Federal Reserve denies The Narrow Bank's master account application

WASHINGTON — The Federal Reserve has denied a master account application to The Narrow Bank after more than six years of deliberations, dealing a potentially fatal blow to the nascent bank whose business model centered on giving customers accounts that bear interest just under the federal funds rate.

The Fed said in a Dec. 13 letter to TNB that the central bank had evaluated TNB's application as a Tier 3 applicant under its new master account application guidelines because of the bank's lack of deposit insurance or a federal prudential regulator, and based on its analysis concluded that "providing TNB a master account would pose undue risk to the stability of the U.S. financial system and would adversely affect the Federal Reserve's ability to implement monetary policy."

The Narrow Bank — a Connecticut-chartered bank that would offer customers accounts with interest rates mirroring the federal funds rate minus a modest haircut — first applied for a master account in August 2017. The bank would allow nonbank firms with large quantities of deposits like money market funds to access a higher rate of return on their deposits with lower risk, bypassing reverse repurchase agreements and commercial paper markets in the process.  

The Narrow Bank sued the Fed in 2019 on the grounds that the central bank's protracted deliberation over its application — a process that typically takes 5-7 business days — amounted to a denial. That suit was dismissed in 2020 after a federal judge determined that TNB had not suffered an injury in fact and therefore lacked standing to bring the case.

'A proliferation'

The Fed said in its letter denying TNB's application that "granting account access to TNB could lead to account requests from like institutions and to a proliferation of such entities." The Fed further argued that the reliance on large volumes of uninsured deposits could subject TNB to deposit flight in times of stress, a phenomenon that "could transmit to other depository institutions with significant shares of uninsured deposits." 

The Fed also said that granting TNB and other banks like it a master account "could incentivize flight to such institutions in times of economic or financial stress, which, in sufficient size, would interrupt critical funding markets and/or credit to the U.S. real economy." Because TNB takes deposits but does not make loans or provide other services that entail risk, TNB and other banks like it could be the recipient of large volumes of deposits from other banks that do assume those risks in service of the economy, giving TNB an unfair advantage over other banks that provide services that are vital to economic growth.

"Granting access to TNB would provide it with assets that are free of the risks inherent to financial institutions that provide credit to the real economy and intermediate critical financial markets," the Fed said in its Dec. 13 letter. "In events where stress is occurring outside of TNB, rather than within it, account access would make TNB the economically incentivized 'safe haven' destination for qualifying institutional depositors. In this case, institutional assets would plausibly shift to TNB out of banking institutions, money market funds, and/or similar entities that fund the real economy and critical markets." 

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In a Feb. 26 letter appealing the Fed's decision, TNB CEO James McAndrews — a former employee with the New York Fed — said the bank has made strenuous efforts to address the risks described by the Fed throughout the application process, including adopting a "surge protector" to limit inflows into TNB and deposit limits similar to those used by the Fed's reverse repo facility, known as ON RRP. McAndrews also said TNB would give the Federal Reserve Bank of New York the power to increase those deposit limits in the first two years of operation or rescind TNB's master account after three years, and also would be able to establish a rule outlining an orderly three-month deposit drawdown for TNB or other banks like it if "trigger events" occur.  The Federal Reserve was not immediately available to comment on the letters.

The Fed said in its Dec. 13 letter that the likely proliferation of other banks with TNB's business model render the deposit cap and surge protector concessions moot because deposits that flow into TNB through the Federal Reserve's FedWire money transmittal system are final upon execution, meaning that TNB or any other bank with a similar business model would only be able to determine that an account holder had exceeded its caps after deposits had already flowed away from other banks. 

"As such, TNB would have no visibility into final transfers coming into its account because those would be initiated outside of TNB's purview by account holders at the other institutions," the Fed said. "This would render any caps proposed by TNB or FRBNY as possibly illusory in times of stress."

TNB vs Custodia

TNB's application for a master account predates neobank Custodia's similar ongoing legal battle with the Federal Reserve Board and Federal Reserve Bank of Kansas City, which also centers around Custodia's application to receive a Fed master account. Custodia, which is designed to serve as a banking partner for cryptocurrency firms, had its application for a master account denied in 2022 over what the Fed described as insufficient risk controls, liquidity measures and resolution planning, among other issues.

Julie Hill, a law professor at the University of Alabama School of Law, said the facts surrounding TNB's denial are quite different from those surrounding Custodia's, though both indicate a uncertain unwillingness on the part of the Fed to offer master account access to novel charters, and an apparent unwillingness by the New York Fed to find some combination of restrictions or conditions for TNB to obtain a master account. 

"This decision suggests maybe that the New York Fed isn't amenable to a bunch of account restrictions or managing accounts in that way," Hill said. "Whether the Kansas City Fed would take the same approach — I don't know that it necessarily does. And don't know the extent to which the [Fed] board is weighing in on this."

Aaron Klein, a senior fellow at the Brookings Institution, said TNB's denial — and the reasoning behind it — ring hollow in light of the fact that TNB's business model is built around reducing the spread between interest rates available to nonbanks at the Fed's own reverse repurchase facility and the interest paid to Fed member banks on their reserves parked at the Fed itself. That the application process is a process at all, he said, reflects the evolution of master account access from a routine technicality into a source of policy debate. 

"There's a deep irony when a former senior Fed staffer figures out a legal and safe way to arbitrage the Fed's monetary policy tools only to be denied authority to do so by the Fed under arguments of systemic risk," Klein said. "The episode highlights how master account access has morphed from a legal requirement to a tool of discretionary policy." 

Hill added that there were some glaring inconsistencies in the Fed's reasoning for denying TNB's application, including the conflicting views on whether deposits would flow into or out of TNB in times of stress and the fear that approving TNB's application would lead to a flood of similar banks — even though the Fed itself has the power to grant or deny such access.  

"Their position is they have the discretion to deny master accounts to any bank that they deem risky, and to do that they've adopted a process that looks a lot like a chartering scheme," Hill said. "It's weird to say 'We're gatekeepers,' and then on the other hand say 'If we have one we can't be the gatekeeper in the future.'

"What I get from that is not that there's some principled problem that they're trying to avoid," Hill continued. "They just don't want to do it."