Why traditional finance needs a full reset – Part 4 (Role of Commercial Banks)

In the last 3 articles, I discussed how fiat currency, central banks, reserve currency have made the existing financial ecosystem unfair, arbitrary, fragile & unsustainable. In the last article of this series, I will discuss the role of commercial banks in making traditional finance corrupt & toxic. Let’s dive in..

Bank business model

Banks obtain license from the Central Bank to collect deposits from savers and lend that money to borrowers. Collecting deposits increases liabilities for the bank (bank pays money to its depositors in future) and lending capital creates assets for the bank (bank receives money from its lenders in future). To understand how a bank operates, we first need to intuitively understand the business model of a bank.

Let’s take an example to understand how bank makes money. Bank ‘A’ obtains a license from Central Bank – Central Bank asks Bank ‘A’ to deposit a capital of 100$ as ‘reserves’ to get a license. Central Bank will keep this 100$ as a ‘stability fund’ – incase Bank ‘A’ cannot pay back its depositors, Central Bank A will use these reserves to pay back depositors.

Bank assets and liabilities (a simplistic view)

Let’s say Bank ‘A’ borrows money at 6% (ie Bank agrees to pay its depositors 6% on their savings account) and lends money at 10%. Let’s say Bank raised 1000 $ in deposits & lends 800$ to interested borrowers. Bank receives a net revenue of $20 (800*10% – 1000*6%) – since bank has locked up 100$ of its own capital as ‘reserves’ with Central Bank, return on equity for bank is 20% (20$ profit/100$ capital)

Return on Equity for Bank

How can a bank increase its profit? There are 2 ways to do this:

Increase the interest differential, ie either lend at a higher rate or borrow at a lower rate. If your lending rate is too high, you will stop getting high quality borrowers. You will end up with a pool of low quality (high risk) borrowers who could not get a loan from other banks offering a lower rate than you. Similarly, your borrowing rate cannot be too low. Savers will prefer other banks offering higher deposit rate than Bank A. So there is a limit to how much you control the interest differential

Increase the lending amount: If in our previous example, if we could borrow 2000 from the market & lend all 2000$ at the same interest rates, we end up with a net revenue of $80 (2000*10% – 2000*6%). Your return on equity jumps 4X from 20% to 80%. This would be wonderful news to bank’s shareholders, right? Well, not exactly. This is where the concept of ‘Leverage’ and ‘Credit Risk’ comes in.

Leverage & Credit Risk

To simplify, Leverage is the ratio of the amount you borrow v/s the amount you hold in your reserves. What you hold in reserves is your own capital whereas what you borrow is other’s capital. Leverage is the ratio of what you borrow and what you stake – higher the leverage, greater is the revenue.

Banks run a high leverage to remain profitable

But what about risk? Some percentage of loans provided by banks, regardless of the quality of borrowers, will go bad, ie. borrowers cannot repay the loan amount. In such cases, banks are exposed to default risk (also called ‘credit risk’)

Credit risk is an existential risk for every bank

Let’s go back to our previous example – suppose Bank A borrowed 2000$ as deposits and lends 2000$. Note that Bank A has only 100$ reserves held with the Central Bank. Now assume, 2% of the borrowers default on their loan and are unable to payback. Loss on capital for Bank A is 40$ (2000 * 2%) wiping out 40% of its reserves. Note that capital loss cannot go below $100 – Bank would be unable to meet its liabilities if all depositors want to withdraw at the same time (run on the bank).

2% credit risk (loss on loan book) can create a 40% loss on reserves because of 20X Leverage

Central Bank does not allow bank A’s reserves to fall below a particular level – this means that Central Bank controls the minimum capital held in reserves. Central Bank also imposes a ceiling on maximum leverage allowed – say a leverage limit of 10 means that for a 100$ reserve, Bank A can accept a maximum of 1000$ in deposits.

To summarize,

Leverage and risk go hand in hand, higher the leverage, higher the risk

Banks as money supply gateways

In the article on Central Banks, I mentioned how the Fed and other central banks mint new money and supply liquidity to banks. This is primarily done by buying assets from the banks (usually treasury bonds ) and supplying money in exchange. This money is then used by banks to lend to individuals and companies in the economy. Which brings us to an important point – money does nor enter the economy until it is mined by commercial banks.

Money is minded when someone borrows in the economy. Money is burnt when someone repays that money.

Crypto analogy

Crypto enthusiasts are aware of Proof-of-Work and Proof-of-Stake consensus protocols to mine new coins. In traditional finance system, bank mines new currency when it lends to an interested borrower.  Every time a borrower takes a loan, Bank A mines new currency (for which it has a license from Central Bank) and pumps that currency into the economy.  When the borrower repays the principal, this money is burnt by the bank and the money supply is reduced.

Commercial banks are the gateways to supply liquidity to the economy. Without commercial banks, a Central Bank cannot inject liquidity into the system. Financial system will collapse without bank distribution networks. By building a vast credit distribution networks that channel money supply from the Fed to real economy, banks have made themselves an indispensable pillar in the traditional financial ecosystem.

By actings as gateways of liquidity, Banks have made themselves indispensable in the financial ecosystem

Let’s see how banks are exploiting this status:

Government agents

US Government, thanks to its perennial deficit spending, needs to continuously auction treasury bills and treasury bonds. These are securities that allow United States treasury to borrow capital from public in exchange for a bond that pays back a coupon + principal for a fixed maturity.

These securities are considered ‘risk free’ because they are backed by the full credibility of Unites States taxpayers.

Federal debt funded by T-bills and T-bonds

Such large influx of treasury bonds into the markets  has created a money-making machine for banks called flow-trading. A bond flow trader continuously buys and sells treasuries for a small spread with absolutely zero risk. Bond Flow traders made hundreds of millions of dollars of ‘free money’ during the Quantitative Easing program of the Fed. To give a ball park estimate, even a 1 basis point spread on a QE (Quantitative Easing) of > 4 trillion USD since Covid19 gives a whopping 400 million $ of free money to banks . No wonder Flow Traders run away with mind boggling bonuses for adding very little value to the economy.

Even a small bid/ask spread would have lead to huge profits for banks during QE

It is easy for people to see the nexus – US treasury continuously issues bonds to fund its deficits, the Federal Reserve continuously prints unlimited money out of thin air to buy these bonds and release cash to the system, and the dutiful Banks which act as a vehicle to funnel this exchange, ie buy Bonds in the market and sell them to the Fed, thereby pocketing a neat bid/ask spread in the process.

Banks benefit every time there is money supply creation by the Fed and US treasury.

In the entire chain, none of the three, the federal reserve, the US treasury and the banks are adding even an ounce of value to the economy – but this enormous money printing and circulation is immensely benefiting these 3 parties at the expense of the broader economy.

The Derivatives monster

Fiat monetary system coupled with an unlimited money printing machine has created another uncontrollable monster called ‘Derivatives’. I started my career as a ‘quant’ building credit derivative pricing and risk models for the Development Bank of Singapore. I remember using complex Gaussian distributions & stochastic calculus to price these complex products. I was so excited with the complex math & coding that I really forgot to ask some fundamental questions – why do such products exist? Who needs them and how are they helping? Common FUD we got from senior traders (even they knew this was b*llsh^%) was that derivatives help in improving liquidity and enable better price discovery.

A quick look at the derivative trades gives us a clue about how this monster is unleashed in the current financial system.

Derivative notional across asset classes (Source: Bank of International Settlements)

Bank of International Settlements tells us that a total derivatives trade of 610 trillion USD in 2021. Mind numbing, unimaginably huge number – what is the purpose of so many trades when the underlying assets are not even a fraction of that. Let’s take an example of foreign exchange markets – total world goods and services traded in 2020 was US$ 22 trillion whereas the total forex derivatives traded were US$ 97.55 trillion, 4.5X more than the underlying.

Global trade of goods and services (Source: WTO)

Interest rate derivatives are another beast – a whopping 488 trillion USD worth of interest rate derivatives were traded while the entire world debt is $226 trillion (source : IMF).

What is the purpose of so much trading? Would forex derivatives even exist if world was on gold standard with fixed currency exchange rates. Amount of world’s capital deployed in derivatives to manage the inefficient floating exchange rate system is mind boggling.

Cost of maintaining this costly system includes an army of forex traders, trillions of capital, billions of dollars worth settlement & clearances, billions of dollars worth of blow-ups.

Fiat monetary system & banking infrastructure has created huge and complex ‘counterparty risks’. No bank knows the actual exposure from all derivatives it trades.

What is mind blowing is that all this trading adds zero value to the economy. There is no real production of value in this whole process….

Old, creaky settlement layers

Off late, SWIFT inter-bank messaging system was discussed in the mainstream media. US and other world powers kicked Russia out of the global payment settlement system SWIFT.  SWIFT is just a communication service with a set of standard codes that help global banks to communicate with each other regarding payments and settlements.  Apart from being centralized & controlled by a few stakeholders, this system is anything but ‘SWIFT’.

International payments often flow through multiple banks & need layered reconciliation. Core reconciliation software  is also pretty old, often deployed on mainframes running in COBOL or C. These softwares are extremely complex and the people who wrote them are no longer working. And mind you, these were days before GIT or source control existed.

Even though innovations have happened on the application layer, the base layer of settlements is extremely old and proprietary. Banks fear touching these base-level solutions.

A completely base level redesign of the concept of money, reconciliation & settlement rules is needed to make the systems efficient &. low-cost. (sounds like a pitch for Bitcoin, but it is what it is)

Conclusion

To conclude, Banks are effective rent-seekers who love the status-quo. In a symbiotic relationship with Central Banks and Governments, they have made themselves a critical cog in the financial wheel that is now ‘too big to fail’.

Effectively, Banks have become rent-seekers that stifle innovation by scaring people with terms such as ‘KYC’, ‘Money Laundering’, ‘Regulation’ etc.

By having the ultimate control of mining money in the traditional financial system, Banks are a prime reason why money is needlessly circulating without adding any value to the economy. Banks propagate ‘unsound money’ and have accelerated the growth (and the demise) of a fiat based monetary system.