Dan Awrey on *Unbundling Banking, Payments and Money*

Dan Awrey is a professor of law at Cornell Law School, a financial markets regulation scholar, and the editor of the Journal of Financial Regulation. Dan joins David on the podcast to discuss how to promote greater financial innovation, financial inclusion, and alleviate the “too big to fail” problem by safely unbundling banking, money, and payments in our financial system. Dan and David also go on to discuss tensions in the global shadow banking system, the history of how banks evolved to play such a central role in our financial system, how the law has reinforced this bundling of the banks’ roles, and much more.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Dan, welcome to the show.

Dan Awrey: Thank you so much for having me, David.

Beckworth: Well, it's great to have you on. So, Dan, you're one of these individuals, a number of whom I have met online via Twitter. We were just talking before the show how amazing this experience has been. We built up our network of friends of a thoughtful people, cross discipline discussions on many of the issues that we cover for a living that's in our hearts, a passion for us. So, I just add you to that list of friends I've developed via Twitter.

Awrey: Yeah, absolutely. One of the silver linings of the pandemic, for me, has been that it's forced me to be more engaging on social media. And I've really been pleasantly surprised with the people like you that I've met, where it does expand your universe, people who are interested in the same issues you're interested in, but often think of them from different ways, come at them from different disciplines. And it's been really great.

Beckworth: Now, there's a group of individuals like yourselves, which I believe you fall in the group of law and finance, and you're the editor of the Journal of Financial Regulation. And I've had a number of you on the show. And it's been interesting to have this conversation with you. Because again, it's cross-discipline. And I've learned many things.

Beckworth: I'll just give an example. Morgan Ricks, I've had him on several times. And I've learned a lot from the legal perspective of some of his arguments. Your paper, we're going to discuss today, about the unbundling of these three roles in the banking system. And so, it's been really educational for me, and I think for others to have this experience. Now, you are a law professor. You're in the area of financial market regulation. How did you get into that?

Awrey: So, serendipity, I suppose is the answer. After university, after my undergrad in the 1990s, I took a job working for what today we would call a Fintech company, that was developing a lot of the front-end automated software that would eventually replace open outcry at exchanges, like the New York Stock Exchange, and how those automated systems interacted with what was by that point, a fairly automated back office system.

Awrey: Some of which has now been in the news lately. That got me really interested in the plumbing of finance. And there's no better place to go learn about plumbing than to become a lawyer. After law school, went back into the business that I'd been in before. So, advising companies on securities law, and corporate finance. Switched sides to the other team a few years in to go work for an investment fund, where, to be honest, a lot of my scholarly work came from. So, I worked in derivatives, money markets, things like that.

Awrey: Primarily doing mergers and acquisitions work to buy funds that were specializing in these areas. But I just found the technical stuff fascinating. And eventually, decided that I would take the plunge, go do a doctorate in law and finance. Nothing was really planned. But I suppose the thread of fidelity throughout was, I just think that financial markets and institutions are so fascinating, so misunderstood, and so important.

Awrey: And it is a job where I'm never going to run out of new things to learn because there's so much to know. And because it's changing so quickly, that you've got to be constantly updating your understanding of how things work, and your intellectual priors.

Beckworth: Yes. And you're in a great environment there at Cornell. You have this group where you work on these issues. We've had Saule Omarova on the show already. She's there with you. Robert Hockett and Paul McCulley. And you guys work together at the center, what's the name of the center?

Awrey: The center formerly is the Clark Business Law Institute. Bob Hockett has a number of other Cornell and not Cornell affiliated institutes that he works with. But yeah, we co-run the center. And obviously, while we come at things from different perspectives, and probably reside at different points on the political spectrum, we do spend a lot of time bouncing ideas off each other and use each other as resources.

Beckworth: As editor of the Journal of Financial Regulation, I'm curious, what are the hot topics that you're seeing? What are people submitting these days in terms of things they want to publish?

Awrey: That's a great question. I do impart to the transatlantic dynamics of the legal publishing market. We get or have been getting a lot of stuff lately on money, which we'll talk about later, various initiatives in Europe at the European Parliament level at the moment around the legal architecture of money, so quite a bit on that. Quite a bit as well on, and this is a legal idiosyncrasy, I guess, is on the structure of regulation. This is a personal bugbear of mine.

Awrey: I probably shouldn't say this as editor. But lawyers are obsessed with the structure of financial regulators, even though there's not a lot of empirical evidence to suggest that one type of structure systematically is better than others. So, we get a lot of stuff on that. And it's always been something that's featured prominently in the journal. Brexit is another topic that I think is quite topic right now. Again, partially because of the transatlantic dynamics.

Awrey: So many open-ended questions about the impact of Brexit, about what the post-Brexit regulatory regimes are going to look like, specifically around passport. Coming out of the US, it's a lot of tech-based stuff. So, big issues around the OCC's fintech charter, its legality, its optimality, how to foster new innovation and competition in various substrates of the financial services market. And then, particularly for the US audience, I think, power within finance.

Awrey: So, how the structure of various segments of the industry is impacting on competition, inclusion, consumer protection. And then, the interplay between financial regulation and antitrust law as a possible mechanism for addressing some of those issues.

Beckworth: Sounds very interesting. Lots of papers to go through. And imagine as editor, you're very aware of what is the heartbeat of the academy, what they want to cover?

Awrey: It's certainly yes and no. I think it all just comes at you in a big wave. I think I have a general sense of broad trends. And I certainly get to read more of my colleagues' papers than I think the average person might have time to if they didn't have the external constraint of having your name on the letterhead of the journal. But it's a relatively small field.

Awrey: And as a result, I think that at least in the old days, in the before times, pre-COVID, you got just as much of a flavor of what was happening through scholarly conferences, through panel discussions, and things like that.

Beckworth: Okay. Well, today, we're going to talk about your new working paper titled “Unbundling Banking, Payments and Money.” It's a great read, and we'll provide a link to it for our listeners in the show notes. But before we do that, Dan, I wanted to jump to another paper, spend just a few minutes on it, because it's a hobbyhorse of mine. And this paper of yours is titled, “Brother, Can You Spare a Dollar? Designing an Effective Framework for Foreign Currency Liquidity Assistance”.

Beckworth: And listeners of the show will probably know where I'm going with this. Because a question that's vexed me for some time, over the past year, actually, is how to deal with the run-ability of the global shadow banking system or global shadow dollar system. We've had people on the show that want to really tap down shadow banking and minimize the runs, which is an understandable concern. And there are solutions that we can think through for the US, but there's a global nature to this phenomenon. And we saw it last year, right?

Beckworth: The Fed had to step in with all these facilities, including an expansion of its dollar swap lines. It also set up a repo facility for foreign governments as well. So, it massively intervened not just in the US, but overseas in response to the pressure on the global shadow banking system. And one solution would be to have a new international arrangement. But to me, that sounds like a whack-a-mole approach. You're going to tap down one area, it might appear somewhere else. But how do you wrestle with this issue in this paper?

Tensions in the Global Shadow Banking System

Awrey: Poorly, I suppose, is the answer. My paper is really, what it's designed to expose in the first instance is this tension from the fact that the dollar is used internationally. And the law, at least as it applies to money, doesn't really operate internationally. The international law of money is quite obviously the national law of money, which means that states don't have control of how claims denominated in their currency abroad are used and abused.

Awrey: And so, against that backdrop, it's really just outlining a menu of possible ways that you could go about this, acknowledging that none of them solve that fundamental tension. And you've got a set of tradeoffs, and I think ultimately, the optimality of which depends on whether you like the current dollar-based international system, or whether you'd like to see a transition to something else. Whether it be a multipolar world, or a world with some international reserve currency.

You've got a set of tradeoffs, and I think ultimately, the optimality of which depends on whether you like the current dollar-based international system, or whether you'd like to see a transition to something else. Whether it be a multipolar world, or a world with some international reserve currency.

Awrey: I would add a series of other concerns that I would have in addition to the whack-a-mole problem. I think for very short-term liabilities, demand and very short-term time deposit substitutes, we can sit down, have a beer and come up with an at least the text of an international treaty that was relatively robust to arbitrage. But if only money markets were restricted to those narrow type of claims, which of course they're not.

Awrey: And it's those other types of dollar liabilities, international dollar shadow money that become more problematic to deal with, especially when they're so different in functional terms. How you deal with trade finance might be different to how you want to deal with more straightforward foreign dollar deposits, for example. So, I list a few solutions in the paper. One, the classic Bancorp solution where we need an international currency, ranging downward from there towards more bespoke solutions.

Awrey: The narrowest of which is really a set of more transparent bright line rules for the Federal Reserve when it comes to who to give international dollar swap lines to and on what terms. As you know full well, the decision during the financial crisis to extend the swap lines was one that was made on an ad hoc basis, and on the basis of criteria that we're of the moment as opposed to pre-determined. I don't mean to be uncontroversial, but I'm pretty agnostic about where we come out in terms of these different proposals.

Awrey: It's such a thorny issue, that on the one hand, a full international reserve currency raises lots of questions about its optimality and effects going back to economics from the 1960s and '70s about optimal currency areas and things like that. On the other hand, having something that's domestic like rules on the Feds, rules that make the Fed's decision, making more ex-ante predictable and transparent, really only solidifies the role of the dollar in the international system. Because now, it's just that much more predictable, ultimately.

Awrey: And the Fed and Congress will still face a time and consistency problem that in the event that that system is really going to jeopardize the financial stability of the United States, those rules may not be abided with in the moment. So, it's more of a paper about a problem. Its initial title was actually “The International Money Problem” in response to Morgan Ricks' proposal in his great book, to narrow and ring-fence the domestic banking system in the United States.

Awrey: One of the implications of which would be to change the structure of the international dollar system. So, the bottom line, I'm equally skeptical that there are good solutions out there to this particular problem.

Beckworth: Well, that answers one of my key questions. And that is, if you were to put strict rules on how you designed the dollar swap lines, and this is what I was thinking last year, and apparently, you've already wrestled with it, is maybe we need some criteria, which country gets it, which country doesn't get it, how much, under what terms.

Beckworth: And there are all these rules, but you mentioned they were ad hoc. In the heat of the moment, we turn this on switch and we added a few tweaks to it. But even if we were very strict and like you said, we impose structure on this, more structure so it was predictable who would get it ahead of time, there would still be this issue that these dollars being fungible and finding their way overseas through other facilities, through other channels. Is that correct?

Awrey: I think so. So, I think we've got to differentiate between the dollar swap network of official foreign currency liquidity assistance, and then, the unofficial bilateral relationships whereby US dollar liquidity can flow overseas via private financial institutions. And there, that's a much trickier needle to thread, ultimately, in terms of trying to close those opportunities, unless you are also willing to take a giant step back from financial globalization.

Awrey: So, unless you're willing to countenance capital controls of some variety, there's really no way to get around that issue but to have a less interconnected financial system to fragment that liquidity in good times, so that it doesn't rush back and cause instability in bad times.

Beckworth: So, this is a tough issue. And I imagine we'll continue to have this conversation for many, many years moving forward. Well, let's move to the paper that is the thrust of our show today. And again, the title of it is “Unbundling Banking, Payments and Money.” And you have this paper up online, we'll have it linked to in our show notes, as I mentioned earlier. And I want to begin our conversation by reading a quote where you start off the paper, it's a great quote. And it really gets you thinking. I think it'd be great for the listeners to hear it.

Beckworth: Here's what you say: “Banks. you have probably been aware of their existence for most of your life. As a child, you saw them on television, learned about them in school, and perhaps even heard your parents talk about them at the kitchen table. As a young adult, you probably opened your first bank account, an important rite of passage alongside your first job, your first kiss, your first heartbreak. Today, your salary probably comes out of one.

Beckworth: “There's also a good chance that you or someone you know has borrowed money from a bank, whether to go to college, buy a house, or start a new business. Banks are a part of the fabric of our world, institutions in every sense of the word. And yet, like so many of our core institutions, few of us have ever taken the time to consider the various functions that banks perform, how they are able to perform them, and how exactly they became so important part of our life.”

Beckworth: So, it's a great paragraph to chew on. Banks are a key part of our life. And you're right, we take it for granted. We ultimately do this because it's easy, it's convenient. And you mentioned there's three roles that banks play in our lives. So, why don't you tell us what they are and how that motivates this paper?

Three Roles Banks Play in our Lives

Awrey: Sure. So, the three roles are really the classic lending role, which I think is important. It was certainly very important for large parts of the 20th century in the United States. But it is empirically becoming less important. And I'm okay with that because I'm a plumbing guy. And as a plumbing guy, I think it's the other two functions that are the ones why banks are so central to their lives. The first one is money creation.

Awrey: So, bank deposits represent about three quarters of the money supply in the United States, whether it be demand, time, other types of deposit liabilities. And then payments, where for reasons that I talked about in the paper, not only are banks the interface through which we make most electronic payments, but they are the owners and operators of the payment system through which by far the vast majority of payments flow.

Beckworth: Okay, so those are the three roles. And what you want to do is to unbundle that, to unpack them. And your paper's making the case, if we do, there will be greater innovation, greater inclusion, and we'll minimize too big to fail. So, before we get into all that, let me just asked, how did we get to this point? I mean, a key part of your argument is, is that banks are the main provider of these services.

Beckworth: And there's not much room for competitors. And we'll talk about some of the barriers to entry. But how do we get to the point where we just take for granted that it is a bank that will provide these services?

Awrey: It's a great question. And there are elements of the answer that I feel comfortable with my own knowledge answering. And those are the ones around the technological evolution of money in payments in the United Kingdom, eventually the United States. Where the nature of banking gives banks certain advantages, including the ability to lend out money that generates profits that then enables them through interest to pay their depositors to park their money in a bank.

Awrey: There's also a regulatory story here, going back a long way, really in the United States to Confederation. But also, in particular, in reconstruction during the 1860s, where you get the federal government deciding that it wants a banking system that is overseen by the federal government, that issues liabilities that are used widely as a form of money. And then, sets up a whole tiered banking system that's designed to make sure that that happens.

Awrey: And there were a lot of side effects that came from setting up that particular system. But one of them was the path dependence of putting banks at the heart of all of this. And so, while we wouldn't recognize a bank from the 1860s and what it was able to do then, once we started putting our money in these institutions called banks, and once they started adapting technology like clearing houses in order to facilitate interbank payments, we really set ourselves on a road, a path-dependent road, towards their central role in the economy.

Once we started putting our money in these institutions called banks, and once they started adapting technology like clearing houses in order to facilitate interbank payments, we really set ourselves on a road, a path-dependent road, towards their central role in the economy.

Awrey: So, that element of it is confluence of history, technology, regulation, are all things that I think I can be fairly confident in saying, led us teleologically almost to this point. But there's all sorts of other variables at play here. There's the politics and relationship between banks and their regulators, between banks and Congress that undoubtedly played a role here. There's the social role of banks in communities, right?

Awrey: Banks are things that we know. Banks are things that our parents knew and that our grandparents knew. And I think it'd be foolish to think that some of this bundling that we see isn't due to these softer, harder to observe, but no less powerful factors.

Beckworth: Yeah, I wonder to what extent the path dependencies and the soft factors have interacted over time. And I say that if I step back and look at the history of banking in the US versus, say, Canada, two very different paths. And you see lots of unit banking, for example, in the US, which there's the extensible argument, well, we don't want these big banks coming in. But the alternative argument is, it's keeping up competition, too, for the local bank.

Beckworth: And a lot of history of federalism, one of different characteristics that come into play. And that's something we have to wrestle with and contend with in thinking about these issues. Is that fair?

Awrey: That is fair. That's actually the next paper in this series on money and federalism. So, as a Canadian living in the United States, working in the area of banking law, I wake up every morning thinking about these differences. And one of the fascinating things about the United States is its outlier status as a country that has split division of powers over money. Now, it's extensively overbanking. But we have the dual system, the dual chartering system.

Awrey: And that, because of the role that banks play in money creation, means that we effectively have a constitutional division over the institutions that create monetary liabilities over the money supply. So, while the Department of Engraving and the Mint are federal, we have 50 state banking regulators that oversee the production of far more money than Washington ever will.

Beckworth: Yeah, it's fascinating you mentioned the number of banks we have in the US. We have 4,500 licensed commercial banks, over 5,200 credit unions, 659 thrifts, that's a huge number. Now, compare that to Canada, even on a per capita basis, there's no comparison, right?

Awrey: There's none. I actually have this data somewhere myself. There are between 40 and 50 banks in Canada. And on a population weighted basis, the US has about 30 times more banks per person, I believe, than Canada does. You can also look to the European Union, to the United Kingdom.

Awrey: Some of the comparative data there… the US just has a much, much bigger system in terms of number of players than other countries. Although, the caveat being, and I talked about this in the paper as well, there's actually a very small core of banks in the United States that are responsible for the vast majority of money in payments. And the Fed has done some great network analysis on this.

There are between 40 and 50 banks in Canada. And on a population weighted basis, the US has about 30 times more banks per person, I believe, than Canada does. You can also look to the European Union...the US just has a much, much bigger system in terms of number of players than other countries.

Awrey: And it's really starting to see what is in effect, a huge number of very small banks that are gravitating around about 60 to 70 banks at the center. And at the center of that 60 to 70 banks are four or five global money center banks that really are the beating heart of the US system.

Beckworth: That's a nice segue into the point I wanted to bring up that you outlined in your paper. There's three parts to the payment system in our country. You mentioned the central bank, number one, Federal Reserve. And you mentioned there's some number of clearing houses that play a role. And then, these big banks that really do a lot of the netting and clearing among the smaller banks. And that's the system where we are today.

Beckworth: And what you want to do is to unpack that, to unbundle it, or at least part of it, and allows competition and innovation to go into that space. So, let's move on and talk about why again we're here. You mentioned some of the history of path dependence, some of the soft issues. But let's get specific and talk about how the law entrenches this bundling, this packaging of money, payments and lending. And again, you're focusing here on the money and the payment part. But what laws do we have that reinforce this tendency?

How Laws Enforce this “Bundling” of Bank Roles

Awrey: Sure. So, the first type of law that we have that enforces this is really the financial safety net that exists for banks and the regime of prudential regulation and supervision that we then employ in response to that safety net to address moral hazard and other problems. The effect of that is to give banks comparative advantage over all of us. Not just non-bank payment providers but really all of us in making short term money like promises. Your bank can credibly promise to pay you back.

Awrey: Because standing behind your bank is the FDIC. And the FDIC and other banking regulators are making sure that the risks that those banks take don't jeopardize, or enable the bank to engage in socially excessive risk taking. Now, that system doesn't work perfectly. But it makes those promises more credible promises. I, as somebody looking for a place to put my accumulated savings, want, in many cases, to be able to get it back right away. And banks can promise to do that for me in ways that other institutions can't.

Awrey: And the reason that they can't in effect comes down to the fact that almost all of bank regulation is designed to make sure that banks never touch general corporate insolvency. Once a firm goes bankrupt, the claim that I had on it in order to get my money back changes. And if that firm is subject to the basic rules of corporate bankruptcy law, I might have to wait a long time to get my money back. And then, I might not get all of my money back. If I'm in the conventional banking system, everything changes.

Awrey: I have, at first instance, FDIC deposit insurance that's going to protect me up to a certain value. And then, if I don't happen to have the benefits of deposit insurance, I have this larger apparatus of bank capital regulation, supervision resolution frameworks that are designed in effect to continue to protect the value of those claims as best as possible to find hopefully, a new purchaser for a failed bank over the course of a weekend that can then honor my deposit liabilities on Monday morning.

Awrey: So, that's the first change. The paper isn't designed to frame the financial safety net in a bad light. The financial safety net is incredibly useful. But one of the side effects, if you will, is that once we get to call it a bank, once we license a bank, it is going to have a set of privileges and protections that no other competitors will.

Beckworth: So, that creates a barrier to entry then. If I wanted to set up an alternative payment system or money, I don't have that certainty to give to my customers. And they're going to go down the street to the regular bank instead. Go ahead.

Awrey: And I'm not the first person to point this out, right? For scholars in financial regulation, I think this is a fairly agreed upon starting point for this analysis. That the tradeoff for making banks safe via the financial safety net is to impose this comparative advantage that erect barriers to entry.

The tradeoff for making banks safe via the financial safety net is to impose this comparative advantage that erect barriers to entry.

Beckworth: Later in your paper, I think you call this the central policy problem, right? That you've got to wrestle with this if you want allow competition to come in.

Awrey: Yeah. So, my view of the central policy problem is slightly different. The classical framing is that you have a tradeoff between financial stability and competition. And that something like deposit insurance is deciding that we're going to prioritize financial stability over competition. And in general, I think that a good way to start out as a policymaker is understanding that there's often a tradeoff there.

Awrey: But then, I think that using the rhetoric, in effect, that I'm employing to support my proposal, you can find situations where you are maybe not getting a free lunch. The benefits for competition are disproportionately high relative to the impact on financial stability.

Beckworth: Okay. So, the financial safety net is the first barrier to entry that's created by the existing framework and laws surrounding banking. The second one you mentioned is the infrastructure access. So, what do you mean there?

Awrey: Sure. So, in the United States, as we talked about earlier, the vast majority of payments between banks and therefore between bank customers are cleared through either public or private clearing houses and then settled on the bank's accounts, so called master accounts with the Federal Reserve. Under the Federal Reserve Act, only banks, only insured deposit taking institutions specifically have access to these ``master accounts.

Awrey: On Twitter, I don't know if you've noticed this, David, there seems to be a group of people who question this claim that only banks have access to master accounts. I've never quite understood what the root of that claim is, because it's a pretty clear reading of the statute, who can have access to a master account. There are a number of exceptions. So, the Treasury, TGA, for example, is specifically listed as another type of institution that can have an account.

Awrey: But to a lawyer, the fact that there are exemptions only reinforced the idea that unless you're specifically exempted, you don't have access to an account. So, that's the first infrastructure access issue there is that non-banks can't settle transactions on the accounts of the Fed. That's then linked both legally and operationally to restrictions on membership in the major clearing houses.

Awrey: So, the clearinghouses, because they all settle on the accounts of the Fed, make it an operational requirement that you have to have a Fed master account to be a member, this then sets up the architecture as it exists today, which is we have banks. Although interestingly, not all banks. Although, that's a project for a different day. But the majority of banks in the United States have a Fed master account. There are then a number of members in the major clearing houses.

Awrey: So, ranging from about 50, I think, with CHIPS. I think RTP is approaching or around 80 to 90 now. And then, Fedwire, the public option being the largest by a significant margin, but it's only banks. And this sets up a system whereby non-bank payment platforms, so PayPal, Circle, TransferWise have to indirectly access the payment system through their correspondent relationships with member banks. So, that's the second legal issue here, this infrastructure access.

Beckworth: So, to paint this picture here, what you're saying is PayPal, for example, can't have its own master account. So, it has to work through a bank and has to have the added cost of working through a bank. Is that the issue?

Awrey: So, the cost isn't the issue, per se, in terms of the competition dimension. It is more the fact that both parties know. So, I believe Pay Pal, correct me if I'm wrong, its primary correspondent account relationship is with Wells Fargo. And so, in order to, in effect, access and make payments, PayPal has to use one of its principal competitors to provide an essential intermediate input. And in classic transaction cost economics terms, this presents it with a huge holdup problem.

Awrey: In so far as Wells Fargo will understand that relationship and potentially use it to its advantage. Now, that's reinforced by the third set of rules that we'll talk about in a moment where a broken deposit rules effectively limit PayPal's options in dealing with its correspondent banking relationships. And in fact, as a result of recent changes to those rules, it's likely the case that firms like PayPal are going to have to concentrate all their deposits in a single correspondent bank.

Beckworth: Okay. So, it's not the cost. It's just the fact that your competitor knows what you're doing, who your customers are, and all this inside information that normally you wouldn't want to share with your competitor?

Awrey: That's right. I think the cost components, for various reasons, is relatively limited. Interestingly, under these new rules, it'll be the case that correspondent banks will likely have to pay very, very minimal, if any, interest on these accounts ostensibly designed to make sure that banks don't compete using interest to try to attract PayPal and things like that. But simultaneously, then locking PayPal into these relationships where they're forced to have a correspondent bank to route everything through the correspondent bank.

Awrey: And then, have that bank have a set of legal rules that make it less costly for those banks to take that business, and really become an important component product of the business models of firm like PayPal.

Beckworth: Okay, so anybody trying to come into this space and provide payment and money services really has the deck stacked against them. They have to go to their competitor in order to even operate, which does not seem fair and creates problems. And let's move to those you called distortions created by this system. First thing you mentioned is less competition, innovation and inclusion. So, walk us through that.

Competition, Innovation, and Inclusion

Awrey: Sure. So, there's a lot of dimensions to this. And to be honest, what's in the paper will form the basis of a much longer-term research agenda. We've hit on the competition dynamics already. I've got a set of competitors to conventional deposit taking banks, that due to the existing infrastructure access restrictions, are forced to use banks simply to honor their obligations to their customers. If you took away banks from PayPal, PayPal could only pay people within PayPal's network.

Awrey: PayPal would have to develop a completely different infrastructure, network infrastructure essentially from scratch in order to replicate the business that it has now. And building those large networks from scratch is incredibly costly and erect barriers to entry. So, you've then got the legal barrier to entry creating important and extremely costly business barriers to entry in the form of high initial infrastructure investments.

Awrey: Tacked on to that is a set of issues that is peculiar to the US around innovation. The paper lists some of the great many ways in which, for reasons that are related to what we're talking about, but I don't think are fully explained by this bundling, the US has fallen behind, The US isn't adapting the last generation of point-to-point payment technology at a particularly high rate. So, whereas, most of the rest of the OECD, for example, is moving towards tap technology, so near-field technology, where you just swipe your card over a reader.

Awrey: So, get it within six inches of the reader and you're fine. The US is still trying to roll out the previous generation of chip-and-PIN technology where you still inserted the card into some mechanical reader. That's just one of many examples where the US has fallen behind. They range from the mundane. So, to pick on a point that I know that some of your previous guests and regular listeners have picked up on.

Awrey: The fact that Fedwire keeps bankers' hours, Monday to Friday, 9:00 to 4:30, or whatever it is, that's anachronistic at this stage. There are issues around the continuing use of costly paper checks, costly in all sorts of ways, costly to administer, environmentally costly. And there are issues around open banking, where a lot of international financial centers have been experimenting with developing the legal and technological architecture of open banking for almost two decades.

Awrey: The US is making news this past month because it's moving forward with some issues around open banking. And really, it's only at the very early stages of understanding how institutions like Plaid, for example, really do change the nature of the game for conventional financial institutions, including banks. And then, the last piece of this puzzle is financial inclusion. We get the FDIC household banking survey every year.

The US is making news this past month because it's moving forward with some issues around open banking. And really, it's only at the very early stages of understanding how institutions like Plaid, for example, really do change the nature of the game for conventional financial institutions

Awrey: In general, it's a good news story, the number of unbanked people in the United States is decreasing. But I think for a developed country with the financial sophistication of the United States, it's still too high. And I think a lot of people would agree with that. And if you look at the reasons why the unbanked are unbanked, they've, or at least consistent with the hypothesis that there's still a competitive problem.

Awrey: Despite our 10,000 insured deposit taking institutions, high fees, poor product features still feature quite highly on the list of things that people who are unbanked cite for why they don't have a bank account. So, that's the first distortion. And I want to be clear that I think bundling is one of the reasons, perhaps an important one for these issues around innovation, inclusion and competition. But there are others. And it's important to acknowledge that unbundling is only one part of that.

Beckworth: Sure, sure. We don't want to oversell this point. But the point is, the lack of competition that has arisen because of this bundling means that we're not keeping up with the latest technological innovations that they're doing overseas, for example, with payment systems?

Awrey: Yeah. So, as somebody who lived in the UK for over 10 years, and whose family still lives there, I have two bank cards in my wallet, my US bank card and my UK bank card. And every time I travel back and forth, you just have to get your head in a different space about what a card means, what you're using it for, the ease of use, your access to payments and account information on your phone. All of these things just fundamentally change.

Awrey: It's almost difficult to describe to somebody who doesn't live the transatlantic life. I look at my Halifax bank card in the UK, and I look at my Tompkins County trust card in the US. And I don't even view them as representing equivalent product features, in effect. They both have the same shape. But the things I can do with one vastly exceed what I can do with the other.

Beckworth: So, when you fly from the UK to the US, you're stepping back a decade in time in terms of financial services. Let me ask this question, in the UK then, is it the case that the PayPals of the world over there do have access to the equivalent of a master account at the central bank?

Awrey: Yeah, so PayPal is a tricky one. There's no good way to answer this without turning this podcast into a mini-series. But the Bank of England's payment system, which is different than the US in the sense that it's more centralized, and there's more public oversight of the clearing and settlement system relative to the US. There is now an option that I believe PayPal and TransferWise and other firms have taken up for these non-bank financial institutions to have settlement accounts.

Awrey: This is not what we think of when we think of a Federal Reserve master account. These, in effect, during the business day, enable you or these payment institutions to affect transfers with other member institutions. But the money has to be funded out of a bank account. So, that's the key difference why I say that these are unlike Fed master accounts. So, you still need a bank. You still need to instruct your bank to send money to these accounts.

Awrey: The only difference is that in the US, while that instruction would ultimately be routed through the Federal Reserve's master account in the name of that bank, now, the account is in the name of TransferWise, PayPal, whatever. But there's still a bank that sits in between the two. PayPal is complicated because PayPal actually has a European banking subsidiary. So, in theory, PayPal has the ability to route payments in the same way that a bank would, at least euro denominated payments.

Awrey: Interestingly, and this feeds back into this paper of someone, although I don't deal with it here, because it's not a European paper. PayPal also makes it very clear that despite the fact that its quasi-depositors are putting money in a bank, that those quasi-deposits are not insured deposits. So, there's a very strange relationship that I'm pretty skeptical of in Europe, where, effectively, PayPal is saying to its customers, "Here, come put your money in a bank. Oh, but by the way, way down in Article four in the fine prints, you're not really a depositor in this institution."

Awrey: So, yeah. Other countries, in short, have been moving in this direction. India is also experimenting with this. China quite famously with WeChat Pay and Alipay effectively forced those institutions to open up master accounts with the People's Bank of China. There are a number of models all over the world. The reason why this would need to be a mini-series is that apples to apples comparisons of these models is quite difficult.

Beckworth: Fair enough. Let me ask this question. So, your proposal of opening up the master account, we'll get to the details in a minute. But what you're suggesting here at least is opening it up to non-bank financial firms that currently don't have access to master accounts in the US. And I see this as a halfway step between Morgan Ricks' proposal of opening up Fed accounts to everyone.

Beckworth: You're saying, "Let's take maybe a baby step first and open up to non-bank financial firms, and see what they can do, what they can provide. And maybe we'll have more innovation, more inclusion. All those good things."

Awrey: So, I think it's right to compare and contrast the Ricks, Lev Menand, and Crawford proposal to this. I'm not sure I'd call it a halfway step though. Because I often joke that my career is basically writing papers that say that Lev and Morgan are only 85% right. But their work is so important and so well thought out, that I spend a lot of time trying to understand why I think I can't get 100% on board, and only 85%.

Awrey: And the reason in this case is actually that I don't think this would be a halfway step. If that accounts works, that is to say that if it becomes a sufficiently large store of value, and therefore a linchpin of the payment system, my concern is atrophy around the development of that infrastructure. So, I think at that point, it's safe to say that there are questions around incentives for private innovation, if the federal government has all of the deposits on its balance sheet or if the Fed has the deposits on its balance sheet.

Awrey: And looking at the Fed's history, I don't feel very excited about the prospect of that infrastructure being maintained and updated in a timely way that takes advantage of the best possible technologies. So, this proposal, one, where in effect, we're giving access to these institution's turnkey access, in effect, to vital infrastructure. So, Fed master accounts, and thereby remove one of the key barriers to eligibility in the clearing networks.

Awrey: There's still very much in place the private incentives to use these technologies to develop better products and services for customers. To use the data that comes from the collection of this money and the flow of payments. To find ways of enhancing user experience, to get to new markets, to expand access to new customers. And so, in that respect, I think that's the key difference.

Awrey: I do think on a financial stability perspective, both Fed accounts and my proposal are motivated by similar underlying phenomenon. I think our rank ordering or our relative concern over competition versus stability, maybe slightly different.

Beckworth: So, just to repeat and summarize what you said there, what you're aiming to do is to preserve the private sector's ability to innovate and to have new technologies, new ways to improve payment system, which would affect, again, inclusion as well. And maybe if we go down the other route where it's just pure Fed accounts, there'd be a lack of that because the government just isn't good at innovating.

Awrey: That's the essence of my concern [is to], yes. Not only preserve competitive incentives, but enhance them. Because I want to see banks subject to more competition in the money and payment space.

The essence of my concern [is to] not only preserve competitive incentives, but enhance them. Because I want to see banks subject to more competition in the money and payment space.

Beckworth: Okay. Now, you list two other distortions. We don't have time to go into them really in depth, but I'll just mention them here. You also are concerned about the destabilizing regulatory arbitrage created by this bundling that now exists in banks. And finally, it exacerbates too big to fail. Maybe in the last one, speak to why this bundling exacerbates too big to fail.

Exacerbating “Too Big to Fail”

Awrey: Sure. So, we need banks for everything. We don't have reliable access to the payment system. We don't have good money except through the banking system. And in that world, banks play an outsized role. Both economically, which becomes an issue for policymakers when it comes to expanding the safety net, going beyond a conventional safety net to bail out banks during times of stress.

Awrey: And it gives them an outsize political role in terms of influence over political institutions that then reinforces the likelihood that we will provide them with state support, taxpayer support during periods of distress. Now, that's the basic gist there. One of the, I think, justified push backs that I've gotten on the paper, although I think I do have an operating response to is, there's 10,000 banks in the United States.

Awrey: What do you mean too big to fail? This is a very dispersed system. And I take that critique seriously. But again, I point out that really the United States has five or six really big banks, a few dozen big banks, and then a whole bunch of banks for which the idea of too big to fail was never going to be an issue.

Awrey: And it's those banks that are at the heart of the payment system, that all have the infrastructure access, the broker deposit rules, and the financial safety net really benefits from a competitive perspective that I think then means to flip that on its head, make it less likely that we could ever let these institutions fail while not experiencing ripple effects.

Awrey: And so, by having more business models, non-bank business models that potentially compete with these firms, the intuition is that we might be able to alleviate some of that pressure that builds up by putting all of our eggs in one basket.

Beckworth: I find it a convincing argument. So, you've got me sold. Well, let's talk about your proposal we've touched on already, but you have three steps. So, walk us through the steps that you would have the US policymakers go down?

How to Unbundle Banking, Payments, and Money

Awrey: Yeah. So, step one, we've already talked about, simply amending the Federal Reserve Act to enable a new category of institutions, and let's call them for the moment, non-bank financial institutions to have access to Fed accounts. But two, because I do think that the logic of unbundling has some serious intellectual logic propelling it is that if you're going to unbundle, you got to lose something. And the thing that I think it makes most sense to lose is the lending function.

Awrey: That is to say that we would couple this rule, enabling access to Fed master accounts, with a rule that said they had to put all customer funds into a Fed master account, and keep them there. The goal here is both to recreate deposit insurance in the sense that this money is now a liability that is owed by the Fed to the customers, which gives it the imprimatur of good money.

We would couple this rule, enabling access to Fed master accounts, with a rule that said they had to put all customer funds into a Fed master account, and keep them there. The goal here is both to recreate deposit insurance in the sense that this money is now a liability that is owed by the Fed to the customers.

Awrey: But also, to prevent an erosion of the regulatory perimeter à la, I hate to say, the OCC's Fintech charter proposal, where we're just recreating banking but with a slightly laxer regulatory framework. And then, that leads you to the last element of the proposal, which is really me once again borrowing what I think is the most persuasive element of Morgan Ricks' book, The Money Problem.

Awrey: Which is that the definition of a bank, and specifically its relationship with the definition of a deposit under federal law in the United States is tautological. You can't be a bank unless you take deposits. And deposits are defined in a way that means they're only issued by banks. This has created a loophole that really has created opportunities for regulatory arbitrage. And I think over the longer term, the classic reemergence of shadow money at a large scale in the retail space.

You can't be a bank unless you take deposits. And deposits are defined in a way that means they're only issued by banks. This has created a loophole that really has created opportunities for regulatory arbitrage. And I think over the longer term, the classic reemergence of shadow money at a large scale in the retail space.

Awrey: And so, the third prong is then adopting Morgan's proposal for a tighter, more functional definition of what a deposit was, that made sure that now we've got two worlds of money. We've got bank deposits, and then we've got the liabilities sitting in the Fed master accounts of these non-bank payment institutions.

Beckworth: So, to flesh this out in terms of an example, PayPal would now have a master account in this program?

Awrey: So yeah, there are questions around whether we should force PayPal to do so or give them the option of become a bank, stay in your existing lane, where you have a correspondent bank, or give them access. Or whether we actually collapse some of the options into, you're either a bank, or if you create money and issue payments, you'd fall into this non-bank financial institution category. But yes, if they either adapt to or are required to open that master account, PayPal would be able to do so under this proposal.

Awrey: All of the customer liabilities that PayPal currently has would be warehoused in this master account. And PayPal would have the primary legal obstacle to becoming a direct member in various clearing houses removed as well.

Beckworth: Now, I'm not sure I know PayPal's business model, or Venmo, or any of those fintechs. But what would be the way they make money, whether it be fees that would charge for the convenience of having this account or something else?

Awrey: Yeah, so there's two ways you can look at it. There's the way they make the money now, which probably we don't have time to go into. But PayPal has figured out pretty effectively how to arbitrage federal banking law. You just stick the liabilities in one institution and the assets in another institution. And then, you rely on the fact that existing regulatory frameworks allow the cited issues liabilities, unfetter the ability to lend to the institution that holds the assets.

Awrey: So, PayPal is, to my mind, always been operating as a bank. It's just that they can engage in this regulatory arbitrage. Not even very difficult, to be honest, in the world of regulatory arbitrage. So, against that backdrop, then how would PayPal be able to make money in this world? Well, it would lose the ability to generate income from its investments. It would no longer be able to engage in financial intermediation. As a first port of call, then we would have the interest on reserves that the Fed pays institutions with master accounts.

Awrey: There's a whole another debate here about the design of that system and how it would intersect with the issues that we're talking about. Second, all that data. All the data on how people are using PayPal who they're making payments to, things like that. This is the standard story of Fintech, right? We're not bank, we're doing this differently and better. And the differently and better is the rhetoric of this paper. Because if I take that seriously, sometimes I do, sometimes I don't.

Awrey: But if I take that seriously, then this is how they're going to make money. Using these data flows, these payment flows as a means to provide better products and services to customers. And if they're unable to do that, I think that tells us something about whether Fintech is just shiny flash without any real substance. Or whether, in actuality, they just wanted to run a bank without all the pesky bank regulation.

Beckworth: So, that's interesting. So, you're saying if you set this up such that the Fintechs could choose to continue operating as they do through their corresponding banks or have their own master account, and they all chose to stick with their corresponding banks, then it would really tell us something?

Awrey: Yeah. I'm no economist, but I love myself a good revealed preference. And at the moment, there's not a lot of choice set that gives me a lot of information about this. And if I gave them a choice where I'm notionally relieving a big problem, enabling them to compete, and nobody takes the Fed up on that offer, then that does tell me, I think, quite a bit as a policymaker, about what the actual constraints and opportunities that these institutions are facing.

Beckworth: Well, in the time we have left, one last question, Dan. And that is, what would it take to get this implemented? So, you mentioned in your paper, the narrow bank, it's not quite the same, but it tried something similar in spirit, right? And it was rejected by the New York Fed, maybe by the Board of Governors. We don't know all the background details, but it was rejected. So, there'd be some persuasion, maybe some changes in law, what would it take to get us there?

Awrey: Yeah, well, the first order of change would be an amendment to the Federal Reserve Act just to allow access to non-bank financial institutions. After that, and I don't want to minimize the importance of this, there would have to be exploration and policymaking by the Fed to build out a framework that incorporated these institutions. And as it happens, I don't know when this podcast goes out, but on Thursday, both Lev and I are presenting this proposal in Fed accounts to the systemic risk forum at the Fed.

Awrey: And one of the things that we're going to be talking about then is if you wanted to go in these directions, what are the next steps? Underneath the legislative framework, what are the next steps in terms of making sure that the Fed's master account framework, in particular, are then well suited to both the objectives that Lev and I are concerned about? But also making sure that everything works with the Fed's existing operating framework in this area.

Awrey: And I should say, I used the narrow bank example in the paper, as the Fed's taking very seriously the idea that only conventional banks can access a Fed master account. But I don't dismiss their concern either, that what TNB was effectively doing was engaging in an arbitrage opportunity of the Fed's existing rate structure within those accounts.

Awrey: And those are the type of issues that would have to be reconciled, I think, and dealt with effectively at the next stage of the process, which would inevitably involve the Feds revising its operating frameworks for master accounts.

It can only be good news, I think, if Chairman Powell is taking a cautious approach to understanding the tradeoffs at play before we launch into any what would be fairly fundamental restructurings of our monetary and payment systems.

Beckworth: Well, this is super fascinating. We've seen the Fed say that they are considering, for example, central bank digital currency. Jay Powell recently said, "We want to be very slow, careful and do it right, not just do it." And the fact that you're presenting your idea and Lev's presenting the idea of a Fed account, this is an interesting conversation that will continue probably for some time. It'll be interesting to follow it and see where we end up.

Awrey: Yeah. I think we're still at the very early stages of this. I think if anything, people underestimate the variety and importance of different design choices that are available to us and the tradeoffs. And we've got a whole subsection of this debate that's talking about privacy features. We've got issues of what technological platforms we're dealing with. Whether we're dealing with pure on network transactions, or whether we want a system where you can, in effect, take digital dollars offline.

Awrey: All of these things are incredibly important. The lawyers have a role to play, the technologists have a role to play, the central bankers have a role to play. So, I do think that it's good news for folks like us who like to talk about these issues. And it can only be good news, I think, if Chairman Powell is taking a cautious approach to understanding the tradeoffs at play before we launch into any what would be fairly fundamental restructurings of our monetary and payment systems.

Beckworth: Well, with that, our time is up. Our guest today has been Dan Awrey. Dan, thank you so much for coming on the show.

Awrey: David, thank you so much. It's been a pleasure. I'm a huge fan of the show. And I really appreciate you having me on.

Photo by Daniel Slim via Getty Images