Depending on applicable state or federal law, public unit deposits may be secured by collateral or assets of abank or financial institution. In the event of the failure of the bank, the FDIC will honor the collateralization agreement if the agreement is valid and enforceable under applicable law. The FDIC does not guarantee, however, that the collateral will be sufficient to cover the amount of uninsured funds. As such, although it does not increase the Insurance coverage of the public unit deposits, collateralization provides an avenue of recovery in the unlikely event of the failure of an insured bank. FDIC insurance covers deposits up to $250,000 for each entity. Deposits above this FDIC limit must be collateralized to ensure the safety of public funds.
Collateralization of public deposits through the pledging of appropriate securities or other instruments (i.e. surety bonds or letters of credit) by depositories is an important safeguard for such deposits. The amount of pledged collateral is determined by a governmental entity's deposit level and the policy or legally required collateral margin. Some states have established programs for the pooling of collateral for deposit of public funds. All collateralization agreements between financial institutions and public entities must adhere to state and federal laws, including FDIC regulations.
GFOA recommends the use of a written agreement with pledging requirements as protection for state or local government's deposits. GFOA further recommends that governmental entities establish adequate and efficient administrative systems to monitor such pledged collateral, including state or locally administered collateral pledging or collateral pools. To accomplish these goals, GFOA recommends the following:
- Governmental entities should review applicable federal, state statutes and confirm compliance. The governmental entity should establish and follow procedures for on-going review of collateral. In addition, a periodic report of collateral holdings and compliance with state statute and local policy should be provided to the governing body or investment committee (or other committees as applicable).
- In the absence of a state program for pooling collateral, public entities should establish and implement collateralization procedures, including procedures to monitor their collateral positions. Monitoring informs a public entity of under collateralization, which may threaten the safety of an entity's deposits, and overcollateralization, which may increase the cost of banking services. Governmental entities, however, should not accept the liability for maintaining collateral levels which is the responsibility of the financial institution.
- Governmental entities/depositors should take all possible actions to ensure that their security interests in collateral pledged to secure deposits are enforceable against the receiver of a failed financial institution.
- Governmental entities should have all pledged collateral held at an independent third-party institution (custodian) outside the holding company of their bank, and evidenced by a written agreement between the custodian and the government. Governmental entities should know and understand securities pledged as collateral.
- Governments should seek a margin level of at least 100%, or as dictated by state statute. The government should also indicate its desired margin level in its investment policy. The value of the pledged collateral should be marked to market and reported monthly, or more frequently depending on the volatility of the collateral pledged. Some state statutes dictate a minimum margin level for collateral based on deposit levels.
- Margin levels and bank balances should be monitored daily as there may be a large influx of deposits for a short amount of time (e.g., semi-annual/annual tax payments within the span of a day or two).
- Substitutions of collateral should meet the requirements of the collateral agreement, be approved by the governmental entity in writing prior to release, and the collateral should not be released until the replacement collateral has been received.
- The public entity should require, at a minimum, monthly reporting directly from the custodian. The custodian should warrant and be signatory to the agreement.
- Letters of credit may be pledged in lieu of securities. The governmental entity should perform a legal review of the terms and conditions of any letters of credit. Such letters of credit must be issued by a federal agency or government sponsored enterprise (e.g., Federal Home Loan Bank, etc.) and be irrevocable.