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The Fed refuses to do business with the safest bank on earth – and depositors pay the price

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If you live in Connecticut, there’s a new bank in town whose only business goal is to pay its depositors a rate very close to the Federal Reserve’s IOER (interest on excess reserves) rate. The current IOER rate is 2 percent and likely to rise to 2.25 percent by year-end. This new bank, TNB, plans to pay its depositors this generous rate without taking on any risk — none. The only thing stopping TNB from opening its doors, taking deposits, and paying high deposit rates is the Federal Reserve Board.

US Federal Reserve Chairman Jerome Powell holds a news conference in Washington, D.C., on September 26, 2018. REUTERS/Al Drago

Banks have deposit accounts at the Fed, called master accounts. These accounts are similar to customer checking accounts at banks. Banks settle claims by transferring Fed reserve balances amongst themselves through the payments system just like customers pay bills by writing checks or entering electronic payment orders.

Prior to 2008, the Fed paid no interest on banks’ reserve balances, so banks held as few reserves as possible. Once the Fed started paying interest in 2008 and augmented the supply of bank reserves through QE operations, banks began holding trillions of dollars in excess reserve balances, earning the IOER rate on every penny.

Unfortunately, banks have yet to pass their IOER Fed earnings on to their own depositors. The November 26 weekly FDIC deposit rate survey (below) shows that the current IOER rate, 2 percent, is truly generous compared to the miserly average rates banks pay their depositors.

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Source: Federal Deposit Insurance Corporation

If you deposit $1 dollar in a bank account, the bank can deposit that dollar at the Fed and earn 2 percent while the bank pays you, on average, somewhere between 0.09 percent and 1.22 percent, depending on the type and maturity of the account. In theory, competition for deposits among banks should have put pressure on the rates banks pay depositors and pushed them closer to the IOER, but after ten years under the Fed IOER regime, this has not happened.

One reason competition has failed is that the IOER rate is only paid to banks. While there are a handful of nonbank institutions that are legally permitted to have master accounts at the Fed, the Fed only pays interest on banks’ reserve balances.

TNB, which stands for “The Narrow Bank,” wants to break bankers’ monopoly access to the IOER by forming a new bank that takes large deposits from money market mutual funds and invests them in a master account at the Fed. The state of Connecticut has approved TNB’s application for a banking license under the restrictive business plan — take in large customer deposits, invest them in the Fed, earn IOER, pay depositors interest, and do nothing else. This business plan will make TNB the safest bank on the planet without federal deposit insurance.

TNB has been granted a license to operate as a bank, but more than a year after filing an application, the Fed has yet to approve TNB’s request to open a master account. The Fed is stalling even though the Fed appears to be bound by law to provide TNB a master account and access to the Fed’s payments system.

Once money market funds are able to earn close to the IOER rate by placing deposits at TNB, money funds can offer higher returns with less risk because Federal Reserve deposits are riskless and the TNB deposit investment is inexpensive to execute. However small, the TNB must cover operating expenses, so its pass-through rate will be slightly less than the IOER. Still, money fund yields will become more attractive, enticing depositors to shift balances from bank accounts. Banks will be forced to raise deposit rates or risk losing customer balances to money funds.

While this might sound like a welcome improvement for you and me, the Fed hates the idea, and the decision to withhold approval on TNB’s application for a master account came from the top. Chairman Powell reportedly has “policy concerns” with TNB’s plans but has yet to be more specific. In August, TNB sued the Federal Reserve in federal district court, seeking a court judgement that affirms TNB’s right to open a master account. The court has not yet issued a ruling.

I hope you can join us on Monday, December 3, when AEI will host a policy forum to discuss the TNB issue. TNB’s president and CEO, James McAndrews, will speak about TNB, its business plan, and the regulatory issues this newly chartered bank faces. AEI has assembled a panel of banking experts — Robert Eisenbeis, Oliver Ireland, and Morgan Risks — to offer their views on TNB and the possible policy concerns its application may raise for the Federal Reserve.

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