Wednesday, March 13, 2019

Fed vs. Narrow Banks

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?

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?

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.

Update: A last thought, not mentioned here. If anyone should worry about narrow banks it is money market funds, especially those that hold only treasuries. Treasures -> Fed -> reserves -> narrow bank -> consumer is better than Treasuries -> money market fund -> consumer. Money market funds take a day or two to settle, bank accounts are instant, and could now pay higher interest.

Here, I think the Fed should cheer. I bet it won't. Though the rise of money market funds caused a huge headache in the 1980s, the Fed seems to like them now. Some of the reason for a quarter percent rather than zero interest rate target was to keep money market funds alive, and the Fed now allows money market funds to invest in reserves. Doing it through narrow banks will engage the Fed's balance sheet (hold more treasuries, issue more reserves). Underlying all of this, the Fed seems determined to lower the size of its balance sheet, even though we have learned from the last 10 years that a large supply of reserves is a great thing. I think this desire is more political than economic, which is not to dismiss it.


  1. Please file as friend of court brief if possible.

  2. This is a good post with strong arguments against banning narrowing banking, but your discussion of whether there is competition for deposits among conventional banks is weak. You point to Chase still offering roughly zero. But it's interesting you still choose to use Chase. If all you wanted was narrow bank functionality, you could switch to one of many higher-rate bank. In fact if you open up a savings and checking account at Ally, Amex, Citi, Capital One, CIT or many others, you can get FDIC insured savings at the IOER rate -20bps to +5bps on an online savings account and transfer funds instantly and with no fees to a parallel online checking account for bill paying and check writing. Either you stay with JP Morgan because of switching costs or some other benefit you receive in lieu of interest. Ironically the billions in advertising already spent by these direct banks growing deposit bases at low deposit wedges is great evidence against the Fed's concern that a narrow bank will have some calamitous affect on the banking system. But that's because the deposit market is already more competitive than you think and will be even more competitive over time given the significant decline in switching costs and geographic advantage recently.

    1. The chart at 49:26 in clearly shows that there is significant lack of competition in the retail deposit market.

  3. But if they did this, then the liquidity would flow to the least risky, most profitable short term investments and flee the less efficient, leaving a very large puddle of blood, not to mention residual risk, to be put in evidence of mistaken policy decisions of the last few decades or so.

    It's good to be the King. I'll take Rent Seeking for $300, Monte!

  4. The Fed could solve this quite easily by going back to not paying interest on reserves.

  5. Wow.

    "The perfectly normal business of taking deposits, and investing them is now maligned as 'arbitrage.'"

    Maybe it's not true, riskless arbitrage, but c'mon. The banking system may not be perfect but it can help foster economic activity. Access to credit helps growth, no matter which way you slice it. The alternative is essentially an Autarky world, where arbitrage opportunities are nil, taking things to an extreme. Why the Fed wants to put the lockdown on TNBs is beyond me, unless they're anti-competitive or have a desire to control damage/rewards.

  6. Why do you (or anyone else) hold any significant cash at any of the big banks? Banks like Ally, Discover, Amex, Goldman, etc. have been paying close to the Fed rate on their savings account for the last 10 years. They have superior customer service and benefits.

    Why would anyone still hold money at the big banks?

  7. Well-deserved take-down of an embarrassing pair of documents.
    I agree with (what I take to be) your recommendation that the FOMC target the repo rate, as opposed to the funds rate. The Fed did this in the aftermath of 9/11, accepting all bids for repo financing at a rate equal to the funds rate target. Given current arrangements -- paying interest on reserves -- the most natural approach is to set an administered rate and let markets sort out the spreads between it and various other rates, the same way the Fed used to set the funds rate and let markets handle the spread to repo and other rates. It never used to bother the Fed when repo was 10-20 basis points above or below the funds rate target. And having the FOMC target the repo rate would sidestep the delicate governance problem posed by the fact that the interest rate on reserves is set by the Board, not the FOMC.

  8. Broadly speaking, I agree with the post. However, I don't think the narrow bank idea goes far enough.

    Everyone -- banks, non-banks, and individuals -- should be able to have risk-free transaction accounts at the Fed. Banks would not get special privileges simply because they are banks.

    Given this facility, insured deposits would no longer be necessary, and in fact it might make sense to eliminate retail deposits, requiring small investors to go through money market funds to make sure they are adequately diversified.

    All qualifying institutions (not just banks) should have access to an API (Application Programming IUnterface) that would allow them to offer transaction processing services, including ATM access, checking and debit cards, as well as monthly reporting, for Fed account holders.

    The above approach obviously modernizes the financial system. More crucially, it clearly separates transaction processing from financial intermediation and increases competition in both areas.

    Should the Fed pay interest on these transaction accounts? I'm not sure I know enough about the subtleties of post-crisis monetary policy to say for sure. However, my instinct (which could easily be wrong) would be to say no. My concern is that an interest rate lever might be misused (either economically or politically).

    1. Correct!

      Fed would never agree to this as they will never want to monitor all the transactions themselves for AML\KYC, so they push it down to the banks, and then DoJ can fine the banks when they don't monitor\enforce AML laws.

      More feasible idea is to have a designated license for this, such as the e-Money license in the UK or Lithuania, and grant them access to a transaction account with the Fed and allow them to issue their depositors account under their own name. The result is almost like you say - direct deposits for anyone who so wishes - only with a plurality of (cheap-to-setup) PTIEs/TNBs/e-Money-institutions to monitor transactions for AML/KYC compliance.

  9. Tyler Cowen just released a podcast of a discussion he had with Ragu Rajan. It included a short section on narrow banking that still doesn’t make a lot of sense to me. Here it is:

    COWEN: Can narrow banking proposals work?
    RAJAN: Not really, for the reasons we just discussed. Narrow banking basically requires all the deposits to be invested essentially in safe treasuries, and no lending.
    COWEN: But you’re lending to the government, and then other private capital can do the private lending.
    RAJAN: Well, that’s the part, right? All the deposits first go to the government, and if the government has an excess of funding, it has to find a way of recycling it back to the private sector. It’s that part that people don’t talk about.
    What is the way the government is going to recycle it back? Is it going to start buying corporate bonds? Which bonds is it going to buy? What’s the kind of worry about cronyism that takes place at that point? Those are the kinds of issues we don’t talk about in narrow banking, and I think they deserve to be opened up.
    The other point is, of course, is there virtue for banks to be financed with shorter-term debt while lending longer term? And that’s part of what I’ve been trying to talk about.


    What am I missing? Why does Rajan say that “narrow banking requires all deposits to be invested in safe treasuries, no lending”? Sure, narrow banks won’t lend but they won’t hold all the deposits. If narrow banks are operating, can’t commercial banks still attract deposits by—I don’t know—paying more than 1 basis point? Maybe Rajan just likes the whole cross-subsidization business that John finds so annoying.

    If so, it’s too bad John isn’t still at Booth. I’d love to listen to a podcast of the lunchroom conversation where the two of them work it out.

    1. Mr. Rajan seems to assume that once a narrow bank exists traditional banks will no longer exist, so money for business investment will dry up unless the government supplies it.

  10. "Why do you (or anyone else) hold any significant cash at any of the big banks?"

    Brick-and-mortar banks have an oligopoly due to archaic laws on new branches and <$10 billion regulations. Banks with less than $10 billion in assets get much higher debit card fees and have a lower burden. So the local small banks will not compete for deposits which will put them over $10 billion. The large banks have little incentive to raise savings rates for a temporary boost in deposits. For big banks, the oligopoly game theory is very instructive.

    For institutional investors, they have to actually worry about counterparty risk. The largest custodian banks are State Street, BNY Mellon, JP Morgan and Citibank. State Street only has institutional accounts, with no retail or FDIC-insured deposits.

    State Street's domestic deposits yielded an annual rate of 1.2% in Q4 2018. The Fed's IOER was 2.2% for all of Q4 2018. With domestic deposits of $114 billion, the interest rate spread grossed $1.1 billion. Maybe I'm missing something from the complex world of banking. But the operational costs of merely handling FedWire or CHIPS transactions seems like they should be far, far less than $1.1 billion.

  11. Great post. The Fed reference to "wealthy depositors" was obnoxious

    By the way the Fed is schizophrenic on the class warfare scale.

    In its Beige Books, the Fed constantly refers to "worker shortages" reported by their "contacts" within the 12 districts.

  12. Great post. I agree with most of it (and I am a Fed economist), but I have an issue with your title.

    I know the Fed as an organization is fighting the TNB, but this is probably a decision of some of the leadership in DC and maybe NY. I am not aware of any system wide effort to discuss the desirability and regulation of narrow banks, as it’s the case, for example, for fast payments. I am actually curios to know who are the economists backing this regulation, and what are the papers that they are using to argue in favor of it. At least at the Richmond Fed, research economists don’t go saying things to the leadership without pointing to the related papers -- even when the current papers don’t cover exactly the topic in hand and some educated guess must be made. So these economists must have some research in their minds and I would like to know what exactly are the papers they are thinking about.

    Let me also add two comments on the advance notice.

    1. The notice says “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.” What does it mean by the “desired stance of monetary policy”? That rate should be whatever rate takes the economy to full employment. If the existence of narrow banks move other rates up and it affects lending to productive activities, the Fed can just lower the target rate in the next meeting. There is no reason the Fed has to expand its balance sheet. By the way, it is normal that shocks, such as demographic movements, trade wars and yes, financial innovation, move the natural rates around. That is why the Fed keep track of the economy and adjust its instance of monetary policy frequently. Fighting every change that can potentially move the natural rates seems a lost cause.

    2. The notice says “When Congress amended the Act to authorize Reserve Banks to pay interest on balances of depository institutions, it specifically restricted the receipt of such interest to a limited class of institutions. The Board is concerned that paying IOER to PTIEs would effectively amount to paying IOER to entities that Congress did not intend to receive it.” Wait a minute, I am not a lawyer, but the Fed is already paying about IOER to non-depository institutions through the reserve repo program. If the FRB recognizes that this was not Congress intent, then the reverse repo program amounts to pure regulatory arbitrage. We are a bank after all, so maybe regulatory arbitrage is in our DNA.

  13. Why not AA rated Commercial paper? No Fed. NO TBTF. Very low default rates. Shareholders are only ones at risk. One can purchase 1 day paper up to 270 days. While there is no FDIC, interest rates account for that risk. If the argument is only large deposits can purchase the paper, it seems the issuer could offer smaller amounts in a competitive market place.

  14. Great that you are focusing on the exclusivity given to Banks in deposit-making with the Central Bank(s) and - importantly in addition - also the exclusivity in accessing local (ACH, FedWire) and global (SWIFT) payment systems, as the source of the grandest monopolistic power in humanity today - the Great Global Banks Cartel!

    I think the latter exclusivity in access to the payment system(s) deserves more attention, because there is a silent war of boycott and exclusion out there that people are not fully aware of.

    Banks globally are discriminating against businesses operating in their own sphere by refusing to let them open accounts. Small financial services are the businesses that are particularly targeted (hedge funds, peer-to-peer lending platforms, cryptocurrency exchanges, ...) and also in particular any cross-border business.

    Banks excuse this by not wanting to risk fines from regulators, and this is a valid point, yet their boycott of these industries, especially cryptocurrencies exchanges and offshore hedge funds is clearly predatory monopolistic behavior.

    There are many side effects to this monopolization, which start first and foremost with the exclusivity in deposit taking from the public (free financing) and access to the payment system (deciding who gets to transfer money), such as egregious Compensation Packages, very long tenures at the top, bonuses which are managed such that RoE never exceeds 10%, lending which is biased toward big companies (bigger deals = bigger bonuses to banker, even if financing smaller borrowers is more profitable as a whole it does not serve as good justification for egregious bonuses), and in small countries has led to bank-asset concentrations with a few key borrowers, who in turn exerted monopsonistic power to impose haircuts on the banks' shareholders, and many more examples. Banks are all about control, and they have monopolized every vertex of it in financial markets.

    The solution is as you say:

    1. Allow e-Money license institutions (or TNBs or PTIEs or Payment Service Providers) to deposit directly with the Central Bank(s) globally.

    2. Allow the same above institutions access to local payment systems directly, not via incumbent banks, and allow them to issue to their depositors their own local bank details under their own name (e.g., Account Holder Name = Depositing Client Name, wherein client gets their own account number).

    What is particularly disheartening, is the incompetence of central banks to allow and endorse this, and proactively oppose it, which would have been understandable if they were bribed into sustaining the GGBC, but they're not, instead they are enabling this out of sheer lack of character, business experience, and leadership.

  15. If the Fed really wanted to crush "the narrow bank" then they just need to go back to the pre-crisis policy of no interest on reserves. Or, the even the in-between policy of no interest on excess reserves.

    But, it seems to me that the narrow bank is moving into the space of money-market mutual funds. Taking funds from shareholders and investing them in some combination of short-term investments, passing all but a modest fee back to the investors. Back in the day, money funds priced at $1.00 and offered the illusion of no risk of principal. They have to price with more precision which gives mild price risk, but, still that price risk is small.


Comments are welcome. Keep it short, polite, and on topic.

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