A National Depository System

William F Hummel

October 10, 2016

A near melt-down of the financial system in 2008 sparked a renewed interest in full reserve banking. Some believe that fractional reserve banking is a root cause of asset price bubbles that can end in debt deflation and deep recessions. In full reserve banking each bank would need two reserve accounts at the Fed. One would hold “bound reserves” as needed to meet the full reserve requirement at all times. The other would hold “free reserves”, the bank's discretionary funds.

A Brief Overview

The National Depository System described here is the functional equivalent of a full reserve system, but simpler and more efficient. It consolidates the transaction deposits of the many thousands of banks and thrifts into a single depository, run as a public service by the Fed. The depository role of banks would no longer exist, but banks would continue to function as profit-seeking financial intermediaries.

The Depository would offer accounts to all who need the payment services of a traditional bank. It would only hold transaction deposits and would pay no interest. The Depository would neither lend nor borrow. It would simply execute payment orders and handle the accounting.

The deposits themselves would be liabilities of the Fed and therefore legal tender. The term reserves would no longer be relevant and could be dropped from the financial lexicon. The deposits together with the circulating currency would comprise the entire U.S. dollar money supply. 

One should not confuse the National Depository with Federal Reserve Banks. The latter would continue to implement monetary policy through open market operations (OMO) and loans to banks. All such transactions result in credits or debits to accounts in the Depository and thus affect the private sector money supply.

 Transition to the National Depository System

Transition to the National Depository system would begin after the full reserve system had been in operation long enough to settle into steady state. All reserve accounts at the Fed would be transferred to the Depository. Bound reserves would become deposits of the respective owners. Free reserves would become deposits of the respective banks. At their option, banks could exchange their vault cash for deposits at the Depository. The balance sheets of banks would be downsized by the transfers, but the net worth of each would remain unchanged.

The required infrastructure would have to be built and ready for use. It would consist of a secure computer network of the 12 district banks of the Fed and their 24 branches, and an ATM system to withdraw or deposit currency. The ATMs could be located in banks that offer to provide the service as well as in post offices. The Depository itself would not handle currency.

Banking after the Transition

Banks could neither create nor accept transaction deposits. However they could accept fixed-term loans of various maturities and pay interest on them. They could also offer interest-earning savings accounts in the form of indefinite term loans, redeemable on 7-day notice. All loans to banks would be insured by the FDIC, which would be renamed the Federal Loan Insurance Corporation (FLIC). The funds paid by an investor in a loan to a bank would be credited to the bank's account in the Depository, and immediately available to the bank for its own investments.

No longer able to create deposits through lending, banks would operate much like ordinary intermediaries, borrowing to lend at a profit. Differences from ordinary intermediaries include privileges with the Fed and FLIC, a fiduciary role with clients, and regulatory constraints. Banks could execute payment orders out of client accounts if authorized; offer loans out of their own Depository accounts; offer insured interest-earning investments; and provide on-line banking services and ATMs for cash management. Fees could be charged but a bank would likely provide such services without charge as long as the client held a term loan to the bank. 

The computers used by the National Depository would be an extension of the Fed's computer system. Payment orders would be accepted by electronic means via plastic cards, the Internet, Fed wire, smart phones, or by telephone. Paper checks would be phased out, after which verifying balances and making payments would all be done in real time. The time delays and nuisance of check float would vanish. Payments would be executed by simply transferring funds between accounts. The only exception would be transactions with the Fed which would involve a transfer of funds by wire in or out of the Depository.

Managing Bank Liquidity

Since money in the Depository earns no interest, banks would normally hold only what is needed in the near-term for operating expenses, making investments, and redeeming maturing liabilities. Money acquired in excess of that would be invested in Treasury securities and in loans to the Fed or the money market.   

If a bank had to acquire additional funds in order to issue a loan, it has several options -- borrow from the Fed, borrow from a bank, borrow from a non-bank, repo securities, or sell securities outright. Borrowing from the Fed would increase the total money supply, but the other options would simply move funds between accounts within the Depository.

The Fed would offer 7-day loans at its policy interest rate to any bank that can pledge collateral for the amount of the loan while maintaining a capital/asset ratio of at least 10%. Loans could be renewed indefinitely as long as the financial requirements were met. Banks should therefore hold a good supply of Treasury securities to serve as collateral in borrowing from the Fed. The Fed would also accept 7-day loans from banks at its policy rate. That would provide a secure place to park a bank’s unneeded funds in the near term while earning a return. It would also reduce the amount and cost of interbank lending.

The purchase of securities from the non-bank sector by Fed OMO would not directly increase bank liquidity. The proceeds of the sales would all flow to the sellers’ accounts in the Depository. However the sellers would normally reinvest the proceeds to earn a return rather than leaving them idle in the Depository. Banks should therefore actively seek term loans from the sellers by offering competitive interest rates. Such loans would directly increase bank liquidity and require no pledged collateral since they would be FLIC-insured.

Monetary Policy Implementation

The control variable for monetary policy would be the interest rate set by the Fed in lending to or borrowing from banks. That determines the cost of funds to banks and, after a markup, the interest rate banks would charge on loans to private sector borrowers. For any given policy rate, the Fed would play a passive role in meeting the ;liquidity demands of the private sector.

Based on the aggregate amount of lending and borrowing with banks, the Fed could determine the approximate amount of money to add or drain by OMO to achieve a balance. It would purchase securities in the open market when its lending exceeded its borrowing by some threshold amount, thereby increasing private sector liquidity and decreasing the demand for bank loans. 

Conversely the Fed would sell securities in the open market when its borrowing exceeded its lending. By maintaining an approximate balance in its borrowing and lending, the money supply would automatically increase in a growing economy. How well that meets the liquidity needs of the economy  would depend on the policy interest rate set by the Fed.. 

Improving Banking System Stability

To improve banking system stability, new operating rules and restrictions for banks should be established. For example a bank's book value plus retained earnings should be at least 10% of its risk-weighted assets. A bank should be required to carry on its own balance sheet at least 10% of each loan it issues so as to share in the risk of a default by the borrower. Permissible investments should exclude those whose basic purpose is to leverage bets in the financial markets. Since banks could no longer hold demand deposits on their own balance sheets, there is little possibility of a classic bank run in the National Depository System.

Each account in the Depository would be labeled to indicate the type of owner, for example: bank; credit union; non-bank financial; non-bank non-financial; non-profit; Eurodollar bank; foreign central bank; U.S. Treasury; or individual. Without disclosing the account owners or their holdings, the data could be aggregated on a minute by minute basis and made available for economic analysis. That would be particularly useful in times of economic or financial stress.

Treasury Operations 

In addition to serving the private sector, the National Depository would serve the U.S. government, and offer accounts to foreign banks and governments that need to transact in U.S. dollars. With the exception of U.S. currency in circulation, the entire U.S. dollar supply would exist in accounts at the National Depository. 

The general fund of the Treasury would be held in the Depository where it would deposit receipts from Federal taxes and the sale of its securities. All government spending would be paid out of the Treasury's account. To avoid interfering with the Fed’s monetary policy operations, the Treasury would target a fixed balance in its account, sufficient to meet its near-term payment obligations. It would do so by selling or redeeming securities to cover the imbalance between government spending and tax revenues, in effect paying for government deficit spending with securities rather than money.