Narrow banking

... someone came up with a much simpler and amazing solution. It’s this:

• Start a bank;
• Take deposits;
• Invest 100 percent of those deposits in reserves at the Fed; and
• Pass the interest on to your depositors.

It is called TNB USA Inc. (for “The Narrow Bank”), it is run by the former head of research at the New York Fed, and it is simultaneously a dumb simple one-sentence idea and the most interesting bit of financial engineering that I’ve seen this year. ...

... TNB wants to offer its accounts only to “the most financially secure institutions,” meaning apparently money-market funds and foreign central banks, and it does not plan to “provide any retail banking services for individuals.” It is a pure interest-rate arbitrage for money-market funds: Instead of effectively depositing money with the Fed through its reverse repo facility at 1.75 percent, funds could deposit their money with TNB and get the Fed’s higher rate on reserves, 1.95 percent. Presumably TNB would take a cut, but its expenses would be small: It would have only a relatively small number of very large customers, so there’s not a lot of administrative overhead, and it’s not doing any lending or investing work.

It’s fine, you know, it’s a trade, but if it works the really interesting extension is to do it for retail. The overhead would be higher — you’d need at least a website, a customer service department, ATM cards — but the opportunity is intriguing. You could offer retail depositors a checking account at a bank that is immune to financial crises, runs and bad investments, a checking account that is fully backed by the Fed.

Also, weirdly, you might be able to pay them more interest than regular banks offer. “The FDIC recently reported that jumbo deposits — $100,000 or more — on average earned eight basis points (0.08 percent) from savings accounts, and five basis points (0.05 percent) from checking accounts, while the Federal Reserve Banks pay 195 basis points (1.95 percent) as the IOER rate,” notes TNB. If banks are mostly investing in things that are riskier (and so higher-return) than Fed deposits, they should be able to pay interest that is higher than the rate on Fed deposits. But of course if you’re a regular bank doing that, you have to hire a lot of bankers to evaluate those loans and investments, and risk managers to check up on them, and some of the investments will go bad and you’ll lose money, and you probably have branches, and the whole thing is just big and expensive. The TNB model is much leaner, and it is quite possible that it could pay a higher rate.

But so far it doesn’t work. TNB is in the news because it got a provisional banking charter in Connecticut, set itself up as a bank, and went to the Fed asking to open a reserve account, but the Fed said no. So TNB is suing the Fed, arguing that the Fed’s rules require it to open an account for any qualified bank, and that it is a qualified bank. Here is TNB’s complaint; here are an analysis from John Cochrane and an article about it in the Wall Street Journal. From the complaint it seems like TNB is mystified about why the Fed said no, but it apparently goes all the way to the top: The New York Fed declined the account “reportedly at the specific direction of the Board’s Chairman,” Jerome Powell. The Fed has not said what its objection is.
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Given that reluctance to completely scrap the banking system and start over, people have proposed more incremental, optional steps: FedAccounts, or now TNB. In these plans, nothing changes in bank regulation; banks can keep doing exactly what they’re doing now. But their competitive landscape changes: Instead of just competing with other banks, or other non-government-backed sources of money-like claims (money-market funds, etc.), the banks would now have to compete with interest-bearing accounts issued directly (or, with TNB, somewhat indirectly) by the Fed. But that is tough competition! If you can get paid 1.95 percent on perfectly safe deposits, getting 0.08 percent on imperfectly safe deposits is not very appealing. Narrow banking by competition might end up in the same place as narrow banking by regulation: If banks can no longer attract deposits — or, with TNB, if they can no longer attract short-term funding from money-market funds who go to TNB instead — then they will effectively be forced to transform into something else. (Cochrane uses the term “equity-financed banks”: They would have the assets of traditional giant banks — loans, securities, etc. — but their liabilities wouldn’t include anything deposit-like; they’d just be funded by equity and long-term debt.) If you think that that would be a bad thing — if you think that pulling deposits from big banks would precipitate a crisis, or at least reduce lending — then you won’t want to do it accidentally. You won’t want to open a Fed account for a tiny weird bank whose business model might bring the whole system down. No matter how interesting it is.
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... TNB is exclusively meant to serve non-bank financial institutions, and money market mutual funds (MMMF) especially. Its purpose is to allow such institutions, which are not able to directly take advantage of the Fed’s policy of paying interest on excess reserves (IOER), to do so indirectly. In other words, TNB is meant to serve as a “back door” by which non-banks may gain access to the Fed’s IOER payments, with their TNB deposits serving as surrogate Fed balances, thereby allowing non-banks to realize higher returns, with less risk, than they might realize by investing directly in Treasury securities. J.P. Koning gets this (and much else) right in his own post about TNB, published while yours truly was readying this one for press:

TNB is a designed as a pure warehousing bank. It does not make loans to businesses or write mortgages. All it is designed to do is accept funds from depositors and pass these funds directly through to the Fed by redepositing them in its Fed master account. The Fed pays interest on these funds, which flow through TNB back to the original depositors, less a fee for TNB. Interestingly, TNB hasn’t bothered to get insurance from the Federal Deposit Insurance Corporation (FDIC). The premiums it would have to pay would add extra costs to its lean business model. Any depositor who understands TNB’s model wouldn’t care much anyways if the deposits are uninsured, since a deposit at the Fed is perfectly safe.

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Once one realizes what TNB is about, explaining the Fed’s reluctance to grant it a Master Account becomes as easy as winking. The explanation, in a phrase, is that, were it to gain a charter, TNB could cause the Fed’s present operating system, or a substantial part of it, to unravel. Having gone to great lengths to get that system up and running, the Fed doesn’t want to see that happen. Since the present operating system is chiefly the brainchild of the Federal Reserve Board, it’s no puzzle that the Board is leading the effort to deny TNB its license.

How would TNB’s presence matter? The Fed has been paying interest on banks’ reserve balances, including their excess reserves, since October 2008. Ever since then, IOER rates have exceeded yields on many shorter-term Treasury securities — while being free from the interest-rate risk associated with holdings of longer-term securities. But banks alone (that is, “depository institutions”) are eligible for IOER. Other financial firms, including MMMFs, have had to settle for whatever they could earn on their own security holdings or for the fixed offering rate on the Fed’s Overnight Reverse Repurchase (ON-RRP) facility, which is presently 20 basis points lower than the IOER rate.

Naturally, any self-respecting MMMF would relish the opportunity to tap into the Fed’s IOER program. But how can any of them do so? Not being depository institutions, they can’t earn it directly. Nor will placing funds in an established bank work, since such a bank will only “pass through” a modest share of its IOER earnings keeping some — and probably well over 20 basis points — to cover its expenses and profits. But a bank specifically designed to cater to the MMMFs needs — now that’s a horse of a different color.

What would happen, then, if TNB, and perhaps some other firms like it, had their way? That would be the end, first of all, of the Fed’s ON-RRP facility and, therefore, of the lower limit of the Fed’s interest rate target range that that facility is designed to maintain.

Second, the Fed would face a massive increase in the real demand for excess reserve balances that would complicate both its monetary control efforts and its plan to shrink its balance sheet.
TANSTAAFL

OK, so the Fed may not like what TNB is up to. But why should the rest of us mind it? So what if the Fed’s leaky “floor-type” operating system lacks a “subfloor” to limit the extent to which the effective fed funds rate can wander below the IOER rate? Why not have the Fed pay IOER to the money funds, and to the GSEs while it’s at it, and have a leak-free floor instead? Besides, many of us have money in money funds, so that we stand to earn a little more from those funds once they can help themselves to the Fed’s interest payments. What’s not to like about that?

Plenty, actually. Consider, first of all, what the change means. The Fed would find itself playing surrogate to a large chunk of the money market fund industry: instead of investing their clients’ funds in some portfolio of Treasury securities, money market funds would leave the investing to the Fed, for a return — the IOER rate — which, instead of depending directly upon the yield on the Fed’s own asset portfolio, is chosen by Fed bureaucrats.

Now ask yourself: Just how is it that the Fed’s IOER payments could allow MMMFs to earn more than they might by investing money directly into securities themselves? Because the Fed has less overhead? Don’t make me laugh. Because Fed bureaucrats are more astute investors? I told you not to make me laugh! No, sir: it’s because the Fed can fob-off risk — like the duration risk it assumed by investing in so many longer-term securities — on third parties, meaning taxpayers, who bear it in the form of reduced Fed remittances to the Treasury. That means in turn that any gain the MMMFs would realize by having a bank that’s basically nothing but a shell operation designed to let them bank with the Fed would really amount to an implicit taxpayer subsidy. There Ain’t No Such Thing As A Free Lunch.

As it stands, of course, ordinary banks are already taking advantage of that same subsidy. ...

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Yet for all the controversy TNB's lawsuit has generated, its outcome may no longer matter as much as it might once have. For one thing, TNB's success can no longer undermine the Fed's ON-RRP program, which is designed to implement the Fed's target interest rate lower bound, for the simple reason that that program is already moribund. Commenting on my post, J.P. Koning observed that, while the Fed's ON-RRP facility, first established in December 2013, once supplied non-bank financial institutions with an attractive investment alternative, it ceased being so this year. As the chart below, reproduced from J.P.'s comment, shows, the facility — which once accommodated hundreds of billions of dollars in bids — is now completely inactive:
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... the decision not to give TNB a master account was clearly illegal. Unless Congress changes the statutory limitations on the Fed, it is likely that the courts will compel the Fed to provide TNB a master account, opening the door for them, and other similar banks, to further experiment. It’s quite possible that such a decision could force a massive change in the way the Fed influences monetary policy.

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The puzzling question is, how can TNB make money at that? TNB takes money, invests it with the Fed, and the Fed in turn buys US treasuries. How is that better than TNB simply operating a money market mutual fund that invests directly in treasuries?

The answer is, that for most of the last decade, the Fed has paid more interest on reserves than comparable treasury rates. Yes, "money" pays higher interest than "bonds," an inversion of classic monetary theory. Since money is more liquid, how can this survive? The answer is, because only banks can access this kind of "money." TNB was going to upend that.
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The New York Fed has prevented his company, TNB USA Inc., from opening the type of account it needs to make the business model work. That prompted the firm to sue the central bank last year, saying it was obstructing the project. The Fed found another way to fight back as the case continues to unfold. Last month, it proposed rewriting its rules so TNB or any other potential narrow banks -- so named because they are solely focused on taking deposits -- could only get lower interest rates, sabotaging their raison d’être.
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... Here is a notice of proposed rulemaking that the Fed issued on Wednesday, explaining its objections to what it calls “Pass-Through Investment Entities” like TNB, “depository institutions with narrowly focused business models that involve taking deposits from institutional investors and investing all or substantially all of the proceeds in balances at Reserve Banks.” ...

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March 06, 2019

Federal Reserve Board issues advance notice of proposed rulemaking seeking public comment on whether to amend Regulation D to lower certain interest rates paid on balances at Federal Reserve Banks

The Federal Reserve Board on Wednesday invited public comment on whether it should propose amendments to its Regulation D (Reserve Requirements of Depository Institutions) to lower the rate of interest paid on excess balances ("IOER") maintained at Reserve Banks by eligible institutions that hold a very large proportion of their assets in the form of balances at Reserve Banks.

As set forth in the advance notice of proposed rulemaking, these narrowly focused depository institutions ("Pass‑Through Investment Entities" or "PTIEs") could attract a very large quantity of deposits from institutional investors, yet at the same time avoid the costs borne by other depository institutions, such as the costs of capital requirements and the other elements of federal regulation and supervision, because of the limited scope of their product offerings and asset types. The advance notice of proposed rulemaking requests comment on the potential benefits and potential costs associated with the presence of such institutions in the U.S. financial system and their receipt of IOER on their balances at a Reserve Bank.

Comments are due within sixty days after the date of publication of the ANPR in the Federal Register, which is expected shortly.

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A decade on, the real lesson of the Great Recession has yet to be learned. Trust-me banking wasn’t to be trusted in 2008. It’s not to be trusted today. Limited Purpose Banking, which has been endorsed by a who’s who of economists and former high-ranking policymakers, can fix our financial system once and for all. The Fed, if it were doing its job rather than protecting its turf, would do everything in its power to usher in Limited Purpose Banking, starting with the supporting, not blocking Narrow Banking.

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In 2020, the New York Fed successfully got TNB’s lawsuit dismissed on grounds that it was still deciding on the bank’s application. As of press time, the final ruling on TNB was still pending.
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McAndrews and his team are still hoping for good news. In the meantime, he works as a consultant from his home in Philadelphia, “while we sit on our thumbs waiting for the Fed to move, so to speak.”
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