When the US Fed rebuffed a bank for being ‘too safe’

The turmoil in global banking has sparked an intense debate on the mechanism (and morality) of saving careless lenders, safeguarding depositors and ring-fencing the banking system from contagion risks.

Why can’t we just guarantee all deposits in commercial banks and forever remove the overhang of risk from a vital part of the financial architecture, some people are asking.

The limit of $250,000 in the US or Rs 5 lakh in India may cover a majority of individuals, but exposes small and medium companies to unnecessary hazards.

Why should the employees of these firms suffer if the banks blow up due to managerial oversight? Do we expect depositors to comb through bank balance sheets before opening a savings account? Isn’t life dreary enough already?

And so on.

A few years ago, a bold new bank in the US had tried to solve these thorny problems with a solution that was both breathtakingly novel and refreshingly simple. And it paid the price for swinging an axe at the very foundation of the mighty dollar’s dominion.

Simpler is better

The Narrow Bank was set up in Connecticut in 2017 with a straightforward objective – accept deposits from institutions (but not individuals), park the entire amount with the Federal Reserve and pay out the interest received from the central bank (after deducting its fees).

That’s it. No loans, no investments, no purchase of “safe” securities like Treasuries, nothing. Think of it as making the Fed’s vaults available to non-banking entities.

Interestingly, The Narrow Bank (TNB) was cofounded by a former staffer of the New York Fed itself, named James McAndrews. He spent close to three decades at the New York Fed, including as its head of research.

TNB’s intent was not to seek higher yields but deliver complete, infallible safety to its institutional depositors like pension funds and money-market funds.

As we saw in the Silicon Valley Bank saga, piling into government bonds is no guarantee that your funds are safe. Nor can you as a bank or a large depositor just sit on the cash and let inflation gnaw away its purchasing power.

Who better to entrust your funds with than the central bank itself, right?

In a world of over-engineered financial products, which are often just embellished forms of gambling, TNB stood out with an austere elegance and purity of purpose.

The regulator, however, was far from besotted.

The Fed and the furious

TNB received a temporary certificate to operate from the authorities in Connecticut, after which it applied to the Federal Reserve Bank of New York to open a master account so that it could begin depositing funds and earning interest.

The approval process usually takes one week, but the Fed sat on the application for over a year in a passive-aggressive show of bureaucratic power.

An exasperated TNB then sued the New York Fed. Both the parties geared up for a lengthy legal battle that was being closely tracked by the financial community not just in the US but across the globe.

On March 25, 2020, the Southern District of New York dismissed TNB’s complaint. It said the Federal Reserve Board of New York had not constructively denied TNB’s application by delaying the decision for 18 months, and the company lacked the standing to sue.

In its complaint, TNB said it was informed orally by a Fed official that approval would be forthcoming. But the same official later conveyed to TNB that the Fed had rejected its application due to “policy concerns.”

The Fed, like most government institutions faced with uncomfortable decisions, turned more secretive than the Papal conclave and did not publicly spell out these “concerns.” But the financial cognoscenti had a field day speculating on the probable reasons.

Perhaps the central bank worried about the size of its balance sheet in case ‘narrow banks’ became popular and funnelled huge amounts into the Fed’s reserves. Or maybe the Fed fretted about TNB and other such players attracting so much deposits that it would lessen the cash available with traditional banks for lending.

And, as is often the case with matters concerning the Federal Reserve, there was no dearth of conspiracy theories about how it is more concerned about the profits of Big Banks rather than fostering systemic stability and protecting the average Joe.

What made the TNB experiment so crucial was that it struck at the very core of the modern economy – the fractional reserve banking system.

A brave new world

By requiring banks to hold only a portion of their total deposits, fractional reserve banking frees up capital for lending to businesses and individuals, spurring economic growth. Critics, however, rail against this framework with a fervour that early Christians reserved for the anti-Christ.

Fractional reserve banking, they say, is nothing but legalised fraud as banks are accepting depositors’ money by assuring them it will be available on demand, but it is actually not so as their funds are loaned to borrowers. If even a fraction of the depositors turned up to demand their money back, banks would collapse (as was the case with Silicon Valley Bank).

Not only that, the system overheats the economy, debases the currency, encourages debt-fuelled consumption and rewards financial shenanigans by bankers. That’s a heavy list of accusations, and perhaps not entirely without merit, but like most counter-arguments, it mixes the sensible with the sensational.

Keeping peripheral issues aside, the fact is that fractional reserve banking is one of the foremost factors that has made modern life possible.

Any time we have taken a loan for education, housing or buying a car, we have been a beneficiary of the system (and, in the process, contributed to keeping the economic engine humming). Even the interest we earn on bank FDs and savings accounts is made possible because the bank has lent the money out.

If everyone just puts their savings in TNB-type institutions, which, in turn, park them with the central bank, then how exactly will businesses and consumers get funds to fuel their growth?

This is not to say, of course, that the present system is a gift from god. Recklessness by bank managements, red-hot inflation and hyper-consumerism are all worthy targets for attack, but throwing the baby out with the bathwater is hardly a solution.

TNB, in fact, was the offshoot of one such solution.

A group of economists, including Irving Fischer, had proposed ‘full-reserve banking’ in 1935 in response to the Great Depression. Under the proposed system, banks would not lend customers’ demand deposits (like current and savings accounts) but only time deposits (like FDs) to eliminate bank runs and keep a lid on inflation-fuelling money supply.

Other experts have proposed variations of this model to both protect depositors and stimulate the economy.

The current time of tumult presents a golden opportunity to revisit some of these ideas, instead of taking a swing at everyone’s favourite punching bag – the fractional reserve banking framework.