Julie Hill on the History and Recent Developments of Fed Master Accounts

Julie Hill is a professor of law at the University of Alabama’s School of Law and she specializes in the study of the regulation of financial institutions. Julie also has a new paper out titled, *Opening a Federal Reserve Account,* and she joins Macro Musings to talk about the history and recent developments surrounding Fed master accounts. David and Julie also discuss the legal basis for these accounts and the numerous case studies surrounding them, including the Narrow Bank, Reserve Trust, Custodia, and 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: Julie, welcome to the show.

Julie Hill: Thanks so much for having me. I've been a longtime listener, but I've never been on this side of it, so it's exciting to be here.

Beckworth: Well, it's great to have you on and you are another person I've interacted with on Twitter, i've grown to know on Twitter. So Twitter's been a blessing for this podcast in many ways and you're just another data point that illustrates this. And our exchanges have introduced me to your work and you've also done work for Mercatus as well. But you had a really fascinating paper on Fed master accounts, and I love that you went through the history of it. You go into the current controversies and you also provide kind of real-time commentary on Twitter about Fed master accounts. So recently the Custodia Bank was denied access to the Federal Reserve system and a Fed master account. We'll get to that in a bit, but before we do all that, Julie, tell us a little bit about yourself. How did you get into this area of research?

Hill: Well, I suppose my interest in banking is an accident of birth. My great-grandfather was a community banker. My grandfather was a community banker and my dad worked at the same one branch community bank. So before I could think about much else, I was thinking about banking, but there are a tremendous number of opportunities to work at one branch, community banks. And so I went off to law school. I actually worked at a different bank at night in the payment processing to pay for law school. So banking was good to me yet again. And then once I became a lawyer, I worked in Washington, DC spending part of my time representing really large banks. And so that led me to academia where I get to spend lots of time thinking about things that I would've liked to have been able to sort out when I was a community banker. But you just don't have the time or the resources.

Beckworth: Well that's interesting. So you have been both a practitioner of banking as well as a scholar of banking. So you worked with the payment system, I did not know that about you, so you saw it firsthand, the rails of the payment system, and then as a lawyer for banks, you saw that side as well. So you bring a neat perspective into your scholarship and, I imagine, your classroom as well when you discuss these issues.

Hill: As far as I know, I'm the only law professor who paid for law school working in payment processing.

Beckworth: Quite a story. So it'll be written in your biography when that comes out in the future. So you have this great paper on Fed master accounts and listeners of the show will know Fed master accounts, this is a big deal right now and it's become increasingly so over this past year or two. And I was thinking back, when did I first become aware of Fed master accounts and if I had to put something down, I would probably put a couple of things, Julie. First, when we started talking about these personal accounts at the Fed… that notion came up then, well, what is an account at the Fed's balance sheet? So I've had Morgan Ricks and Lev Menand on the show before, we've talked about that. So that probably was the first time I started thinking about this.

Beckworth: But the other, probably big development in recent times was the Narrow Bank and that's when the term master account really, at least in my world, became prominent, and what were the issues and regulations surrounding that and why was this process going the way that it did. So I am excited that you've written a paper on these accounts and you also specifically include the Narrow Bank as one of the examples. So you have a paper that goes through the history, some case studies including the Narrow Bank, and then also you have some policy prescriptions at the end and just a lot of interesting stuff about master accounts. So let's start with the history. How long have we had Fed master accounts?

The History of Fed Master Accounts

Hill: Well, we've had accounts for banks at the Federal Reserve since the Reserve banks were created. The authority to accept deposits from member banks in the United States goes right back to the Federal Reserve Act. So the reserve banks were always seen as someone who would accept deposits from financial institutions and use that to be able to improve the payment rails of the United States.

Beckworth: And in your paper, you note that there was a big change in 1980 with the Monetary Control Act. So you went from banks to all depository institutions, is that right?

Hill: Yeah, so originally the Federal Reserve just had accounts for their member banks. And of course to be a member bank you had to apply for membership, but buy stock in the regional Federal Reserve Bank for your bank was… and in doing so, you became subject to the supervisory regulation of the Federal Reserve. And so the Federal Reserve would provide accounts for their member banks. Well, almost immediately after the passage of the Federal Reserve Act, they decided that only providing payments to the member banks was going to make the payment system not as useful as it might otherwise be. Any payment system is more useful [when] more people can connect to it. If you only have two banks that are working in your payment system, what about all those other people in banks that want to send payments? So right after the passage of the Federal Reserve at, they expanded the list of institutions that could have access and they said the trust companies could have access if they maintained adequate balances, but they could only do it for the purposes of providing clearing services.

Hill: And so for a long time, that's kind of the state of play, that member banks got master accounts as a matter of course, and some trust companies also got accounts in order to facilitate payments. Well fast forward to payment innovation and we have the ACH system being built out. This is the system that allows money to be automatically deposited in your checking account or automatically withdrawn from your checking account to pay your rent or your gym membership or whatever. So the Federal Reserve banks provide the Fed ACH, which is the payment rails that make that operate. And in developing that, private consortiums of banks worked with the Federal Reserve, settlement of those transactions happen through Federal reserve accounts.

Hill: And member banks who were using this were entirely welcoming to thrifts or credit unions that wanted access, but wanted it on the same terms that the member banks were doing and member banks said, "Hey, we have to keep deposits at the Fed and the Fed doesn't pay us any interest. So we're part of the club. We developed these systems. If you want to connect, well maybe, okay, but we're going to charge you for doing that." And thrifts and credit unions weren't super excited about that. So there was a lot of wrangling about that, some of it legal, some of it political. And what we ended up with was the Monetary Control Act of 1980, which said that all banks now would be subject to a Federal Reserve set reserve requirement. So even non-member banks had to keep accounts or had to keep reserves that could either be kept in a Federal Reserve account or in another bank that could pass it through to their account.

Hill: But what they got in exchange for that was this provision that said that the Federal Reserve was supposed to provide its payment services to these depository institutions, other depository institutions, non-member banks, at the same price that they were providing it to their member banks in the past. So they couldn't discriminate based on bank type. And they defined depository institution pretty broadly so that it includes not just those financial institutions that have FDIC insurance or are insured by the NCUA, but also include uninsured institutions that are eligible to apply for deposit insurance. So now we have an even bigger list of financial institutions, banks, if you will, that are eligible to hold Federal Reserve master accounts.

Beckworth: So the 1980 Monetary Control Act, did that open the door for credit unions and savings and loans or were they already having access?

Hill: No, they didn't have access before. It opened the door for them.

Beckworth: So that's interesting. So they're the ones… a big part of the group that was clamoring to get in to get access to get pipes into the Federal Reserve's balance sheet. And it sounds very similar to today's discussions. We have cryptocurrency, stablecoins, some of these banks will talk about very similar requests. We also want to be a part of that rail that goes to the payment system. So in some ways, maybe history is repeating itself and we'll come to the more recent period in a moment. But it was interesting to read, when you get a Fed master account, if I read correctly, you get a nine digit routing number from the ABA, a registered routing number. So just like my own personal checking account, they have a routing number if you have a Fed master account.

Hill: So your routing number, you're probably familiar with it because it's written on your checks and if you have an ACH set up, you had to provide that routing number. It's just the way that banks route payments and it's actually not issued by the Federal Reserve itself. It's issued by the American Bankers Association and their vendor. So the Federal Reserve uses these same ABA routing numbers for your account and to route your payments, but it's technically a trade group of existing banks that provide access to the routing number that you need to be able to send your payments around.

Beckworth: Yeah, it was very interesting to read that. So banks themselves have a routing number to their Fed master account. The other thing that was interesting that you noted… so right after 1980 for some time, and this changes, we get closer to the present, but the process was fairly easy and straightforward. You mentioned there was like a one page form and they said you could expect five to seven days of approval and seems very different than what we have today. So what was it like back then?

Hill: It was simple. You got the form, the form asked for the name of your bank, it asked for your ABA routing number, and it asked you to provide who at your bank was authorized to make payments or to make changes to the account. It was like when you go in to sign, if anybody still does this anymore, maybe they don't go in, maybe they just do it online, but you just sign the signature card at your bank so that you can write checks from your account. It was much the same way. Banks, once they were established, they'd fill out this one page form, they'd send it to their Federal Reserve bank in their area, and then a few days later, once they had set up all of the software, their account would get opened.

Beckworth: Yeah, very straightforward. And you also note in your paper that the regional Federal Reserve Bank wouldn't do a whole lot of due diligence. They would just trust that these entities were already regulated by some bank or financial firm regulator and trust that given this regulation exists, they didn't have to do a whole lot of their own homework. Which again, all of this is very different than what we see today. And to be fair to the Fed, I don't want to [say], “oh, the good old days.” I mean, I know the world's very different today. It's much more complicated. Technology changes, things have come up, but there's also maybe some less benign reasons that things are complicated and we'll get to those in a bit. So let's jump to 1998, because you say in 1998 is the first time we see the term Fed master account, so that's exciting. So what happened in ‘98 that they had a use the term master account?

Hill: Well, so before that, a bank could have more than one account at the Federal Reserve. And before that, banks could have accounts at more than one Federal Reserve Bank. So it could be that a bank could have an account at the Federal Reserve Bank of New York and another account at the Federal Reserve Bank of Kansas City. What was happening during that time was we were just getting on board with bank branching and interstate banking. And so the Federal Reserve decided at that time that rather than having banks that were operating a bunch of different places, have a bunch of different accounts that might or not be easy to coordinate, that the way to do it was just to have one main account and then you could have sub-accounts underneath that. And so they said, look, you need to get an account at the Reserve Bank in your district, and then if you want to have sub-accounts under that for your own accounting purposes or routing purposes, we're going to allow you to do that, but we want all of your accounts to be consolidated into one. And so that's when they start using the term master account.

Beckworth: So I imagine technology is also a part of the story. They could more easily have just one account. And so in my mind, I have this image of someone having multiple accounts at the Federal Reserve and one regional bank doesn't know that the other regional bank has an account first with the same bank, but with technology, better record keeping, maybe it was easy to consolidate, as well as the interstate branch banking issue you brought up.

Hill: Yeah, so I think the main driver was the interstate banking, and trying to figure out a way to make sure that payments function across state borders easily for banks.

Beckworth: But the thought of having multiple Fed accounts… So one bank could have, for example, an account at the Kansas City Fed and could have one at the St. Louis Fed just for a sake of argument. I mean, compare that to today where Custodia is dying just to get one Fed account. And here are these banks back in the past having multiple accounts and having multiple accounts even at one bank. So it's just interesting to see the very different world back then versus today. And again, I know the world's different, technology changes. So let's go from there to the actual law before we get closer to the present, some of the issues. So walk us through the Federal Reserve Act. Where in the Federal Reserve Act does it give us guidance in terms of these accounts? Is there any guidance in there?

The Legal Basis for Fed Master Accounts

Hill: Well, I guess I would argue that it's not so much a guidance as it's a command.

Beckworth: Okay. Command.

Hill: But there's of course a difference of opinion about what exactly section 13 of the Federal Reserve Act says. So its language says that the reserve banks may receive deposits from member banks, depository institutions, and the United States, and then it lays out the sorts of deposits they can receive, cash, other items. And so the Federal Reserve says, "Look, it uses the words, ‘may receive deposits,’ and so that means that we have complete discretion. We don't have to let anyone that we don't want have an account." Other folks say, "Well, that's not exactly what it means." The Supreme Court actually considered that provision in the 1920s, early 1920s, and that was not a case that involved a holder of a master account or who could hold it, but rather a case that was brought by non-member banks that wanted to force the Fed to accept as payment, non-par checks.

Hill: And so there the Supreme Court said, "Well, that may… it's about giving the Federal Reserve discretion over what sorts of payment instruments they receive for deposits." But the Fed these days says it also means accounts. Other folks, however, say, “well, I'm not sure, it doesn't seem like the Federal Reserve ever told member banks that they couldn't have an account. It seems like the Federal Reserve treated that more as a must. And do we really think that the Federal Reserve is free to tell the United States government that they couldn't have an account?" So I think that maybe the Federal Reserve reads too much into that may, especially when you read it in light of the Monetary Control Act, which says that the Federal Reserve shall provide all of its payment services to depository institutions on the same basis that they do their member banks. So I think when you read those two provisions together, it doesn't line up for quite the amount of discretion that the Federal Reserve sometimes claims.

Beckworth: Now you also outline in your paper Operating Circular 1 and a New York Fed handbook. How important are those two for Fed Master accounts?

Hill: So just like how your bank would have some terms and conditions when you sign up for an account and Operating Circular 1 is the Federal Reserve’s terms and conditions for providing their accounts. And so they lay out what you have to do to open account, a little bit. They provide this one page form, they lay out when they can close an account and when you can close your account, that sort of thing. The Operating Circular is basically the terms and conditions of the account, but the terms and conditions in Operating Circular 1 have never included a long explanation of any risk vetting that banks were going to do before they open an account. And in some ways that's not surprising. I mean, it would be sort of unusual for you to see, in your account agreement with your bank, a long list of what they considered before they gave you an account. That's just not really the function of Operating Circular 1.

Hill: And so what the New York Fed did, I think that they were motivated because they started having some requests from offshore banks in Puerto Rico. So these banks, they accept deposits, but they don't have deposit insurance and they typically don't accept deposits from Puerto Ricans. So they kind of act like offshore institutions even though Puerto Rico is part of the United States and they have regular banks too. So there was some concern about these Puerto Rican banks and the risks that they posed. And so the New York Fed came up with their own document that apparently none of the other Federal Reserve banks came up with that said, "When we get a novel account request, from a bank that doesn't have deposit insurance, we're going to undertake some risk vetting. And the banks that like that, that want access to a master account should expect to go through that process. And here's what we think it's going to look like." It might be that other reserve banks had similar policies, but I was never able to uncover them. They were never public like the New York Fed’s was.

Beckworth: And we'll come back to the Kansas City Fed, which maybe had its own implicit handbook, but nothing else was published, so it was neat to see the New York Fed Handbook. And you note in footnote 13, a statement from a Federal Reserve fact on, how can I start a bank? And it's interesting, I'm going to read it because it's interesting to contrast that, again, going back to the good old days after 1980 where five to seven days, one page form, and this is what they say, you note this in your paper, "Starting a bank involves a long organization process that could take a year or more and permission from at least two regulatory authorities, extensive information about the organizer, the business plans, senior management team, finances, capital adequacy, risk management, infrastructure, and other relevant factors must be provided to the appropriate authorities." That's from the Board of Governors, and that all seems reasonable, but again, a big evolution from when it was simpler and how you interpret that.

Beckworth: And that brings us to the present and you go through a number of novel financial firms applying for access to Fed master accounts, and we're going to go through them in a minute. But before we do that, I just wanted to throw out some other examples of financial firms getting access to the Fed's balance sheet. So we're going to work our way through a bank tied to marijuana. We're going to talk about the Narrow Bank, some crypto banks, but there's already been other financial firms getting access to the Fed's balance sheet, and I guess I would like to get your perspective on this. So for example, the central clearing authorities, so the Chicago Mercantile Exchange for example, has access to the, I believe, the Chicago Fed's balance sheet. They have a master account there. You look at money market funds, they have access to the Fed's balance sheet. I'm not sure it's quite a Fed master account, but they have access to the Fed's balance sheet through the overnight reverse repo facility. And Fannie and Freddie, GSEs, they have access as well. So you do see a growing opening, I guess, of the Fed's balance sheet, and I think particularly the overnight reverse repo facility.

Beckworth: Now, I know that was meant to be temporary when it was first introduced, but right now, if you look at the dollar size of liabilities, it's about 5 trillion and about half of that or more is the overnight reverse repo facility. So money market funds have a lot of money parked at the Fed, as much or more than the banks have reserves, and that's implicitly in the same direction, same spirit. So I wonder how you think about that. On one hand, the Fed is opening up its balance sheet quite extensively. On the other hand, it's playing kind of loose… its interpretation of the rules could arguably be called loose, but also very strict when it comes to allowing these novel banks to have access. So how do you weigh those two different scenarios?

Deciding Fed Master Account Access

Hill: Well, I suppose I'll give you, first, the lawyerly answer. And the lawyerly answer is that lots of the examples you mentioned have separate provisions of law. So Congress has specifically told the Fed that they should or shouldn't do this or that. And of course the Fed should do what Congress tells it to do. And it could be… I think it's important to mention maybe even at the very beginning that Congress could resolve the question of whether some of these banks get access by just directing the Fed. Now whether they need to do that or they feel like they already have is, I suppose, an open question. But it's not clear to me that the Fed all by itself has authority to decide who gets access and who doesn't. The Fed itself is… I know you've talked about this before, but the Fed itself is interesting because you've got the board that's a government agency and everybody agrees that it's independent from the executive, but it's a government agency subject to the ABA, subject, with many exceptions, to FOIA. And then you've got these reserve banks that are more ambiguous. They have a public purpose, they're told what they can do by Congress, they were created by Congress, and yet they have private shareholders, a number of their board members are private bankers. So I think that there are big questions about who ought to be deciding this, and it's not clear to me that it ought to be the reserve banks.

Beckworth: And one of your big takeaways from the paper, if I'm going to kind of jump to the punchline here, is that there's just a lack of transparency and clarity in how this process works. And one of the big questions I had coming into your paper, I’ve had over the past year is, who actually makes the final decision? Is it the regional bank or does the board of governors weigh in? And my sense is it's unclear, it's at least stated that the regional bank makes the decision, but who actually makes the final decision? I mean, the chair could weigh in, the board could weigh in.

Hill: Yeah, the new guidelines say that the reserve banks are supposed to consult with the board who acts as their regulator. But I think that it's naive to think that a reserve bank could open an account for a bank that the Fed Board was opposed to granting an account. So I think that the Fed sometimes likes to push the decision off to the reserve banks, sort of like how my mom would say, this decision's up to you, and I really hope you make the right one. I mean, that wasn't giving me the decision. That was like, I knew what I had to pick or there was going to be big, big trouble. Sometimes I think that the board acts like that. They like to have this illusion that the reserve banks are deciding themselves, exercising their own discretion when, in fact, especially when we're talking about these non-standard banks, the board is essentially telling the reserve banks that they think that they're too risky.

Beckworth: And before we jump into these case studies, and I want to jump into the Narrow Bank because I think what you just described, your mom example with you, is very similar to the Narrow Bank, at least I've heard this story. The New York Fed makes a decision, but powers above the New York Fed weren't too happy or thrilled with the Narrow Bank. But before we do that, you mentioned the Fed adopted some new guidelines last year, was it last year? They adopted [them] in 2022. And let me just quickly mention them. There's three tiers. Tier one, tier two, tier three. Tier one consists of federally insured eligible institutions such as chartered banks insured by the FDIC. And these institutions will receive a more streamlined review process because they're already subject to a standard set of federal banking regulations. So that's an easy one. Tier two are eligible firms that are not federally insured, but are subject to prudential supervision by a federal banking agency. Many, if not most of these institutions will have a holding company subject to Federal Reserve oversight. So they may take a little bit longer, but still pretty streamlined.

Beckworth: And then finally, tier three are the institutions that face the strictest level of review. And this group includes eligible institutions that are not federally insured and are not subject to federal prudential supervision. So this is where the fintechs would come into play. And I've had George Selgin on a number of times on the show, and he's been a big advocate of some kind of standardized approach for stablecoins to get access to master accounts. And so I had him on soon after this was released. It was late last year, was it the fall or September sometime? I forget when. But he was on the show soon after that. And I was like, "George, you got your new guidelines, aren't you happy?" And he was like, "Bah humbug, David." He goes, "Tier three does not add any clarity, any certainty. If I'm a fintech, I'm looking at tier three, it's still not very clear to me what hurdles I have to clear how long it's going to take, who I need to speak to, who I need to lobby." Is that your sense as well on those guidelines?

Hill: Yeah. So the guidelines have two parts. The first part, which you didn't mention, is a very long list of risks that they are going to scrutinize. So they say, “look, we're going to look at every risk that could possibly arise from risks that are specific to your bank, your business plan, your amount of capital, your management, to concerns that are about the payment system more broadly, to concerns about our ability to implement monetary policy and whether or not there are banks, a lot of banks like you, if that would cause problems.” So you got this big, huge, long list of every possible risk that the Fed could think of. And then they say, well, if you're an existing bank though, we're going to sort of gloss off over all of those because someone else has already thought about that. If you're a tier two, you don't have deposit insurance, but you've agreed to sort of let us act as your supervisor, we might let you in, but we're going to do some more risk vetting.

Hill: And yeah, I think George is right that the path for a tier three organization to getting a master account has got to be just very, very, very narrow. And I should also mention that lots of fintechs wouldn't meet the definition of a member bank, non-member bank, or depository institution. So they'd be precluded from even being eligible to apply for a master account. So lots of fintechs would fall outside the eligible list and wouldn't even make it to tier three. I think George's proposal and Dan Awrey’s proposal would open the list of people… institutions that could access accounts. So I think George would like to see more legally eligible institutions and certainly tier three institutions that are already banks or depositories.

Beckworth: We'll come back to this later, this discussion, this development, because late last year, the omnibus bill that was passed, the big spending bill, Senator Toomey got thrown in to that mix that the Fed had to report and provide a database that reports who has Fed master accounts and who's applied for it, which is pretty amazing in itself that we don't already know this. But nonetheless, we'll come back to that discussion because you have some thoughts on that as well. But before we do that, let's look at some case studies that you outlined in your paper, and let's start with the Narrow Bank. So tell us that story and what it illustrates about the process of getting a Fed Master account.

The Narrow Bank Case Study

Hill: So the Narrow Bank is a Connecticut chartered bank, and they want to accept deposits, big deposits from institutional investors and just hold them in a Federal Reserve account. These big institutional investors have deposits that are so large that they can't be covered by deposit insurance, which caps out at $250,000. And so when these businesses take money and put it at a bank, they're subject to some risk, the credit risk, the liquidity risk of the underlying bank. And TNB, The Narrow Bank says that they can make a safer place for these institutional investors because instead of lending out the money, subjecting the depositor to credit and liquidity risk, they're just going to take the money and put it in an account at the Fed. And TNB thinks that it could make money because the Federal Reserve pays interest on excess reserves. And so they could earn the money from the Federal Reserve, pass a little bit of it on to their own depositors and pocket the difference, making for profitable business model.

Hill: So they got a charter from Connecticut, life seemed to be good, and they asked the Federal Reserve Bank of New York for a master account and then nothing happened. They hear that the board’s become concerned about their business model, that it might impact the Fed's ability to conduct monetary policy. One of the things that they're very worried about is that during times of economic uncertainty, everyone would decide TNB is safer, and so they'd withdraw their money from traditional banks and put it in TNB. And they say that that would be problematic. Another thing that they're worried about is that because TNB wouldn't be constrained by the same sorts of capital rules, that it would just grow bigger and bigger and bigger. And that might make it hard for the Fed to have the same impact in their efforts to control the money supply.

Hill: So TNB gets sick of waiting after 18 months or so, and they sue. And the Fed's argument in the suit is, look, we haven't made a decision yet. And the court considers it and says, well, it's right. The Federal Reserve hasn't made a decision, so it's not right for us to consider it. Part of the court's decision there too was, I think, this possibility that the Fed might be able to deny the account on some technical ground. The court thought maybe that the Connecticut charter had expired. It hadn't, Connecticut had given them another 18 months to get the bank off the ground, and Connecticut has extended it a number of times since then. But the Narrow Bank has been waiting now for more than five years for the Fed to decide whether or not they can open an account.

Beckworth: Yeah, and as you noted, there was pressure from above. So this is the example of your mom saying, “it's up to you, New York Fed, but I would recommend you make the right choice here.” And what's interesting about the Narrow Bank as well is that Jamie McAndrews was a former Fed official, was leading it, spearheading it, and so he knew people inside the Fed and yet even he had a hard time getting this thing through. But it's sitting there. And the other, I guess, interesting thing about it, they're trying to arbitrage the spread between interest on reserves and their funding costs, as you noted. And so the Fed was worried about that, how they didn't want that to impair their ability to conduct monetary policy as well as cause a, I guess, a run on the banking system during panics?

Hill: Yeah, so TNB's response to that is, well then set some limits on our account. One of the things TNB is willing to do is after a short startup period, a couple of years or something, they'll commit to not growing their deposits at the Fed too quickly. So if there were to be a run, what TNB anticipates doing is just saying, "No, no, we won't take your money. We can't grow that fast." And they say that that should alleviate any Fed concerns about the likelihood that in an economic downturn, money flows to TNB and away from traditional banks. So of course the Fed has lots of concerns. Apparently TNB hasn't made them convinced that they should get an account yet. And what's going on? We don't know.

Beckworth: I want to throw out a cynical take here, Julie, and that is, what role do you think traditional banks are playing in these decisions? In other words, if we can keep out the Narrow Bank, if you can keep out some of the more recent applications. We'll talk about Custodia in a minute. That's great for traditional banking, right? I mean, I know they lobby, I know they write comments on proposed regulations. Am I being too cynical?

Hill: Well, it's hard to be too cynical when they put out a white paper that's called “Beware the Kraken,” right after Kraken applies for a master account, right? So I don't think that it's cynical so much as it is an accurate statement of the existing bank policy that everyone from BPI to the American Bankers Association is not particularly keen on non-traditional banks coming inside the fold. Now, should that impact the Fed's reading of the law? No. That's probably not what we should expect to happen, but here we are.

Beckworth: Right, right. Well, it certainly makes it easier for the Fed to say no, they don't have a bunch of people cheering against them. They have people cheering for them. That's a good decision, Federal Reserve. Well, let's move to another novel institution, novel bank, and let's talk about the Fourth Corner Credit Union, a cannabis credit union.

The Forth Corner Credit Union Case Study

Hill: So Fourth Corner was a bunch of people who got together after Colorado legalized recreational marijuana. And at that time, right after Colorado did that, marijuana related businesses had a really hard time getting access to bank accounts because federal money laundering laws said if you take money from an illegal source like selling or dealing with marijuana, which is still illegal under a federal law, and deposit it into your bank, that's money laundering. Unsurprisingly, not that many banks were excited to do something that federal regulators were going to view as money laundering, especially for a brand new industry, when they've got a whole deposit base, a bunch of loan customers, their life is going along pretty well. Now over time, regulators, I think, softened their stance. They provided some guidance about the sorts of due diligence that banks had to do if they wanted to bank marijuana customers.

Hill: But especially in the very beginning, it was very, very hard for the marijuana industry that was state legal but not federally legal to get access to bank accounts. So the organizers of Fourth Corner Credit Union said, well, what if we just started a new bank? We don't need to put existing customer deposits at risk. We don't need to deal with our existing loan holders, our existing shareholders. Why don't we just start a new credit union that will serve the marijuana industry? And so they go to the Colorado bank regulator who of course thinks it's a wonderful idea because Colorado's legalized marijuana. Why wouldn't they want this industry that they've created to be able to have access to banking? The credit union applies for NCUA insurance, and they apply for a Federal Reserve account, and eventually, both the NCUA and the Kansas City Fed tell them no.

Hill: So Fourth Corner sues and says, “look, if you look at section 13 of the Federal Reserve Act and the Monetary Control Act, once you're a bank, you have to get access to the Federal Reserve.” Federal Reserve says, "No, no, that ‘may’ there in the Federal Reserve Act is really big. And we have complete discretion to deny your account, especially because what you're asking us to do is launder money. Surely you can't think the Federal Reserve Act requires us to launder money," not that bad of an argument on the Fed's part. So while the suit is pending, Fourth Corner gets the idea that this is going to be really hard to convince the Federal Reserve that they ought to process payments that might be viewed as money laundering. And so they amend their complaint to say, "No, no, we won't accept transactions that would be illegal under federal law. We'll just serve marijuana advocacy groups that are pushing for legalization."

Hill: And so this means that when the case goes up to the 10th circuit on appeal, there's lots of confusion about whether or not they were or were not going to do stuff that was illegal under federal law. So you wind up with a three judge opinion that's quite fractured. One judge says they were going to do stuff that's illegal, we should get rid of it. Another judge says, well, it's not right because the Federal Reserve never considered this alternative business plan. And then you have one judge who writes a really long opinion about whether or not master accounts are a matter of right under the Federal Reserve Act and Monetary Control Act, and concludes that they are. What this means is that the case gets remanded, Fourth Corner immediately files a new application, this time promising that they won't engage in federally illegal transactions, and the Federal Reserve grants them a master account conditional on them being able to secure NCUA insurance. They haven't been able to do that. So they're not open yet.

Beckworth: How exciting. So part of the problem then is waiting on the federal government to change its laws on marijuana. When that happens, then it'd probably be easier to get the insurance.

Hill: Yeah, one would think so, assuming they like the rest of the business plan. But this was the first time in the modern era at least, that a court had squarely considered issues surrounding master accounts.

Beckworth: That is so fascinating. The other thing that's interesting is the Fed put a lot of heavy lifting on the word “may.” As you mentioned earlier, in the Federal Reserve Act, it says “may,” and it's the Monetary Control Act that has “shall,” is that right?

Hill: Right. The dueling “may” versus “shall,” what does it all mean?

Beckworth: Yeah. So I wasn't aware of this distinction until this paper, but “may” versus “shall,” big issue for the Federal Reserve and Fed master accounts. Okay, let's go to another really interesting case study that you provide in the paper. And this is of the Territorial Bank of American Samoa, which is a public bank. So walk us through that case.

The Territorial Bank of American Samoa Case Study

Hill: So American Samoa is far from Hawaii, even farther from the US mainland. It had two banks. One of them was the Bank of Hawaii, another was ANZ Australian New Zealand bank. And ANZ didn't really do much payment processing for US dollar transactions and US mainland transactions because they were focused on connections with Australia and New Zealand. So the bulk of banking in American Samoa was done by the Bank of Hawaii who decided that it wasn't very profitable for them and that they were going to leave American Samoa. And so this was going to leave all of the American Samoans without access to the US payment system. And so American Samoa goes through a bunch of things to try to solve that problem. They try to convince Bank of Hawaii to stay. They try to convince other financial institutions to open a branch there.

Hill: They try to get a credit union off the ground. They try to organize a community bank, but ultimately all of those efforts were unsuccessful. And so instead their legislature decides that they should create a government owned bank, the Territorial Bank of American Samoa. Bank of Hawaii gives them their building. They give them a house for the bank manager to live in. They give them their ATMs, and the legislature appropriates money to serve as their startup capital. They create a regulator, one person regulatory shop for the one bank, there on the island. And now all that TBAS needed was access to a Federal Reserve account.

Hill: Initially, their plan wasn't to have their own Federal Reserve account. They hoped to receive an ABA routing number and then use Zions Bank out of Salt Lake as their correspondent. So rather than having their own account, they would have their transactions settled in Zions’ account and Zions could do a bunch of the payment processing for them. But as they worked their way down that path, it turned out that what Zions had promised wasn't going to happen. And it's not exactly clear why it might have been that Zions’ bank's regulator, the OCC, told them it was too risky. It might have been that the Federal Reserve Bank of San Francisco said, “are you sure you want to do this?”

Hill: But at any rate, this possibility of having a correspondent bank didn't materialize. They also contacted a bunch of other banks to try to get correspondent services, and that didn't work out. So they applied for a Federal Reserve account. They had spent a lot of time trying to convince the board, not the Federal Reserve Bank of San Francisco, but actually the Federal Reserve Board, that they're not going to be plagued with corruption, that they have an adequate regulator, that things are squared away there and nothing happens, and nothing happens. And then Randy Quarles is appointed to the Federal Reserve Board, and as it turns out, some of the consultants that were working with the Territorial Bank of American Samoa to get it off the ground, were familiar with Randy Quarles. So they meet in Utah and within a few months they got a routing number and they get a master account. And suddenly people in American Samoa have access to payments again.

Beckworth: And this is a public bank, right?

Hill: Yes. So it doesn't have any private shareholders. All of the capital that is there is applied by the government. In fact, one of the issues they're having now is that only late last year, ANZ decided to leave the island too. And so this leaves just the Territorial Bank of American Samoa there. And as a result, there were a bunch of inflows of deposits from people taking their money out of ANZ and moving it to TBAS. Well, this triggered problems with the amount of capital. And so the legislature had to appropriate more money so that the bank's capital ratios could remain adequate. And of course that's hard to do if you're a legislature because you have public works projects that you'd like to spend the money on, social programs that you'd like to spend money on. And instead, here they're having to appropriate money so that they can keep their access to banking services. Now, they, I think, would like to privatize. So far they haven't been able to get that done. They'd like to have deposit insurance. The FDIC doesn't seem keen to give a public bank deposit insurance. And the whole time they sort of hang out in this weird limbo because they're very non-traditional. And I suppose it could be, if we think that the Federal Reserve has broad discretion over these accounts, that the Federal Reserve could decide tomorrow that the people in American Samoa don't get access to payments anymore.

Beckworth: This is very fascinating. This is a case where a lot of things could happen. I mean, maybe the Fed could offer Fed accounts, do a little experiment in Samoa, right? Just see what happens. Morgan Ricks could fly out there, set up some Fed accounts for the Fed. Now that's probably not going to happen. But I did have that question. Where are the bank regulators? Where's the FDIC or the control of the currency? Why not give them a national bank charter? Is this territory outside of their jurisdiction or they just don't want to go there?

Hill: Well, so I think that it's hard to make money at a bank in American Samoa, structurally. So one of the difficulties there is that in order to own land in American Samoa, you have to be American Samoan. So I can't go there and buy a piece of property and get a mortgage loan. And so mortgage lending is non-existent. They also don't have that great of property records. So there's some lending on the island that's title lending, car lending. But otherwise, it's hard being geographically remote. And then also the problems with the size of the market and then the structural problems with the law. They don't have a uniform commercial code, for example. And I think there's just a lot of reasons why a privately funded bank could have a hard time making money there, which is why it's hard for a credit union or a community bank to get off the ground with investors.

Beckworth: So this is a clear case where some kind of public bank is necessary if the private motive isn't there. And maybe somebody there will be if they change the laws about other people being able to spend or live or invest there. But yeah, this is interesting, need to see where this goes. And it might be a great place to experiment with many different radical proposals out there. Let's move on, and you have two other case studies in your paper, Reserve Trust and then Custodia. Now Reserve Trust is the one related to Sarah Bloom Raskin, right? That's the one that's created a lot of controversy there. So maybe walk us through that, because that, I think… that really gives us the backdrop to some of the things that are happening now, helps paint the context for where we are today.

The Reserve Trust Case Study

Hill: So we don't know a lot about the context for the Reserve Trust master account or now it's lack of master account in part because Reserve Trust never talked about it. They were never using, at least publicly, their political might to try to get a master account. But they’re a fintech company that wanted to facilitate cross border payments. They applied for a Federal Reserve account at the Federal Reserve Bank of Kansas City. The Kansas City Fed says that they initially denied the account determining that they were ineligible, so that they weren't member bank, nonmember bank, or a depository institution. Their charter was a Colorado Trust charter. And so I guess the idea was that they were going to receive trust deposits, but they weren't going to receive non-trust deposits, which was required to be a depository institution.

Hill: So that's not the end of the story, because then what happens is, Sarah Bloom Raskin gets on the board and a little while later, the Federal Reserve Bank of Kansas City opens an account for Reserve Trust and they start using it in processing payments. Now, why did they not get an account before, but they did get an account then? Oh, one theory is that Sarah Bloom Raskin used her influence. She says she doesn't remember calling them. Other members of the Reserve Trust team said she made a call. But it was, just appreciate your work on this, not a, you know, must do me a big favor, call. The Kansas City Fed has said that what happened is that Colorado reinterpreted their law. A bunch of folks, including me, made FOIA requests to the Colorado regulator and they said, "No, no, we don't interpret the law. We never reinterpreted the law." It's not clear exactly how the Fed decided they were a depository institution when they weren't before. It's also not clear why the Kansas City Fed thought they had to decide they were a depository institution because trust companies are eligible for clearing accounts, clearly a trust company. So then we learned that, from Senator Toomey, that the Kansas City Fed decided to close their account. And the Kansas City Fed hasn't explained why. And it appears that Reserve Trust is not operating anymore.

Beckworth: What a rollercoaster ride. Wow.

Hill: But we don't know what happened.

Beckworth: We don't know, a lot of speculation. But nonetheless, it certainly has the appearance that Sarah Bloom Raskin used her influence. And again, that's contestable, but that's the allegation. And it definitely had consequences, the appearances of it. She lost her opportunity to serve at the Board of Governors, that's one of the issues Senator Toomey had with her. It's also prompted him to propose legislation last year, died with the last Congress, but he had this reform for the Fed where the regional banks would be subject to Freedom of Information Act [requests]. I think it was the Fed Transparency Act. I think that was the name of it. And it was co-signed by Senator Elizabeth Warren. So a Republican and Democrat senators. She wanted the transparency because she was concerned about the trading scandals going on at the regional banks. He wanted transparency because, he wanted to know more about the master accounts as well as some of the woke research coming out of the banks. But the Fed master accounts were a big part of this discussion. And I think it also played into the development, I mentioned earlier, that the omnibus bill that included the reporting of Fed master accounts, the database, and who has applied for it. So maybe walk us through that and let's go there. We'll come back to Custodia in a minute, but walk us through that law and what the Fed is doing to respond to it.

Hill: So even before the [inaudible] appropriations [inaudible] legislation, the Federal Reserve has said, look, we're going to consider the possibility of disclosing some information about account holders. This is sort of surprising because the final guidelines that we talked about before, when they came out, the Fed said that they wouldn't consider making any of it public, that it was a proprietary bank information and that it needed to be kept secret and that they'd long kept it secret. Well, they hadn't long kept it secret. They'd long provided lists of account holders. And then only after 1980 when it was imagined that everybody was going to get an account, that they stopped providing a list because it became unimportant. But anyway, better late than ever. So they say, "Look, we're considering making a list of account holders. We're going to give you their name and which reserve bank they're in. And that's going to be basically it." And then Senator Toomey's legislation said, "Well, you need to disclose a bit more than that. You need to disclose the bank, you need to disclose applicants, you need to disclose whether or not they have deposit insurance. And it needs to be in a searchable database format," so that folks like me can have so much fun looking through it. I view it as an early Christmas present.

Beckworth: It definitely is, it's a Christmas gift that will keep on giving for your research agenda on this and provide plenty of fodder for future podcasts as well, so a very interesting development. Julie, how long does the Fed have to respond to this new law to provide this database?

Hill: I think they have 180 days. I expect the database to be live this summer just in time for people like me to spend their summer researching it.

Beckworth: Very nice. Well, let's talk in closing about Custodia because that's the most recent development. Some news just came out surrounding that. So walk us through that story.

The Custodia Development and Case Study

Hill: So a few years ago, Wyoming, the state, created a blockchain task force to figure out how to modernize their state law to be more friendly to financial technology, bitcoin, and blockchain technology. And one of the measures that the legislature passed was a law creating special purpose depository institutions. They say, "Look, what we're going to allow with…" they call it the SPDI Charter, and perhaps it's inaptly named because they're not getting started really speedily. "But what we hope to do with this SPDI charter is let banks get a charter that allows them custody cryptocurrency, provide US dollar payments to be an on-ramp and an off-ramp to cryptocurrency, but would not let them lend. Instead, all of their deposits would have to be stored in safe, relatively liquid assets." And so Custodia applies for this SPDI charter, they get it. They want to custody cryptocurrency for institutional investors, family offices.

Hill: And then they also hoped to have a private stablecoin that would facilitate real-time payments for people in that space. So they apply for a Federal Reserve account, and like a lot of the other novel bank applicants, they wait and they wait and they wait and they get sick of waiting. And so they sue the Kansas City Fed and the Board of Governors of the Federal Reserve. And the first round of legal skirmishing is again like the TNB case about ripeness, because at that point the Federal Reserve hasn't made a decision yet. But unlike the judge in TNB who just got rid of the case, said, it's not ripe. We've got to give the Federal Reserve lots of time to decide these. It's really hard. The judge in the Custodia case said, "Well, I don't know why it takes all those smart people at the Federal Reserve longer than the gestation period of an elephant to decide on these sorts of things."

Hill: I did in fact borrow that from the judge. And so he sets the tentative trial date and lets the case move toward discovery. Well, just last week we learned that the Kansas City Fed has denied the request for a master account. Now, how did we learn it? Did they make a public statement? Did they release their letter to Custodia? No, of course not. We learned that they denied the master account because they asked the judge in the lawsuit to dismiss this case because now Custodia can't complain about the long delay because they've made a decision. I expect that the court will allow… Custodia always had as part of their claims, this idea that master counts are a matter of right for legally eligible institution. So I don't see how the Federal Reserve's decision changes that claim. So I expect at least part of Custodia's claims will survive and we may well be looking at some discovery and maybe even trial this fall.

Beckworth: So the story has not ended for Custodia. There'll be appeals and more court decisions, but all of these cases together paint a picture that this process is not very clear. It's not transparent. If I'm a financial firm trying to get a Fed master account, unless I'm a traditional bank, the process is not very predictable. If I want to plan ahead, if I'm an investor, all of these issues need some clarity, some focus, some certainty, right?

Hill: Yes, absolutely. It shouldn't be that people who want access to the payment system wait more than five years for a decision. That's just ridiculous. And the Federal Reserve ought to be transparent about what they want and are looking for. And it shouldn't also be that they wait for a difficult case like Custodia to suddenly roll out some new rules about here's what you need when you apply. Or they wait for a difficult case like the Narrow Bank and suddenly roll out some rules about interest on excess reserves. That's not the way that the Federal Reserve, who values its credibility, ought to go about behaving in this space.

Beckworth: So what do you propose the Fed do or maybe Congress should do to fix this situation?

Solutions for the Master Account Situation

Hill: Well, simplest thing to do is for the Fed to actually be transparent. They've been told that they have to release information about account holders and account applicants, but they could be a lot more transparent than just providing a list of applicants. They could tell us why Custodia doesn't get a master account, and that would allow other Wyoming SPDIs, for example, to decide whether or not any Wyoming SPDIs can get… is there a path for Wyoming SPDIs or was there something specific about Custodia that led to the problem there? Was it that it wasn't adequately capitalized, did they not like the organizers? Was it because they wanted to issue a stablecoin? We don't know. I mean, maybe, but maybe it was because they think that the SPDI charter is ill-conceived. Why should the other holders of the SPDI charter have to wait five years and pay their lawyers lots of money to find out that they were ineligible in the Federal Reserve's eyes all along? It doesn't make any sense that we put folks to all that work.

Beckworth: So even if the Fed comes down on a permanent basis and says, "No fintechs, stablecoins can't get access to the master account," at least be transparent about it. Lay out the markers, the indicators that would indicate whether you should even apply in the first place.

Hill: Right. I mean, we should know why Reserve Trust was okay, and why Custodia is not, so that people who are trying to plan their business know how to make themselves more like Reserve Trust and less like Custodia, if that's the problem. Look, all of bank regulation runs on this idea that we're going to set a bar and then we're going to let banks do their best to comply with it, and then we're going to use our limited resources to punish banks that we don't think are complying, but we don't have enough resources to make every Bank comply all the time. Our whole system of banking regulation relies on the idea that banks are going to be told what the rule is, and we're going to hope that they do their very best to comply with that rule. Well, that all breaks down if you don't tell them what you're looking for or if you change what you're looking for partway through.

Beckworth: Well, with that call to action, our time is out. Our guest today has been Julie Hill. Julie, thank you so much for coming on the show.

Hill: Thank you. It's been great to be here. There are not that many people who want to talk with me about master accounts, at least not as many as I would like. So thank you for giving me the opportunity.

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