Against Prudential Protectionism

Alexei Alexandrov consults various non-profits, including working on housing and mortgage regulation proposals at the Urban Institute and advising on mental healthcare and homelessness research and interventions in Allegheny County (PA). Prior to that, Alexei served as the chief economist of the Federal Housing Finance Agency, worked in management and director roles at Amazon and Wayfair, and served as a senior economist and a fellow at the Consumer Financial Protection Bureau. Alexei received his Ph.D. from Northwestern University, taught at the University of Rochester, and published academic articles on topics including antitrust and consumer finance.

No less an authority than the United States Department of Justice declares:

Nobody tell the FDIC, Federal Reserve, or OCC. These prudential regulators often appear to favor financial stability over market competition. Current regulatory barriers to competition upheld by these agencies might have resulted in the transfer of hundreds of billions of dollars from consumers to bank shareholders over the last few years, while miring innovation in the deposits market in a slough. All of this could be justified if competition for deposits, and the resulting lower bank profits, were a threat to financial stability. It isn’t. Moreover, regulators’ failure to allow even basic competition in deposits could ultimately result in a political backlash that could dramatically change deposit taking and bank funding as we know it. 

Banking Looks Hypercompetitive – If You Look at the Wrong Numbers

The Hirschman-Herfindahl Index (HHI) is the standard way of measuring market competitiveness. The index goes from 0 – perfect competition – to 10,000 – a monopoly. US banking looks incredibly competitive – there are more than 4,500 banks in the US and the HHI is around 400 nationally for bank deposits. With 1,800+ being an often-used benchmark to start worrying about mergers, including by Biden’s Department of Justice and Federal Trade Commission, it is understandable why bank mergers rarely raise antitrust concerns from government economists, even though some of our banks are enormous^[1]. Thankfully, banking mergers get evaluated market-by-market (so something like a metropolitan area, or even a county for more rural areas), but even there many markets are below or around 1,800^[2]. 

Yet, on a primary function of banking – deposit taking and paying out a savings rate – banks are far from offering competitive rates. After a protracted period of near-zero interest rates, short-term Treasury bills started paying 5% interest in 2023. However, the average savings deposit rate only rose to 0.5%^[3]. I’m going to belabor this point because it is so shockingly simple that it is easy to miss. For the last year, the average bank in the US could borrow money from consumers at 0.5%, lend that same money to the government at 5%, an arbitrage that would make John Tuld blush. Normally, we would expect a bank to pass through Treasury’s higher rates to its depositors – after all the depositor could buy Treasuries themselves, or at least go to a different bank offering more competitive rates. The abysmal pass-through we’ve actually seen is hard to reconcile with what we should see in a competitive market^[4]. Notably, the same dynamic happened in 2016, the last time when the Fed increased rates, suggesting that this is a long term issue in market structure rather than a recent ZIRP fluke^[5].

For banks, the low elasticity of deposits is also a convenient hedge against rising interest rates. Banks lend at fixed interest rates and buy mortgage-backed securities and long-term Treasuries. The value of these longer-duration assets drops when interest rates rise. But the banks’ profits from deposits increase when interest rates rise, since banks do not pass these higher rates to consumers. Banks make their decisions with this dynamic in mind, with at least some banks lulled into a false sense of security as we have seen during the Savings and Loan crisis, and then again in 2023.

The lack of competition evident here is costing consumers billions. There are about $6 trillion in checkable deposits in the US today. The missing 4.5% between Treasuries and bank deposit rates is, on $6 trillion in deposits, $270 billion. That is $270 billion that could have been in consumer pockets and instead went to bank profits. And that is just in 2024. Of course reality is more nuanced than this back-of-the-envelope math, but the back-of-the-envelope math suggests what could have been in an ideal state of the world. We will likely never get all the way there – for example, for someone with $400 in their checking and savings account average balance, the 4.5% difference is only $18 a year, and we might not get switching costs much lower than that. And even more competition might not get us all the way to 5% rates. But it is clear that we are too far away from this ideal state right now.

We’re All Trying to Find the Guy Who Did This

We can and should blame multiple issues and parties for this outcome, including the well-documented poor level of consumer financial education and the banks themselves. Prudential regulators are one of the parties.

A prime example is Regulation Q administered by the Fed until 1986, that set a ceiling on savings interest rates. In the name of stability (and trying to prevent local deposits being used to support lending elsewhere), government-endorsed price fixing ensured that banks would not have to compete for consumer deposits on price – past a certain threshold. Put another way, to protect banks the government regulators rationed how much money consumers could make when they lent their money to banks in the form of deposits. Any companies or trade groups attempting anything remotely similar in any other industry would immediately, and justifiably, trigger an antitrust case from the federal authorities. But in banking, Congress and the Fed actively promoted collusion.

More recently, in 2023, the current OCC Acting Comptroller, when discussing open banking and the CFPB’s 1033 rulemaking, noted that “[account portability] is one of the most promising aspects of open banking, as it may eventually allow consumers to easily move checking and savings accounts from one bank to another… in isolation [account portability] would likely increase the liquidity risk of retail deposits for banks” and that “online and mobile banking may have facilitated unusually large and rapid outflows… at Silicon Valley Bank and Signature Bank [also citing top FDIC officials].^[6]” Of course the actual problem in 2023 was failing to hedge interest rate bets – exactly the same problem that caused the Savings and Loan crisis 40 years ago, and brought down Regulation Q in its aftermath. Meanwhile, regulators in other industries, including cell phone services (as also noted by the Acting Comptroller) or cable boxes, required a version of portability when the technology became available, and the EU regulators required this even from Apple’s cell phone chargers. And in unregulated industries portability and price competition are more of a rule than an exception. It’s the reason gas stations post their prices in large letters on high signs – and the reason drivers fill up their pump at the station charging $.01 less per gallon.

Sometimes the prudentials cross over from encouraging (or at least not actively discouraging) collusion to outright market exclusion, as the Fed did in 2024 when it denied the application of The Narrow Bank (TNB). TNB would have placed all of its deposits into a Federal Reserve account, which pays banks an additional 20 basis points over short-term Treasury, and passed the excess returns onto its institutional depositors. While this was inarguably a great deal for depositors, The Fed argued that during periods of financial market stress, “institutional assets would plausibly shift to TNB out of banking institutions” and this shift to TNB would be “driving up rates.” Translation: If consumers could put their money into TNB, other banks would have to pay consumers more, consumers could also take their money from 0.5%-paying accounts too quickly, and we can’t have that, as it might put a bank out of business. It is hard to imagine a regulator in another industry forbidding a potential entrant from entering because the potential entrant is so safe and has such a good deal for customers relative to the incumbents that customers might leave the incumbents too quickly.

Wait, Why Are We Doing This?

The logic behind prudentials’ liking bank profits and sticky deposits is straightforward. Banks that fail are often experiencing losses (at least “paper” losses on the value of their assets) and are experiencing fast outflows of deposits^[7]. So the regulators should ensure that banks are very profitable and deposits don’t flow too fast. There is also a clear economic intuition. If bank profits are high, then banks should avoid risks – no reason to chase riskier returns (and risk bank closure) when the safe returns are already high.

However, banks have capital leverage constraints. Banks that get more profit will still leverage up to the allowed capital requirements (or close to that), especially when banks can transform ongoing profit streams into immediate earnings (for example, using securitization). Accordingly, more bank profits result in banks that have the same leverage ratio as before, but with more assets, chasing after more opportunities to invest, arguably resulting in more risky^[8] and less profitable investments^[9]. While the empirical research on the effects of competitiveness on bank stability is understandably murky (nobody can run a randomized control trial), a meta-analysis of about 600 studies shows basically no relation between the level of competitiveness and financial stability^[10].

Again, this is back-of-the-envelope idealistic intuition. In a frictionless world, where all the deposits instantaneously move to the highest bank bidder (in terms of APY), there would need to be even more prudential oversight to make sure that the highest bidder can indeed afford that APY, and that the highest bidder is ready to lose those deposits at any time to a future highest bidder who could emerge the next day^[11].

Watch Your Step

The examples of The Narrow Bank and account portability also illustrate that any stability that the regulators are buying with higher bank profits is illusory. The cause of the stability is that banks are not being subjected to true competitive forces. The prudential regulators’ implicit worldview – that banking should have a lot of margin (which itself often results in inefficiency), with plans and capital requirements as if these patterns will persist forever – is due for a shock. New business models and competitors emerge, and arbitrages collapse. A new entrant can completely disrupt this fragile state, as banks simply do not have the expertise to adjust quickly, and neither do their regulators. Regulators prepare for known knowns, but it’s typically known unknowns or unknown unknowns that result in crises^[12].

None of this is new. Back to the Savings and Loan crisis, money market mutual funds (MMMFs) were effectively a way to provide consumers a way around Regulation Q that set deposit savings rates that were too low. And neither banks, nor savings and loans institutions, nor the regulators were ready for MMMFs, with resulting drastic changes in the industry.

The good news is that it isn’t too late for the prudential regulators to embrace more competition, benefiting consumers and making the banking sector more resilient at the same time^[13]. From a consumer benefit perspective, it is important to note that we already know that higher rates on deposits should not translate into higher interest rates on loans to consumers. That’s because banks compete with many non-banks on lending, so the opportunity to increase lending interest rates is limited^[14]. Even in credit cards (the only of the big four consumer lending markets where banks maintain a majority share), many larger issuers do not depend that much on cheap deposits to fund their loans^[15].

Second, cheap deposit rates are not banks’ marginal costs. Banks in search of more money to lend out seldom actually do so by raising interest rates on deposits. That’s because consumers have limited means of shopping and moving their accounts has a high switching cost, making consumers relatively inelastic to higher deposit rates. Even if Comptroller Hsu is correct and open banking completely eliminated deposit switching friction, banks seeking funds would borrow from investors or Federal Home Loan Banks, whose borrowing rates (banks’ true marginal costs) are tied much more closely to the Treasury rates^[16].

Rules(changes) for Radicals

There is another reason prudential regulators – and banks themselves – should embrace more competition in deposits now. A more aggressive prudential regulator appointee would have several more radical tools available to them. Given the economic policy proposals from both parties’ presidential candidates, we could even see such an appointee in the next administration. Such an appointee could tie deposit savings rates to short-term Treasury rates. That could be attempted under multiple guises, and it’s not clear whether it would require Congressional approval. For example, the FDIC could attempt to require a Treasury-like narrow account at every bank (for example, to prevent liquidity flowing to MMMFs in times of stress), with a corresponding savings rate, and charge non-complying banks much higher FDIC insurance rates and hit them in various supervisory ratings. Or the Fed could require something similar to let banks access the Fed window. This could also be propped up by the CFPB who could, depending on the leadership, start a probe into whether this abysmal pass-through of Treasury rates into savings rates is unfair, deceptive, or abusive.

There are more revolutionary proposals than versions of deposit rate control. Several senators and Biden administration nominees discussed versions of revamping the deposit taking bank function, ranging from postal banking to interest-paying central bank digital currency (CBDC)^[17]. The ideas look different, but they all take narrow banking even further. Narrow banks (or properly-regulated interest-paying stablecoins) invest all deposits into short-term treasuries, Fed account equivalent, and maybe overnight repos. Instead, a postal bank (run by the USPS) or interest-paying CBDC could cut the intermediary and skip private banks taking deposits altogether – consumers would directly deposit into a Treasury or a Fed account. Private banks might still have a role as providing an interface and wrap-around services around the Treasury or Fed accounts for minimal monthly fees, but would not be able to use these deposits. And at that point, tech companies might be able to provide an even better interface than banks could.

Anything along these lines would result in banks losing much of their deposit base. Instead, banks would have to raise funds from equity or private debt financing. Some of the upshots are as above: consumers getting much better savings rates and likely having smaller banks (by assets). In addition, there would be no more consumer runs on banks – there is no need to run on either the Fed or the Treasury, and thus we might only need a much reduced FDIC or deposit insurance. We also might get instantaneous money transfers. And it will force prudential regulators to focus on other sources of funding that banks will use, which could present similar run issues especially if prudentials allow for a big share of overnight funding.

The biggest downside of such proposals right now is that most consumers are unlikely to be excited by having a government-run interface on their bank account and government-run call centers, and neither the Treasury nor the Fed might be ready to provide anti-money laundering, fraud protection, and know your customer level of compliance that banks currently do. But an increasing number of people are advocating that outsourcing to bank or tech service providers of consumers’ choice, with the Fed or the Treasury simply providing the behind-the-scenes ledger and access APIs, is not just feasible, but desirable. If banks and their regulators want to avoid this outcome, they will need to find a way to introduce and live with more competition now, and at the very least stop giving more reasons for a solution like this to become reality sooner rather than later.

The opinions shared in this article are the author’s own and do not reflect the views of any organization they are affiliated with.

^[1]  Economist concern is so low that, ironically, the mergers we approve most quickly are the ones where the largest bank in the country is getting even bigger.

^[2] With notable exceptions of many rural areas and bigger metropolitan areas like Charlotte, Cincinnati, and San Antonio. Moreover, deposits HHI is no longer the focal metric to evaluate, as antitrust authorities would evaluate other markets too (like credit cards). Despite the potentially local markets, there is evidence that deposit (and lending) rates at bigger banks are effectively flat across the country, disregarding the local market conditions.

^[3]  The average APY on checking accounts is even lower, at below 0.1%. Everything in this post applies to both checking and savings accounts.

^[4]  While pass-through of changes in costs onto prices is a nuanced economics subject, the standard competitive benchmark is 100% pass-through. Full pass-through (100%) is also consistent with the standard Chicago school arbitrage logic – opportunities for hundreds of billions of risk-free arbitrage are not easy to find, and should disappear quickly when they do appear. Full pass-through is also consistent with banks’ own arguments whenever they don’t like a regulation – that consumers will ultimately bear all the costs. There is evidence of somewhat faster pass-through when costs increase than when they decrease. Oligopolies could go either way, and strategic interaction could actually pass-through higher. Notably, for money market mutual funds, the pass-through of Fed rates into deposit rates is much closer to 100%. For more economics reading, See E. Glen Wyel & M. Fabinger, “Pass-Through as an Economic Tool: Principles of Incidence under Imperfect Competition” (June, 2013), M. Tappata, “Rockets and feathers: Understanding asymmetric pricing” (October 12, 2009), and A. Alexandrov & O. Bedre-Defolie, “LeChatelier–Samuelson principle in games and pass-through of shocks” (March, 2017)

^[5]  If anything, there is some evidence that the current pass-through is higher than it used to be in the past.

^[6] Emphasis mine.

^[7] Research analyzing bank failures in the US from 1865 until 2023 suggests that “Failing banks are characterized by rising asset losses, deteriorating solvency, and an increasing reliance on expensive non-core funding.” Notably, “Bank runs can be rejected as a plausible cause of failure for most failures in the history of the U.S. and are most commonly a consequence of imminent failure.” See S. Correia, S. Luck, & E. Verner, “Failing Banks” (September, 2024).

^[8]  See J. Stiglitz & A. Weiss, “Credit Rationing in Markets with Imperfect Information” (June, 1981), and J. Boyd & G. De Nicolo, “The Theory of Bank Risk Taking and Competition Revisited” (May 3, 2005).

^[9]  For a back-of-the-envelope example, suppose a global systemically important bank finances itself with 100 billion in capital. The minimum supplementary leverage ratio (SLR) is 5%, and so the bank could leverage 20:1. Suppose that the bank “only” leverages 15:1, to appease examiners. Then, the bank’s assets are 1.5 trillion ($100 billion x 15:1 leverage). Suppose that the bank discovers a $5 billion a year profit stream in perpetuity, for example by charging a higher interest rate on loans. The bank securitizes these more profitable assets, and while keeping a much lower than $5 billion annual servicing fee, it also receives $20 billion in lump-sum profit in return for the securitized assets from the secondary market. The bank simply leverages the additional $20 billion, to create $300 billion more in assets ($20 billion x 15:1 leverage). The result is a 20% bigger bank by assets, still leveraged 15:1, and arguably with more risky assets in the system (in this example, due to moral hazard from higher interest rates).

^[10]  There are also dozens, if not hundreds, theoretical studies on the topic of financial stability and competition and/or antitrust, also arguing that depending on the assumptions and the driving factors of the model, several results can happen. For example, see F. Allen & D. Gale, “Understanding Financial Crises” (March 22, 2007), and X. Vives, “Competition and Stability in Banking: The Role of Regulation and Competition Policy” (August 2, 2016). For academic economist book-length treatments, and see https://heinonline.org/HOL/P?h=hein.journals/ylr133&i=1202 for a contemporary take by legal scholars.

^[11]  A truly frictionless world would likely limit using deposits only for short-term highly liquid securities that are relatively stable in value. For example, short-term Treasuries or Treasuries with variable rates.

^[12]  Except for 2023 – interest rate risk and not marking to market issues are very much a known known, and even the high bank profits across the industry didn’t save us.

^[13]  And if we are already discussing the possibility that competition could be good and high profits are not making the system safer, then another thing that would immensely help resiliency is banks having more skin in the game (more capital). That is best left to a future post though.

^[14]  By-far the largest consumer credit market is mortgages, where banks originate fewer than half of the loans, relative to non-bank mortgage originators like Rocket Mortgage and UWM, with both banks and non banks getting the loans guaranteed by the government through either Fannie, Freddie, or Federal Housing Administration or Veterans Affairs. The other three big consumer lending markets are auto loans, credit cards, and student loans. Auto loans are often made by financing arms of car manufacturers (Ford, GM, Toyota), and student lending is predominantly done by the federal government. One could also separate out home equity lines of credit (second mortgages), that at times are as big as auto, credit cards, or student loans. In these markets, there is not as much government guarantee, but the non-banks originators are also active, and there might be more government guarantee in the near future, see A. Alexandrov & L. Goodman, “Freddie Mac’s New Second-Lein Pilot is a First Step Toward Helping Borrowers, but the Cap is Too Restrictive” (June 28, 2024).

^[15] There are smaller markets where banks are still more dominant – for example, personal unsecured lines of credit and smaller business loans.

^[16]  It is possible that most banks right now do not practice marginal cost pricing (as they should based on Econ 101), and instead use some kind of average cost of funds (or weighted average cost of capital) as the input into price setting. In that case, at least some of the higher deposit rates would result in higher lending rates. This type of mispricing could be in and of itself an indicator of a market that is not as well functioning as it could be, and could have many other repercussions, for example slower responses to the Federal Reserve’s rate changes. This type of mispricing could also be effectively collusive – result in higher profits and lower consumer benefits across the industry, see N. Al-Najjar, S. Baliga & D. Besanko, “Market forces meet behavioral biases: cost misallocation and irrational pricing” (September 16, 2008).

^[17]  See E. Warren, “U.S. News Op-Ed: The Big Benefits of Postal Service Banking” and S. Omarova, “The People’s Ledger: How to Democratize Money and Finance the Economy” (October 19, 2021).

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