Friday, September 7, 2018

"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.


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.


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.


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.


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.

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.


  1. Hi JP,

    Just a question - isn't this one of those spectacular ideas that defeats its own purpose once implemented?

    I.E if succesful the spread disappears and the opportunity for profit falls to 0

    1. There's a bit of that going on.

      But even if the spread disappears and interest rates normalize, TNB might be able to do a brisk business in providing payments accounts to corporations and investment firms. Funds held at TNB would be perfectly liquid (i.e. they could be sold at par instantaneously) and also earn interest. The interest provided by TNB would be a bit less than if these corporations/investment firms invested in treasury securities, but they wouldn't have to face the risk of having to sell these securities into a potentially illiquid market. So it would probably make sense for a corporate treasure to park some small proportion of their short-term cash holdings at TNB.

      So even if the opportunity for profit falls to 0, there are other opportunities for them.

  2. Regarding Narrow Banking, the history and the relevant academic literature are summarized in the Website:

  3. In addition to Norway, in the UK there's a state owned savings bank, "National Savings and Investments" which places depositors' money only at the Bank of England and in UK government debt. So depositors' money is totally safe and it earns a little interest.