"The Narrow Bank"

 A strange new bank called TNB, or The Narrow Bank, recently applied to get a clearing account at the Federal Reserve Bank of New York, only to be refused. Funny enough, TNB is run by the New York Fed's former director of research James McAndrews, who left in 2016 in order to get the bank up and running. McAndrews and TNB are now suing the New York Fed.

There's a backstory to all of this kerfuffle. While still employed by the New York Fed, McAndrews coauthored a paper in 2015 entitled Segregated Balance Accounts. The paper proposed a solution to the following problem. Interest rates in wholesale lending markets were refusing to align with each other. Wholesale markets are the sorts of markets which neither you nor I have access to but are reserved for large institutions. For some reason, banks that kept interest-bearing overnight accounts at the Fed were not passing the rate they earned on these accounts to other overnight lending markets in which they were active, say the repo market or the federal funds market. The fed funds rate, for instance, tended to always be 0.2% or 0.3% below the interest rate the Fed paid to depositors.

Why wasn't this gap being arbitraged? After all, if a bank can deposit funds at the Fed and earn 1.95% overnight, then by borrowing in the fed funds market at, say, 1.85%, and putting the proceeds in its Fed account, said bank can earn a risk free return 0.1%. The ensuing competition to profit from this arbitrage should drive the fed funds rate within a hairline of the rate paid by the Fed to depositors. But the massive 0.2-0.3% gap implied that this trade was not being made. 

McAndrews and his co-authors posited that the fed funds market was crippled by a lack of competition. Specifically, there seemed to be a limited number of credible borrowers willing & able to wade into the fed funds market to conduct the trade. This group of borrowers was too small to absorb the funds of all the institutions that were shopping around to lend in the fed funds market. For the most part these lenders did not qualify to get interest from the Fed and were confined to buying fed funds. Thus the small group of borrowers operating in this market exercised a degree of bargaining power over the lenders, allowing them to extract artificially low borrowing rates.

The idea behind the paper was to have the Fed fix these rate distortions by re-introducing competition among borrowers in overnight wholesale lending markets. In short, all those banks that were not considered sound enough to qualify as fed funds borrowers would be able to partner with the Fed to offer risk-free accounts. Specifically, these banks would be able to go to a wary lender and say, "hey, if you lend to us we'll keep your funds hived off from all of our other assets by just depositing them directly at the Fed."

To sanctify this promise, the Fed would create a new type of account, a segregated balance account, or SBA. Once a customer had deposited funds at the the borrowing bank, the bank would transfer these funds into an SBA at the Fed. If the borrowing bank went bust, the swarm of creditors pursuing the bank's assets would not be able to touch the funds locked into its Fed SBAs. The bank itself could not use the funds in an SBA for any other purpose than paying back its customer. By hiving off a wary customers' funds, a risky bank could emulate a Fed account and re-enter wholesale lending markets.

The interest that the bank earned on SBAs would be passed-through to its customer, less a small fee incurred by the bank for providing the service. So if the Fed was paying 1.95% on deposits, the bank might be able to offer 1.90%, thus keeping 0.05% for itself. And since borrowers in the fed funds market were only offering 1.75%, say, then lenders would would avoid them, preferring to invest their funds at banks that offered an SBA solution. To compete, a borrower in the fed funds market would have to offer at least 1.90% themselves. Thus the various wholesale interest rates would be in better alignment.

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Maybe upper level Fed officials took McAndrews aside and said, hey James, we're not going to implement this idea. And he thought to himself, but this is a good idea, why don't I run with it by setting up a private bank. I'm not sure, but whatever the case McAndrews quit the Fed and co-founded The Narrow Bank in what seems to be an effort to implement a market-provided version of SBAs.

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.

In theory, TNB (and any potential copycat) should fix the competition problem that McAndrews and his coauthors alluded to in their Segregated Balance Accounts paper. Presumably all those lenders in the fed funds market that can't find suitably sound borrowers, and thus submit to being gouged by the only banks that qualify, will turn to TNB. After all, TNB is clean. Unlike regular banks, it doesn't partake in all of the traditional banking activities that make a bank risky, such as lending to consumers or businesses, or trading for their own accounts. TNB does one thing only, it acts as a portal to the Fed. Since TNB collects 1.95% from the Fed and has minimal costs, it should be able to pay interest of around 1.90% to its customers, who might otherwise get a paltry 1.75% from competing borrowers operating in the fed funds market. Thus the presence of TNB should remove, or at least minimize, some of the distortions in wholesale lending markets.   

But all is for nought. The Fed has refused to grant TNB a master account. John Cochrane has recently blogged about this as well as helpfully uploading the lawsuit that TNB has filed against the New York Fed. We don't know why Fed officials are dragging their heels, so all we can do is speculate. Cochrane has a few theories, including potential worries among Fed officials about controlling the size of its balance sheet.

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But even if TNB succeeds in its lawsuit, there is a larger threat. The gap the bank is trying to exploit is shrinking. Back in 2016 when McAndrews and his colleagues first embarked on the effort to build a new bank, the fed funds rate was typically 13 to 14 basis points below the rate offered by the Fed. Fourteen basis points was a lot of rope for TNB to work with. But this gap has since shrunk to just 4 basis points (see chart below). Possibly wholesale markets have become more competitive while the bank was being constructed, in which case there may no longer be much of a role for TNB to play. If TNB borrows at 1.91% and invests at 1.95%, that doesn't leave it much wiggle room to pay its fixed costs and salaries.

Even if the gap disappears, could TNB serve as more than just a conduit for engaging in arbitrage? Let's say that in the future rates have normalized. Banks now offer to lend at an overnight rate that is in-line, or even exceeds, the rate that the Fed pays to depositors. TNB no longer has a sweet deal to offer. Even then, large institutions who can't directly bank at the Fed may like the idea of keeping an account at TNB. Although they will earn slightly less then they otherwise would in competing overnight markets, the Fed is a risk-free place to park one's money, unlike say the fed funds market. These institutions could also invest in treasury bills. But even though a treasury bill would provide a higher return than parking funds at the Fed, there is always a risk that it cannot be immediately sold for its face value. Put differently, a treasury bill has duration risk. Funds held at the Fed via TNB have no duration risk. They can be withdrawn in a moment at par.

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How big might this demand be? Interestingly, TNB isn't the first of its kind. On Twitter, Karl Storvik informs me that an analog exists in Norway, the Safe Deposit Bank of Norway. SDBN is a self described "conduit" established in 2013 to provide ultra-high net worth individuals, asset managers or corporate treasurers a means to park funds at the Norges Bank, Norway's central bank.

According to the SDBN's website, its license prevents it from holding any other asset than Norges Bank deposits. The interest that the central bank pays on these deposits flow back to SDBN's customers, SDBN taking a fee for itself. This is basically TNB, Norwegian style. But as best I can tell, SDNB's function isn't to arbitrage small differences between the rate of interest that the Norges Bank pays and other overnight rates. It is trying to provide a product that is in and of itself useful to folks like high net worth individuals and corporations.

From a glance at its most recent balance sheet, I'd say that The Safe Deposit Bank of Norway hasn't been terribly successful. Sure, it is still in start-up phase, but as of the end of 2017 it had only NOK 53 million on deposit at the Norges Bank, or a piddling US$6.3 million. Assuming TNB gets Fed approval, one wonders if this wouldn't be its fate as well.

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Matt Levine has an interesting take on the whole thing. What if TNB were to allow regular folks like you and me to open an account? The overhead involved in serving a retail customer base would be higher than if TNB served a purely institutional clientele, notes Levine: "you’d need at least a website, a customer service department, ATM cards—but the opportunity is intriguing." But unlike a regular bank it wouldn't need to hire loan evaluators or absorb credit losses. So TNB might be able to provide many of the same payments capabilities as a regular bank (debit card payments, ACH payments, and wire transfers), but pass through a larger share of central bank interest payments to depositors.

If it went this route, TNB wouldn't be the first financial institution to operate as a narrow bank, i.e. to swear off lending in order to focus solely on satisfying the public's payments requirements. This is exactly what mobile money platforms like M-Pesa do. Mobile money providers accept incoming customer funds, park this money in trust at a bank, and issue 100%-backed liquid IOUs to the customer. These IOUs can be used to buy stuff at retailers or exchanged with other users on a person-to-person basis. Unfortunately, liquid deposits held in trust at the commercial bank don't yield much interest, so even if a mobile money operator wanted to flow some interest through to its customers it wouldn't have much to draw on.

The novelty introduced by a retail-facing TNB is that the customer's funds would be parked directly at the central bank instead of an intervening commercial bank. So central bank interest payments could flow straight to the narrow bank rather than being sucked up by an intermediary. And so it would be possible, in theory at least, for TNB to offer retail depositors not only a useful payments option but also a financially meaningful flow of interest.

That seems like a decent financial innovation, no? For instance, the Bank of Canada currently pays 1.25% to banks that have clearing accounts, while I make a meagre 0.15% on my no-fee chequing account. If a Canadian version of TNB could offer me a 1% interest rate on an absolutely-no-frills account with a debit card attached to it, I'd definitely consider it. If James McAndrews and TNB get rebuffed by the Fed, maybe they should come up here and try the Bank of Canada.

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P.S. By coincidence, I recently wrote about some of James McAndrews work on financial privacy at the Sound Money Project. And he commented on my Cato Unbound proposal to introduce taxed $500 and $1000 banknotes. Small world.

Central banks deposits for you and me

The Bank of England recently announced that it will end a 300-year tradition of allowing employees to keep chequing accounts at the Bank. You can see an example of a cheque above, which is marked with the sort code 10-00-00. Traditionally, folks like you and me have only been able to get a piece of the central bank's balance sheet by holding banknotes. Central bank deposit accounts, which are far more convenient, have been limited to banks and other financial institutions. But the BoE provides a rare example of regular people, specifically employees, being permitted to directly own fully transferable central bank deposits, at least until recently.

The BoE's termination of this seemingly archaic practice is especially interesting in the context of growing efforts to crack open central bank balance sheets to those who have traditionally been hived off from them. A concrete step in this direction is the Federal Reserve's overnight reverse repurchase facility, which allows money market mutual funds to hold overnight balances at the Fed. More ambitious (but less concrete) is the Bank of England's Ben Broadbent, who describes the idea of a central bank adding more counterparties-

"perhaps a wide range of non-bank financial companies, say.  It might mean something more dramatic:  in the limiting case, everyone – including individuals – would be able to hold such balances."   

Echoing Broadbent, BoE Deputy Governor Minouche Shafik has spoken of the need to rethink "about to whom we give access to the advantages of central bank money with its unique qualities of finality of settlement." The idea here is to allow non-banks involved in fintech direct access to the Bank's real time gross settlement system, as Mark Carney goes on to illustrate here.

Turning to the blogosphere, John Cochrane has recently written about having all money backed by the government in order to end bank runs. And in the same vein, here is David Andolfatto's idea of allowing TreasuryDirect balances to be tradeable, thus providing individuals and firms with a safe place to keep cash other than the banking or shadow banking system.

This democratization of central banking sounds like a novel idea. Nosing deeper into the Bank of England's history, however, we learn that it was not just employees who could hold Bank of England deposits; most people could. Some of them were quite famous. An interesting anecdote from the 1700s has Sarah, Duchess of Marlborough, asking her bankers at the Bank of England to provide her with a freebie, namely some pens because she 'could get none that were good.' [1]

Moving forward a century, we learn that upon opening for business in 1855 the Bank of England's Western branch tended to attract small businessmen and private individuals "of modest means" as clients, including the accounts of the University of London, a Regent Street hatter, and a Sackville Street clothier—all on its first day of operations. Later that year the household of Queen Victoria left its private bank in order to do business with the Western branch. By all accounts, the Bank of England seems to have had excellent service:

"Staff were expected to recognize customers on sight and have a good, clear hand for writing up passbooks. Two porters were always on duty at the main entrance, clad in the pink livery of the Bank of England with silk top hats, and even the cashiers wore top hats when serving at the counter." [2]

The Bank of England kept up a retail presence well into the 1900s. But as public service came to be regarded as the Bank's main role, the aggressiveness of its commercial and retail businesses was reduced and it transitioned into a purely bankers' bank. The Western branch would be sold in 1930 to the Royal Bank of Scotland. [3]

By 1963 the Bank of England's services to the public were limited to a small number of accounts for existing customers. Presumably as they died, these accounts were closed. The most recent example of the Bank of England allowing non-banks to set up accounts comes from 2003, when Bank officials decided to provide Huntingdon Live Sciences, a drug company facing threats from animal rights activists, with a BoE account because commercial banks refused to offer their services.

So while it may seem that the Bank of England's Broadbent and Shafik are introducing a modern approach to central banking, the practice of allowing private individuals and non-financial businesses to directly hold central bank balance sheet space (in a non-cash form) is actually an old one. What lessons can we take from this historical example?

Many people believe that an open central bank balance sheet has the potential to render our traditional banking system extinct. Banks are special. They provide the world's most popular exhange media—deposits—as an offshoot of their primary business, lending. But as Robert Sams points out, if individuals are allowed to own safe central bank deposits directly there may no  longer be a reason for them to hold risky bank accounts. Demand for bank deposits falling to zero, banks will have to fund their loans to the public with regular bonds or equity, even as payments are re-routed through the books of the central bank. Fractional reserve banking as we know it is dead.

Depending on who you ask, the replacement of fractional reserve banking with so-called narrow banking, or 100% reserve banking, can be either good or bad. I'll leave that discussion for another day. Whatever the case, Bank of England history illustrates that private bank deposits can coexist with an open central bank balance sheet. Given the choice between keeping accounts with the safe Western branch or a risky private bank, individuals did not collectively flock to the former.

No doubt this was partly due to the two things, the Bank of England's policy of charging for servicing unprofitable accounts and of not paying interest on deposits. Its competitors, on the other hand, did pay interest. In essence, private banks had to retain customers by offering better services.

Which brings us back to the Bank of England's recent decision to close employee accounts. Given the Bank's stated intention of opening up its balance sheet, wouldn't it have been an opportune time to open up its retail banking business to all of England rather than shutting it down? The Bank maintains that it had been having trouble competing with services like online banking being offered by private banks. But as history shows, since a central bank offers something private banks can't —safety—it needn't be as competitive in the services it provides. Alternatively, it could be that the Bank will be following a different strategy of opening itself up, say through a distributed ledger or something like PositiveMoney's Digital Cash Accounts. Whatever the case, don't be fooled by the technological terminology; if the Bank were to open itself up, this would be more of a returning to the fold than a bold new future.

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[1] Bank of England: first report, session 1969-70 (link)
[2] Western Branch of The Royal Bank of Scotland - The Story of a Bank and its Building (pdf)
[3] Branches of the Bank of England, 1963 (pdf)

ETFs as money?

Blair Ferguson. Source: Bank of Canada

Passive investing is eating Wall Street. According to 2015 Morningstar data, while actively managed mutual funds charge clients 1.08% of each dollar invested per year, passively managed funds levy just a third of that, 0.37%. As the public continues to rebalance out of mutual funds and into index ETFs, Wall Street firms simply won't be able to generate sufficient revenues to support the same number of analysts, salespeople, lawyers, journalists, and other assorted hangers-on. It could be a bloodbath.

Here is the very readable Eric Balchunas on the topic:

Because when an inv switches from active to passive, it basically means a 70% drop in revenue for industry. #DOLrule https://t.co/HntHyDi3rJ

— Eric Balchunas (@EricBalchunas) April 7, 2016

Any firm that faces declining profits due to narrowing margins can restore a degree of profitability by driving more business through its platform. In the case of Wall Street, that means arm-twisting investors into holding even more investment products. If Gordon Gecko can get Joe to hold $3000 worth of low margin ETFs then he'll be able to make just as much off Joe as he did when Joe held just $1000 in high margin mutual funds.

How to get Joe to hold more investments? One way would be to increase demand for ETFs by making them more money-like. Imagine it was possible to pay for a $2.00 coffee with $2.00 worth of SPDR S&P 500 ETF units. Say that this payment could occur instantaneously, just like a credit card transaction, and at very low cost. The coffee shop could either keep the ETF units as an investment, pass the units off as small change to the next customer, use them to buy coffee beans from a supplier, or exchange them for a less risky asset.

In this scenario, ETF units would look similar to shares of a money market mutual fund (MMMF). An MMMF invests client money in corporate and government debt instruments and provides clients with debit and cheque payments services. When someone pays using an MMMF cheque or debit card, actual MMMF shares are not being exchanged. Rather, the shares are first liquidated and then the payment is routed through the regular payments system.

Rather than copying MMMFs and integrating ETFs into the existing payment system, one idea would be to embed an ETF in a blockchain, a distributed digital ledger. Each ETF unit would be divisible into thousandths and capable of being transferred to anyone with the appropriate wallet in just a few moments. One interesting model is BitShares, provider of the world's first distributed fully-backed tracking funds (bitUSD tracks the U.S. dollar, bitGold tracks gold, BitCNY the yuan, and more). I wrote about bitUSD here. Efforts to put conventional securities on permissioned blockchains for the purpose of clearing and settlement are also a step in this direction.

Were ETFs were to become a decent medium of exchange, people like Joe would be willing to skimp on competing liquid instruments like cash and bank deposits and hold more ETFs. If so, investment managers would be invading the turf of bankers who have, until now, succeeded in monopolizing the business of converting illiquid assets into money (apart from money market mutual fund managers, who have tried but are flagging).

Taken to the extreme, the complete displacement of deposits as money by ETFs would get us to something called narrow banking. Right now, bankers lend new deposits into existence. Should ETFs become the only means of payment, there would be no demand for deposits and bankers would have to raise money in the form of ETFs prior to making a loan. Bank runs would no longer exist. Unlike deposits, which provide fixed convertibility, ETF prices float, thus accommodating sudden drops in demand. In other words, an ETF manager will always have just enough assets to back each ETF unit.

Two problems might emerge. Money is very much like an insurance policy—we want to know that it will be there when we run into problems. While stocks and bonds are attractive relative to cash and deposits because they provide superior returns over the long term, in the short term they are volatile and thus do not make for trustworthy money. If we need to patch a leaky roof, and the market just crashed, we may not have ETF units enough on hand. Cash, however, is usually an economy's most stable asset. So while liquid ETFs might reduce the demand for deposits, its hard to imagine them displacing traditional banking products entirely.

A fungibility problem would also arise. Bank deposits are homogeneous. Because all banks accept each others deposits at par and these deposits are all backed by government deposit insurance, we can be sure that one deposit is as good as another. And that homogeneity, or fungibility, means that deposits are a great way to do business. ETFs, on the other hand, are heterogeneous. They trade at different prices and follow different indexes. Shopkeepers will have to pause and evaluate each ETF unit that customers offer them. And that slows down monetary exchange—not a good thing.

Somewhat mitigating ETF's fungibility problem is the fact that the biggest ETFs track the same indexes. On the equity side, three of the six largest ETFs track the S&P 500 while on the bond side, the two largest ETFs track the Barclays Capital U.S. Aggregate Bond Index. Rather than just any ETF becoming generally accepted media of exchange, the market might select those that track the two or three most popular indexes.

In writing this post, I risk being accused of blockchain magical thinking—distributed ledgers haven't yet proven themselves in the real world. All sorts of traditions and laws would have to be upended to bring the world of securities onto a distributed ledger. Nevertheless, it'll be interesting to see how the fund management industry manages to squirm out of what will only become an increasingly tighter spot. Making ETFs more liquid is an option, though surely not the only one.

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PS. Here is the blogosphere's own Tyler Cowen (along with Randall Kroszner) on "mutual fund banking" in 1990:

In contrast to traditional banks, depository institutions organized upon the mutual fund principle cannot fail if the value of their assets declines. Since the liabilities of the mutual fund bank are precisely claims to the underlying assets, changes in value are represented immediately in a change in the price of the deposit shares. The run-inducing incentive to withdraw funds at par before the bank renders its liabilities illiquid by closing vanishes with the possibility of non-par clearing. In effect, there would be a continuous (or, say, daily) “marking to market” of the assets and liabilities. Such a system obviates the need for much of the regulation long associated with a debt-based, fractional reserve system, as the equity-nature of the liabilities eliminates the sources of instability associated with traditional banking institutions.

With the rise of ETFs and blockchain technology, the modern version of mutual fund banking would be something like distributed ETF banking described in the above post,