The Fed Wants to Close the Window on Narrow Banks

By J.P. Koning

Narrow banks, a new type of financial institution, are attempting to take root in the U.S. But the Federal Reserve seems determined to prevent this from happening. Should narrow banks be given a chance?

A narrow bank is an odd creature. We are all familiar with traditional banks. These centuries-old financial institutions accept customer deposits while investing in a range of different assets including business loans, mortgages, and consumer credit. In 2017 a state-chartered bank called The Narrow Bank (TNB) applied for a master account at the Federal Reserve. Like a regular bank, TNB plans to accept customer deposits. But rather than investing in the traditional range of bank assets, TNB intends to hold just one type of asset: balances in its Fed account.

Why invest in balances at the Federal Reserve? Prior to 2008, the Fed paid no interest to account holders, all of which are banks. That year the Fed began to pay interest on all balances. TNB and other narrow banks intend to harvest this interest and pass it back to depositors after covering bank expenses.  

From the customer's perspective, a narrow deposit is a unique financial product. It is perfectly safe. A narrow bank holds a dollar at the Fed for each dollar it has issued to its customers. This means it will never have any problem meeting each and every client request to cash out. Because a regular bank's assets are risky and relatively illiquid, it may run into problems trying to meet depositors’ redemption requests. Deposit insurance protects depositors at traditional banks, but only up to a certain amount. Anything above that ceiling is unprotected.

Narrow deposits would also provide customers with a useful alternative to Treasury bills. The price of Treasury bills fluctuates a little bit each day, but a narrow bank deposit has a fixed price. So a narrow bank’s customer always knows ahead of time exactly how much she will get if she liquidates her portfolio.

So far, the relationship between the Fed and the nascent narrow banks has been fraught with conflict. The Fed has refused to provide TNB with a master account. TNB has responded by suing the Fed for failure to connect it to the payments system.

Something is obviously troubling Fed officials. This March, the Fed issued an advance notice to the public concerning a potential change to its rules. Regular banks would continue to earn the full interest rate from the Fed, says the notice, but any bank that keeps a “very large proportion” of its assets in the form of balances at the Fed would earn a lower reward.

In other words, the Fed is floating the idea of destroying the narrow-bank business model before it can ever be tested in the market. After all, if narrow banks like TNB can only get a significantly inferior rate from the Fed, they won't be able to provide their depositors with deposit rates that are competitive with traditional banks.

The notice provides us with our first glimpse into the nature of the Fed's thinking on the matter. Let's run through a list of the Fed's criticisms of narrow banking.

First, the Fed worries that narrow banks could unfairly undercut traditional banks by “avoiding regulatory costs,” specifically capital requirements. This is an odd argument. Bank capital can be thought of as a buffer that protects depositors from fluctuations in the value of a bank's asset portfolio. On a spectrum, the riskier the asset, the higher the capital requirement. Narrow banks like TNB invest in a single low-risk, low-return asset, Fed balances, on which regulators set a low capital requirement. A narrow bank's choice of assets therefore does not constitute avoidance of regulations, but compliance with them. It is simply choosing a different end of the regulatory spectrum on which to base its business. Most traditional banks have chosen to participate on the high-risk, high-return end of the spectrum.

The Fed is also worried about financial stability. It seems to think that when a financial crisis hits, the presence of narrow banks will aggravate the situation. As panicking depositors withdraw funds and deposit them in safe havens like narrow banks, traditional deposit-issuing banks will be forced to cut back their lending to businesses, states, and municipalities.

But isn’t this already the case? Government-issued securities, such as Treasury bills, offer a risk-free haven during crisis, as do insured deposits, banknotes, and too-big-to-fail financial institutions. A narrow bank would provide another option for depositors to flee it, but it's not what one would call a game changer.

Fed officials are also apprehensive that monetary policy could be complicated by narrow banks. Specifically, if narrow-bank deposits were to become popular, overnight interest rates like the federal funds rate — the rate the Fed uses to communicate monetary policy — could become more volatile.

This concern is even more baffling. In a recent response to the Fed's advance notice, TNB’s James McAndrews points out that the Fed itself has already created its own version of the narrow bank: the overnight reverse repurchase (ON RRP) facility. The ON RRP facility, which debuted in 2013, allows all sorts of financial institutions that would not otherwise be able to hold and earn interest on federal funds  to do so. One of the reasons Fed officials offered for introducing the facility was to ensure that the broad assortment of overnight rates remained close to the Fed's target. Given that a narrow bank is just a private version of the ON RRP facility, it is hard to see why the Fed’s earlier argument would not apply.

Lastly, the Fed worries that narrow banks could reshape the financial system by drawing large quantities of deposits away from traditional banks. This disintermediation could have perverse effects on the public. For instance, banks could be forced to respond by raising rates on loans to households and businesses.

But this needn't be the case. In a recent paper, St. Louis Fed Vice President David Andolfatto (who writes regularly at MacroMania) found that when there is a lack of competition in the banking sector, the introduction of a new way of holding central bank money need not lead to disintermediation. (Andolfatto was writing about the introduction of a new central bank digital currency, but his argument applies just as well to narrow banks.) Rather, the emergence of a new competitor forces incumbents to increase the rates they offer to depositors, at the expense of monopolistic profits.

The Fed seems to see narrow banks as financial godzillas, causing irreparable damage to the financial system. It is just as likely that they will turn out to be something far less threatening: providers of a niche product that attracts a small but dedicated customer base. Rather than fleeing their bank, most depositors are likely to stay put. Traditional banks provide a broad range of financial services under one roof. This is very convenient.

A few corporations, individuals, states, or municipalities that are willing to forgo convenience for the promise of safety and a slightly higher return than a traditional bank deposit may see some benefit in opening an account at a narrow bank. And they will probably become loyal customers. But this niche can only emerge if those entrepreneurs who are trying to get these platforms off the ground are provided with the same access to the American financial plumbing as other banks.

Sign up here to be notified of new articles from J.P. Koning and AIER.

J.P. Koning

J.P. Koning is a financial writer and blogger with interests in monetary economics, economic history, finance, and fintech. He has worked as an equity researcher at a Canadian brokerage firm and a financial writer and publisher at a large Canadian bank. More recently, he has written several papers for R3, a distributed ledger company, on the topics of central bank cryptocurrency and cross border payments. He founded the popular blog Moneyness in 2012. He designs economics and financial wallcharts at Financial Graph & Art.

Koning earned his B.A. in Economics from McGill University.