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Clients will today receive our in-depth analysis of the Fed’s proposal to radically realign access to the nation’s payment system. As we make clear, the Fed is eyeing a change many banks fear will put them at an acute competitive disadvantage.  Ordinarily, this would slow the central bank.  Now, not a bit, a sea-change from longstanding Fed thinking.  If it lasts, banking will never be the same.

Is that all to the good? In the request for input on new payment accounts, the Fed says the following about what it has taken considered formulating these “skinny” payment accounts:

[T]he Board has considered the risks identified in the Guidelines (i.e., risks to the Reserve Banks, to the overall payment system, to financial stability, to the overall economy as a result of illicit activities, and to the implementation of monetary policy. In addition, the Board considered features that could limit Payment Accounts’ impact on the Federal Reserve’s balance sheet.

Did the Board just forget about banks?  I don’t think so.  Arguably, only captive regulators work to protect their charges from market forces.  Market efficiency is enhanced if uncompetitive banks seek to clog the rails for low-cost, high-innovation services.

Or so it would be if this were a fair fight, which it isn’t.  Banks are of course under an extensive – some might say crippling – set of prudential standards designed in part to ensure clearing-and-settlement capability.  They are also key to financial intermediation.  As we noted last week, a new FRB-NY study …

As we noted, the OCC last week loosed an anti-debanking fusillade at nine of the nation’s biggest banks.  Among other things, the agency sanctions banks for deciding on customers based on “values” and for evaluating relationships affected by negative press coverage.  The OCC demands that key business sectors be served without scruple even if, as with “adult entertainment,” there may be good reasons to demur.  Some “adult entertainment” may be legal, but much isn’t and even that which is legal may still be reprehensible.  Must a bank owned by devout Christians still lend to support activities it believes to be sinful?  Should it do so, its community is likely to abhor the bank, unaware of the OCC’s policy as it rallies against the bank in righteous rage.  To meet the OCC’s edict and still adhere to risk-management policies, would banks need to ensure – God knows how – that no performers were trafficked and the most vile scenes were all made with images, not children?   Can the OCC in fact order banks to eschew values, subjective business judgment, and political opinion?  I think and hope not.

We’ve been in such a debanking frenzy that a fundamental examination of what it means has never been overtly undertaken by those demanding an end to it.  Most Members of Congress are rightly moving cautiously with a focus largely on ending “reputation risk” reviews, while banks reasonably point to Obama and Biden era no-banking orders to show that the fault lies not with them, …

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.    …