States and their municipalities are facing unprecedented short- and long-term challenges caused by:
- Severe federal cutbacks that directly undercut state revenue, and create material gaps in the support of vital needs of citizens, which states concerned about the needs of their residents must address.
- The recent federal government shutdown.
- Natural disasters due to climate change which create billions of dollars of damage, the costs of which are no longer supported by funds from the Federal Emergency Management Agency.
- A health care crisis due to cuts to Medicaid/Medicare and insurance premium increases for Affordable Care Act insurance set to go into effect at the end of the year.
- A vast shortage of affordable housing.
- An economy experiencing stagflation driven in the main by unneeded tariffs with an effective rate of about 17-18.5%, the highest since the Great Depression.
While states will develop various policy responses to these challenges, the creation of state-owned banks would be uniquely impactful. This article will explore the purpose of a state-owned bank, ways it could address the aforementioned challenges, how it could be formed and its governance structure. It will also address objections to its formation.
Purpose
The purpose of a state-owned bank would be to leverage state monies to foster economic development designed to accomplish defined public purposes. These purposes could include making loans, purchasing debt, participation in debt, or making investments in each case at below-market rates to support affordable housing and post-high school education, climate change mitigation, natural disaster recovery aid, small businesses, community development financial institutions, community banks, and health care institutions in need. The bank's activities could also promote full employment or mitigate inflation as needed.
The bank would not take deposits from individuals and would not sponsor retail products.
A state bank would not be designed to maximize profit as its essential motivation, but rather to serve public purposes while preserving and expanding its financial basis for accomplishing these purposes. That is why it would and could make loans and investments at below-market rates.
The bank's lending activities would address the impact of severe cutbacks in federal spending, the suffering therefrom and the other challenges described above. Here are some examples.
The country faces a severe crisis in affordable housing. The state bank could alleviate this crisis by making low interest loans to (1) not-for-profit affordable housing developers, (2) CDFIs, credit unions and community banks (all of the above "community financial institutions") that make below-market interest mortgage loans to communities locked out of the home buying market, and (3) community land trusts. It could purchase affordable housing loans from community financial institutions to provide continuing liquidity for the making of more such loans. It could also finance the construction of new affordable housing in communities of need and then either rent out such housing or sell it encumbered with long-term affordable housing restrictions.
Climate change-caused natural disasters are on the rise and will not be mitigated with funds from FEMA. States and municipalities will need to issue bonds to finance costs of addressing these disasters. To lower the interest rate on such bonds a state bank could agree to buy a portion of these bonds at below-market rates. The bank could also provide a short-term low interest bridge loan until bonds are issued based on a commitment of the state to issue such bonds.
Small businesses are being hit particularly hard by tariffs. A state bank could provide below-market loans to small businesses to refinance existing high-interest loans. Such loans in certain cases could save small businesses from going out of business. Loans could also be made to support small businesses in new endeavors or expansions.
Formation
A state bank would be created by state legislation. Such legislation would set forth such things as the bank's purposes, powers, governance structure, ethical rules and fundamental approach to banking.
By fundamental approach to banking, we mean that the legislation would explicitly state that the bank was not formed based on maximizing profits, but rather on serving its public purpose. This means it would be mandated to function like a CDFI in its approach to lending and servicing its loans. We note that during the Great Recession no CDFI went out of business while about 157 commercial banks went under in 2010. In addition, CDFI losses were 1% or less during this severe recession.
It could provide that the enabling legislation may only be amended with a two-thirds supermajority vote. This would allow for stability between changes in state administrations.
Governance structure
A state bank would need to have a governing structure that would facilitate implementing the bank's purpose and prevent the bank from being utilized in a partisan political manner. The bank would have a board of directors and a management team.
The board of directors would set policy but have no power relating to day-to-day decision making. It would have members chosen by each of the governor, the state treasurer/comptroller and leaders of the state legislature. A majority of the members would be independent community-based representatives.
Senior management would be hired by the board. They would then operate and manage the affairs of the bank without day-to-day interference from the Board.
Financial structure
The first question in this regard is what monies would fund the bank. Would it be all revenue collections which are otherwise deposited with commercial banks? Would it be proceeds from the issuance of municipal bonds? Or would it be surplus funds accumulated by the state over time?
Revenue collections are needed to fund day-to-day operating expenses. The technology needed to track numerous revenue sources and disperse monies for day-to-day operating expenses is extremely sophisticated, complicated and expensive. Unfortunately, even the vast majority of existing banks cannot perform such functions. However, states often have consistent excess cash balances that are rarely if ever utilized.
A state could do a historical analysis of the amount of its excess cash balances. Then a large portion of this amount could be deposited with the state bank. If liquidity was needed at any point the state bank could use its Federal Reserve membership to draw short-term funds. This amount of state deposits (which could also include deposits from state agencies and authorities) would constitute the state bank's lending base. Over time, as the state bank got more sophisticated it could take more deposits from the state that were previously deposited with commercial banks.
The bank would have other sources of funds which could include bond proceeds or surplus reserve funds. Bond proceeds are a possible source but could be a costly one in the present relatively high interest rate environment. A state could capitalize a bank with general obligation bond proceeds. To be meaningful the capitalization amount should be sizable. This could be a large additional obligation for a state to incur.
Accumulated surplus funds would be the best source of capitalization. Most states have rainy day reserve funds accumulated in years where there are budget surpluses. These funds are typically invested in safe, liquid investments. The use is generally for one-time capital expenditure or for years in which there are budget shortfalls. A capitalization payment from surplus to a state bank would be akin to a one-time capital payment for infrastructure.
Each state could access the minimum capitalization amount to allow its bank to accomplish its purposes with a sufficient safety cushion. Then it could fund this amount from its surplus reserve if the reserve possesses enough funds or with a combination of surplus funds and bond proceeds.
Objections
There have been two main objections to public banks. One is that they irresponsibly put public funds at risk. The other is that these banks will be used as partisan political tools.
As shown above, these objections may be addressed very effectively. By requiring that the state bank approach lending and servicing in the same manner as CDFIs, public funds will be safeguarded. This approach would maximize the preservation of principal as shown by the entire financial history of CDFIs. In addition, state bank liquidity would be significantly enhanced by the bank becoming a part of the Federal Reserve System. This would allow for intra-day bank loans at very low rates and, if needed, loans from the Fed.
A carefully thought out framework for the governance structure can safeguard against these banks becoming partisan political tools. We all agree with this potential danger, but it can be addressed with a dispersion of power between different offices and branches of state government, with the requirement of a majority of community based independent directors, with a clear wall between the board establishing policy and management making day-to-day loan and operating decisions, and with clear statutorily mandated ethical principles.
Conclusion
The formation of a state bank can be a critical tool of a state in addressing multiple challenges at this juncture in history. Bold, responsible, forward-looking actions are called for in this moment.
David L. Dubrow is an attorney at ArentFox Schiff. He wrote this commentary in his individual capacity.
