Collateral – Pledged securities

As the economy continues to expand, so do the appetites of financial institutions for additional funding sources. Political subdivisions can be a significant funding source without cannibalizing a financial institution’s local retail market. Political subdivisions are funded through county sales and property taxes, user fees, and state and federal sources.  Their funding repeats annually regardless of the economic cycle, making political subdivisions reliable and consistent sources of deposits.

However, there are challenges with political subdivision deposits. Most require collateral on balances in excess of FDIC insured limits in order to participate in funding opportunities.  Collateral requirements are predicated on individual state statute and/or local investment policies.

Our focus here is dedicated to collateralization involving the pledging of securities held in a financial institution’s investment portfolio.  There are several key steps that must be adhered to when pledging collateral to insure the depositor’s interest is perfected. Simply acknowledging that a security is set aside/pledged does not constitute a “perfected interest” and, in the case of default, may be nullified by the FDIC.

The FDIC requires that a formal agreement exist in writing, executed by both parties, that collateral be segregated and held by a third-party custodian, and that the financial institution’s Board of Directors approve the agreement and authorized individuals. The formal agreement is comprised of a Security Agreement and Pledge Agreement which can be executed individually or combined into a single agreement.  

The Pledge Agreement is a triparty agreement between the financial institution, depositor and custodian describing controls and the custodian’s responsibilities to both parties. The Security Agreement is a bilateral agreement between the financial institution and the depositor intended to address collateral, maintenance and reporting requirements in relation to state statue and/or investment policy to grant the depositor a “Perfected Security Interest.” If utilizing two separate agreements (Pledge and Security), it is necessary to reference the Pledge Agreement within the Security Agreement connecting both documents.  The process may seem complicated, but once in place it is very straight forward. The key is to take the appropriate steps at the onset to ensure there is a perfected interest.

As part of a holistic funding plan, pledged securities can be a valuable method. Often times, financial institutions may be idly holding securities in their investment portfolio without realizing their ability to be pledged. When used correctly, these securities can be a valuable method for attracting larger block funding from political subdivisions and can create a reliable and consistent source of deposits.

Co-author: Todd A. Terrazas