

“You work for a school district; you must have the summer off!”  Certainly, this is not the case for school district officials completing their 10-year Long-Term Facilities Maintenance (LTFM) plan.

The Minnesota Department of Education (MDE) requires four key pieces of information as part of your School Board’s approval of the annual LTFM program in order to qualify for LTFM revenue in the following year.

Market Commentary

The Fed Hits Pause…For Now.

Three months ago, this market commentary observed that predictions for future Fed tightening had greatly diminished in the wake of the collapse of Silicon Valley Bank. That commentary went to print while the SVB news was still fresh, and potential contagion across the banking system was the topic of the day. Three months later and that seems almost like ancient history. Not only has the market moved on from fears of a systemic banking meltdown, but we have survived the rise and fall of another “crisis” entirely in the form of the debt ceiling impasse in Washington.

Banking Services Requests for Proposal

Getting the Most From Your Banking Relationship

Do you ever open your community’s bank analysis statements and wonder if you’re getting the best value or benefit from your current banking relationship? Are your interest earnings competitive? What are your total hard charges per month?  Does your bank provide the latest in fraud protection services?  For many, the potential benefit of conducting a more thorough study of those questions is often overshadowed by the convenience and familiarity of “just staying put” with your current banking services provider.  Yet, as the steward of public funds, you have an obligation to review banking service contracts periodically.

The Power of Communication, Part II

Can You Hear Me Now?

“Can you hear me now?” That catchy tagline from Verizon wireless commercials years ago often comes to mind when I think about communication. The ability to effectively communicate a key component relative to how leaders are perceived. It’s an impactful way to build trust and credibility with others and it represents the heart of executive presence.

Connect With Us

Get more information about Ehlers or speak directly with a Municipal Advisor.

    1-800-552-1171
    info@ehlers-inc.com
    Join our mail list

How can we help?

Ehlers - Public Finance Advisors © 2025 Ehlers, Inc. All Rights Reserved
  • Home
  • Careers at Ehlers
  • Bond Sales
  • Bond Sales Results
  • Locations
  • Disclosures