The Fed Fights a New Bank It Fears. The Startup Sees Nothing to Worry About

(Bloomberg) -- The Federal Reserve is trying to kill a fledgling bank before the newfangled business takes root, arguing it’s a dangerous idea. The nascent company says there’s no reason to fret about its plan to give big investors access to the central bank’s highest interest rates.

Figuring out who’s right is no easy task.

James McAndrews, once the New York Fed’s director of research, created the bank in 2016, hoping to give pensions, insurers and other large institutional investors higher yields on their cash by parking money at the Fed. Currently, only a select few banks can receive that top-tier rate, now at 2.4 percent. The best that money-market funds -- a popular cash receptacle for the firms McAndrews is targeting -- can get from the Fed is 2.25 percent.

The New York Fed has prevented his company, TNB USA Inc., from opening the type of account it needs to make the business model work. That prompted the firm to sue the central bank last year, saying it was obstructing the project. The Fed found another way to fight back as the case continues to unfold. Last month, it proposed rewriting its rules so TNB or any other potential narrow banks -- so named because they are solely focused on taking deposits -- could only get lower interest rates, sabotaging their raison d’être.

Setting the legal merits aside, the Fed has reason to be conservative when considering the core of its mission: keeping the U.S. economy and financial system safe and healthy. A spokesperson for the New York Fed declined to comment.

“The Fed basically finds itself with a Rube Goldberg machine that happens to be working pretty well,” said Brian Smedley, the head of macroeconomic and investment research at Guggenheim Partners LLC, which manages more than $265 billion. “They don’t want to tinker with it too much because it may break, which is why they seem to find the narrow-bank model to be so problematic.”

TNB disagrees, saying that narrow banks would safely increase interest rates for depositors. “These actions will improve the transmission of monetary policy, much as the Fed itself has done through its overnight reverse repo facility,” McAndrews said Tuesday.

What follows are three problems the Fed has with narrow banks, TNB’s rebuttals and an assessment of the arguments:

Issue #1: Monetary policy

  • Fed’s view: Narrow banks might place a large amount of reserves, or excess deposits, at the Fed. That could undermine the central bank’s goal of paring back the assets it’s hosting as it seeks to move toward normalcy and end an emergency measure used to revive the banking system after the financial crisis a decade ago.
  • TNB’s view: TNB sees no “looming policy disaster,” explaining that the money it anticipates adding as reserves will be a “modest fraction” of the approximately $1.5 trillion in reserves currently parked at the Fed.
  • Assessing the argument: Policy makers keep reiterating they need an ample supply of reserves to keep their interest-rate benchmark under control; a return to lower pre-crisis levels is unlikely. And Alex Roever, head of U.S. rates strategy at JPMorgan Chase & Co., says the Fed will keep more reserves than what banks actually need. So TNB contributing a trivial amount doesn’t seem like much of a risk.

Issue #2: Market volatility

  • Fed’s view: Trading volume in funding markets -- particularly fed funds -- could dry up if money shifts to narrow banks, causing volatility. In other words, short-term rates might meander far from where central bankers want them to be.
  • TNB’s view: There would actually be less volatility. TNB says it would actually help keep the fed funds rate from moving outside the Fed’s desired band, strengthening control over monetary policy. How? If, like conventional banks, TNB could get the Fed’s interest on excess reserves rate (IOER), that would place competitive pressure on large banks to boost rates on deposits for all customers. That would enhance the Fed’s ability to steer the fed funds rate using IOER.
  • Assessing the argument: To some extent, the argument is moot: The fed funds market has already shrunk, to $71 billion a day last quarter from hundreds of billions before the financial crisis. As a result, the Federal Open Market Committee in November started discussing potential alternative policy benchmarks to control short-term interest rates, an indication the Fed believes the fed funds market is broken. The fed funds market is “essentially dead because banks are holding a huge supply of reserves,” John H. Cochrane, a senior fellow at the Hoover Institution at Stanford University, wrote in a blog post last month. Cochrane also said that if fed funds were to become more volatile, indexes could move to Libor, general collateral repo or other rates.

Issue #3: Financial stability

  • Fed’s view: In times of stress, haven-seeking investors would flock to the central bank instead of scooping up high-quality assets like Treasury bills. The Fed says that’s bad because when the financial system is strained, investors that would typically provide funding to myriad financial and non-financial institutions could withdraw from the funding markets in favor of narrow banks, “greatly amplifying systemic risk.”
  • TNB’s view: There would be no threat to stability. Investors already have havens besides bills, including the Fed’s overnight reverse repurchase-agreement facility (RRP) and the foreign reverse repo pool, and the world hasn’t ended.
  • Assessing the argument: Post-financial crisis, institutions from central banks to money-market funds have found higher-yielding alternatives to funding markets like repo and Treasury bills. Peak usage of RRP hit almost $475 billion in 2015 as institutions ranging from money-market funds to banks used it to secure additional funding. The foreign reverse repo pool -- where central banks invest cash at the New York Fed at a rate that is comparable to market-based repo rates -- is averaging about $240 billion a week. If during a crisis investors pull deposits from conventional banks and put them into TNB, it could cause financial-stability issues, according to Peter Yi, head of short-term fixed income at Northern Trust Asset Management. “The real challenge and risk to the financial system of this narrow bank is that its business model can present itself as a flight-to-quality asset class for depositors,” said Yi, whose firm manages $402 billion in fixed-income assets. “That could create a run on the traditional banks.”

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