There is value and incentive for states, localities, and other government entities to create a public bank to localize their financial incentives for investing in their communities and provide low-cost financing to those communities.
What is a public bank? It is owned and controlled by a state, municipality or other government entity. There is currently one public bank in the United States, the Bank of North Dakota. The state legislature created it to promote economic development and all state money and instruments are deposited in the bank.
Why do municipalities not mobilize their own funds as traditional banks do by creating their own public banks in which they would deposit all their funds? This is exactly what North Dakota did by creating its bank. The bank is a member of the Federal Reserve and is able to tap into these funds like any other bank.
However, since the bank was established to serve a public purpose and not to maximize profits, it operates differently from private banks and is not designed to compete with private banks. This is the case in several 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 all funds from a municipality deposited in a public bank should 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 should back those funds with $50 million of safe investments, such as US Treasury bonds.
While some have concerns, well-designed public banks would be safer than private banks and guaranteeing deposits of public funds in a public bank does not make financial or political sense.
Let’s start by explaining why a public bank makes financial sense. A public bank allows a government entity to leverage its own funds for public purposes, as opposed to a private bank which leverages public deposits for private gain. To understand why this makes sense, let’s first discuss how private banks leverage public deposits.
Municipalities collect taxes and other revenues to provide public services and before these funds are spent, the funds are deposited in bank accounts or liquid investments. Public funds deposited in banks are mobilized by banks as are all funds deposited with banks.
Banks pay very low interest rates on deposits, 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 money from their bank account?
The answer comes from cash, interbank loans, or Federal Reserve Bank loans. Bank-to-bank loans are usually made at very low interest rates known as federal funds rates. Members of the Federal Reserve System can also borrow directly from the Federal Reserve Bank’s discount window at low rates. Being a member of the Federal Reserve provides a bank with regular liquidity at low interest rates.
The Bank of North Dakota raises public funds. It works closely with and partners with local community banks and credit unions to support economic development. Loans are given to farmers, small businesses, students and homeowners. The bank does not engage in retail business such as 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 liquidities in treasury bills.
As a result, the bank remained very stable and grew its assets steadily to around $8 billion. As needed, in some years he transferred funds to North Dakota when the state ran into budget shortfalls. In other words, he not only improved North Dakota’s economic development, but he also improved and stabilized the state’s financial condition.
Virtually all states have laws requiring banks to fully back public funds with securities or other assets. The Bank of North Dakota does not guarantee its public deposits. This is the case for two reasons.
One of the reasons is that the bank is managed in a tax-conservative manner, so it has not suffered any losses but rather has been profitable.
The second reason is that it would defeat the purpose of the bank, which is to mobilize public funds to promote economic development. If the bank were required to guarantee 100% public deposits, it would not be able to leverage its funds and would have no reason to exist. Indeed, the bank has almost exclusively public deposits as deposits. Therefore, if the state and its instruments deposited $100 million in the bank, the bank would have to invest those funds in safe investments like treasury bills to secure the deposits. This would leave no money to make loans and fulfill the purpose of the bank.
If public banks were allowed in municipalities across the country, they could also be structured very securely to eliminate any need to guarantee public deposits. This is the case for a number of reasons.
On the one hand, the newly created public banks would also become members of the Federal Reserve System, thus having access to constant liquidity. This would raise funds like any other bank.
But more importantly, since a public bank would not be created to maximize profits, it would be materially safer than private banks. The financial activities and investment options of a public bank would be significantly limited. Loans would be made to promote the public good, serve historically underserved communities, and promote equitable economic development, including affordable housing, renewable energy, and small businesses. Risky financial activities such as speculative investments, derivatives such as credit default swaps and investment banking would be prohibited.
In addition, public banks would operate in the same way as community development financial institutions. Since profit maximization is not the primary motivation of a public bank, its primary objective would be capital preservation. The history of CDFIs is very instructive in this respect.
CDFIs are licensed by the Treasury Department’s CDFI Fund. 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 with a mission. They seek to serve communities not usually served by commercial banks. They seek to build community wealth through small business loans and financing for affordable housing and home ownership.
Since profit maximization is not the goal of CDFIs, these institutions work with their borrowers to facilitate loan repayment. This means that they extend maturity dates or lower interest rates as needed to facilitate repayment and avoid defaults. As a result, CDFIs have been extremely successful in preserving principal repayment.
This is best illustrated by the performance of CDFIs during the Great Recession. No CDFIs failed or ceased operations compared to, for example, 157 banks in 2010. Moreover, during the Great Recession, CDFIs suffered losses on average of only 1% or less. Although CDFIs make less profit than commercial banks, delinquency and resulting losses are extraordinarily low.
Since state-owned banks would be designed to operate as CDFIs, they should also incur very low losses. For these reasons, policymakers should oppose any law that would force public banks to guarantee public deposits.
There is a bill in the New York legislature called the New York Public Banking Act that allows municipalities in New York to establish public banks. The bill is supported by more than 150 labor and community institutions and numerous state legislators. New York’s public banks created under this bill would: (1) focus on lending to underserved communities to promote small business, affordable housing, and renewable energy; (2) not be required to secure public funds with securities; (3) be governed by a diverse council chosen by each branch of local government and composed of a majority of members who are independent representatives of the community; (4) be required to operate in accordance with strict ethical principles; and (5) be structured to operate in a secure and financially sound manner.
Similar bills exist in state legislatures across the country. It is only a matter of time before public banks exist at the municipal level to mobilize public funds to promote equitable economic development.
David Dubrow is a partner at ArentFox Schiff, specializing in public finance.