Why Can’t We Just Have Safe, Boring Banks?

Amid the current financial panic, calls for “safe banks” are once again pouring in – but this time they’re coming from mainstream voices like Harvard Business Review, Silicon Valley entrepreneurs/podcasters, macroeconomic analysts, the CEO of biotech company, and individuals on social media. All such calls echo a similar sentiment: why can’t my money in the bank simply be there when I need it? Answer: your money can be made safe in your bank, even above the $250,000 FDIC insurance limit. Ironically, the Federal Reserve is blocking the path to make it so.

If banks were “money warehouses” that simply hold your deposits for you, the financial system would be far more stable than it is today. 

Assume you park your car at a valet garage and come back from dinner to find that the garage has rented out your car to an Uber driver and pocketed the earnings. You’d of course be angry. And if the Uber driver crashed your car, you’d be livid because you would face an unexpected financial loss. Instinctively, most of us recognize the unfairness of this scenario. Yet, that’s exactly what banks do with our money every day, legally – they rent it out and pocket the earnings, while you bear the risk of loss. Until very recently, we accepted this as normal. But it wasn’t always so. 

Throughout most of human history, banks were just “money warehouses” that stored money and charged customers a fee for the service. What we think of as banks today – both a lender and a depository together – is comparatively new. Why? Because both storing and lending the very same customer money is inherently an unstable proposition – its stability could be fleeting because it rests on the idea that not all customers will want their money back at the same time. 

Such a system inherently is prone to periodic crises, the amplitude and frequency of which tend to increase over time. In today’s era of easy access to information and online banking tools that make the analog bank runs of the It’s A Wonderful Life era appear quaint, the notion that banking system stability rests on the shared confidence that everyone won’t withdraw simultaneously has proven to be a dangerous idea.

The U.S. had no central bank between 1836 and 1913, which meant banks during this period survived or failed on the basis of their own success. There were no government bailouts and there was no government lender-of-last-resort. Fraud and many bank failures happened, for sure. But during this period American banks – without any government backstop – successfully financed the industrialization of America, which brought improved living standards and a burgeoning middle class.

America created a backstop for the banks in 1913 when Congress authorized the Federal Reserve. Banks evolved away from the “money warehouse” model toward the riskier model of “borrow short-term and lend long-term” – i.e., banks both storing and lending very same customer deposits. 

In the thick of today’s social media-accelerated, online-banking accelerated banking crisis, that “borrow short-term and lend long-term” model is less stable than it has ever been. And it’s about to become even less stable – because the speed of money movement in the U.S. is scheduled to accelerate this July, when the new FedNow payment system comes online. Intended to replace Fedwire, FedNow will allow depositors to access their bank deposits 24/7/365. Just imagine how much worse today’s banking crisis would be if panicked depositors could move their funds during the news-filled weekends. Borrowing from Hoover’s famous Depression-era statement, deposits would be flinging around “like a loose cannon on the deck of the world in a tempest-tossed era.” 

It need not be so. The solution to the problem is simple: some banks need to become “money warehouses” again – specifically, to hold *cash* to back all deposits that might be withdrawn on short notice. In other words, the solution need not involve a new government guarantee of uninsured deposits. As a new Harvard Business Review article correctly points out, vital payments like business payrolls frequently exceed the $250,000 FDIC-insured deposit limit. (The FDIC’s deposit insurance fund has only $128.2 billion of assets, compared to $17.6 trillion of deposits in U.S. banks.) Were non-lending “safe banks” to be able to offer such payment accounts, they would need no government backstop from the Fed, the FDIC or otherwise. Such non-lending bank charters already exist in several states, including Connecticut, Wyoming and Nebraska. 

Unfortunately, the Federal Reserve has been blocking non-lending banks from accessing Fed payment systems, though, which means the “safe banks” either cannot operate at all or cannot provide the very “safe banking” services that consumers want. But loud calls for “safe banks” from many mainstream places indicate they represent an idea whose time has come.

Two questions arose during recent social media conversations about “safe banks“:

1. How would “safe banks” make money? Answer: fees instead of net interest margin. Such “safe banks,” by definition, would not be low-cost providers. Depositors could vote with their feet based on their own cost/benefit tolerance. 
   
2. Wouldn’t such a bank trigger the very deposit run that traditional lending banks fear? Answer: No, because “safe banks” cannot afford to pay competitive interest rates to depositors (since “safe banks” do not lend). On the contrary, the entrance of “safe banks” would likely impose a healthy market check on lending banks by forcing lending banks to pay competitive interest rates to depositors to compensate them for credit risk — which they are generally not doing today. In other words, consumers would win. Depositors could choose between safety and yield based on their own preferences. Two additional factors would act as brakes on how big “safe banks” could grow during banking system panics:
   
   (a) the high capital requirements that apply to all banks, which means “safe banks” would need to turn depositors away if they did not have enough capital to handle a sudden deposit influx, and
   
   (b) deposit concentration limits that limit the per-depositor balance at a “safe bank.”

The Harvard Business Review article summed up the case for “safe banks” well:

“The reality is that the U.S. banking system has become much less dynamic since the global financial crisis [of 2008]. Entry is nearly non-existent. While the number of U.S. banks may be high relative to many other countries, the truth is that we don’t need more traditional banks — we need different kinds of banks. Crises are terrible things to waste, and this one could lead us to a much safer banking system by recognizing the problem of the uninsured depositor and creating a home for them.”

Mihir A. Desai and Sumit Rajpal, How “Payment Banks” Could Prevent the Next Bank Collapse,
harvard Business Review, March 17, 2023