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The Skinny on The Narrow Bank

New York Fed, master account, TNB inc, narrow banking, ioer
The New York Fed's Gold Vault

Dedicated Alt-M readers may recall my having reported here several years ago the suit filed by Colorado's Four Corner's Credit Union against the Kansas City Fed — after the Fed refused it a Master Account on the grounds that it planned to cater to Colorado's marijuana-related businesses. Until then the episode was almost unique, for the Fed had scarcely ever refused a Master Account to any properly licensed depository institution. Eventually the Fed and Four Corners reached a compromise, of sorts, with the Fed agreeing to grant the credit union an account so long as it promised not to do business with the very firms it was originally intended to serve!

Well, as The Wall Street Journal's Michael Derby reported last week, the Fed once again finds itself being sued for failing to grant a Master Account to a duly chartered depository institution. Only the circumstances couldn't be more different. The plaintiff this time, TNB USA Inc, is a Connecticut-chartered bank; and its intended clients, far from being small businesses that cater to herbalistas, include some of Wall Street's most venerable establishments. Also, although TNB is suing the New York Fed for not granting it a Master Account, opposition to its request comes mainly, not from the New York Fed itself, but from the Federal Reserve System's head honchos in Washington. Finally, those honchos are opposed to TNB's plan, not because they worry that TNB's clients might be breaking Federal laws, but because of unspecified “policy concerns.”

Just what are those concerns? The rest of this post explains. But I'll drop a hint or two by observing that the whole affair (1) has nothing to do with either promoting or opposing safe banking and (2) has everything to do with (you guessed it) the Fed's post-2008 "floor" system of monetary control and the interest it pays on bank reserves to support that system.

What's In a Name?

To understand the Fed's concerns, one has first to consider TNB's business plan. Doing that in turn means demolishing a myth that has already taken root concerning that enterprise — one based entirely on it's name.

You see, "TNB" stands for "The Narrow Bank." And some commentators, including John Cochrane, initially took this to mean that TNB was supposed to be a narrow bank in the conventional sense of the term, meaning one that would cater to ordinary but risk-averse depositors — like your grandma — by investing their money entirely in perfectly safe assets, such as cash reserves or Treasury securities. For example, the Niskanen Center's Daniel Takash says that, if TNB wins its suit,

it would offer many businesses (and potentially consumers) the option [to] save their money in a safer financial institution and increase interest-rate competition in the banking industry.

Fans of narrow banking see it as a superior alternative to the present practice of insuring bank deposits while allowing banks to use such deposits to fund risky investments.

The assumption that TNB has no other aim than that of being a safer alternative to already established banks naturally makes the Fed's opposition to it seem irrational: "Fed Rejects Bank for Being Too Safe," is the attention-getting (but equally question-begging) headline assigned to Matt Levine's Bloomberg article about the lawsuit. It seems irrational, that is, unless one assumes that Fed officials place other interests above that of financial-system safety. "That the Fed, which is a banker's bank, protects the profits of the big banks' system against competition, would be the natural public-choice speculation," Cochrane observes. Alternatively, he wonders whether his vision of a narrow banking system might not be

as attractive to the Fed as it should be. If deposits are handled by narrow banks, which don't need asset risk regulation, and risky investment is handled by equity-financed banks, which don't need asset risk regulation, a lot of regulators and "macro-prudential" policy makers, who want to use regulatory tools to control the economy, are going to be out of work.

Get Lost, Grandma!

No one who knows me will imagine that I'd go out of my way to defend the Fed against the charge that it doesn't always have the general public's best interests in mind. Yet I'm compelled to say that explanations like Cochrane's for the Fed's treatment of TNB, let alone ones that suppose that the Fed has it in for safety-minded bankers, miss their mark. Such explanations badly misconstrue TNB's business plan, especially by failing to grasp the significance of the declaration, included in its complaint against the New York Fed, that its "sole business will be to accept deposits only from the most financially secure institutions" (my emphasis).

You see, despite what Cochrane and Levine and some others have suggested, TNB was never meant to be a bank for me, thee, or the fellow behind the tree. Nor would it cater to any of our grandmothers. And why would it bother to? After all, unless grandma keeps over $250,000 in her checking account, her ordinary bank deposit is already safer than a mouse in a malt-heap. There's no need, therefore, for any Fed conspiracy to keep a safe bank aimed at ordinary depositors from getting off the ground.

Instead 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.

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.


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. But two wrongs don't make a right. Or so my grandmother told me.