Opinions of contributing entrepreneurs are their own.
If you’re reading this, you’ve probably encountered some of the recent turmoil within the US banking system. In particular, we have seen the collapse of several notable banking institutions, including Silicon Valley Bank, Silvergate Bank, and Signature Bank.
To date, the vast majority of the blame for these recent failures has been attributed to the excessive risk and volatility associated with the emerging cryptocurrency (crypto) industry and start-up companies, when in reality the main cause of these failures stems from a age-old mistake of our banking system. Specifically, today’s bank failures were somewhat preordained, as bank runs are a known, well-understood threat to the health of any fractional reserve banking system.
Now more than ever, it is time for the American people to fight to reduce our archaic banking system. After all, we are the ones who suffer the most, not the ultra-rich.
Related: Why the American Dream is Dead
Table of Contents
What is a fractional reserve banking system?
In the simplest terms, a fractional reserve banking system allows banking institutions to lend a certain percentage of customer deposits held on the bank’s balance sheet. The reason why a bank might do this is simple: free money. For a nominal interest rate paid back to depositors, banks can borrow money and generate substantial returns from a variety of investments. You may be wondering what rules are there to make sure your money is there if you choose to withdraw, so let’s take a quick history lesson.
In 1913, the Federal Reserve Act aimed to accomplish a number of important points:
- Creation of the Federal Reserve Banks (in total the Federal Reserve System)
- Set minimum reserve requirements for banks (set at 13%, 10% or 7%, depending on the type of institution)
Fast forward to the middle of the century, and minimum reserve requirements rose marginally (to 17.5% for certain banks) before settling in the 8-10% range between the 1970s and the 2010s. Most recently, in 2020, reserve requirements were abolished and replaced by the Interest on Reserve Balances (IORB) system, whereby banks paid interest on funds held on their balance sheets, incentivizing them to lend out fewer deposits from customers. Crazy, right?
In case you’re wondering how much interest banks were paid for sitting on customer deposits, it was 0.15% (or 15 basis points) from 2020 to early 2022, when the Federal Reserve started raising rates. Do you see where I want to go? In a world where shareholders are constantly looking for yield, the opportunity cost of holding reserves when the S&P 500 (or even real estate) pays high single-digit annualized returns encourages risk-taking, which favors the country’s elite. good comes. the cost of deposits (everyday Americans).
Related: You may not know you’re a high-risk client for mainstream banks
What you were told
An important point to note is that fractional reserve banking systems do not only benefit banking institutions. In fact, fractional reserve banking is one of the biggest drivers of economic growth: businesses can scale and produce more products, while consumers have easier access to capital. Credit cards, mortgages, car loans and small business loans are all made possible by the realignment of customer deposits. It really is one of the greatest innovations of modern finance; however, it does not come without risks. Unfortunately, many of those risks are not well known to the general public.
More likely you were told to make sure the banking system is good.’ More likely, you have been told that the biggest risk to the United States financial system is the crypto industry. More likely, you have been told that decentralized frameworks are breeding grounds for fraudulent activity, when in fact it is the centralized nature of our banking system that forces the need for consistent over-regulation due to incentives that always seem to be misaligned. .
Fractional reserve banking is a major pillar that brought us into the 21st century, but with how much the economy has grown over the past century, we need to start migrating to new banking frameworks. In particular, frameworks that better limit excessive risk-taking and function, regardless of whether the general public trusts it or not.
Related: Banking troubles = bearish thumb on stock market scale
What you need to hear
Banks are centralized organizations whose sole mission is to increase profits, and within centralized infrastructures, checks and balances are often pushed aside in exchange for speed and efficiency. Shareholders are pressuring banks to make a profit while banks are pressuring regulators and legislators for looser regulation which forces an infinitesimally small group of people to make tough decisions that affect the well-being of the common person who knows very little by the way of what happens to their money once they deposit a paycheck.
For this system to work, the common person has to place immense faith in the powers of good actors. If depositors withdraw money on a large scale, banks run the risk of not having enough money to process requests. And because there is minimal visibility into a bank’s position at any given time, Americans are forced to blindly trust that their money will be there when they need it.
Crypto and, more specifically, self-custody solves this problem, as your wealth only really becomes your wealth when you keep it yourself. Decentralized ecosystems completely eliminate the risk of a bank run, but also eliminate the most efficient funding a bank could ever get. And I already know what you might be thinking, “What about credit cards and mortgages?” Decentralized financeor “DeFi” for short, ushers in a new paradigm in which these kinds of transactions can be facilitated by smart contract logic that is auditable and public.
The threat the crypto industry poses to the traditional financial system is palpable. That is why we have shamefully sold the narrative that crypto fraud is possible when in reality it is difficult to commit a financial crime in crypto frameworks as every event is public and lives on the blockchain.
In addition, the media often fixates on the financial crime occurring within the crypto industry, as evidenced by the fixation and coverage of the Sam Bankman-Fried and FTX fraud cases. Ironic, traditional banks have outstanding cases dwarfing the financial fraud that has taken place within the crypto industry. Moreover, it is because of the centralization and opacity that lives within the traditional banking system that implicative decisions can be made, which in turn harms those who participate in the system.
Conclusion
Now, more than ever, it’s time to be skeptical about the way we live our daily lives. We have long been forced to take the risks associated with traditional financing due to a lack of better financial systems. And as with any major structural change, friction and major drag is to be expected. After all, despite being a multi-trillion dollar problem, the United States financial system is also a trillion dollar market opportunity that could shrink significantly if crypto and other decentralized frameworks were implemented. TLDR: Traditional finance is not going down without a fight.
That said, it’s up to us to protect ourselves, and the first step we can take towards financial freedom is education – do your best to learn more about what’s at stake while supporting those around you makes aware. If you want to go fast, go alone. If you want to go far, go together.
