Fed vs. Narrow Banks

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Suppose an entrepreneur came up with a plan for a financial institution that is completely safe — it can never fail, it can never suffer a run, it offers depositors perfect safety with no need for deposit insurance, asset risk regulation, capital requirements, or the rest, and it pays depositors more interest than they can get elsewhere.

Narrow banks are such institutions.  They take deposits and invest the proceeds in interest-bearing reserves at the Fed. They pay depositors that interest, less a small profit margin. Pure and simple. Economists have been calling for narrow banks since at least the 1930s.

You would think that the Fed would welcome narrow banks with open arms.

You would be wrong.

The latest chapter in the Fed’s determined effort to quash The Narrow Bank (TNB) and at least one other effort to start a narrow bank is unfolding. (Previous posts here and here.)

Last year, TNB sued the Fed for refusing to allow TNB an account at the Fed at all. The Fed has just now filed a motion to dismiss the suit. The Fed has also issued an advance notice of proposed rule making, basically announcing that it would, on a discretionary basis, refuse to pay interest on reserves to any narrow bank. In case anyone gets a bright idea to take a small bank that already has a master account and turn it in to a narrow bank, thereby avoiding TNB’s legal imbroglio, take note, the Fed will pull the rug out from under you.

I find both documents outrageous. The Fed is acting as a classic captured regulator, defending the oligopoly position of big banks against unwelcome competition, its ability to thereby coerce banks to do its bidding, and to run a grand regulatory bureaucracy, against competitive upstarts that will provide better products for the economy, threaten the systemically dangerous big bank oligopoly, and reduce the need for a large staff of Fed regulators.

I state that carefully, “acting as.” It is my firm practice never to allege motives, a habit I find particularly annoying among a few other economics bloggers. Everyone I know at the Fed is a thoughtful and devoted public servant and I have never witnessed a whiff of such overt motives among them. Yet institutions can act in ways that people in them do not perceive. And certainly if one had such an impression of the Fed, which a wide swath of observers from the Elizabeth Warren left to  Cato Institute anti-crony capitalism libertarians do, nothing in these documents will dissuade them from such a malign view of the institution’s motives, and much will reinforce it.  

On the outrage scale, the first paragraph of the Fed’s motion to dismiss takes the cake:


Plaintiff TNB USA Inc. (“TNB”) asks the Court for a declaratory judgment and an injunction compelling Defendant Federal Reserve Bank of New York… to accept deposits from TNB so that it can arbitrage a critical interest rate the Federal Reserve uses to fulfill its statutory mandate to set and execute United States monetary policy. … TNB seeks to open a deposit account at the New York Fed not so that it can engage in the typical business of banking, but solely so that TNB can park the funds of its wealthy, institutional depositors in the account and pass TNB’s IOER earnings on to them, after taking a cut for itself.
(Emphasis mine.) The perfectly normal business of taking deposits, and investing them is now maligned as “arbitrage.” Moreover, this is precisely what a large swath of the banking and financial system is doing right now. Government agencies cannot invest in reserves, so they are depositing money with banks at rates you and I can’t get, with those funds going straight to reserves. Many of the interest paying reserves are going through foreign banks this way. The Fed allows money market funds to invest in reserves through its reverse repo program. Apparently money market funds investing in reserves is fine, but a bank doing exactly the same thing is a disparaged “arbitrage.”

But savor the last sentence. Wealthy? The Fed is now in the income-redistribution business, dog-whistling inequality, and “wealthy” investors legal rights are to be disparaged? Is no-one “wealthy” or earning profits among the management or customer base of, say Chase? (Actually, there is a reason that TNB set up only to take institutional money: Not love of the wealthy, but  to avoid the regulatory costs imposed by the Fed if one takes retail deposits.)

“The typical business of banking” reveals a Fed view reinforced elsewhere in the documents. The Fed  apparently does view its habit of paying large interest on reserves as a subsidy to banks who receive them, and it expects banks to use that money to cross subsidize other activities according to the Fed’s wishes. That narrow banks might undercut such cross-subsidies is clearly its major concern.

Much of the rest concerns the legal question whether TNB can sue the Fed. Most of this is not my expertise or relevant to the policy questions. Some is strained to the point of hilarity — if you’re not TNB.
TNB does not have standing to bring this action. TNB’s application for an account at the New York Fed is still under consideration. TNB thus has suffered no injury in fact,
The Fed, like many regulators faced with uncomfortable decisions, has chosen the path of endless delay — precisely why TNB is suing them. If it delays long enough, then TNB will run out of money and give up. This is a larger issue in all regulatory agencies, and a good reason for a shot clock regulatory reform.

It goes on to the idea that the Fed’s discretion to pay interest extends to discretion to treat individual banks differently based on the Fed’s unlimited discretion to reward business models it likes and punish business models it doesn’t like. I hope the court stamps that one out forcefully. And finally it reiterates the incoherent policy arguments of the proposed rule.

The advance notice of proposed rule making is an even more revealing document. In an era of supposedly science-based policy it contains nothing more than speculation — might, could, may, — of vague possible problems, and offers no argument or evidence, just assertion of the Fed’s “beliefs” against standard arguments for Narrow banks. At least it acknowledges the latter exist.

It starts with subtle denigration. The notice calls them
narrowly focused depository institutions (Pass-Through Investment Entities or PTIEs) 
refusing to use the word “bank,” which is what they are. They are state-chartered banks, with every legal right to have accounts at the Fed.

Obtaining a master account would
enable PTIEs to earn interest on their balances at a Reserve Bank at the IORR and IOER rate, yet at the same time avoid the costs borne by other eligible 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.
You get the sense right away. Wait, that’s unfair competition! They don’t have to pay big regulatory costs! Indeed they don’t, and because the regulations are somewhat sensible and recognize that narrow banks pose absolutely zero systemic danger. That they can avoid regulatory costs is a plus, not a minus! You can see how a reader infers the Fed wants to protect big banks from “unfair” competition.

The Fed’s ostensible arguments are different,
The Board is concerned that PTIEs, …have the potential to complicate the implementation of monetary policy…. the Board is concerned that PTIEs could disrupt financial…intermediation in ways that are hard to anticipate, and could also have a negative effect on financial stability,….
 Concerned. Have the potential too. Could disrupt. Hard to anticipate. Could have. On that basis we write rules denying a financial innovation that has been advocated for nearly a century, and has the potential to end financial crises forever?

Let’s look at the arguments.

1. “Complicate” monetary policy
some market participants have argued that the presence of PTIEs could help the implementation of monetary policy. … the activities of PTIEs could narrow the spread between short-term rates and the IOER rate, potentially strengthening the ability of the Federal Reserve to manage the level of short-term interest rates.
Count me in! Right now, interest on excess reserves is not spreading uniformly throughout the financial system. Banks are remarkably uncompetitive. For example, when the Fed was paying 0.25% on reserves, my bank, Chase, paid 0.01% on my checking account. Now that Chase is getting 2.4% on its abundant reserves, and all market rates have risen accordingly, Chase is paying….


the same lousy 0.01% on checking accounts. Well, obviously there is not much competition for deposits. Competition from narrow banks would force interest rates closer to the Fed’s IOER. The same is true for the rather puzzling spreads between IOER, treasury rates, and various overnight rates for institutions that aren’t Banks. Arbitrage indeed. Arbitrage is good — it forces rates together.

The Fed says nothing to counter this argument. Instead, it offers a falsehood and an easily contradicted worry about balance sheets.
The viability of the PTIE business model relies on the IOER rate being slightly above the level of certain other key overnight money market rates. 
First, this is false. Anything more than the 0.01% Chase is paying will make a narrow bank go. TNB, the obvious target of all this, was indeed trying to offer money market funds a bit more than they can get by their deposits at the Fed. But the newer narrow banks are going after large commercial and retail deposits that don’t care about that small spread.

But just why is the Fed holding IOER above market rates, and above the rate it pays money market funds, contrary to the clear statement of the law? If this is the problem, the Fed can just offer money market funds IOER and PTIEs would disappear. It is the Fed’s desire to pay big banks a bit more than everyone else causing the problem, if there is one, in the first place.
The ability of PTIEs to attract a very large amount of deposits…could affect the FOMC’s plans to reduce its balance sheet to the smallest level consistent with efficient and effective implementation of monetary policy. … In order to maintain the desired stance of monetary policy, the Federal Reserve would likely need to accommodate this demand by expanding its balance sheet and the supply of reserves. 
This just makes no sense at all. The Fed controls the supply of reserves, period. If the Fed refuses to buy assets, reserves are what they are, and other interest rates adjust. To bring money to a narrow bank, a depositor must tell his or her current bank to transfer reserves to the narrow bank. The current bank may have to sell assets, driving up interest rates until market rates equal the rate on reserves. When quantities do not adjust prices do. You can tell confusion by bureaucratese. What is the “stance of monetary policy” here if not the interest rate on reserves and the balance sheet?

Anyway, why is the size of the balance sheet important? The Fed is doing a very curious dance, trying to set a price (the interest rate) and a quantity at the same time. If the Fed wants to set interest rates at, say, 2.4%, it should say “we trade short term treasuries for reserves at 2.4%. Buy and sell, come and get them.” It should say that to anyone. Why is a large short-term treasuries only balance sheet a problem?

Continuing,
PTIEs could be an attractive investment for lenders in short-term funding markets such as the federal funds market. If the current lenders in the federal funds market shifted much of their overnight investment to deposits at PTIEs, the federal funds rate could become volatile. Such a development could require the FOMC to change its policy target on relatively short notice. Moreover, a marked change in the volatility of the federal funds rate could have spillover effects in many other markets that are linked to the federal funds rate such as federal funds futures, overnight index swaps, and floating-rate bank loans.
Could. If. Could. Could. Could. Is there a single fact here other than rampant speculation, of the solidity to deny people the right to start a perfectly legal business? Moreover, the analysis is airy speculation. Federal funds is where banks lend money overnight to other banks. The Federal funds market is already essentially dead, because banks are holding a huge supply of reserves. That’s a good thing. Lenders in the federal funds market are already banks, and they can access reserves! What fed funds lender is going to give money to another bank to invest in reserves rather than do so directly! Contrariwise, arbitrage makes prices more not less equal. Why in the world would more access to IOER make any other rate more volatile. And if Fed funds become more volatile, let indexes move to Libor, general collateral, or other rates. Do we forbid promising businesses to start because current indexing contracts are written in stone somewhere? 

Financial intermediation (and protecting the banks)
Deposits at PTIEs, as noted above, could become attractive investments for many lenders in overnight funding markets. Lenders in the overnight general collateral (“GC”) repo market could find PTIE deposits more attractive than continued activity in the overnight GC repo market. 
That’s the whole point! Has the Fed forgotten October 2008 when the repo market froze and we had a little financial crisis? Money invested in repos leads to financial crises. Money invested in narrow banks cannot spark financial crises. The Fed should be cheering a demise of the repo market in favor of narrow banks!

What does the Fed have to say? 
If the rise of PTIEs were to reduce demand for GC repo lending, securities dealers could find it more costly to finance their inventories of Treasury securities. 
Aw, gee. Isn’t this the same Fed that was railing at “wealthy” investors making “arbitrage” profits? 
PTIEs could also diminish the availability of funding for commercial banks generally. To the extent that deposits at PTIEs are seen as a more attractive investment for cash investors that currently hold bank deposits, these investors could shift some of their investments from deposits issued by banks to deposits with PTIEs. This shift in investment, in turn, could raise bank funding costs and ultimately raise the cost of credit provided by banks to households and businesses.
Now we’re getting somewhere. Here it is boldface: The Fed is subsidizing commercial banks by paying interest on reserves, allowing the banks to pay horrible rates on deposits, because the Fed thinks out of banks’  generosity — or regulatory pressure — banks will turn around and cross-subsidize lending to households and businesses rather than just pocket the spread themselves. 

Regulators forever have stifled competition to try to create cross-subsidies. Airline regulators thought upstart airlines would skim the cream of New York to Chicago flights and undermine cross-subsidies to smaller cities. Telephone regulators thought competitive long-distance would undermine cross-subsidies to residential landlines. 

The long-learned lesson elsewhere is that regulation should not try to enforce cross-subsidies, especially by banning competition. You and I should not be forced to earn low deposit rates, and innovative businesses stopped from serving us, if the Fed wants to subsidize lending. 

And needless to say, buttressing big bank profits, stopping competition, and then hoping the big banks turn around to pass on the cross subsidy to lenders rather than take it as profits, is nowhere in the Fed’s charter. 

If deposits flee to narrow banks, then let banks raise money with long-term debt and equity. The transition to a run free financial system will happen on its own, and we will never have financial crises again. If the US government wishes to subsidize lending, let it do so by writing checks to borrowers, not through financial repression of depositors. 
Some have argued that the presence of PTIEs could play an important role in raising deposit rates offered by banks to their retail depositors.
Yes, me! See above snapshot. 
The potential for rates offered by PTIEs to have a meaningful impact on retail deposit rates, however, seems very low. …retail deposit accounts have long paid rates of interest far below those offered on money market investments, reflecting factors such as bank costs in managing such retail accounts and the willingness of retail customers to forgo some interest on deposits for the perceived convenience or safety of maintaining balances at a bank rather than in a money market investment. 
That makes no sense at all. In 2012, Chase paid 0.01%, and IOER was 0.25%. In 2019, Chase is paying 0.01% and IOER is 2.4%. The costs of managing retail accounts have not risen 2.15 percentage points. Retail deposit rates are very slow moving because banking is very uncompetitive. Banking is very uncompetitive because the Fed has placed huge regulatory barriers in the face of competition. And it is in the process of doing so again. 

Financial stability. The big issue. 
Some have argued that deposits at PTIEs could improve financial stability because deposits at PTIEs, which would be viewed as virtually free of credit and liquidity risk, would help satisfy investors’ demand for safe money-like instruments. According to this line of argument, the growth of PTIEs could reduce the creation of private money-like assets that have proven to be highly vulnerable to runs and to pose serious risks to financial stability. Some might also argue that PTIE deposits could reduce the systemic footprint of large banks by reducing the relative attractiveness to cash investors of deposits placed at these large banks.
Yes, yes, a thousand times yes! By just allowing narrow banks, we will move to an equity-financed, run-free financial system. Economists have been calling for this since the Chicago Plan of the 1930s. What does the Fed have to offer?
The Board believes, however, that the emergence of PTIEs likely would have negative financial stability effects on net. Deposits at PTIEs could significantly reduce financial stability by providing a nearly unlimited supply of very attractive safe-haven assets during periods of financial market stress. PTIE deposits could be seen as more attractive than Treasury bills, because they would provide instantaneous liquidity, could be available in very large quantities, and would earn interest at an administered rate that would not necessarily fall as demand surges. As a result, in times of stress, investors that would otherwise provide short-term funding to nonfinancial firms, financial institutions, and state and local governments could rapidly withdraw that funding from those borrowers and instead deposit those funds at PTIEs. The sudden withdrawal of funding from these borrowers could greatly amplify systemic stress.
In short, in the face of nearly a century of careful thought about narrow and equity financed banking, the Fed has nothing coherent to offer, and only this will-o-wisp. This argument does not pass basic budget constraint, supply and demand thinking.

There is, if the Fed wishes, a fixed supply of reserves, and thus a fixed supply of narrow bank deposits. There is nowhere to run to. Moreover, the Fed does not try to fight runs by forcing investors to hold risky assets. In a crisis, the Fed is on the frontlines, buying assets and issuing reserves as fast as it can. The Fed itself makes the supply of reserves elastic in a crisis. If narrow banks could do this — if they could take in risky assets and offer reserve-backed deposits in exchange — the Fed should be cheering the final answer to the central cause of runs. Alas they cannot.

If narrow banks posed a systemic risk in this way, federal money market funds or treasury bills themselves would do so — after all, people can (try to) run to those too in a crisis. The tiny differences between narrow bank deposits, reserves, federal money market funds, or underlying short-term treasuries are irrelevant, and whether some of the supply of treasuries flows through the fed, to narrow banks, to deposits, or flows through money market funds, to those investments, or are held directly by large banks is irrelevant, and certainly not a basis on which to deny one slightly different flavor of this intermediation.

Now it is true that in a crisis the fixed supply of reserves could drain from big banks to narrow banks, if once again despite the Fed’s massive asset risk regulation the big banks lose a lot of money, if once again the Fed’s liquidity and capital regulations prove ineffective, and so forth. But once again, we see the Fed protecting big bank’s prerogative to continue in a systemically dangerous and massively leveraged way. And even then, the narrow bank option is so close to treasuries and money market funds, that the kinds of large institutional investors that would run can do so just as easily.

But the point is that investors already in PTIE deposits don’t need to run anywhere. We trade a system based on a small amount of run-free government money and a large amount of run-prone private money for a system with a large amount of run-free government money (reserves, transmitted through narrow banks) and a small amount of run-prone private money (repo, overnight lending). There is a lot less run-prone shadow banking to run from in a crisis. We get rid of this whole crazy idea that risk management consists of “we’ll sell assets on the way down.”

The Fed ruminated over this argument when debating whether to allow money market funds access to  IOER. It seems the incoherence of the argument settled in, and now the Fed is happy with money market fund access to IOER. What is the difference between money market funds and narrow banks? Only that the latter threaten to compete away cheap funding for large commercial banks.
In addition to the foregoing, the Board is also seeking comment on the following questions: 
1. Has the Board identified all of the relevant public policy concerns associated with PTIEs? Are there additional public policy concerns that the Board should consider?
Yes. There is the perception, if not the reality, that the Fed is acting in the interests of big banks to enforce their oligopoly, to hold down deposit rates thereby boosting bank profits, and to needlessly expand its regulatory reach. Allowing narrow banks to compete mitigates all of these.
2. Are there public policy benefits of PTIEs that could outweigh identified concerns?
PTIEs, as you insist on calling them, have for 90 years been identified as the one crucial innovation that can end financial crises forever, just as the move from private banknotes to treasury notes ended forever runs on those notes in the 19th century. Deposits moving to narrow banks will lead regular commercial banks to a much higher equity position naturally, without the Fed having to push.

3. If the Board were to determine to pay a lower IOER rate to PTIEs, how should the Board define those eligible institutions to which a lower IOER rate should be paid?
The board should offer the same rate to all comers.
4. If the Board were to determine to pay a lower IOER rate to PTIEs, what approach should the Board adopt for setting the lower rate?
The board should not discriminate.
5. Are there any other limitations that could be applied to PTIEs that might increase the likelihood that such institutions could benefit the public while mitigating the public policy concerns outlined above?
None.

PS. Dear Fed: These vague, unscientific, speculative and incoherent arguments — many of which would make easy spot-the-fallacy exam questions —  make you look foolish. They reinforce every negative stereotype that you serve the interests of big banks, that you have no idea how financial crises work.  Welcome narrow banks with open arms. Give them a non-systemic-danger medal.