The Federal Reserve has proposed a rule that could skewer a new type of banking business model.
The Narrow Bank, or TNB, plans to be the first in the U.S. to implement a narrow banking model, taking only deposits from institutional clients and placing them in a "Master Account" with the Fed that allows banks to earn interest on reserves. TNB would then pay its clients an above-market rate, passing through most of the central bank's payments.
On March 6, the Federal Reserve Board issued an advance notice of proposed rulemaking regarding the narrow banking model. The notice requests comments on limiting the interest that could be paid to "narrowly focused depository institutions."
The narrow banking business model
TNB's founder, James McAndrews, is a veteran of the Federal Reserve Banks of Philadelphia and New York. At the New York Fed, he served as the head of research and statistics. He says the goal of TNB is to increase pass-through, or the percentage of changes in market rates that banks pass on to their customers — also known as the deposit beta. Profit is not a top concern, McAndrews said in a panel discussion about TNB hosted by conservative think tank American Enterprise Institute in December 2018.
"If the Federal Reserve pays interest on reserves to banks, and that interest is passed on to depositors, then the bank will not be able to book any profits on its reserve revenue from the Fed, and that's the aim that The Narrow Bank is pushing toward," he said.
McAndrews said TNB would offer more safety for large institutional clients with deposits over Federal Deposit Insurance Corp. limits.
McAndrews also said a narrow bank would compete mainly with Treasury bills, not bank lending. However, depositors would have the ability to withdraw funds at any time and would receive a specific, pre-stated rate, unlike Treasury securities, which are subject to time frames on withdrawals and market forces, he said in an interview.
The bank submitted its application for a Master Account in August 2017. Though the Federal Reserve Bank of New York typically responds within a week, after an extensive review that lasted more than a year, it ultimately refused to grant the account on the basis of "policy concerns," according to a lawsuit TNB filed against the New York Fed.
Issues with the model
The advance notice of proposed rulemaking could offer insight into the New York Fed's decision to deny the account. The notice did not mention TNB by name and came from the Federal Reserve Board, as opposed to the New York Fed, which is the defendant in the TNB lawsuit. However, the notice stated that narrow banks generally can "complicate the implementation of monetary policy" and "could disrupt financial intermediation" and "could also have a negative effect on financial stability."
Media representatives for the New York Fed declined to comment, but academics said the bank's model presents potential systemic issues, such as draining deposits that other banks would use to fund loans. The Fed first started paying interest on reserves in 2008, partly as an attempt to keep the fed funds rate from falling to zero.
The Fed may have misgivings about paying interest to the large institutional clients that would be TNB's depositors, according to Kathryn Judge, a professor at Columbia Law School. The Fed currently pays banks an interest rate of 2.4% on reserves; banks pass some of this as well as the rate they receive on loans on to depositors. At TNB, payout on deposits would be solely dependent on the Fed rate. If other banks followed suit, the Fed could essentially be paying large-scale institutional investors through narrow banks.
"They don't want to be writing massive checks to large, sophisticated investors," said Judge. "The aim here is to find a way to have those rates passed on into activities that support the real economy."
Morgan Ricks, a professor at Vanderbilt Law School, said TNB might present a more fundamental, systemic concern to the financial system. Banks typically use deposits to fund loans, so a successful TNB could potentially result in fewer loans, which are widely considered core drivers on economic growth.
"If there were large-scale migration to The Narrow Bank, or other narrow banks that may be created, it would drain deposit funding from the broader banking system," Ricks said.
The Fed's reticence to approve TNB's master account could also stem from monetary policy concerns, Ricks and Judge suggested.
"The Narrow Bank is going to offer something [that can't be had elsewhere], which is essentially access to interest-paying base money," said Ricks. "If you had a really large migration to the narrow bank business model, then it would pose a challenge for the banking system and the Fed."
A blow to narrow banking
The Fed's proposed rulemaking suggests that the central bank could pay a lower rate to narrow institutions than to traditional banks. The proposal suggests either changing the current rate of 2.4% to 0% for such institutions or creating tiered interest rates based on how much capital each institution holds at the Fed.
According to a statement from TNB, the Fed issued its advance notice of proposed rulemaking two days before the New York Fed's response to TNB's lawsuit was due. TNB said it was not aware that the Fed was preparing the notice.
"The ANPR appears to be aimed specifically at thwarting TNB's business model," bank management wrote in the statement. "The ANPR is not founded on commonly understood banking principles and is inconsistent with the governing statutory framework."
Even if TNB wins its lawsuit over the Master Account, the Fed's proposed changes could render the account useless, according to Ricks. He said TNB's business model would suffer even if the Fed chose the tiered system. "I think [TNB] really need[s] full access to be able to pass on sufficient interest to their clients for their business model to work," he said.
"It does seem the Fed is digging in its heels on this," Ricks added.