How the Federal Reserve drained the financial system of deposits

The depositors fleeing Silicon Valley Bank (svb) did not ask for notes and coins. They wanted their balances wired elsewhere. Nor were deposits written off when the bank went under. Instead, regulators promised to make svb’s clients whole. 

Although the failure of the institution was bad news for shareholders, it should not have reduced the aggregate amount of deposits in the banking system.

The odd thing is that deposits in American banks are nevertheless falling. 

Over the past year those in commercial banks have sunk by half a trillion dollars, a fall of nearly 3%. This makes the financial system more fragile, since banks must shrink to repay their deposits. 

Where is the money going?

The answer begins with money-market funds, low-risk investment vehicles that park money in short-term government and corporate debt. 

Such funds saw inflows of $121bn last week as svb failed.

Yet there is one new way in which money-market funds may suck deposits from the banking system: the Federal Reserve’s reverse-repo facility, which was introduced in 2013. 

The scheme was a seemingly innocuous change to the financial system’s plumbing that may, just under a decade later, be having a profoundly destabilising impact on banks.

For those lacking a banking licence, leaving money at the repo facility is a better bet than leaving it in a bank. Not only is the yield higher, but there is no reason to worry about the Fed going bust. 

Money-market funds could in effect become “narrow banks”: institutions that back consumer deposits with central-bank reserves, rather than higher-return but riskier assets. 

A narrow bank cannot make loans to firms or write mortgages. Nor can it go bust.

The Economist 21 March 2023

Money-market funds swell to record $5.4 trillion as savers pull money from bank deposits

This idea of 100% reserves on checking deposits would be advocated by other economists in the 1930s, including Lauchlin Currie of Harvard and Irving Fisher of Yale.

A more recent variant of this reform idea is to be found in the "narrow banking" proposal.


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