Hello! Kiah here. Welcome to Fintech Takes Banking, my weekly newsletter where I highlight things I think are interesting or important for bankers and the surrounding environs.

This newsletter is coming after an absolutely brutal U.S. men's loss in the World Cup round of 16 last night. While the atmosphere surrounding the game was full of controversy, the match itself was pretty straightforward. Wish I was more ebullient, but I'll still be catching games. And don't forget: the Women's World Cup is next year and will be here before you know it. ⚽

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A Brief and Recent History of the Fed Master Account

I have a bank account. My bank also has a bank account.

My bank account allows me to spend and save money via products and services like cards, bill pay, transfers, savings accounts and loans. My bank’s bank account (or my bank's bank's bank account) is at the Federal Reserve — one of the 12 around the country — and it’s called a master account. The Fed master account offers my bank, and your bank and all the insured depository institutions in the country, somewhat similar products and services, only specialized for depositories. Some of the services my bank offers me are only possible because of its account at the Federal Reserve, or cost what they do because of the price that the Fed charges my bank for the service.

But not every financial services firm has one of these Fed master accounts. Depository institutions do. Some trust banks do. Some payroll providers do. Some state finance offices do. But increasingly, innovative financial technology, cryptocurrency and national trust banks want them. After years of excluding these firms from outside of the club of master account holders, has the time finally come to let them in? Who gets to decide that? And why does it matter?

But first: What are we talking about and why?

The Bank's Bank

The modern Fed master accounts were created in 1998, when the Federal Reserve Banks decided to combine two separate account types and functions — reserve and clearing, or payments — into a single structure to accommodate interstate bank branching, wrote Julie Hill in her 2023 paper “Opening a Federal Reserve Account.” Hill is the dean and Wyoming Excellence Chair at the University of Wyoming’s College of Law.

The account gives an institution access to Fedwire, which is one important part of the payment system in the U.S. and abroad, and FedNow. While there are private sector alternatives, the Fed offers these payment processing services at cost, which can offer significant savings to companies, said Roman Goldstein, senior director at Klaros and the former lead innovation policy analyst at the Federal Reserve Board. A master account is also the repository for discount window loans.

It is the master account’s access to the payment system that seems to be of most interest from nondepositories.

Today, all depository institutions, including thrifts and credit unions, have access to Reserve accounts, thanks to the Monetary Control Act in 1980. Julie wrote that for decades, it was pretty quick and straightforward for an institution to open one of these accounts, with the applications indicating it took about five to seven business days. Depository institutions apply to the regional Federal Reserve Banks for these accounts; the Reserve Banks are the organizations that are responsible for issuing and overseeing these accounts.

One reason for the short and speedy application is a proxy in the due diligence. Julie wrote that if a bank or credit union applied for a master account, the Reserve Bank could rely on the judgment of the state or federal group that had granted the financial institution a charter.

“[T]he Reserve Banks relied on the fact that the depository institution had been vetted by some other federal or state bank supervisor. Applications were rarely, if ever, denied,” she wrote.

But it wasn’t only insured depositories that obtained these accounts, Roman said. He pointed out that the Texas Comptroller of Public Accounts has one, granted in 1995. The Tennessee Valley Authority has one, granted in 1994.

But for the most part, for most of the history of the U.S. economy, it was a nonissue which companies received master accounts. That changed in the late 2010s and into this current decade with new and novel financial companies, including fintech, crypto and cannabis-focused entities that wanted to enter the walled garden the Fed built.

One example of a novel recent applicant that succeeded in obtaining an account is Territorial Bank of American Samoa, a public bank in American Samoa. But its path was by no means smooth, Julie wrote. American Samoa’s legislature decided to establish a public bank after the exit of Bank of Hawaii in 2015 closed the territory’s last bank branch. The government-owned bank was modeled loosely after the Bank of North Dakota, the only state-owned bank in the United States. The bank opened in October 2016 without a routing number or Fed account; it received its ABA routing number in December 2017 after working for more than a year to address questions and concerns and meeting with then-recently appointed Federal Reserve Governor Randal Quarles.

The Federal Reserve Bank of San Francisco opened its account at the end of 2017. The master account meant the bank could operate and provide the thousands of residents of American Samoan with adequate access to the U.S. banking system. (Brief author aside: It is unconscionable that a banking system and regulators that promulgate and enforce so many laws that dictate the forms of financial access could leave an entire American territory cut off financially from the rest of the United States, and that they did so for more than a year because they were worried about some harm that was seen as greater than the harm being enacted and lived by thousands of residents.)

"TBAS organizers credit Quarles with understanding the need for banking in American Samoa," Julie wrote. "Ultimately, the Federal Reserve’s decision to grant TBAS an account may have been driven more by benefits that TBAS provides to the people of American Samoa, rather than by the risk TBAS presents."

Here Lies a Novel Master Account Application

Julie’s paper thoroughly documents the graveyard of halted and short-lived master account applications from novel institutions through 2022. We’re going to discuss them because of the literary device called “foreshadowing.” They include:

• Fourth Corner Credit Union, a Colorado-chartered cannabis credit union. Colorado legalized recreational cannabis use in 2012; Fourth Corner received its charter in November 2014 and its ABA routing number a month later. But the federally illegal status of marijuana complicated its ability to open. The National Credit Union Administration denied its federal share insurance in mid-2015 and the Kansas City Fed denied Fourth Corner’s account application shortly afterward. Fourth Corner reapplied for an account in 2017 after promising not to serve cannabis businesses, and the Kansas City Fed conditionally granted access in 2018. But the credit union lacked the private or federal share insurance it needed to open, so it remained without a Fed account. Fourth Corner is not listed on the Colorado Division of Financial Services’ credit union page or on the NCUA’s credit union locator page. It is also not listed in the Fed’s database of existing or requested master accounts.

• TNB USA, a Connecticut-chartered uninsured bank. The idea of founder James McAndrews, the former head of research at the Federal Reserve Bank of New York, was to take large deposits from institutional investors and put them entirely in a Fed account. TNB, which stood for The Narrow Bank, would intermediate between depositors and the Fed, take a few basis points off the overnight rate and give the rest to depositors, said Jasper Sneff Nanni, managing principal at FS Vector. Even with that cut, this rate would likely still be a better rate than most deposits received at other institutions. This arrangement would also create de facto deposit insurance for large accounts. TNB received a Connecticut bank charter and an ABA routing number in 2017, but its application to the New York Fed in the same year stalled after the Board in Washington expressed concerns that TNB could subvert monetary policy implementation. TNB sued in 2018 but the lawsuit was dismissed in 2020 as unripe because the Fed had not reached a final decision. In 2023, the Fed rejected the application, according to the Fed database.

• Reserve Trust Co., a Colorado-chartered fintech nondepository trust. Reserve Trust was founded to provide payment services to fintechs. Its 2016 application to the Kansas City Fed was denied because the firm wasn’t a depository institution. In response, the company changed its business model and the state reinterpreted its eligibility, after which the Kansas City Fed opened the account in 2018. The application approval was scrutinized after it came out that Reserve Trust board member Sarah Bloom Raskin, a former Federal Reserve governor, personally contacted the Kansas City Fed on the company’s behalf — information that surfaced during her failed 2022 Senate nomination to be the Federal Reserve’s vice chair of supervision. The Kansas City Fed closed Reserve Trust's account in 2022 without explanation, and Reserve Trust appears to have ceased operations.

And then, of course, there is Custodia.

Forcing the Fed’s Hand

Custodia Bank is a Wyoming-chartered special purpose depository institution that offers crypto custody. It applied to the Kansas City Fed for an account in 2020 and separately applied for Federal Reserve membership, which Julie wrote was to demonstrate its commitment to regulatory compliance; neither persuaded the Kansas City Fed. Custodia sued both the Kansas City Fed and the Federal Reserve Board for unreasonable delay in 2022.

The lawsuit forced the Fed’s hand a little. Jasper Sneff Nanni, managing principal at FS Vector, said these applications and the Custodia lawsuit persuaded the Federal Reserve Board to adopt an approach of “‘we need to put some guardrails around this. Master account access is decided at the Reserve bank level, but we need a framework so we're all playing from the same playbook.’”

In 2022, the Federal Reserve Board unveiled the Guidelines for Evaluating Account and Services Requests, which includes six principles to evaluate access requests and a three-tier framework that articulated the scrutiny that different applications would receive. It then asked the court the next day to dismiss Custodia’s lawsuit, citing its day-old public framework.

“Honestly, it makes the guidelines seem like they were written, in part, to get courts to give [the Board] more deference when it winds up in litigation,” Julie told me back in 2022.

I wrote about this development at the time. The reception to the guidance was that it codified existing practices but didn’t offer much insight into how nonbanks can get these accounts. Institutions with federal depository insurance receive streamlined review, while institutions without a federal supervisor face the strictest scrutiny. Most fintechs interested in these accounts were no better informed after the guidance than before. But importantly for these companies, it wasn’t a straight “no” from the Fed.

But it would be a “no” for Custodia. The Fed denied Custodia's membership application and the Kansas City Fed denied its master account request on the same day in 2023. The organizations cited Custodia’s novelty and risk of its crypto business model. Later in 2023, the Fed launched its database that details the institutions that have master accounts and those that have requested one.

There is a really good reason why the Fed gives these applications, and the companies making them, such weight in considering them. Once an institution is in the Fed’s payment system, it’s in. Roman said the Fed’s system “assumes that all participants are trustworthy. … The general idea is everyone in there is a responsible financial institution — serious, sober, prudent bankers who will make sure everything gets done properly.”

He added a master account can be a hedge against debanking, or a proxy for belonging. If a company like Circle had an account at the Fed, it would probably be easier for Circle to keep accounts in good standing at other banks.

But for the most part, the trust that underpins the payment execution running over the network comes from state or federal supervision and regulation tied to the charters. These are the entities that conduct the exams for financial controls, internal audit and cybersecurity. By contrast, nondepository institutions, even today, are different: different supervision, different compliance regimes and different incentives.

Of course, there has been a change in presidential administration since 2022, along with new leadership at the federal banking agencies and the Federal Reserve Board and Banks. These individuals have been quite open about their approaches to financial innovation and their willingness to consider applications from novel companies. This includes master account applications.

We’ll get more into that in a future newsletter.

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FROM THE VAULT

What’s on my mind and filling my time:

🥳 Are we having fun yet?! A new Bloomberg article makes the case that fun — measured by activities and spending — is down, and unhappiness is up. It made me think about how one of my favorite things about the World Cup has been watching the game with my friends at watch parties — hard to not have a good time.

🤝🏻 Trust me: This Wall Street Journal article about how a con man running an $60 million investor scheme was a fascinating analysis of how scammers build trust with their marks via empathy and building connections. And also: the audacity!!

🎙️ On Bank Nerd Corner: I chatted with Christian Ruppe, a fintech founder who joined a community bank to see how it worked from the inside, nuts to bolts. He’s now helping community banks with their technology, which includes negotiating contacts and executive their strategic initiatives.

Thanks for reading! Let me know your thoughts! - Kiah