Why does the Fed oppose narrow banking?
By Scott Sumner
John Cochrane has an excellent new post on narrow banking, the best post I’ve read in a long time. Cochrane discusses the Fed’s opposition to a new business structure called “narrow banking”. A narrow bank takes deposits and invests the money in interest-bearing reserves deposited at the Fed. Because that’s all these banks would do, they would be very low cost and hence could pass along to depositors the interest earned on reserves, minus a small fee. Narrow banks could attract many large depositors, who currently receive much lower interest rates on their deposits at ordinary commercial banks. Here I’ll offer a few preliminary comments, but you really should read his entire post.
Cochrane is exasperated by the weak and unpersuasive explanations being offered by the Fed. You might argue, “What else is new? Government bureaucracies often do this sort of thing.” Actually, this is sort of new. Yes, government agencies often present obviously weak arguments to buttress decisions being made, especially when the “real reason” would be politically unpopular. But that’s not generally been the case for the Fed. You or I may disagree with a certain Fed action, but it’s usually justified with arguments that even independent experts find to be fairly persuasive. The Fed is a semi-independent branch of government, which has traditionally taken the high road in policy formation. Thus it’s dismaying to see such a weak defense of their opposition to narrow banking. Here’s Cochrane:
The Fed is acting as a classic captured regulator, defending the oligopoly position of big banks against unwelcome competition, its ability to thereby coerce banks to do its bidding, and to run a grand regulatory bureaucracy, against competitive upstarts that will provide better products for the economy, threaten the systemically dangerous big bank oligopoly, and reduce the need for a large staff of Fed regulators.
I state that carefully, “acting as.” It is my firm practice never to allege motives, a habit I find particularly annoying among a few other economics bloggers. Everyone I know at the Fed is a thoughtful and devoted public servant and I have never witnessed a whiff of such overt motives among them. Yet institutions can act in ways that people in them do not perceive. And certainly if one had such an impression of the Fed, which a wide swath of observers from the Elizabeth Warren left to Cato Institute anti-crony capitalism libertarians do, nothing in these documents will dissuade them from such a malign view of the institution’s motives, and much will reinforce it.
Like Cochrane, I have a relatively high opinion of Fed officials as individuals. So as I continued reading his post, I kept asking myself, “What’s this really all about?” I began to wonder if this wasn’t actually about “cross-subsidization”, the federal government’s longstanding practice of banning certain forms of competition, in order that existing firms would earn enough profits in one area to subsidize loss-making service to another sector. Thus the Post Office bans competitors from delivering first class mail in New York City, so that they can earn enough profit to provide costly service to remote towns in Alaska, at the exact same price. They don’t want competitors skimming the cream off their most profitable markets.
Sure enough, as I kept reading I found that Cochrane had reached that conclusion even before I did:
Now we’re getting somewhere. Here it is boldface: The Fed is subsidizing commercial banks by paying interest on reserves, allowing the banks to pay horrible rates on deposits, because the Fed thinks out of banks’ generosity — or regulatory pressure — banks will turn around and cross-subsidize lending to households and businesses rather than just pocket the spread themselves.
Regulators forever have stifled competition to try to create cross-subsidies. Airline regulators thought upstart airlines would skim the cream of New York to Chicago flights and undermine cross-subsidies to smaller cities. Telephone regulators thought competitive long-distance would undermine cross-subsidies to residential landlines.
The long-learned lesson elsewhere is that regulation should not try to enforce cross-subsidies, especially by banning competition. You and I should not be forced to earn low deposit rates, and innovative businesses stopped from serving us, if the Fed wants to subsidize lending.
There’s a lot to say on narrow banking, and I’ll have another post over at TheMoneyIllusion. Here I’ll focus on the cross-subsidy aspects of the issue.
While I strongly oppose the Fed’s action here, if you put a gun to my head and forced me to try to defend their action it would be something like this:
The US banking system has been made highly inefficient as a result of a flawed regulatory regime that encourages excessive risk-taking. Much of that regime (FDIC, Too-Big-To-Fail, the GSEs, etc.) is a product of Congress, and beyond the Fed’s control. At the same time, the Fed does have a regulatory role to play. So how can it make the best of a bad situation?
American commercial banking consists of a hodgepodge of activities, some of which are quite safe, others are more risky. Narrow banking would siphon off the safe parts of banking, leaving traditional commercial banks with the riskier activities. If you tightened regulation sufficiently to offset the increase in risk, say sharply raising capital requirements, Congress might complain that credit for business was drying up, or that America’s big banks could not compete with Europe’s big banks.
Cochrane is right that narrow banking could open the door to the sort of ideal financial system that economists have been dreaming about for almost a century. (The longer paragraphs are from a Fed document, quoted by Cochrane):
Financial stability. The big issue.
Some have argued that deposits at PTIEs could improve financial stability because deposits at PTIEs, which would be viewed as virtually free of credit and liquidity risk, would help satisfy investors’ demand for safe money-like instruments. According to this line of argument, the growth of PTIEs could reduce the creation of private money-like assets that have proven to be highly vulnerable to runs and to pose serious risks to financial stability. Some might also argue that PTIE deposits could reduce the systemic footprint of large banks by reducing the relative attractiveness to cash investors of deposits placed at these large banks.
Yes, yes, a thousand times yes! By just allowing narrow banks, we will move to an equity-financed, run-free financial system. Economists have been calling for this since the Chicago Plan of the 1930s. What does the Fed have to offer?
The Board believes, however, that the emergence of PTIEs likely would have negative financial stability effects on net. Deposits at PTIEs could significantly reduce financial stability by providing a nearly unlimited supply of very attractive safe-haven assets during periods of financial market stress. PTIE deposits could be seen as more attractive than Treasury bills, because they would provide instantaneous liquidity, could be available in very large quantities, and would earn interest at an administered rate that would not necessarily fall as demand surges. As a result, in times of stress, investors that would otherwise provide short-term funding to nonfinancial firms, financial institutions, and state and local governments could rapidly withdraw that funding from those borrowers and instead deposit those funds at PTIEs. The sudden withdrawal of funding from these borrowers could greatly amplify systemic stress.
In short, in the face of nearly a century of careful thought about narrow and equity financed banking, the Fed has nothing coherent to offer, and only this will-o-wisp. This argument does not pass basic budget constraint, supply and demand thinking.
Cochrane’s dream of risk-free narrow banking with equity financed risking banking (which is also my dream), is a nightmare to the Democrats and Republicans on Capitol Hill, and if anything an even greater nightmare to the Trump Administration (which is gradually reducing capital requirements on US banks that are protected by all sorts of taxpayer backstops.) For them the socially excessive risk taking is a feature, not a bug. Just as overdevelopment of hurricane-prone coastal areas is a feature of federal flood insurance, not a bug.
Cochrane’s right that narrow banking might nudge us toward a much more rational banking system, but our political elite does not favor that sort of system.
By the way, this nearly made me spit out my coffee:
PTIE deposits could be seen as more attractive than Treasury bills, because they would provide instantaneous liquidity, could be available in very large quantities, and would earn interest at an administered rate that would not necessarily fall as demand surges.
Here the Fed is warning that during a financial crisis the public might want to put their funds into safe narrow banks (PTIEs), which earned interest on bank reserves at the Fed. Hmmm, you mean like in October 2008, when the Fed thought it was a bright idea to pay interest on bank reserves in the midst of America’s worst banking crisis since 1933? If the Fed still plans to pay interest on reserves during the next financial crisis, then it can truly be said that absolutely nothing was learned from 2008.