The Demise of the Dual Banking System 

The District Court of Wyoming announced an important decision on Friday, March 29. While seemingly arcane, the issue concerned the denial of the application of Custodia Bank for an account at the Federal Reserve. Such an account, called a “master account”, is held by all commercial banks and some other depository institutions in the United States. 

Why does this matter? A master account allows a financial institution to make direct transfers to and from other banks. The alternative is to use an account at an institution that has a master account and pay charges for transfers. This puts the institution without a master account at a competitive disadvantage. Worse, having an account at another institution is, of course, up to the discretion of the other bank and indirectly the other bank’s regulator. 

Part of the purpose of Custodia Bank, Inc. is to provide banking services to cryptoasset firms. These firms have run into difficulties establishing and maintaining deposit accounts. Federal banking regulators explicitly said in February 2023 that “Banking organizations are neither prohibited nor discouraged from providing banking services to customers of any specific class or type, as permitted by law or regulation.” That said, they then proceeded to suggest that a bank’s liquidity risk associated with deposits by cryptoasset firms are extraordinary because those deposit accounts may be more volatile than typical bank deposits. Therefore, a bank’s risk management must allow for rapid withdrawals by cryptoasset firms. It is worth noting that Custodia proposes to be a 100-percent-reserve bank so there is no issue of being unable to redeem deposits. In other contexts, it has been suggested that working with cryptoasset firms also may be associated with amorphous “reputational risks” for banks. In its May 2024 Supervision and Regulation Report, the Federal Reserve says that operational risks associated with fintech are a Fed supervisory priority for community and regional banks. To put it mildly, that priority is unlikely to encourage banks to begin business relationships with fintech firms. 

Many (including the law firm Davis Polk) have concluded that banking regulators are making it difficult for cryptoasset firms to have deposit accounts in the United States. Serious empirical evidence is scarce. That said, firms involved in cryptocurrencies frequently complain that their banking relationships have been cut off, a recent example being a bitcoin payments firm, Lightspark. 

The federal court’s decision concerning Custodia was on motions for summary judgments concerning Custodia’s application. Both Custodia and the Federal Reserve Bank of Kansas City and Board of Governors of the Federal Reserve System filed motions for summary judgment. The main issue was whether a Federal Reserve Bank has discretionary authority to deny a master account, although there also was an issue of whether the Federal Reserve Bank and the Board followed correct procedures. The District Court decided that federal reserve banks have discretionary authority to deny a master account even to state-chartered banks. This is mostly a legal question, and I am not a lawyer, but it is unlikely that the last word has been heard. 

Among other things, an amendment to the Federal Reserve Act by Senator Pat Toomey (PA-R) played a nontrivial role in the decision. The provision requires the Federal Reserve to maintain a database of all institutions with master accounts and all firms that have applied including rejected and pending applications. In an amicus curiae brief, former Senator Tommey denied that the amendment was intended to give the Federal Reserve permission to reject applications, the interpretation given to the amendment by the Federal Reserve and the District Court. He simply knew that some recent applications were pending and might be denied. 

In the end, the issue comes down to whether a state-chartered bank that fulfills the legal requirements for a master account can be denied one by the Federal Reserve. 

Banks in the United States can obtain their charters from the federal government or from the state banking regulator where they are headquartered. The Office of the Comptroller of the Currency charters national banks and the 50 state banking regulators charter state banks. This system is called the “dual banking system” and has existed since the creation of national banks in the 1860s. 

The dual banking system has served the United States well. Having two options for obtaining a bank charter makes it difficult for regulators to become overly restrictive in granting a charter, or to grant charters only to favored applicants. Sometimes, and the District Court’s decision actually suggests this, it is claimed that the two sources of charters could result in a competitive “race to the bottom” of regulation. The academic literature does not find support for this possibility. 

Instead, research indicates that the dual banking system has contributed to innovation because sometimes different regulators reach different conclusions about the riskiness of activities. For example, some states introduced deposit insurance for banks well before the federal government did. As the Federal Deposit Insurance Corporation’s A Brief History of Deposit Insurance in the United States says, “The basic principles of the federal deposit insurance system were developed in these [proposed national] bills and in the experience of the various states that adopted insurance programs.” 

If the Federal Reserve can deny a master account to all newly chartered banks, then the Federal Reserve effectively becomes the regulator determining whether a newly chartered uninsured state bank can begin operation. There will be little or no difference between a federal charter and a state charter; national banks and state banks will be effectively subject to the same restrictions to start a new bank. That is the demise of the dual banking system. 

Consequently, an innovative bank in a permissive state will find it very, very difficult to experiment with banking structures or strategies that are not permitted by the Fed because doing so will mean they are unable to acquire a master account. Hence, they will find it difficult or impossible to compete successfully with banks that have master accounts. As a result, the Federal Reserve effectively will become a state-bank chartering authority. State bank charters will become a trivial, uninteresting detail about United States banking. 

This decision at the District Court level is not likely to be the last word in the case. Custodia is taking preliminary actions to file an appeal. The final result will have substantial effects on the future development of the United States financial system. 

Note: At the invitation of the Bitcoin Policy Institute, the author contributed to an amicus curiae brief for the Custodia case that was submitted by the Blockchain Association and payment system scholars.