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A Look at the Fed’s Recent Custodia Bank Denial and the Central Bank’s Push Back Against Narrow Banking

A Look at the Fed's Recent Custodia Bank Denial and the Central Bank’s Push Back Against Narrow Banking

Over the past century, the number of American banks has significantly decreased, dropping from 30,000 banks in 1921 to 4,997 U.S. banks in 2021, according to data from the Federal Reserve. Recently, the U.S. central bank denied Custodia Bank of Wyoming, a financial institution that holds $1.08 for every dollar deposited by customers. Although there appears to be a need for such a bank after the collapse of three major U.S. banks, the Federal Reserve stated that board members have “heightened concerns” about institutions with plans to focus solely on a narrow sector.

The Fed’s Explanation on Why it Denied Custodia Bank Highlights Adversity to Crypto-Asset Sector

Shortly before the collapse of Silvergate Bank, Silicon Valley Bank, and Signature Bank, the Cheyenne, Wyoming-based financial institution, Custodia Bank, was denied membership in the Federal Reserve System. The Federal Reserve Board specified that the application submitted by Custodia was “inconsistent with the factors required by law.” This week, the Fed published its explanation as to why it rejected the Wyoming bank. Custodia would be distinct from the numerous banks currently in operation, as it holds a complete reserve and more to cover deposits.

A statement from Custodia published on March 24 highlighted the need for a bank that operates in this manner, following the collapse of several banks. “Historic bank runs in the last two weeks underscore the dire need for fully solvent banks that are equipped to serve fast-changing industries in an era of rapidly improving technology,” the company stated. “That is the exact model proposed by Custodia Bank – to hold $1.08 in cash to back every dollar deposited by customers. Regrettably, the Federal Reserve did not pay enough attention and allowed bank run risks to accumulate at conventional banks.”

The Fed stated in its decision that it had “fundamental concerns” about Custodia’s application, including its “novel and unprecedented features.” One problem the Fed has with Custodia’s business model is its concentration on narrow banking and the provision of services to crypto clients. “In general, the board has heightened concerns about banks with business plans focused on a narrow sector of the economy,” the U.S. central bank’s board stated. “Those concerns are further heightened concerning Custodia because it is an uninsured depository institution intending to concentrate nearly solely on offering products and services connected to the crypto-asset sector, which raises greater concerns of illicit finance and safety and soundness risks.”

Could Narrow Banking Pose a Threat to the Current Fractional Reserve Model?

Narrow banking is a system that restricts lending activities to only safe, low-risk investments and maintains a 100% reserve requirement against these investments. It is sometimes called “100% reserve banking.” However, as Bitcoin.com News reported in another article on fractional reserve banking, narrow banking is not a widespread practice these days, especially among the 4,997 banks in the United States. The U.S. has not witnessed many narrow banking practices since the Suffolk System, a method developed by a group of New England-based banks in the early 19th century.

During the Suffolk System, member banks had to maintain 100% of their deposits in reserve with the Suffolk member banks, which issued a common currency that could be used by customers of any participating bank. Despite its success in stabilizing the New England banking system, the Suffolk System was eventually replaced by fractional reserve banking. The system is also believed to have functioned similarly to modern-day central banks, as one study indicates that the “private commercial bank also provided some services that today are provided by central banks.”

The International Monetary Fund (IMF) has published a paper on narrow banking, but the author of the report says that the “economic costs of narrow banking could be particularly significant in developing countries.” The IMF report also suggests that a core banking model would be a better alternative. The U.S. Federal Reserve has been pushing back against narrow banking for quite some time, even before the Custodia denial. An editorial published by klgates.com in 2019 detailed how “the Board of Governors of the Federal Reserve System recently took action aimed at maintaining the status quo.”

The article noted that on March 12, 2019, the U.S. central bank issued an advance notice of proposed rulemaking (ANPR) to Regulation D. The authors, Stanley Ragalevsky and Robert Tammero Jr., detailed that the Fed ANPR came around the same time the Federal Reserve Bank of New York won a lawsuit against the financial institution TNB USA. The “nonbank” TNB sued the Federal Reserve in 2012 over its application to become a narrow bank in 2010.

At the time, TNB claimed that the Federal Reserve’s delay was motivated by pressure from traditional banks that saw TNB’s narrow banking model as a competitive threat. TNB’s argument may just be the crux of the situation as the current modern banking model is entirely based on the fractional reserve model. At a time when banks are failing, a narrow bank or 100% reserve-based financial institution’s model could be very popular.

It could also encourage other banks to follow the trend, as outlier banks that copied member banks within the Suffolk System in the early 19th century benefited from the idea of full reserve banking. Counter-arguments against the Suffolk System suggest the bank was attempting to establish a monopoly. However, with the number of banks decreasing by 83.34% over the last 100 years from 30,000 to 4,997, one could argue that there’s a monopoly over free banking practices.

Meanwhile, Custodia says it is taking its issues with the U.S. central bank to court. “The recently released Fed order is the result of numerous procedural abnormalities, factual inaccuracies that the Fed refused to correct, and general bias against digital assets,” Custodia explained in a statement on Friday. “The recently released Fed order is the result of numerous procedural abnormalities, factual inaccuracies that the Fed refused to correct, and general bias against digital assets,” Custodia said. “Rather than choosing to work with a bank utilizing a low-risk, fully-reserved business model, the Fed instead demonstrated its shortsightedness and inability to adapt to changing markets.”

Custodia added:

Perhaps more attention to areas of real risk would have prevented the bank closures that Custodia was created to avoid. It is a shame that Custodia must turn to the courts to vindicate its rights and compel the Fed to comply with the law.

What are your thoughts on the Federal Reserve’s stance towards the crypto-asset sector and narrow banking methods? Share your opinions in the comments section below.

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