The safest bank the Fed won’t sanction

A ‘narrow bank’ offers security against financial crises

John H. Cochrane

The Grumpy Economist

John H. Cochrane | Nov 30, 2018

Michael Byers

One might expect that those in charge of banking policy in the United States would celebrate the concept of a “narrow bank.” A narrow bank takes deposits and invests only in interest-paying reserves at the Fed. A narrow bank cannot fail unless the US Treasury or Federal Reserve fails. A narrow bank cannot lose money on its assets. It cannot suffer a run. If people want their money back, they can all have it, instantly. A narrow bank needs essentially no asset risk regulation, stress tests, or anything else.

A narrow bank would fill an important niche. Right now, individuals can have federally insured bank accounts, but large businesses need to handle amounts of cash far above deposit insurance limits. For that reason, large businesses invest in repurchase agreements, short-term commercial paper, and all the other forms of short-term debt that blew up in the 2008 financial crisis. These assets are safer than bank accounts, but, as we saw, not completely safe. 

A narrow bank is completely safe without deposit insurance. And with the option of a narrow bank, the only reason for companies to invest in these other arrangements is to try to harvest a little more interest. Regulators can feel a lot more confident shutting down run-prone alternatives if narrow bank deposits are widely available.

A narrow bank for deposits allows us to think about equity-financed banks for risky investments. If banks making risky investments get their money by issuing equity or retaining earnings rather than borrowing short-term, they too become immune from runs and financial crises. Now, the most common objection to equity-financed banking is that people and businesses need deposits. Well, narrow banks can provide those deposits, and can do so in nearly unlimited amounts. Narrow banking, providing completely safe deposits with no danger of crisis, opens the door to equity-financed banking, which can provide risky loans with no danger of crisis.

Given that the Fed mostly invests in US Treasuries and agency securities, you might ask: Why not just start a money-market fund that invests in Treasuries? Instead of following the monetary path of deposit  narrow bank  Fed  Treasuries, why not make it just deposit  money-market fund  Treasuries, and cut out the middle person? Well, a narrow bank is really a bank. A money-market fund cannot access the full range of financial services that a bank can offer. If you’re a US business and you want to wire money to Germany this afternoon, you need a bank.

Suppose someone started a narrow bank. How would the Fed react? I would have supposed it would cheer, and hand out a gold star while saying, “Thanks for helping us to create a bank that poses no systemic danger at all.” As it turns out, that’s not what happened. 

TNB, for “The Narrow Bank,” has been trying to commence operations, and the Fed is resisting in every possible way. In fact, TNB filed a complaint against the New York Fed in district court, stating that the Fed went so far as to act illegally. It makes great reading. Some excerpts:

. . .  “TNB” stands for “the narrow bank”, and its business model is indeed narrow. TNB’s sole business will be to accept deposits only from the most financially secure institutions, and to place those deposits into TNB’s Master Account at the FRBNY [Federal Reserve Bank of New York], thus permitting depositors to earn higher rates of interest than are currently available to nonfinancial companies and consumers for such a safe, liquid form of deposit. 

3. TNB’s board of directors and management have devoted more than two years and substantial resources to preparing to open their business, including undergoing a rigorous review by the State of Connecticut Department of Banking (“CTDOB”). The CTDOB has now granted TNB a temporary Certificate of Authority (“CoA”) and is fully prepared to permit TNB to operate on a permanent basis. 

4. However, to carry out its business—indeed, to function at all—TNB needs access to the Federal Reserve payments system. 

5. In August 2017, therefore, TNB began the routine administrative process to open a Master Account with the FRBNY. Typically, the application procedure involves completing a one-page form agreement, followed by a brief wait of no more than one week. Indeed, the form agreement itself states that “[p]rocessing may take 5–7 business days” and that the applicant should “contact the Federal Reserve Bank to confirm the date that the master account will be established.”

6. This treatment is consistent with the governing statutory framework. Concerned by preferential access to Federal Reserve services by large financial institutions, Congress passed the Depository Institutions Deregulation and Monetary Control Act of 1980 (the “Act”). Under the applicable provision of the Act, 12 U.S.C. § 248a(c)(2), all FRBNY services “shall be available” on an equal, non-discriminatory basis to any qualified depository institution that, like TNB, is in the business of receiving deposits other than trust funds.

7. TNB did not receive the standard treatment mandated by the governing law. Despite Connecticut’s approval of TNB—as TNB’s lawful chartering authority—and the language of the governing statute, the FRBNY undertook its own protracted internal review of TNB. TNB fully cooperated with that review, which ultimately concluded in TNB’s favor. At the same time, the FRBNY also apparently referred the matter to the Board of Governors of the Federal Reserve System (the “Board”) in Washington, D.C. 

8. In December 2017, TNB was informed orally by an FRBNY official that approval would be forthcoming—only to be called back later by the same official and told that the Board had countermanded that direction, based on alleged “policy concerns.” 

9. TNB’s principals thereafter met with staff representatives of the Board, as well as the President of the FRBNY, to explain that there was no lawful basis to reject TNB’s application for a Master Account. On information and belief, the FRBNY and its leadership agreed with TNB and were prepared to open a Master Account. 

10. Though TNB had satisfactorily completed the FRBNY’s diligence review, the Board continued to thwart any action by the FRBNY to open TNB’s Master Account, reportedly at the specific direction of the Board’s Chairman. 

11. Having delayed the process for nearly one year—effectively preventing TNB from doing business—the FRBNY has repeatedly refused either to permit TNB to open a Master Account or to state that the FRBNY will ultimately do so. 

[FRBNY declined our request for comment on TNB. —Ed.]

So we’re left to wonder, why does the Fed object so much?

It may worry about controlling the size of its balance sheet—how many reserves banks have at the Fed, and how many Treasuries the Fed correspondingly buys. If narrow banks get really popular, the Fed might have to buy more Treasuries to meet the need. 

Alternatively, the Fed might have to discriminate, paying narrow banks less interest than it pays “real” banks, in order to keep down the size of the narrow-banking industry. It would then face hard questions about why it is discriminating and paying traditional banks more than it pays everyone else. It’s already a bit of a puzzle that the Fed pays interest on reserves larger than what banks can get anywhere else, even Treasuries.   

But why does the size of the balance sheet matter? Why does it matter whether people hold Treasuries directly, or via a money-market fund or a narrow bank, the latter of which holds reserves at the Fed, which holds Treasuries? Why should the Fed want to keep down the size of a completely safe alternative to traditional deposits?

“Money” is no longer money, and does not cause inflation. When the Fed pays interest on huge amounts of excess reserves, the size of the balance sheet no longer matters, especially in this regard. If people want to hold more Treasuries indirectly through a narrow bank and the Fed, and correspondingly less directly, that has no stimulative or depressing effect at all. Even if you think quantitative-easing purchases—supply-driven changes in the balance sheet—matter, it is not at all clear why demand-driven changes in the balance sheet should matter.

The Fed already allows a reverse repo program, the Overnight Reverse Repurchase Agreement Facility, through which 130 nonbank institutions such as money-market funds can (in effect) hold reserves as deposits. Now, the Fed currently pays those counterparties 20 basis points (0.2 percent) less than it pays banks. TNB’s main initial business model is to give money-market funds a way to earn the extra 20 basis points that banks get to earn. The Fed may simply be mad at this effort to undercut the advantage it gives to banks. 

If the Fed is worried about financial crises, it ought to encourage narrow banks and give people and businesses gold stars for using them.

A second possible concern the Fed may have with narrow banks is captured in the argument, made during the discussion about reverse repos, that narrow banks are a threat to financial stability, not a guarantor of it as I have described, because people will run to narrow banks and away from repo and other short-term financing in times of stress.

This is, in my view, completely misguided. Again, narrow banks are just an indirect way of holding Treasuries. There is nothing now stopping people from “running” to Treasuries directly, which is exactly what they did in the financial crisis.

Furthermore, the Fed does not, in a crisis, seek to force people to hold illiquid assets having a run. The Fed pours liquid assets into the system like Niagara Falls, and buys illiquid assets from others, all in massive quantities.

Moreover, the whole point of a narrow bank is that large businesses don’t hold fragile, run-prone, short-term assets in the first place. By paying interest on reserves, and allowing more and more people to enjoy run-proof government money, there is less gasoline in the financial system to begin with. If the Fed is worried about financial crises, it ought to encourage narrow banks and give people and businesses gold stars for using them.

The emptiness of both hypothetical concerns is easy to see from this: banks today already contain narrow banks married to investment banks. There are about $2 trillion of demand deposits—mostly checking accounts—overall. Banks have $1.8 trillion of reserves at the Fed and another $2.5 trillion of government securities (according to the Fed’s Z.1, H.6, and H.8 reports at federalreserve.gov). The Fed could carve narrow banks out of current banks tomorrow. If there were some threat to monetary policy or financial stability posed by banks being able to take deposits and funnel them into reserves, we’d be there now. The only difference is that if big banks such as Chase and Citi lose money on their risky investments, they drag down depositors too, and the government bails out the depositors. A true narrow bank just separates these functions and keeps them distinct in bankruptcy court.

By not explaining its concern, the Fed leaves room for dark conjecture. Narrow banks would put a lot of regulators out of business. Narrow banks would undermine profits of the big banks, which today pay you next to nothing on your checking accounts, and earn 2.2 percent from the Fed on the reserves, where they park your money. 

Whatever the reason for the Fed’s reluctance to permit TNB to get off the ground, it is sad to see financial policy makers turn down such an obvious boon to financial stability and efficiency, and slow walk it to regulatory death, despite what appear to be clear legal rights of TNB to serve its customers and the economy.

John H. Cochrane is a senior fellow of the Hoover Institution at Stanford University and distinguished senior fellow at Chicago Booth. This essay is adapted from a post on his blog, The Grumpy Economist.