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- The core banking system sucks.
- It sucks for everyone, but it sucks more if you are poor or live under a dictatorship.
- Technology allows us to build a better core banking model.
- By core banking, I mean deposits and loans existing in the real economy. Not just transferring value between users or creating synthetic financial products.
- Here is the formula for a better banking model: matched funding (deposits-loans) + insurance + blockchain technology.
- This will help reduce inequality, combat authoritarianism and diminish excess variance in the business cycle.
- In this coming struggle, you are either with the spirit of our better human values epitomized by Satoshi Nakamoto or you are with the big banks.
Billions of people live in a darkness that a better banking model can lighten.
According to the World Bank, approximately 3.5 billion people live in poverty and don’t have a savings account at a bank. This means that a couple in Mozambique has no savings mechanism that could help them in their hope to educate their daughters. Like many, their only choice is to operate in cash, even though the father has a job.
The Human Rights Foundation estimates that 4 billion people live under authoritarian governments. This means that a young man studying in Vietnam keeps quiet about the malignancies he sees in the system. He does this because he dreams of getting married and to get the girl he needs a house and to get the house he needs a mortgage from the state bank.
Consider this reality closer to home:
“Bank of America will charge low-income customers $12 per month for their checking accounts unless they have a $1,500 account balance.”
@laura_nelson, Twitter, 2018
“Finally, a bank with some fresh ideas on how to make poor people poorer.”
@kashanacauley, Twitter, 2018
Let’s see what binds these people together
A secure savings account is foundational to a full life, a life where the individual can express the truth as they see it and also participate in the natural uplift of the real economy. It is the solid ground that allows us to formulate our own thoughts without outside influence and provide a better future for our families.
Although we tend to overlook such basics in the West, the virtues arising from secure savings accounts are indispensable to higher-order democratic structures. This can be seen graphically, as a kind of Maslow hierarchy of needs.
If you want to reduce poverty, you need to start at the bottom of this hierarchy and let the benefits flow upwards. Similarly, if you want to promote democratic societies, you need to get the bottom right in the first place.There is typically a positive statistical correlation between poverty and an authoritarian form of government, and between wealth and liberal democracy.
This flows not from elections at the top, but from secure savings accounts at the bottom, plugged into the real economy. Where people have the independence to come up with their own opinions without coercion and are able to share in the productivity of the economy, societies flourish.
So, what binds those living in authoritarian countries, the unbanked in Africa, and the financially excluded in America together? They are all missing the secure, productive savings account foundation needed as a defense against the related evils of authoritarianism and inequality.
What would core banking look like, if it were truly to serve society?
A core banking system built to serve society would have the values set out below.
Today’s fractional reserve banking system is designed for the benefit of the few rather than the many. The very nature of fractional reserve banking is incompatible with a truly healthy society.
Why does the current core banking system suck?
Our banking system originates from precious metal guilds in the Middle Ages. Deposited gold mainly represented value that had already been created in the economy. These guilds developed the concept of issuing paper IOUs against the deposited gold. As not all depositors typically demanded their gold back at the same time, this led the depositories to issue more paper IOUs for making loans than the gold that they held. They retained a “fraction” of the gold, in case a merchant needed physical gold. These depositories evolved into today’s banks, whose core model is based on the same fractional reserve concept.
This core banking system is inherently dishonest. At its heart are three fundamental lies that pervert society and the economy:
- The bank will tell you that the money you deposit belongs to you. In fact, legally the money becomes the property of the bank. In law, you are an unsecured creditor to them. In return, the bank gives you an IOU, called a deposit account. The deposited money is recorded as an asset on their balance sheet and deposit accounts are recorded as their liability to you.
- The bank will tell you that “your” money is safely held at the bank. In fact, the bank holds only a fraction and then loans the rest of it out. If you want more than this fraction of your money back, the bank takes it from elsewhere.
- The bank will tell you that your funds are “insured” by the government, up to a certain amount. In fact, there is no government insurance fund that corresponds to these deposit amounts. It isn’t insurance; it is a government undertaking, in a failure situation, to print more money to give to the banks so that they can repay their liability to you.
Fractional reserve banking is illustrated below.
Banking’s greatest deception is that the power of money creation is mainly in the hands of private commercial banks, not the state. The Federal Reserve doesn’t create most of the money in the United States; large American banks do, through the loan-deposit account process. Since both paper money and bank created money have purchasing power, they are both officially considered money.
There are two main reasons why this core banking system sucks: it leads to inequality in society and it’s dangerous for the economy.
Inequality in society
The banking system uses the funds of depositors as their own to make high returns, driven by profits on loans. Deposits and loans are the core of banking and are exceptionally profitable given the risk assumed. The system essentially is a mechanism for taking a little bit from everyone and channeling it to owners, who are disproportionately the 1% of society. All depositors are disadvantaged by their exclusion from the rewards of the natural productivity of the economy, whether they are middle-class savers in America or a wealthy family office in Switzerland or a corporation in Japan.
In addition, the biases in the lending process, driven by human preferences that manifest themselves technically in the debt service coverage ratio or interest rate on loans, inevitably favor in-groups over out-groups. This bias is institutional, exacerbated by the structural nature of fractional reserve banking.
Further, the current banking system has completely failed the poor, in developed and developing countries. In general, they remain excluded from being able to participate meaningfully in the financial system. Those who do participate have few means to share in the benefits of economic growth that could help lift them out of poverty.
Here are two graphs from the United States that illustrate how the current banking system contributes to inequality.
Share of the finance and insurance sectors in the United States since WWII (% of GDP)
This graph shows that the role in the economy assumed by the financial sector has quadrupled since the end of WWII.
This graph shows that lower- and middle-class income has been declining over the same period. It is similar in most developed countries.
When you put the two charts on top of each other, you have a clue as to where this income has gone over the past decades. It has gone (partially) to the financial sector. It has also gone to other areas, like globalization, but a large part of the benefits of the economy has been captured by big banks at the expense of the lower and middle classes.
Dangerous for the economy
Bank credit money creation is the largest source of funds for loans in the economy. There are three uses of loans: (1) for productive economic activities, (2) for time shifting of consumption, or (3) for asset purchases. The first two rely on future cashflows for repayment. The third, asset loans, rely on the future valuation of those assets.
When bank-created money is used for asset loans, it leads to upward valuation levels that create excess variance in the business cycle. When asset prices reset to lower levels, this causes recursive destruction of both the loan value (on the asset side) and the bank-created credit money (on the liabilities side). It is this process that is mainly responsible for excess downward variance in the business cycle. Bank money creation used for asset loans explains most of the booms and busts in the economy. This can be seen in the graph below, with recessions in grey.
This graph shows that recessions are a regular occurrence as part of a fractional reserve banking system; they are an inherent part of a bank money creation model.
The main objectives for a central bank that oversees the fractional reserve banking system are price stability and employment. Let’s have a look at a chart of the purchasing power of the US dollar since the inception of the Federal Reserve to the end of 2017, to see if the price has stayed stable.
OK, so the product has lost 95% of its value and you wanted it to be stable. That isn’t so great on the CV. But, it has outperformed almost every other nation state currency and that is why it is the global reserve currency today. The only other money product that has done better is gold, which somehow has held its value since Neolithic times.
Now you understand the dangerous effect of being able to print more paper money versus a monetary asset with a fixed (or slow growth) supply. Even worse, the banking system creates more money than the state. Further, the rewards of banking accrue only to bank owners and employees while the risks of their actions are borne by society as a whole.
This is our modern fractional reserve banking system. It is not at all capitalist; it is more like a closed, medieval guild system, and it will always foster inequality and exclude out-groups by its very nature. It is as destructive as it is dishonest. It is about as far away from the concept of value, and from our better human values, as you can get.
What is the solution?
Until recently, there was no feasible alternative to a centralized banking system that favored the few at the top.
Then, in 2009, Satoshi Nakamoto created a system of money that corresponds to how humanity exchanged value for most of our history, directly, before the rise of modern banks. The implications are spectacular: you can now trust exchanging value with another person or institution directly, globally, even if you don’t know them.
As the crypto system is based on radical transparency and honesty, as well as the inability for anyone to create money; it is antithetical to the fractional reserve banking system. It is global and impervious to authoritarian control.
The solution to the fractional reserve banking model is to use Satoshi’s technology to radically rethink how core banking could actually be used to benefit society. Here are some ideas, based on the two values identified above.
This should lead to banking being unbundled, like many other industries. The base layer will be core banking. Other banking services can be add-ons; the consumer can choose the best ones for them without having to accept an entire package and without the silo inefficiencies that exist today.
Banking should function more like a utility and stop eating such a large share of the economy. Returns should flow to depositors. In the future, bankers should be more like servants of other people’s money than arrogant masters of the universe.
A better banking model
The new bank should do what technology does best: attack high and unjustified margins and share the benefits with users.
Here is the formula for a better core banking model:
Better banking = matched funding (deposits-loans) + insurance + blockchain technology
This new bank should have a narrow focus: matching deposits to loans, using sophisticated matching software.
To provide security for depositors, the loans and deposits should both be insured. This is well possible and insurance is vital in providing trust to depositors. Banks rely on their brand name and government deposit insurance for trust. For a new bank, providing genuine deposit insurance would neutralize these advantages.
The new bank should run on blockchain architecture, principally the bitcoin blockchain. As core banking requires identification, there will need to be a permissioned layer, best built using open-source Hyperledger software. This should have safeguards to ensure that control remains with the user and not with the bank. Both the core banking function and the insurance element should move to as decentralized a model as possible and basic functionality should be encapsulated in smart contracts, not left to management discretion.
There is no reason that ownership of the new bank should only be in the hands of a few shareholders. All depositors contribute to success and their contribution to making the pie bigger for everyone should be rewarded with an amount of equity tokens in the new bank over time. All users could be owners.
There is also no reason for the new bank to report only selective information and only a few times a year. A new model of radical openness that reported daily and hashed key information to the blockchain would inspire confidence in users.
The new bank should explicitly be founded on the idea of making the world a better place. A good example is for the new bank to have a policy of donating a set amount of profits to local charities, say 10%.
What is not a better core banking model
The fractional reserve banking model sucks. Putting this model on a blockchain architecture doesn’t make it suck any less.
Fintechs, challenger banks, crypto banks typically don’t do core banking and are not a new model; they are just a lesser evil. The JPM coin framework is not crypto, not a new model and not a lesser evil.
Now is the hour to choose a side
It is time for a better banking model, for a better world. The cornerstone of this new relationship must be a secure savings account that guards against authoritarianism and allows users to participate in the productivity of the real economy.
This is a rare moment in history to create a new model, which won’t last forever. Most technology has in-built authoritarian tendencies. Satoshi’s invention is an exception, an opportunity to re-create a system without centralized control. The crypto system will only change the world if it can connect in a meaningful way to the real economy and deliver tangible value to users in a simple offer.
The fight to establish a better banking model will be demanding, against an entrenched enemy. However, the market is enormous and the financial rewards compelling. The possibility of making a better, healthier society should lead us on. If the idea of a better banking model speaks to you, and you are willing to get your hands dirty, join us.
Robert is part-Canadian, part-British, somewhat autistic and lives in Geneva. He is going to link the crypto system to the real economy and create a better banking model, or die trying. His interests include mountain-climbing, chess, piano, programming and distrusting authority. In his early career, he was an M&A investment banker in London, then in private equity, and then moved to Switzerland to invest his own money. He holds an MSc degree in Finance from London Business School.