By Ryan Dinse – Money Morning.
I got some good feedback from Wednesday’s article on how fintech is a big threat to the banks.
Good feedback in that it was interesting, even if some of it wasn’t positive! There were some very good points, which I think need to be addressed.
‘This article misses the point.
‘The banks do not make most of their money from providing a platform for exchange of funds between governments, businesses and natural people. Blockchain technologies may well replace this role of banks as financial intermediaries but this is a peripheral business.
‘The banks make their real money from their monopoly right to create credit out of thin air, literally nothing, and charge interest on the money thus created that had prior existence whatsoever.
‘Very few people grasp this fact although it is fully explained on the Bank of England’s website in their series “Money in the modern economy”.
‘Until this magical power of money creation is removed from Banks or given to rival organisations who in effect would play the role of banks in money creation, they will always be profitable as long as they remain prudent in their leading practices.’
Let me start by saying that I agree with David’s comments.
To an extent…
To quickly summarise the original article…
I started by saying that Open Data policies, as seen in the UK, could drive an increase in bank switching.
Australia’s big four banks are the most profitable in the world. Their customers are generally not happy. But they stay due to the difficulty in moving banks. Part of this difficulty is rooted in psychology.
Because the original decision to choose a bank requires a lot of effort to research the right information and set up accounts, this ‘sunk cost’ has a value to us. A value that makes us less likely to move banks. Mandated ‘Open Data’ policies and new financial technology reduce the effort required to compare and switch. Thus making customer more likely to switch. This will mean banks have to be more competitive in their pricing. Thus reducing profits.
That was point one and is more to do with fintech putting pressure on the very high — by world standards — profit margins enjoyed by Australia’s big four. But the broader point David makes is that the license to create credit underpins banks’ profitability. And fintech wouldn’t make a dent in this fact. It’s a valid point. And it will not change in a hurry. But it could eventually. How?
Let me explain.
The power of fractional reserve banking
David’s right to point out that the fractional reserve banking system is the key driver of bank profits.
This is the system whereby a bank can lend out a multiple of what it takes in from savers.
A blockchain future that is simply a better ‘piping’ mechanism for making transfers doesn’t dent this advantage.
I’ll get back to this shortly…but first, fractional reserve banking.
Being able to lend out almost as much as 10 times what you take in as deposits. So, not only do you pay interest to savers at a lower rate, and lend it out at a higher rate. But you also lend it out those same dollars many times over!
But there are some rules a bank must obey.
They can’t just lend money out willy-nilly. They have to meet certain reserve ratios fixed by government regulators.
Only sovereign nations can create money out of thin air at will. This is our current fiat system of money.
This gets to the heart of one of the biggest strengths of cryptocurrencies.
My article was certainly not saying this fintech revolution would happen overnight.
Indeed, to use the original Kodak analogy further, they invented the digital camera in 1975. A full two decades before the devastating effects of digital cameras hit them.
To David’s point about the banks’ power of credit creation, let me say this.
The banks power to create fiat credit (money) is only powerful if the fiat currency is of value. This requires confidence in the system.
A system in decline
In a western country, David might be correct — at least for the time being — that our system of fiat money is quite strong. But there are countrys all around the world like Zimbabwe and Venezuela that aren’t. Their currencies are in trouble.
The value of our money is based on faith. Faith in the credit of our government’s monetary policy. Faith is the base layer, below the banks, which supports the entire credit system. But since the GFC in 2007, ‘honest money’ has taken a battering. The US government has created credit out of thin air and given it to banks, in an effort to help grow the economy. Banks in turn used this cheap money to prop up their ailing balance sheets and meet their required reserve ratios. And then, thanks to the fantastic fractional reserve ratio, lend it out many times over. This money didn’t go into increasing productivity. It simply pumped up asset values like property and the stock market.
And the US isn’t the only place this has happened. All countries are at it.
The Swiss Bank owns US$80 billion of US stocks. That’s US$10,000 for every man, woman and child in their country. How do they do this? They print money out of thin air and buy them!
Does that sound sustainable?
It might seem I’m going a bit off point. It might even seem to back up David’s point that the game is rigged in the banks’ favour, so the profits will continue. But think about this. Money only has value because the public trust it to. It’s backed by ‘full faith and credit’ of the issuing government. Trust in this system, even in Western countries, is fast failing. Incomes are stalling, the middle class is shrinking, the gap between rich and poor is widening, and political extremism is on the rise. All as the result of this long running money printing experiment.
It can’t go on forever.
There’s only so much that pumping money into the economy can do. What happens when the tap turns off?
Governments have to default on debt. Could you imagine if the US, which owes $62,000 for every man, woman and child, decided to default? Would there be any international faith in the US dollar then? I don’t think so.
What currency would the world turn to? There isn’t one that would be trusted with the role the US dollar now has.
And like I said, it’s not just the US. Little old Luxembourg’s citizens are up for US$6.7 million each if they go under!
Remember, debt is fiat money. And fiat money is debt. If one fails, they both fail.
Or the government might confiscate a percentage of people’s bank deposits, like happened in Cyprus in 2012. What would this do for confidence in banking?
So, at some point it becomes a rational act for people to … get their wealth out of this fiat money system. Like the Venezuelans, Argentinians and other at-risk countries are already doing. Where to then?
21st century gold?
Into somewhere safe. Untouchable by governments. Useful. Something that can’t be changed by human intervention. Scarce, and only controlled by you. The usual suspects don’t cut it.
Property can be taxed. Gold can be confiscated. Shares can be manipulated. Fiat currency can be devalued.
This is why the concept of the blockchain and cryptocurrencies is so powerful. They are useful as a new, better way to move money around. But they’re also useful as an alternative to fiat money. Blockchains have fixed rules that no one entity can tamper with. They are decentralised. This is a key to both their effectiveness and their superiority over the existing centralised banking systems. People may start to realise it’s the only safe haven left in the next crisis.
This won’t happen overnight. It could be decades. Or never.
But as blockchains get integrated into the system, the associated cryptocurrencies that underpin them creep in too.
At first the blockchain will be used for simple transactional benefits. Such as only paying 2 cents to transfer money overseas. Or 1 cent to buy and sell shares.
Or it might be to find new ways to secure and own your own data. A fast-growing problem that the decentralised blockchain and cryptocurrencies will enable. You see, open data and an increase in competition are just the beginning. Combined with blockchain, they’re a Trojan horse for the current banks.
As banking starts to become more decentralised, the money held by banks, their crucial reserve ratio, falls. The less money they hold, the less they can lend out. And the less profits they can make. Banks profits are tied to fiat money. Which is tied to debt. Which is tied to government debt.
We may even move from ‘faith in credit’ of issuing governments, to faith in incorruptible cryptographic maths. It will probably take a crisis to do this. But when it does, the fintech revolution will be complete.
And we will move to a new system, without centralised manipulation.
The future of money. Where money is data. And data is money. And both are owned, held and controlled by you.