Karen Petrou: What Happens if Bank Deposits Follow Assets Out the Door?
Last week, Treasury Under-Secretary McKernan outlined a critical strategic phenomenon: the growing transformation of bank deposits into financial instruments lacking the sticky permanence or taxpayer backstops that characterize core deposits. Does the financial system need bank deposits, or could it do as well with other liabilities or even representations of liabilities? This question signals, Mr. McKernan said, a policy transformation warranting attention in the most senior quarters, not just among “technocrats.” He’s right, and here’s why.
As the American Banker rightly pointed out last week, analysis here must carefully differentiate tokenized deposits from deposit tokens. Tokenized deposits are deposits, albeit with additional functionality. Deposit tokens – the transformational alternative – are tokens with deposit features that are only deposits in practice, depending on confidence that others will accept the tokens as either a medium of exchange or store of value. Deposit tokens are thus private money and, if they work as an alternative to central-bank money, pose an even more profound strategic challenge to banking as we know it than all of the NBFIs gobbling up traditional bank assets.
Quite simply, deposits are the lifeblood of banking. Could deposit tokens prove to be the vampires that transform legacy banks before tokenized deposits mount a meaningful defense?
Stablecoins are the nearest concern because they are clearly deposit tokens and perhaps front of Mr. McKernan’s mind since Congress blessed them as a new monetary instrument. Stablecoins are of course digital representations of “money” exchanged on a blockchain that are intended to handle payments as seamlessly as bank deposits moving through the traditional payment system. Under new U.S. law, each token represents a dollar’s worth of other, dollar-denominated assets. These “reserve assets” are supposed to secure the deposit token’s redemption value, but there are many reasons to question how well this works under stress. […]
Karen Petrou: The Fed’s Secret Safety Net for Cayman Island Hedge Funds
In a speech last week, Secretary Bessent described Treasury obligations as “not only the bedrock of the global financial system, but also the American dream.” So they are, but they are also a huge source of profit to basis-trading hedge funds happily evading U.S. taxes in the Cayman Islands. Should the Fed grow its already-gargantuan portfolio at still more taxpayer risk and expense just to keep the good times rolling? Are there no better ways to ensure Treasury-market stability without a Fed portfolio so large that, as Secretary Bessent has also said, it makes America ever less equal? There are indeed better ways and the Fed should deploy them, not just comfort the morally hazardous with still another backstop.
An October Federal Reserve study finds that a longstanding source of FRB systemic-risk worries —basis trading hedge funds — is dramatically under-counted in conventional Treasury-market data sources. Cayman Island-domiciled hedge funds are now, the Fed data show, the largest foreign holders of Treasuries with $1.85 trillion as of the end of 2024 – a trillion-dollar run-up in just two years. Their holdings now eclipse those of each of China, Japan, and the U.K. who are otherwise the largest foreign holders. Only the Federal Reserve holds more Treasury obligations than all these hedge funds in the tax-free sun.
At the same time, short-term rates continue to show significant signs of stress surely worsened by the fact that leveraged basis-traders borrow repos without posting lending to net out most of the risk. FRB officials at last week’s Treasury-market conference were thus at pains to say not only that the central bank will resume buying Treasuries as the FOMC promised, but do what it takes to ensure that the Fed’s portfolio is funded by bank reserves that are at least “ample,” if not […]
Karen Petrou: How to Bank on Biomed and Revive ESG Investing
Ever since ESG investing was born, the “E” for environment has swallowed virtually every billion of private capital dedicated to doing good in addition to doing well. Billions flowed into green renewable energy and carbon capture, leaving even fewer private-sector resources to meet urgent social needs encapsulated in ESG’s long-ignored “S” for social. Banks thus did much to address climate risk when that was in vogue. Now that it’s not, regulators, along with banks on their own and via new ESG-investing options can mobilize private philanthropic and investment capital to reduce a problem even more urgent than global warming: suffering people.
Bill Gates last week rightly argued for a new focus: promoting public health, especially when it comes to getting proven vaccines to vulnerable populations left still more defenseless as U.S. resources are yanked from anything that smacks of foreign aid or U.S. public health. But vaccines are only part of the answer. The public good also requires the quickest path possible to successful biomedical research, preventing and treating disease if we are not to be defenseless against the next pandemic and stand by as all too many adults and children die too young or suffer too long.
How could private capital make a lot more of a contribution to this urgent ESG objective?
There is of course the philanthropic option, more than important in rare diseases where the likely profit gained from funding new treatments may not suffice to draw in biopharma funding. The banking agencies should make it clear that bank funding of or investment in early-stage biomedical research earns CRA credit and is a more than eligible public-welfare investment. There are many ways to conjoin biomedical research with community development, with support for broadening genetic diagnoses to underserved communities and creating in-community clinical research facilities just two that come […]
Karen Petrou: How a “Finality Account” Would Make Skinny Master Accounts Make More Sense
As I’ve recently noted, the barrier between banking and commerce is ever more evanescent. This isn’t, though, because the banking agencies are letting legacy banks into anything redolent of commerce. It’s because the FRB, OCC, and FDIC are letting nonbanks into banking with few of the regulatory and supervisory costs demanded of existing banks big and small, with one of the most consequential one-way tickets proffered by FRB Gov Waller in his recent proposal to give eligible special-purpose banks access to the Fed’s payment system. He describes these new master accounts as “skinny,” but they have yawning pitfalls and not just for banks.
Ever since the Herstatt failure in 1974, it has been clear that payment-system hiccups give the financial system acute gastric distress. This is why central banks dominate national payment systems, with the 1980 law authorizing the Fed to do so based in large part on the Fed’s arguments that only it could be trusted to keep the payment system’s lights on. And so the Fed said again when rationalizing the need for its own instant payment system rather than entrusting technological evolution to the private sector even though the private sector led the way to real-time payments long before the Fed bestirred itself.
If it is indeed essential for the central bank to control the payment system, then access to the payment system is a public good that should only be allowed for entities able to protect the public. This is of course one of the key reasons banks are regulated as heavily as they are – if banks cannot ensure payment finality, then the Fed and thus the taxpayer must do so. Rules are designed to make this as unlikely as possible because banks have mandatory liquidity with which to transmit payments and capital backstops to fund them […]
Karen Petrou: Why Scoring is Better Than Tailoring
A friend of mine last week commented that she was a size 2 in high school, but somehow has become a size 8. If she were a bank, she’d still be forced into her size 2 jeans even if she could only pull them up over one leg and her ability to appear in public was, to say the least, impaired.
Current “tailoring” rules take no account of inflation or, even worse, much that matters when it comes to risk. In 2020, the banking agencies issued tailoring standards categorizing banks via a series of size and “complexity” thresholds that determine applicable prudential standards and supervisory vigilance, or so it was said at the time. The final rule also reserved the regulators’ right to alter a bank’s category –presumably to a tougher one – based on whatever worried them. In practice, the standards have been implemented almost exclusively by reference to a bank’s size and nothing – not even all of the risks evident at some mid-sized banks ahead of the 2023 crisis – led supervisors to look harder.
A bank below $250 billion was deemed simple and safe; any above that threshold, almost certainly not. Further, any bank above $700 billion turned into a pumpkin – that is, a GSIB – even if it is neither global nor systemically-important. Big equals bad even though bad is remarkably indifferent to asset size when there is rapid growth, ill-begotten incentives, lax supervision, or negligent risk management.
The banking agencies rightly plan to revise tailoring, and the FDIC has even begun to do so. However, the focus so far seems principally to be on relief for the smallest banking companies along with inflation indexing. That’s all fine, but it’s far from enough.
Asset size, inflation-adjusted or not, is a poor risk indicator, and the current approach to […]
Karen Petrou: Say Bye-Bye to the Banking/Commerce Barrier
In his comments last week about stablecoins, FRB Gov. Barr worried aloud about cracks in the banking/commerce barrier. How quaint. This barrier has been crumbling for years, but two decisions last week knocked it down. The big issue these days isn’t keeping commercial firms out of banking – give it up, they’re in. Instead, the big question is whether this nation also wants relationship-focused, regulated banks insulated from conflicts of interest and buffered against market shocks. If it does, then traditional banks need new powers, fast.
The most impermeable barrier between banking and commerce was supposedly erected in the 1956 Bank Holding Company Act along with the narrow set of permissible BHC powers allowed in 1970. These laws sought to keep insurance and commercial firms from controlling insured depositories much as the Glass-Steagall Act did in 1933 when it came to securities firms. However, Sears Roebuck took advantage of gaping loopholes, opening a bank in the early 1980s. Congress did little but legitimize these charters, allowing a class of “nonbank banks” in 1987 and broadening bank/nonbank affiliation in 1999.
FDIC Acting Chair Hill has now made it clear that he will go even farther. Next time a bank fails, look for a private-equity company or other nonbank to pick up the pieces. Mr. Hill stated that the FDIC will now not only cotton to these acquisitions, but even facilitate them with “seller financing” and a pre-qualification program akin to one established in 2024 by the OCC.
Would these nonbank owners need to become BHCs? Not necessarily – I can think of lots of ways these firms could enjoy the best of both worlds now that the “business of banking” is rapidly expanding to include all things digital.
This too was made manifestly clear last week in the new national-bank charter preliminarily approved by the […]