Another day, another set of puzzling statements from the Federal Reserve about writing the future for financial innovation in America.
This time, the words came from Federal Reserve Board Gov. Michelle Bowman during the recent Wharton Financial Regulation Conference in Philadelphia.
“We need a viable pipeline for the creation of new banks in the United States,” Bowman said. “There are troubling indications that we are falling short on this front, with a continued decline in the number of banks in the United States, the continued interest in charter strip applications, and the ongoing shift of traditional bank activities into shadow banks.”
The statement blew up the Twitter feeds of a couple of Wyomingites with an interest in the digital asset banking sphere who clearly could not believe what they saw.
“I HAVE NO WORDS,” Custodia Bank CEO Caitlin Long tweeted above a link to an American Banker article about Bowman’s recent comments.
“In a stunning reversal, the FED says the quiet part out loud, while actively being sued for doing the opposite,” former Wyoming lawmaker Tyler Lindholm tweeted. “I’ll say it louder for those in the back, END THE FED.”
Side-Step The Fed
While ending the Fed may have been a bit of hyperbole in the moment, it’s not an exaggeration to say that innovators in the financial sector are finding ways to creatively sidestep the Federal Reserve’s regulatory process.
Charter strip applications, for example, have become an increasingly common entry point for those with a new business model. By buying an existing bank, complete with charter, those with a bright new idea for a banking business model can avoid the Fed’s increasingly unfriendly front-door regulatory process.
FTX is among entities that approached things that way. It bought an $11.5 million stake in a tiny bank worth about $5 million because it already had a charter.
“When evaluating a bank acquisition, regulators often rely on the legacy bank’s management performance and the existing supervisory and compliance record,” Bowman said.
In contrast, the Federal Reserve treats new banks that don’t have a past record as a black, unknowable box.
Charter stripping avoids that problem, as well as stricter capital requirements and business model restrictions that would have applied during the first few years of a new operation.
Bowman suggests the existing regulatory framework is stifling innovation inside the regulatory perimeter and points out that the flight of new ideas into shadow banks does not necessarily avoid negative consequences to the overall financial system when things go awry.
Though she doesn’t mention it, this was seen in dramatic detail with the implosion of FTX, which regulators saycommingled funds and used deposits for risky ventures — without telling customers what it was doing — as well as used customer funds to buy real estate and fund a lavish personal lifestyle for executives.
That wasn’t a cryptocurrency issue so much as plain and simple fraud, Long and other cryptocurrency advocates have pointed out.
“The growth of lending in the shadow banking system can have significant consequences for the availability of credit over economic cycles, with losses eventually being transferred to regulated depository institutions, as appears to have occurred after the 2008 financial crisis,” Bowman said. “While the disfavored activities may be pushed out of the regulated banking system, losses may be transmitted back into the banking system through related activities like the extension of credit by banks to those same nonbank lenders.”
Slamming The Front Door
Custodia Bank, meanwhile, is a de novo digital asset bank that tried to go through the front door with the Federal Reserve.
It sought a master account nearly three years ago under Wyoming’s Special Purpose Depository Institution laws, which were written hand-in-glove with the Kansas City Federal Reserve.
While initially told by the KC Fed that there were no “showstoppers” in its application, Custodia Bank’s application was ultimately denied in an 86-page manifesto in which the Federal Reserve not only staked out a larger position in the digital asset sphere. The document suggested at one point that any ties to cryptocurrency are not in anyone’s best interest despite the fact that sector has been in play for almost a decade, and also seemed to altogether reject Wyoming’s state banking charter.
The state’s charter, written with the help of the Kansas City Fed, requires digital asset banks to hold 100% of the value of all digital assets in reserve and does not allow them to participate in fractional reserve banking, where a portion of deposit values are used for lending.
It also requires all the usual “know your customer” rules against money laundering and supporting terrorism, as well as requiring banks to be well capitalized and to take prudent steps to protect customers.
Cowboy State Daily has been told Wyoming had more than 100 meetings with the Federal Reserve to develop its rules for special purpose depository institutions.
Custodia Bank, meanwhile, took the extra step of pledging to hold 108% reserves for all of its digital assets to ensure that it could more than meet all demands for withdrawals.
Custodia has a lawsuit pending against the Federal Reserve over its application for a master account, contending the regulatory agency does not actually have the authority to reject state banking charters as it did with Custodia.
The judge in the case has twice denied motions to dismiss filed by the Federal Reserve, although the regulatory agency has recently filed a third such motion, trying again to make Custodia Bank just go away.
Wyoming, meanwhile, has filed a motion to join the Custodia Bank lawsuit to defend its charter and states rights.
Bowman Not Wrong
While the words from the Federal Reserve governor who represents community banks were irksome, Long told Cowboy State Daily Bowman was not wrong in her assessment.
“In fact, I’ve made these statements before too, that the number of banks in this country is down by more than 50% in the last 15 years or so,” Long said. “But how do you square the circle with her actual vote against us? It’s classic watch what I do, not what I say.”
The migration of financial technology outside of the U.S. regulatory perimeter is something that should be significantly concerning to everyone, including the Federal Reserve, Long added.
“That is exactly why Wyoming created the special purpose depository institution charter and worked hand-in-glove with them,” she said. “The whole point of what Wyoming was doing was to bring it inside the regulatory perimeter.”
The sudden about-face, where regulators who’d previously been friendly to cryptocurrency and digital assets are filing enforcement actions right and left, is bound to drive even more digital asset companies across the waters and into the shadows, Long said.
“They are just throwing the baby out with the bathwater,” Long said. “And they’re trying to take regulatory power that they don’t have, that Congress did not give them.”
Overseas Means Beyond Fed Reach
Lindholm is among those who has noticed an increasing number of innovators in the financial sector locating outside of America.
“The reality is, not all of those folks are scammers,” Lindholm said. “There’s a lot of technologists involved here who are doing some amazing things. And the United States could be and should be the place where technology thrives, in a sandbox of regulations that benefits everyone and protects consumers at the same time.”
The financial sector needs to innovate to stay relevant, Lindholm added.
“I mean, you’ve got stable coin issuers, cryptocurrency exchanges, you’ve got Venmo and PayPal, there’s all these different types of FinTech companies that are very active, very much like a bank doing banking type activities, but they have never entered the banking space,” he said. “And so, for the Federal Reserve, and for the OCC and banking regulators across the United States, you would think it would make them scratch their head, like why are they not actively participating in the banking process? And why have the number of bank applications dropped significantly?”
The situation risks impeding American innovation, which isn’t good for consumers, nor for geopolitical goals, such as a strong American dollar.
Russia, for example, has recently been seen cozying up to China’s digital Yuan, as has Saudi Arabia. China has long been seeking a path to upstage the American dollar with its own Yuan.
“The reality is if banking is going to stay relevant in the next 20 to 30 years, in a manner that it currently is, they’re going to have to actually meet technology,” Lindholm said. “They’re going to have to meet the demands of consumers, versus just blocking them.”