NON-BANK PAYMENT FIRMS play an important and highly visible role in the rapidly changing modern payment ecosystem. However, almost without exception, these firms are unable to participate directly in U.S. settlement systems. Non-banks are not eligible to open master accounts at Federal Reserve Banks, and they are similarly excluded from direct membership in the major private payment systems. As a result, such firms, like other non-bank entities, must rely on relationships with depository institutions to settle payment transactions on behalf of their customers.
Over the past several years, growing numbers of non-bank firms have been seeking to shed this dependence and gain direct access to U.S. settlement systems. Such firms are particularly interested in opening Federal Reserve master accounts, with some employing increasingly creative means to gain access to such accounts.
This article discusses this growth in demand among non-banks for direct access to U.S. settlement systems, with a focus on Federal Reserve master accounts, and evaluates the key considerations that inform possible responses from U.S. policymakers and the banking industry. One set of responses includes options for expanding eligibility for master accounts. Any of these options would require creation of new federal-level regulatory mechanisms to address policy concerns about the integrity of the payment system. Such parallel mechanisms, while feasible, carry risks of unnecessary duplication, competitive inequity, and both under- and over-regulation.
Other responses, however, would target the underlying drivers of non-bank demand for direct access – particularly the restricted availability of U.S. bank charters and licenses. Expanding opportunities for suitable firms to obtain federally supervised banking charters or licenses would ensure that such firms are subject to comparable supervisory and regulatory standards as incumbent participants, without the need to create parallel regimes. At the same time, non-bank firms that do not want to (or simply cannot) become banks could continue to operate under their current models.
THE PAYMENT LANDSCAPE: CHANGE AND STABILITY
The U.S. payment landscape is evolving rapidly as new products, participants, and technologies emerge. Non-bank firms have taken on an important and highly visible role in providing payment-related services as the volume of electronic and online transactions has increased. These firms provide front-end access to retail payments for consumers and businesses, perform back-end operational and technical processing for depository institutions, and facilitate a growing variety of cross-border and cross-currency transactions, among other services.
Some non-bank payment firms operate without direct licensing or regulation. Others are subject to various financial services licensing and regulatory regimes, including those governing money-services businesses or trust companies. Some also operate banks outside of the U.S.
For purposes of this article, any such firm is a “non-bank” provided it does not operate pursuant to a U.S. charter or license that could make it eligible to open a Federal Reserve master account. “Banks” that do qualify for master accounts include:
• Federal Reserve member banks
• Depository institutions, as defined in Section 19(b)(1)(A) of the Federal Reserve Act, including banks, thrifts, and credit unions that are insured by the Federal Deposit Insurance Corp. or eligible to apply for FDIC insurance
• U.S. branches or agencies of foreign banks
• Edge or agreement corporations
Opening a master account – or, in certain cases, simply being eligible to open one – is key to the ability to settle U.S. payments without a depository institution intermediary. Settling directly through such Federal Reserve Bank Services as Fedwire requires a master account, for instance. Similarly, major private payment systems’ various membership criteria effectively limit direct participation to institutions that hold or are eligible to open a master account. Non-bank firms that lack a master account must work with institutions that hold one in order to provide or facilitate U.S. payment services.
GROWING DEMAND FOR DIRECT ACCESS
For many non-bank firms, settling through a depository institution is unproblematic. One might reasonably ask whether there is even a need to consider extending master account access to non-bank firms, which already have established a viable economic niche for themselves. After all, in the last decade, non-bank firms have achieved notable success in areas such as cross-border payments, merchant processing, and prepaid cards. Non-bank payment firms have greatly increased in number and variety due to marketplace changes, including growth in the scope and penetration of electronic payments, the demands of mobile technology and e-commerce, the venture-driven FinTech phenomenon, and the advent of cryptocurrencies.
Nonetheless, among some non-bank payment firms, appetite for direct access has grown markedly in recent years. This increasing interest in direct access arises from the combination of the market developments described above with two key phenomena: bank de-risking and the difficulty of getting U.S. banking charters and licenses.
In the last decade, the U.S. banking industry has undergone several rounds of de-risking, in which depository institutions terminate or restrict banking relationships with certain types of non-bank payment firms. De-risking results from a combination of actual regulatory pressure on certain relationships and bank concerns about possible future regulatory action. It poses a particular threat to non-bank firms’ clearing relationships with banks because, from the banks’ perspective, the relatively low profit margins from such relationships often cannot justify the elevated risks and risk management expenses that attend regulatory scrutiny.
The impact of de-risking falls particularly on money transmitters, specialty third-party payment processors, and non-U.S. banks without a U.S. branch (deemed “non-banks” for our purposes). As a result of de-risking, many such firms have found the effort to obtain and maintain banking relationships increasingly expensive and challenging. Meanwhile, non-bank firms with established banking relationships have come to see their dependence on unaffiliated depository institutions as increasingly risky, leading some to seek risk mitigation through direct access.
DIFFICULTY OBTAINING BANK CHARTERS OR LICENSES
An obvious means of gaining direct access is to obtain one of the banking charters or licenses that confer eligibility for a master account. But gaining regulatory approval for such charters or licenses has been difficult during the past decade, particularly for non-bank financial institutions.
The availability of U.S. bank charters and licenses has significantly constricted in the decade following the 2008 financial crisis. Obtaining approval for new FDIC-insured banks has been especially challenging because regulators have exercised caution in approving applications. While receptivity to new bank applications has increased over the past two years, it has not yet translated into fully successful applications by payment firms.
Non-bank payment firms face particular obstacles due to the typical business models of their proposed banks. Bank applications involving nontraditional or narrow business plans – common attributes of proposals by non-bank payment firms – have faced especially tough scrutiny in the past decade. The U.S. banks that have been approved during this period have typically followed traditional business models, even as non-U.S. jurisdictions have been approving payment-focused banks, “challenger” banks, and other narrow or nontraditional institutions. Though there are signs some U.S. regulators have become more open to nontraditional business models, it is too early to say how far down this road they will be willing to go.
Non-bank payment firms seeking a bank charter or branch license must also confront another distinctive feature of the U.S. regulatory system: the Bank Holding Company Act’s restrictions on non-banking activity. Many non-bank firms are unable to comply with these restrictions, or to qualify for the full scope of exemptions afforded to certain qualified foreign banking organizations (QFBOs).
NO INHERENT BARRIER
Given the right legal and policy changes, there is no inherent barrier to granting non-bank payment firms master accounts at the Federal Reserve. A number of non-depository governmental and quasi-governmental bodies such as the U.S. Treasury Department and the government-sponsored enterprises are eligible to open master accounts and use their accounts to settle payments on their own behalf. Moreover, most of the non-bank payment firms under discussion function as depositories in practice. Some even carry customer-owned asset accounts with third-party payment capabilities as liabilities on their balance sheets. The only functional distinction between such firms and certain nonlending banks is that the “non-banks” lack master accounts.
Eligibility criteria for master accounts have evolved over time. With the establishment of the Federal Reserve System in 1913, only Federal Reserve member banks were eligible to open an account and use Federal Reserve services. The Monetary Control Act of 1980 subsequently expanded eligibility to all U.S. depository institutions. As recently as 2017, the Federal Reserve articulated principles for opening joint accounts as it granted the application of several participant banks to open an account in support of the new RTP (Real-Time Payments) system, with The Clearing House Payments Company as the joint account’s agent. Although this most recent action did not modify the core eligibility criteria for opening a master account, it demonstrated the Federal Reserve’s continuing responsiveness to the evolving payment landscape.
The Bank of England recently carried this policy responsiveness a step further. In May 2017, the Bank of England published a blueprint for allowing non-bank payment service providers to apply for a settlement account in its real-time gross settlement (RTGS) system. In April 2018, the central bank announced it had opened an RTGS settlement account for TransferWise, a non-bank payment firm, and approved TransferWise as a participant in the U.K.’s Faster Payments system.
Explaining this change in policy, a 2017 Bank of England publication noted that “enabling a payment system to access settlement in central bank money can have monetary and financial stability benefits. The financial stability benefits can be realized in two different ways: through the mitigation of risk for the users of the system; and also through supporting greater innovation and competition in the provision of payment services, which encourages diversification and the development of new, risk reducing technologies, and thus supports the Bank’s objective to promote financial stability in the longer term.”
ACCESSIBILITY AND EFFICIENCY
In articulating its own objectives with respect to payment system policy, the Federal Reserve has stated that it seeks to “foster the integrity, efficiency, and accessibility of U.S. payment and settlement systems.” It is reasonable, therefore, to evaluate the case for non-bank direct access by asking to what extent non-bank firms might contribute to or detract from the integrity, efficiency, and accessibility of U.S. payment systems if they were able to access these systems directly.
There are grounds to argue that direct access for non-banks would make the system more accessible, both in the strictly literal sense and in terms of broader impact. Non-bank providers have proven their ability to expand payment system access to previously unserved and underserved sectors. At present, however, the degree of that expanded access remains constrained by depository institutions that serve as additional gatekeepers through their third-party oversight activities. Removing one gatekeeper would clearly increase access to the system (whatever other effects it might have).
There are also reasons to believe that giving non-banks direct access would increase the efficiency of the payment system. As a matter of basic economics, increased competition should lead to increased efficiency. Moreover, non-bank firms have a long history of efficiency-boosting innovations in technology and operating models.
There are, however, a couple of caveats to the argument for increased efficiency. First, there is no obvious, causal relationship between giving non-banks settlement accounts and incrementally increasing efficiencies above current levels. After all, non-bank payment firms have not needed direct access to bring about successful advances in efficiencies, technological innovation, increased competition, and other benefits they have created under the current system.
Second, since they are not regulated as banks, some non-bank payment firms might achieve time and cost savings through externalization of risk, rather than increased efficiency. In other words, while many non-bank firms find innovative ways to make payments better, others may merely be cutting corners in managing credit, compliance, or operational risks.
INTEGRITY OF THE PAYMENT SYSTEM
This last caveat highlights the critical role of the Federal Reserve’s third policy objective – ensuring the integrity of payment systems – in considering direct access for non-banks. Integrity considerations are paramount because the current master account eligibility criteria – both formal and informal – are central to the Federal Reserve’s strategy for managing risks in the payment systems it operates.
According to the Federal Reserve Policy on Payment System Risk, “controls to limit participant-based risks, such as membership criteria based on participants’ financial and operational health[,]” are “key features” of a payment system’s rules and procedures.
The Federal Reserve’s eligibility criteria do not, on their face, include any consideration of an account holder’s financial or operational health. Indeed, the Federal Reserve Banks, in their role as payment system operators, do not have independent mechanisms to evaluate or monitor the soundness of depository institution account holders. Instead, the Federal Reserve relies on prudential bank regulation to manage participant-related payment system risk. This reliance manifests itself most explicitly in the Federal Reserve System’s daylight overdraft rules, which use an institution’s supervisory ratings and prompt corrective action status to establish limits for the institution.
Viewed in this light, the master account eligibility criteria contain implicit assumptions regarding the regulations and supervisory regimes to which eligible depository institutions are subject. While the criteria may appear on the surface to set the eligibility boundary based on the legal formality of charter or license type, the real boundary is based on the level of regulation and supervision that the charter or license types imply.
This observation is realized in situations where legal formality does not match regulatory substance. Like other central banks, the Federal Reserve reserves the right to decline to open an account for an institution that technically meets the minimum eligibility requirements. Two recent high-profile cases have drawn attention to this fact, though they are by no means the only examples.
Uninsured state non-member banks seem particularly likely to encounter situations where Federal Reserve Banks decline to open – or restrict – master accounts for facially eligible institutions. This is notable because, unlike other depository institutions eligible for master accounts, uninsured state non-member banks are not subject to federal prudential supervision or to key federal prudential banking regulations.
Non-bank payment firms, likewise, do not have federal prudential supervisors and are not subject to federal prudential bank regulation. To be sure, some specific types of non-bank firms are subject to a variety of other regulatory and supervisory regimes. For example, state-licensed money transmitters and registered broker-dealers hold licenses and are regularly examined by their supervisors, while certain large processors are periodically examined by the federal banking agencies as technology service providers. But these oversight regimes vary considerably in scope and depth, as well as in the substantive regulatory requirements (e.g., minimum capital standards) applied to regulated institutions.
This is not to say that an institution without federal prudential supervision could never open a master account under current policy. But, given its dependence on prudential supervision to manage participant-based payment system risks, the Federal Reserve limits approval of such accounts to situations in which circumstances mitigate risk in other ways. Such mitigating circumstances do not exist for typical non-bank payment firms.
OPTIONS FOR DIRECT ACCESS
Direct access to master accounts by non-bank payment firms would therefore require changes to the Federal Reserve’s approach to managing participant-based risk in Federal Reserve-run payment systems. These changes could take various forms.
One option is to limit the expanded access to certain types of regulated non-banks and rely on the existing applicable non-bank regulatory regimes to provide the necessary information and assurance regarding financial and operational soundness. This option would require the Federal Reserve to evaluate the relative worth and weight of different non-bank financial regulatory regimes and regulators and determine how to fit them into a single risk management framework. In the past, such apples-to-oranges comparisons have proven difficult and tended to leave all stakeholders dissatisfied with the outcome.
The effort would be particularly challenging when it comes to state-based regimes, given the considerable variability in the approaches and resources of different state financial regulators. One can hardly expect the Federal Reserve to discriminate among similar institutions in different states based on its judgment of the relative rigor of supervision in one state versus the another.
The approach also risks competitive unfairness to conventional depository institutions, whose applicable regulatory and supervisory regime would likely remain more rigorous than that for other institutions. On the other hand, making the non-bank regimes more “bank-like” would impose unnecessary burdens on the great majority of non-banks with no interest in master accounts.
A second option is to authorize the Federal Reserve to create and administer a new supervisory and regulatory regime for non-bank firms with master accounts. The applicable Federal Reserve Banks could use the supervisory resources based at their respective banks to examine the non-bank payment firms as prudential regulators. While the Federal Reserve can already impose account approval conditions, some of which can have de facto regulatory effects, the full scope of authority and resources needed for effective regulation would likely require legislative action.
The Bank of England employs a combination of the two options, relying on non-banks’ existing regulators while imposing a strengthened supervisory regime and tailored operational arrangements beyond those applicable to ordinary non-bank firms. This is also, in a sense, the path originally followed by the Federal Reserve when it established supervision of its member banks in parallel with supervision by their chartering regulators.
That said, the second option suffers some of the same drawbacks as the first. The need to “adapt” the prudential bank regulatory regime to a non-bank financial institution evokes the complexity and controversy that attended supervision of systemically important non-bank firms under the Dodd-Frank Act. Moreover, making such an adapted regime sustainable for a non-bank payment firm may still require regulators to place traditional banks at a competitive disadvantage.
THE BANK CHARTER ALTERNATIVE
The second option for facilitating direct access by non-banks also has a more fundamental drawback: In a sense, it reinvents the wheel. The option posits a non-bank firm prepared to be regulated as a bank, and then proceeds to propose the creation of a new “bank-like” supervisory and regulatory regime to satisfy this requirement. Rather than creating yet another U.S. financial regulatory system, it seems more logical to examine the obstacles preventing the firm from actually becoming a bank.
Expanding opportunities for banking charters and licenses need not mean lowering standards. Rather, it involves reexamining certain regulations and licensing policies that pose particular obstacles to payment firms’ banking applications. The reexamination would weigh the original justifications for such regulations and policies, as applied in the context of non-bank payment firms, against the potential benefits of expanding direct access to the payment system in a safe and sound manner. Such assessments can draw on policy discussions already underway in the U.S. bank regulatory community and the experiences of other jurisdictions with more flexible licensing environments.
One potential area for reexamination is the scope of acceptable business models for de novo banks. A more nuanced approach to narrow business models – particularly payment-focused ones – could permit non-bank payment firms to charter U.S. banks comparable to the payment-focused banks some already operate in other jurisdictions. In addition, limited-purpose bank charters, such as the FinTech charter announced by the Office of the Comptroller of the Currency, could function as a U.S. version of the e-money/payment service provider licenses available in Europe – effectively, a money transmitter subject to federal prudential supervision and federal banking rules.
Policymakers could also consider reviving certain types of uninsured depository charter types that, while technically available, have fallen into disuse. Uninsured state member banks, uninsured deposit-taking national banks, and foreign-owned Edge Act corporations are all eligible for master accounts, have federal prudential supervisors, and are subject to federal prudential bank regulations under existing law. Uninsured charters are not suitable for every non-bank business model, but they may be a good fit for some.
Finally, even though it would require a change in regulation, it may also be worth reexamining the application of the “bank chain requirement” of the QFBO test to non-U.S. payment firms that own banks outside the U.S. In a surprising number of cases, this relatively unknown requirement turns out to be the decisive and insurmountable obstacle preventing non-bank payment firms from operating under U.S. banking licenses. It is worth asking whether the policy objectives behind the test are well served by excluding firms engaged predominantly in payments activities based on the legal entity structure through which they conduct those activities.
The most effective policy response to non-banks seeking direct access to the payment system may therefore be expanding opportunities for suitable firms to obtain the banking charters or licenses that confer eligibility. This option would ensure these firms are subject to the same supervisory and regulatory standards as incumbent participants, without the wasteful duplication and competitive inequity inherent in creating a parallel regime. At the same time, non-bank firms that do not want to (or simply cannot) become banks could continue to operate pursuant to their existing regulatory regimes and to rely on indirect access to payment systems through banking relationships – including, potentially, relationships with new payment-focused banks.