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 if all else fails.
Mr. Waller’s “skinny” master account idea is designed to protect the public good, but apparently only when that is synonymous with the Fed’s self-interest. As Mr. Waller envisions them, skinny master accounts would protect the Fed in part by not providing the daylight-overdraft privileges accorded to banks that bridge payment interruptions via chubby master accounts. But what if the payor’s depository isn’t a bank and thus has far less liquidity and capital and no daylight-overdraft window?
Mr. Waller premises this provision on the protections it accords the Fed, apparently assuming that the system will still function and get funds to the payee. Really? How could payees be sure given that the nontraditional banks granted skinny accounts have minimal capital and liquidity and neither discount-window nor FDIC rights? The Fed may have no daylight-overdraft risk, but it nonetheless might have to step in, extending yet one more source of emergency liquidity without regard to ex ante safeguards. Thus, the central bank saves itself daylight-overdraft risk in exchange for that associated with yet another systemic bailout.
Would a skinny accountholder’s distress really pose that much risk? The 2023 financial crisis was sparked by sudden recognition that deposit insurance didn’t cover all deposits. What about sudden recognition that all Fed-system payments might not be finalized? Mr. Waller notes that possible balance caps could also reduce the Fed’s skinny-account risk, but it’s hard to see how they dampen systemic danger.
There is a better way. A raft of rules now requires banks engaged in derivatives trading to post margins that bolster payment capacity, with funds pledged for this purpose usually housed in “segregated” accounts. As a result, a bank is likely to sustain the highly-systemic derivatives market even if it’s otherwise falling apart.
The same can and should be done if nontraditional banking charters gain access to the Fed. They can and should be required to post the funds necessary to ensure clearing-and-settlement finality under stress which are housed in segregated accounts subject to regular audit and examination. As with margin accounts, the resources posted in what I’ll call a “payment-finality account” must be cash equivalents of super-short maturity, but they are not the same as stablecoin reserve-asset accounts because they cannot be leveraged, rehypothecated, or otherwise put at risk.
Friday’s Tenth Circuit decision on Custodia makes the skinny master account still more essential to the payment innovators Mr. Waller champions. Given the small odds that the Fed will provide chubby master accounts to these companies, the national trusts lining up for OCC charters will hang their expensive hats on skinny doorknobs. They are most unlikely to care that daylight-overdraft access or other privileges are not on offer – what they need is payment-system access as soon as possible as inexpensively as regulators will allow.
The less capital and contingency funding these new charters have, the fewer their incentives to align risk protections with the long-term interests of customers, the FDIC, and systemic stability. These business models are actually intended to privatize profit and socialize risk. This is a costly construct, as we’ve reason to know all too well.