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Well-Intentioned Illegality: The Fed’s Decision to Nix the Narrow Bank

A key component of the 2008 Great Recession, which cost the average American over $70,000, was the complexity of banking that former Goldman Sachs investment banker Matt Levine describes as “alchemical, taking lots of dodgy ingredients and stirring them up into something more attractive.” In response to the failures of complex banking, a competing financial philosophy has emerged: The simpler, the better. A pioneer in this new ideology is The Narrow Bank (TNB), a Connecticut-based institution that champions the principle of simplicity. TNB’s entire operation consists of accepting deposits from “the most financially secure institutions” and parking them at the Federal Reserve. The Fed pays interest on banks’ excess reserves (IOER), a rate currently set at 2.20%, which is higher than the rate they give non-bank institutions for short-term loans through reverse repurchase agreements. Thus, TNB gives its customers, risk averse firms like Money Market Mutual Funds, access to a virtually risk-free place to park their assets that pays higher interest than they can currently get from the Fed. However, the Fed refused to provide TNB with a master account, which means TNB cannot participate in the Fed’s payment system and thus cannot open. TNB’s system of banking would severely undercut the Fed’s ability to control the economy and is thus dangerous; however, the Fed violated statutory constraints on their power by refusing to give TNB a master account, creating a dangerous precedent for future overreach.

Critics of the decision not to give TNB a master account have ascribed nefarious motives to the Fed; some even suggest that Federal Reserve employees made the decision to protect their own jobs. Though it is impossible to know the Fed’s true intentions, such conspiracy is unlikely. The existence of an institution like TNB would hamstring the Fed’s ability to influence short-term interest rates, so the Fed needed to take action. To help raise interest rates, the Fed has instituted a overnight reverse repurchase (ON-RRP) policy through which non-banks can earn interest by providing short-term loans to the Fed. This is similar to what the Fed does for banks with interest on excess reserves. However, the Fed pays non-banks 20 base points (.2%) less in interest than the IOER rate. The difference in rates is important, as the Fed uses the IOER rate to nudge short-term interest rates into target ranges, and uses the ON-RRP rate to set harder rate controls.

Essentially, TNB would profit from the arbitrage between rates provided to banks and other institutions. TNB provides institutions that previously had access only to short-term Treasury bonds and the overnight lending rate for non-banks access to the higher short-term rate earned by banks. Even with TNB taking some of the difference, non-bank institutions would make considerably more on short-term loans when they give capital to TNB. The resulting shift of capital to the Fed would massively expand the Fed’s balance sheet, an unwelcome development for an institution actively trying to shrink its holdings. Moreover, by providing all firms with access to the IOER rate, the rate’s function would have to change. The ON-RRP rate  is only used because non-bank institutions don’t have access to the IOER rate, so TNB would functionally eliminate the ON-RRP rate. Moreover, the IOER rate is currently higher than short-term bond yields, so non-bank institutions would favor giving money to TNB over investing in short term bonds. This would transform the IOER rate’s function to a hard interest rate floor. If given the choice between a bank that paid 2.20% interest and a less safe Fed bond that paid less, any actor would choose the bank. No rate would exist to take over the IOER’s current function, because TNB could allow non-banks to access any new rate given solely to banks. This would limit the tools at the Fed’s disposal. The only solution would be rate discrimination between traditional banks and narrow banks, but such discrimination would be controversial, and even then price discrimination would be less effective than the traditional model.

The inclusion of TNB into the financial landscape would be harmful, but the Fed tried to eliminate TNB in the wrong way. The Fed’s decision not to give TNB a master account is unlawful use of discretionary authority. The Fed’s review of TNB (even the review is an anomaly—providing a master account is usually just procedural) concluded in TNB’s favor, so the decision to refuse a master account was policy-oriented. The Fed believes that TNB would be dangerous, so it wants to stop TNB from opening. Thus, the pertinent legal question is whether the Fed has the discretionary authority to restrict a bank’s operation because it doesn’t favor the business model.

In 1980, Congress passed a law that reads: “All Federal Reserve bank services covered by the fee schedule shall be available to nonmember depository institutions.” Given that TNB is a depository institution and the administration of master accounts is a service provided by the Fed, the act suggests that the Fed has no discretionary control over which institutions can receive a master account. Peter Conti-Brown, Assistant Professor of Legal Studies at Penn, agrees that “the statute appears to eliminate the Fed’s discretion entirely.” In its suit, TNB notes that “More than one federal circuit judge has interpreted the Act to mean […] equal access to Federal Reserve Bank services for all qualified depository institutions.” Recently, The Court of Appeals for the Tenth Circuit held in Fourth Corner v. Federal Reserve Bank of Kansas City that the act “unambiguously entitled all nonmember depository institutions to a master account.” These rulings suggest that the Fed doesn’t have the discretionary authority to choose which banks receive a master account, so its decision to prevent TNB from receiving one was illegal and should be overturned. If the Fed isn’t compelled to give TNB a master account, a precedent would be set that the Fed can decide who gets access to their services. Though denying TNB a master account was a good policy decision, Congress limited the Fed’s discretionary authority for a reason—all banks should have access to our financial system if they receive a charter to open. The Fed is a minimally democratic institution, so checks on its power are necessary. Thus, while TNB needed to be stopped, Congressional action was the far more appropriate response.

TNB is an interesting development in a rapidly simplifying financial environment, but it would make the Fed’s job considerably more difficult. Though it would clearly help non-bank institutions that want to profit off of the Fed’s inflated IOER rate, such profits would come at the expense of one of the Fed’s valuable financial tools. Even if narrow banking would create long-term progress (which is far from clear), short-term disruption would be inevitable. Thus, it makes perfect sense that the Fed wants to prevent them from going into business. Unfortunately, the Fed is bound by institutional constraints on its discretionary power, and the decision not to give TNB a master account was clearly illegal. Unless Congress changes the statutory limitations on the Fed, it is likely that the courts will compel the Fed to provide TNB a master account, opening the door for them, and other similar banks, to further experiment. It’s quite possible that such a decision could force a massive change in the way the Fed influences monetary policy.

Photo: “Marriner S. Eccles Federal Reserve”

About the Author

Jackson Segal '22 is a Staff Writer for the US Section of the Brown Political Review. Jackson can be reached at