Banking reforms may bite weakest institutions

Indiana banks soon might have to pay the state as much as $300 million in new fees for deposit insurance at a time the industry
is experiencing its deepest woes in decades.

And even if they can avoid those assessments, the state’s weakest banks would face a Catch-22: Pony up collateral as
security for government deposits, or cede a huge slice of their business to stronger competitors.

“For those who have to put up collateral, it increases costs substantially and creates an unfair playing field,”
said Mike Alley, chairman and CEO of Integra Bank, a struggling Evansville-based institution.

So far during this economic slump, Indiana has been lucky. Columbus-based Irwin Union’s collapse
last year has been its only bank failure. But public officials fear more are imminent, so they’re scrambling to shore
up Indiana’s public insurance system for the first time since 1937.

The Federal Deposit Insurance Corp.’s $250,000-per-account protection covers only a fraction of the $12 billion in
state and local government cash on deposit in Indiana banks. The money represents nearly 13 percent of all Indiana bank deposits.

State legislators’ proposed solution: a law requiring an obscure regulatory board—for the first time—to
grade the default risk of every bank that maintains a branch inside state lines.

Using that risk analysis, the Indiana Board for Depositories would establish a sliding scale for how much collateral banks
would need to set aside to secure government deposits. It’s a system that would benefit the strongest banks, which likely
would need no new guarantees. Weaker banks, however, would be forced to dig deep for collateral, hindering profitability.

The legislation also would grant the public depositories board power to issue up to $300 million in debt, with proceeds used
to replenish the Indiana Public Deposit Insurance Fund. The money would be repaid by the 197 financial institutions that hold
Hoosier government cash.

As of IBJ’s press time March 11, Republicans and Democrats from both chambers of the Legislature had agreed
in conference committee to approve House Bill 1336, which modernizes the PDIF.

But its final fate was tied to partisan negotiations over separate legislation, particularly the proposed delay in the payroll
tax hike meant to stabilize Indiana’s bankrupt unemployment insurance fund. (For an update on the status of the deposit-insurance
legislation, visit ibj.com.)

Banking history

Indiana created PDIF during the Great Depression as a backstop against huge losses of government deposits if any
bank failed. For decades, Hoosier banks paid annual assessments based on the percentage of public deposits they held. The
PDIF now has $308 million in assets.

Because bank failures have been rare in recent decades, Indiana has waived the assessment since 1985, and the state even
has tapped the fund for other needs. Since 2003, for example, Indiana has used all of PDIF’s interest to help shore
up pre-1977 police and firefighter pensions.

The Indiana Bankers Association helped develop this year’s PDIF changes, which it argues are necessary to protect cash
flow to public services if a mega-bank should topple.

All of the 13 largest banks doing business in Indiana, such as Chase, PNC and Fifth Third, hold more than $300 million in
public funds.

“If one went down, those losses would be catastrophic,” said Indiana State Treasurer Richard Mourdock, the PDIF’s
investment manager.

Indeed, the state nearly suffered that nightmare scenario last year. In March 2009, Mourdock said, Irwin Union Bank CEO Will
Miller paid him a visit. Miller warned that $540 million in public deposits held by his troubled bank were at risk.

“That was a huge shot across the bow that we need to fix this system,” Mourdock said. “Had they gone down
that day, we’ve just lost our $300 million reserve fund, plus an additional $240 million.”

Ultimately, Indiana suffered no losses when the FDIC arranged and guaranteed Irwin Union’s sale to Cincinnati-based
First Financial Bancorp. But Mourdock worries next time might not be so lucky. The FDIC last month said it had 702 troubled
banks on its watch list, though it wouldn’t reveal their names or where they’re located.

Mourdock said it’s “inconceivable” Indiana won’t have at least a few bank failures this year.

“Every Friday, I hold my breath,” he said. “When these [bank closure] transactions occur, it’s always
on a Friday.”

Sliding scale

State Rep. Jeb Bardon, an Indianapolis Democrat who serves as chairman of the House Financial Institutions Committee,
agreed the state is unlikely to be spared additional failures.

“Whether it’s one bank, two banks or three banks, we don’t know for sure,” said Bardon, author of
the deposit-insurance legislation. “But there are banks that have had some rough times, and we have to acknowledge that
reality.”

Nationwide, nearly 200 banks have failed since January 2008, and experts fear this year could even be worse. That’s
because so many bank loans are tied to commercial real estate that depreciated in the recession. And unlike subprime mortgages,
commercial loans are bread-and-butter business for nearly every bank.

To assess individual banks’ risk of failure, backers of the legislation—including Gov. Mitch Daniels—want
to hire a ratings service, such as Maryland-based LACE Financial Corp. or Texas-based Highline Financial. The PDIF board would
then use the ratings to set collateral requirements.

Risk analysis

But Integra’s Alley believes his bank would be a big loser under the approach. Integra, which has 46 branches, lost
$191 million in 2009 and $111 million the year before.

He said the collateral requirement would boost its costs, reducing the competitiveness of the interest rates it could pay
government customers. That would make its task of returning to profitability even tougher.

“Rather than create an unlevel playing field … it should be uniform across depositories, and not discriminate
against someone they perceive to have a higher risk level,” said Alley, former head of Fifth Third’s central Indiana
operations.

Complying with the collateral system also could be burdensome and overly complicated for smaller institutions, said Kenneth
Carrow, an IUPUI associate professor of finance who concentrates on banks and insurance. In contrast, he said, enormous banks
have the resources and economies of scale that would absorb the PDIF overhaul with ease.

“Banks will look at how much [public money] they have now and [ask], how important is it to keep working with those
institutions?” Carrow said. “Some may find it too costly, and pull out on that basis.”•