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Safe banking and fractional reserve banking

This post originally appeared on ZeMing M. Gao’s website, and we republished with permission from the author. Read the full piece here.

Caitlin Long has criticized the leveraged banking system. I think her criticism is spot on.

But as to the ‘safe bank’ solution Caitlin advocates, it is debatable.

At the same time, ‘over-capitalization’ is probably an oversimplistic criticism of the safe bank model. Yes you can call the safe bank ‘overcapitalized’, but who is to decide? The options today range from the 100% capitalization of the safe bank model to the 3-10% capitalization of the existing banks. That’s a really large gap. Yet strangely, there is nothing in between, not because people cannot conceptualize anything in between, but because the two models are based on entirely different business models that go diametrically different extreme directions.

It should be left to the market and economics to decide. But the trouble is the current regulatory framework does not even give a chance for the safe bank solution to compete. It would only be fair if the government allows both types of banks to operate, and, instead of giving preferential deposit guarantees to leveraged banking (and God forbid even bailout!), make the rules uniform and let the free market decide. Specifically, layout the benefits and risks to both kinds of banks, and let the depositors decide.

Banking regulation is necessary

However, that does not mean there should be no regulations. Banking must be regulated, for otherwise it opens the gates for all kind of frauds. For one thing, totally unregulated banking would mean that all kinds of investment fund raising can be done under the disguise of banking.

Just consider this scenario: Fraudster has this investment idea, say, buying BTC using other people’s money. He can’t simply advertise his idea to the capital market to raise money because that would come under the scrutiny of securities law. So he sets up a bank to attract deposits. And he commits to ‘100% capitalization’ of his bank and promises not to do any fractional reserve lending, because he doesn’t lend money to others but only uses all deposits to buy BTC.

This sounds safe because he’s not as greedy as other bankers who leverages the deposits, right?

Of course not. Fraudster is not a bank in this scenario. What he’s doing is illegal fundraising.

As shown in the above example, the level of capitalization is only one thing, but how the deposits are deployed and managed is a whole other thing.

Banking regulations are therefore necessary. They just need to be fair. Currently, the problem is not that there are banking regulations, but that the rules are not fair.

The alternative

However, my theory is that ultimately neither type of bank is the ideal solution. Nor is anything linear in between.

What we need is an entirely different kind of financing framework.

To the economy, the most important function of fractional reserve banking is the availability and liquidity of funding to economic activities especially business activities. This is a lubrication of the modern economy. Current banks do a good job in providing this function, but at a huge cost.

The cost is a very fundamental one: with the modern banking system, payment and credit intermediation are mixed and both carried out through the same institution, the banks. As a result people can’t make payments unless they have a bank account held at the bank that is allowed to perform leveraged financial functions by providing credit intermediation.

As the current banking crisis has indicated, this model can be so fundamentally unstable that it may even be a fatal flaw that would inevitably cause an ultimate (albeit timed) collapse of the entire financial system and the economy.

On the other hand, going with a 100% capitalized bank maybe safer, but could make the banking insufficient in providing enough lubrication to the economy.

The solution is a true credit-based community money system.

Yes, it is going to be credit-based, for otherwise you cannot solve the liquidity/lubrication problem, but not bank credit, nor credit card credit. The banking credit system always involves an interested third party to be the key decision-maker.

The credit should be direct credits extended between related business parties. Like the proverbial village baker who issues a private redeemable note to neighbors and needs to have actual goods (bakery) to back up the note he issues.

Of course, the modern economy is far more sophisticated than a village economy. But the village baker’s note is the kind of money that is based on real credit which in turn is based on actual productivity, which in turn is evaluated according to a community standard and consensus. The operative standard for offering and accepting credits is established through market and economic forces that are operative on the firsthand economic participants, rather than decided by a third party who has an interest to overleverage the system.

Combined with a scalable public blockchain like the genuine Bitcoin (BSV), the payment and the credit intermediation can be separate, removing the most dangerous contradiction in the modern banking system.

It is also within this framework that the new truth-based Triple Entry Accounting will be helpful.

All this touches upon the essence of Bitcoin as originally invented (but perverted by BTC). See BTC and Bitcoin are fundamentally different. The genuine Bitcoin will succeed first in payment, but will use its programmability and contract automation to extend to a real productivity-supported credit-based monetary system.

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