Custodia offers deposit insurance innovation

At a time when some are calling for changes to the deposit insurance system, the Federal Reserve has shut the door on an option that seemed to be building momentum. The Federal Reserve on January 27 denied an application by Custodia Bank to become a member. Custodia represents innovation; the Fed should have worked a little harder to find a way to accommodate the Wyoming-based special purpose depository institution.

The founders of Custodia Bank want to serve the crypto-asset industry, which is worthy of its own column, but for now, let’s focus on the bank’s approach to holding deposits. The bank does not have FDIC insurance but proposes to hold $1.08 in reserves for each dollar of deposits. This is a departure from the fractional reserve system that characterizes the kind of banking with which most of us are familiar. Clearly, Custodia Bank has other plans for making money than extending credit funded by deposits. 

But in its 86-page membership denial, the Fed cites a lack of FDIC insurance as a key reason for rejecting the application. What a lack of imagination! Custodia is saying it will keep more money on hand than its deposits to make sure it can always meet the liquidity needs of its customers, and the Fed is concerned about FDIC insurance? That strikes me as an unfounded worry, kind of like worrying about a broken freezer in a northern Minnesota home during January. Custodia wants to over-reserve; maybe all the Fed needed to do was suggest it keep that money in escrow or some third-party equivalent so that it is truly there if needed.

Deposit insurance is back in the news and policymakers are floating ideas. The current rules actually work quite well for typical consumers, but there seems to be a genuine need to look at new ways to protect payroll accounts and others that could easily hold balances in the millions of dollars. Pledging can be the answer in some cases, but not typically in the case of a private company. Ideally, solutions will come out of the private sector, which is more likely to give a bank the option of acquiring such protection if it makes sense for their customers. That’s better than an across-the-board mandate typical of a government one-size-fits-all approach. When an innovator offers a credible potential solution, as Custodia Bank has, federal agencies really should take extra steps to try to make it work.