In a recent Reason magazine interview, Lyn Alden makes a very good point:
And Lyn Alden, founder of Lyn Alden Investment Strategies, says “banks are basically highly-leveraged bond funds with payment services attached, and we treat it as normal to keep our savings in them.” She argues that the Federal Reserve makes it nearly impossible for banks to hold the bulk of their customers’ deposits in cash because “regulators want banks to be reasonably safe, but not ‘too safe.’ They want all banks to be leveraged bond funds to a certain degree, and won’t allow safer ones to exist.”
Is this really true? Do regulators refuse to allow ultra-safe banks? John Cochrane makes the same claim (from a 4-year old blog post):
Suppose an entrepreneur came up with a plan for a financial institution that is completely safe — it can never fail, it can never suffer a run, it offers depositors perfect safety with no need for deposit insurance, asset risk regulation, capital requirements, or the rest, and it pays depositors more interest than they can get elsewhere.
Narrow banks are such institutions. They take deposits and invest the proceeds in interest-bearing reserves at the Fed. They pay depositors that interest, less a small profit margin. Pure and simple. Economists have been calling for narrow banks since at least the 1930s.
You would think that the Fed would welcome narrow banks with open arms.You would be wrong.
Both are referring to the fact that the Fed refuses to approve “narrow banks,” which invest their funds in the safest way possible—accounts at the Federal Reserve.
The media focuses on mistakes made by bankers and/or regulators, but the banking system is set up to be unstable. Our political leaders want banks to take risks. And when the inevitable happens, there’s a great deal of moral grandstanding.
READER COMMENTS
Andrew_FL
Mar 19 2023 at 9:09am
The business model you’re talking about is only “risk free” conditional on the Fed always paying interest on reserves. If it ever ceases to do so this “bank” will have to start charging customers not paying them. In other words it depends on a permanent subsidy to exist.
Bill Woolsey
Mar 20 2023 at 7:04am
The Fed owns assets that earn interest. Paying some of that over to banks holding reserves is not a subsidy. Paying no interest on reserves seems more like an abuse of monopoly power.
Scott Sumner
Mar 20 2023 at 12:21pm
For the record, I’m opposed to interest on bank reserves.
Spencer
Mar 19 2023 at 9:23am
Savers never transfer their savings outside the banks.
Reg. Q ceilings were enacted by the Banking Act of 1933 to decrease the competition for deposits. Banks used to store their liquidity, and now they unrestricted in the buying of their liquidity through open market devices. This creates the need to “reach for yield”.
The competition between the regional banks and the TBTF banks has shifted the uninsured deposits “across the system”. It has destabilized the core deposit structure.
See: March 2023 Newsletter: A Look at Bank Solvency – Lyn Alden
All monetary savings, income not spent, originate within the payment’s system. But banks don’t lend deposits. Deposits are the result of lending.
The solution to the Austrian Business cycle is to gradually drive the banks out of the savings business altogether.
Why do you think yields just dropped so much?
Samuele
Mar 19 2023 at 10:12am
Correct me if I’m wrong, but doesn’t the Fed oppose narrow banking as it would act as a conduit through which non-depository financial institutions could access the interest on excess reserves? And thus, with the accompanying smaller remit to the treasury, cost taxpayers?
Dylan
Mar 19 2023 at 10:51am
Matt Levine in the long piece you quoted from last week, linked to this piece on Interfluidity from 2011 that says much the same thing, but thinks this is a feature and not a bug. I’m guessing you disagree, but would love to hear your response.
Here’s the synopsis:
James
Mar 19 2023 at 11:01am
“The core purpose of status quo finance is to coax people into accepting risks that they would not, if fully informed, consent to bear.”
I don’t think he is saying that is a good thing, just that the system is effective in making it happen.
Dylan
Mar 19 2023 at 1:41pm
In the rest of the piece he makes an externality argument that this excess risk taking (compared to what individuals would choose on their own) allows for greater growth.
Scott Sumner
Mar 19 2023 at 12:02pm
Finance certainly allows for diversification, which encourages risk taking. As for the opacity argument, I don’t get it. Even with no deposit insurance, your money is safer at JP Morgan than in a safe in your home.
Dylan
Mar 19 2023 at 1:37pm
Probably in reality, but I’m curious what the perception is. Do you know of any data that looks at the percentage of assets in banks before and after deposit insurance? Or cross country comparisons?
Dylan
Mar 20 2023 at 6:59pm
Trying to answer my own question, this paper looks at savings in the 1920s and compares states with bank deposit insurance to deposits with the Postal Savings system (which is used as a proxy for “money under the mattress”) and finds that deposit insurance is associated with a 56% increase in local banking capacity. That’s just one paper, and I’ve only read the abstract so far, but would be interested to see other evidence on the relationship of deposit insurance to the percentage of savings held in banks.
Spencer
Mar 19 2023 at 11:20am
Smaller banks, 250b, then 700b, to “opt out”, then the big boys can switch investment categories (shift securities from “available for sale” to “hold to maturity,” a classification that means unrealized losses won’t affect a bank’s regulatory capital ratios)?
Who could have seen it coming?
Thomas Lee Hutcheson
Mar 20 2023 at 5:32pm
The classification should not have blinded regulators to the mismatch in interest rate mismatch and to the need to restrain it.
Richard W Fulmer
Mar 19 2023 at 12:38pm
Once legislators decided to insure savings accounts, regulating banks and their investments was a logical response to the moral hazard thus created. An unintended consequence is that regulations tend to “herd” regulated institutions onto approved paths, which reduces diversity and increases downside risk. In this case, the Basel III Accords led banks to overinvest in government bonds. When the Fed hiked interest rates, bond values dropped. Banks were forced to sell their bonds all at once, which, in turn, created a freefall in the bond market. Regulatory herding leads to regulatory stampedes.
vince
Mar 19 2023 at 3:16pm
This is directly from the 12/31/22 SVB 10K: both SVB Financial and the Bank exceeded the required ratios under the Capital Rules and were considered “well-capitalized” for regulatory purposes.
Hidden beneath allowable rules, SVB was insolvent.
Thomas Lee Hutcheson
Mar 19 2023 at 4:49pm
Basil may have led banks to invest in government securities, but not necessarily in long term, fixed rate securities. THAT is on them and the re3gulators
Justin
Mar 24 2023 at 6:20pm
That’s correct, banks could have parked their excess cash at the Fed, purchased shorter term securities with lower durations or even purchased higher duration securities but use pay fix swaps to swap them to floating and eliminate the duration risk.
None of these things are as profitable in the short-term as buying higher yielding high duration securities, which is why SVB went that path but ultimately blew up due to taking on too much interest rate risk.
Matthias
Mar 19 2023 at 7:27pm
Bank regulation in the US long predates FDIC.
Scott Sumner
Mar 20 2023 at 12:04am
Very good points.
T Boyle
Mar 20 2023 at 2:57pm
As Cochrane has pointed out, narrow banks would be a simpler, better solution.
Jeff
Mar 19 2023 at 6:35pm
The whole concept of “banks” seems anachronistic. In recent history the only financial products most people ever needed were a combination of stocks and (maybe) a few short-term treasuries. If you need a mortgage, that will (ultimately) be provided by the GSEs. It seems like the government made banking largely a thing of the past, but somehow feels they have to furiously prop up this buggy whip “industry”
Matthias
Mar 19 2023 at 7:29pm
That GSEs are involved in mortgages is an entirely American accident.
Saner countries don’t have their government guarantee mortgages.
Spencer
Mar 20 2023 at 10:20am
re: “That GSEs are involved in mortgages is an entirely American accident.”
It was no accident. It was predicted by Dr. Leland James Pritchard in May 1980 in response to the DIDMCA of March 31st, 1980. Banks don’t lend deposits like the thrifts did.
Dr. Barnett says the money stock is too tight. Dr. George says precautionary savings deposits haven’t reached critical mass.
If the FED wanted to continue QT, it should raise capital requirements, which destroy bank deposits, dollar for dollar.
See: Basel’s Capital Curse by Steve Keen
Capt. J Parker
Mar 20 2023 at 12:29pm
I think it’s absolutely true that legislators and regulators want to facilitate the current fractional reserve business model of banking at least as it is practiced by the biggest banks. When legislation covering an entire industry is written, the largest firms in that industry get input into the legislation that, if it doesn’t favor them outright it at least doesn’t harm them. This is true of banking, health insurance, Drugs, and nearly all regulated industries.
But,
Saying regulators refuse to allow narrow banks who would rely for income on IOR is proof that regulators want more risk goes too far. IOR was supposed to be a special circumstance. If the Fed ever does go back to the no-IOR, scarce reserves regime then banks based on IOR would start to look very risky. Depositors would flee either in search of yield or to escape a fee for service bank model.
There is also the question of what would the management of monetary policy look like if big chunks banking deposits ended up back at the Fed. Wouldn’t the fed need to then fund loan making directly? Would that not be a much more centrally planned economy to everyone’s detriment?
Anonymous
Mar 20 2023 at 2:32pm
“Wouldn’t the fed need to then fund loan making directly?”
Why the heck would they do that? Let investors do it.
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