In this issue of The Institutional Risk Analyst, we republish an important comment by Robert Eisenbeis, Vice Chairman & Chief Monetary Economist at Cumberland Advisors, on the fight to create narrow banks that do not require federal deposit insurance. This decision has broad implications for other parties seeking access to the Fed's payments network. For now, in order to gain access to a master account at a federal reserve bank, the applicant need be an "insured depository institution" as defined by Section 12 of the U.S. Code.
April 17, 2020
In a move largely overlooked due to the virus pandemic, on March 25, Judge Andrew L. Carter, Jr., of the United States District Court for the Southern District of New York dismissed a case filed by principals of The Narrow Bank (TNB) against the Federal Reserve Bank of New York. What is The Narrow Bank, and what are the issues it poses? Narrow Banks For the past two years, a former Fed employee and investors have been pursuing a charter for what they call The Narrow Bank. The Narrow Bank would be structured as a state-chartered, uninsured, non-retail bank whose sole function would be to hold a master account at the Federal Reserve Bank of New York, through which it would earn interest on its reserve holdings and pass that return, after extracting a small fee, to its depositors, comprised of hedge funds, accredited investors and other financially sound institutions. The proposed bank applied for a charter in Connecticut, whose banking department issued a temporary approval subject to conditions, including obtaining a master reserve account at the Federal Reserve Bank of New York before final approval would be granted. All states require that a bank that accepts retail deposits (deposits from individuals who are not accredited investors) must have Federal Deposit Insurance from the Federal Deposit Insurance Corporation. However, because TNB would not accept retail deposits, it would be regulated only by the State of Connecticut and not need FDIC insurance, nor would it be regulated by the FDIC or any other federal bank regulator. It would also not be subject to the FDIC’s large bank risk assessment charge that large federally insured banks must pay should TNB attract significant deposits. As noted in the judge’s ruling, the master account application process involves a one- page form and is usually acted upon in a week or so. But in this case the process dragged on for weeks, with the New York Fed’s attorney finally indicated that several conditions must be met, including having at least $500K in deposits, proof of final charter approval, and completion of due diligence by the New York Fed. In late December 2017 the application was escalated to the Fed’s Board of Governors, which was concerned about the implications of such an institution for the efficacy of the Fed’s monetary policy tools, including IOER (interest on excess reserves).
On March 6, 2019 the Board issued proposed changes to Regulation D that would lower the interest rate paid on reserves to institutions such as The Narrow Bank, essentially making TNB uneconomic. No final ruling has been forthcoming from the Board, but the advent of the COVID-19 financial crisis has essentially made TNB uneconomic for the moment, given that the IOER is at 0.1%, compared with the 1.0% that it was in August 2017, when TNB was granted a temporary charter certificate, or the 2.4% that it reached in December 2018 before plunging to its current level. Some might claim that TNB has been treated unfairly and has been denied due process, an argument that at least one court has rejected. But TNB raises three general policy questions. First, is there a public policy reason to broaden access to Federal Reserve services and interest on reserves beyond banks, perhaps even to individuals? Second, are there risks associated with narrow banks that may impact financial stability? Finally, what implications are there for the efficacy of the Fed’s monetary policy tools? The answers to these questions are complex and not always clear. As for who should have access to Federal Reserve services, it should be recognized that as a central bank, the institution’s main function is to conduct monetary policy, not to provide payments services to individuals or to the general public. It does provide wholesale payments clearing and settlement services, which evolved out of its historical check-clearing activities. It also serves as fiscal agent for the US Treasury and aids in issuance of Treasury debt. The appeal of TNB and similar entities when it comes to retail payments is that they provide a riskless alternative. In this respect the idea of a 100% reserve backing as a means to provide riskless payments services to individuals is not new.
Irving Fisher and others put forth such a proposal in 1935 in the aftermath of the Great Depression; and later, Milton Friedman supported a 100% reserve requirement for checking accounts to counter what many thought was the inherent instability of a fractional reserve banking system. Today, there are many payments options, and for individuals it is possible to have FDIC insurance to cover most payments and savings needs. (There have even evolved workarounds to get more than $250K of insurance on accounts). So the case for individuals to have access to the central bank is weak and could provide a distraction to the Fed’s main monetary policy function. The second concern is potential risks that TNB and similar institutions might pose to financial stability. Because narrow banks’ only assets are reserves on deposit at the Federal Reserve, they are essentially riskless, and the rate that they earn is a riskless rate. In times of financial stress, when there is a flight to quality, the concern is that funds would disintermediate from the Treasury market, from money market funds, and from banks into narrow banks, thereby creating liquidity and, potentially, solvency problems. While this is a hypothetical concern, recent experience in both the repo market and the liquidity problems that have emerged across a wide range of financial markets during the pandemic shows that in desperate times there can be extreme pressures on certain financial markets and institutions. The recently announced nine Fed programs to support primary dealers, the corporate credit market, the municipal market, money market mutual funds, and the commercial credit market are but a few examples of the need to address such stresses. Finally, and perhaps most importantly, there is concern about the implications of narrow banks for the efficacy of the tools the Fed employs to implement monetary policy. These tools include, but are not limited to, reserve requirements, interest on reserves (IOER), the discount rate, and the federal funds rate. These tools provide levers that flow into the economy through short-term money markets and across the term structure. Reserve requirements have receded into the background as a tool, since they are so low as to not be binding.
The Fed could not pay interest on reserves until it was permitted to do so under the Economic Stabilization Act of 2008, which authorized payment of interest on both required and excess reserves. Because of the Fed’s asset purchase programs, bank reserves ballooned; and the Fed began paying the same rate of interest on both excess reserves and required reserves. That remains the case today. The IOER was intended to put a floor on the band within which the Fed would set its fed funds target rate. However, for much of the period since IOER was adopted, the effective federal funds rate was slightly below the floor supposedly set by IOER.
The reason for this lies in a technical problem, in that Freddie Mac and Fannie Mae as well as the Federal Home Loan Banks are permitted to hold deposits at the Fed but are not permitted to receive interest on those funds. So they lend the funds out in the overnight market at rates slightly below IOER. These entities would appear to be prime candidates for placing deposits in TNB and similar narrow banks. While eliminating the discrepancy between the effective federal funds rate and IOER might be a desirable outcome, it is not obvious that simply permitting the Fed to pay interest on GSE and Home Loan Bank funds is not a better alternative, especially since these entities are, at present, government institutions. In summary, the issues raised by the narrow bank proposals are complex and not always clear. What is needed at this point is a serious and in-depth reassessment of the Fed’s policy tools, the structure of the markets in which those tools are applied, and how the tools are linked, both theoretically and practically, to the macroeconomy. Just one example may serve to illustrate that need.
The present primary dealer system is a relic of the past when Treasury securities were paper documents and primary dealers submitted paper bids in connection with daily open-market operations. With the evolution of technology, including digital securities and electronic bidding, there is no reason that all sound member banks and other qualified entities should not be permitted to bid and eliminate the privileged position of the primary dealers. Right now, more than half of primary dealers are affiliates or subsidiaries of foreign banking institutions that are currently being supported by the Fed though the primary dealer credit program, effectively subsidizing foreign institutions.
Bloomberg News (April 28, 2020)