Is a Government Backstop the Only Solution?

Over the past two months, a number of banks and financial institutions have collapsed worldwide – SVB, Signature, and Credit Suisse, to name a few. Governments and central banks have stepped in to backstop customer deposits, for these banks are viewed as ‘too big to fail’ and ‘pose a risk of systemic contagion to the economy.’

A common denominator in these failures has been poor risk management and a lack of transparency around deposit liabilities on banks’ balance sheets. The viability of the fractional reserve banking system has been called into question.

Bitcoin maximalists are predicting (and betting on) an inevitable and imminent demise of thousands of regional banks, causing a larger contagion.

This would leave central banks with two options:

1. Let the banks fail and cause catastrophic damage to the economy, or
2. Backstop deposits, save the banks and risk hyperinflation.

Even if central banks are able to walk the tightrope between the two options, commercial banks must find a new way to offer their depositors confidence in the balance sheet and solvency. DeFi may be part of this solution.

The case for reforming the fractional reserve banking system

The fractional reserve banking system is the most common banking model in the world.

Under this system, commercial banks only hold a small percentage of depositor liabilities in liquid reserves. They deploy capital from customer deposits to a variety of investment vehicles – T-bills, bonds, mortgages, and equities to receive higher returns. This is how they fund interest payments for depositors & generate profits.

Crucially, they must ensure they have sufficient liquidity to process withdrawal requests. They rely on statistical models to predict customer withdrawal and transfer volumes to determine how to invest the assets in their custody to offer the most competitive return & optimise profits.

However, if withdrawal requests exceed what their models predict – they have to borrow from the central bank or other commercial banks to meet their obligations.

This is actually a common, almost daily practice. There is an active market for interbank lending to ensure they can stay solvent. The issue arises in cases where a commercial bank’s balance sheet is not strong – they might not be able to borrow funds (especially when rates are high).

This is when the bank becomes insolvent. Further, the news or even hints of insolvency cause a run on these banks which exacerbates the issue.

Almost all of us, individuals and businesses, trust banks to safeguard our life savings & treasuries. Yet most of us are ignorant about our bank’s balance sheet and solvency.

Asymmetry of information between banks and depositors

At SVB, the bank had heavily invested depositors’ funds into bonds – $91 billion, according to the FT. As interest rates soared, these bonds were no longer worth $91 billion but $76 billion. SVB hadn’t intended to sell the bonds – until rumors of insolvency got out and panicked customers asked for their assets to be returned all on the same day, sparking a bank run.

The bank run on SVB and its subsequent collapse happened at an alarming speed. In the digital era, information spreads quickly. Combined with the speed at which money can be withdrawn, the perfect firestorm began.

As a result, SVB was forced to realize a $15 billion loss to access liquidity.

If the withdrawals had stayed within their risk model & interest rates came down within a medium-term period (as many expect – given the FED’s prerogative), SVB’s bond portfolio would have regained its value. The bank would have been solvent again.

What becomes clear is that banks have an incentive to maintain the asymmetry of information between themselves and their customers. “It is a feature – not a bug,” as we tech developers would say. Ignorance is what keeps customers from causing a run on the banks.

Centralization and private bank databases in fractional reserve banking further lead to opacity around the liabilities on banks’ balance sheets. Depositors need to rely on 3rd party auditors to get an understanding of the bank’s solvency, which happens on a quarterly basis. This 3-month lag creates room for existential uncertainty.

This asymmetry of information is a hallmark of the fractional reserve banking system. The question must be asked – with developments in DeFi, can a new system be created that can give the depositors real-time assurance of the solvency of their bank?

The backstop feeds the cycle

Financial markets have calmed recently with the US government’s backstop on the banking system.

Though the concept “too big to fail” is usually reserved for the largest financial institutions whose collapse would be disastrous for the entire economy. US authorities sent a signal to the world that even smaller banks are “too big to fail” when it propped up SVB. The bailout of SVB is estimated to cost $20bn.

To rescue these banks, the government needs to print more & increase the money supply, which in turn will drive inflation and push up interest rates even higher. As a result, banks will need rescuing again in the near future.

In order to address this issue, a commitment to stringent and effective auditing is necessary. This can improve transparency, risk management, accountability, and decision-making, ultimately helping to repair customer confidence in banking – let’s look at these in more detail.

Reducing information asymmetry through audits

Customer confidence has hit a low in the wake of the recent bank collapses. Reducing the asymmetry of information inherent within the fractional reserve banking system is necessary to repair trust in banking.

Commitment to stringent and effective auditing can improve a number of areas in banking, including:

1. Transparency: Auditability provides transparency and visibility into a bank’s financial transactions and operations, which helps to build trust with customers and stakeholders.
2. Risk Management: Effective auditing and monitoring of financial transactions can help identify potential risks and prevent fraudulent activities.
3. Accountability: Auditing provides a way to hold banks accountable for their financial decisions and actions, which is especially important given the significant impact that banks can have on the wider economy.
4. Decision-making: Audit reports provide valuable information for decision-making and strategic planning, both within the bank and for external stakeholders.

Current limitations of audits in banking

Auditing in the banking industry faces various limitations that hinder the process of ensuring transparency and accountability.

One of the main limitations is the lack of access to complete and accurate data on all their assets and liabilities. Gaining this data is time-consuming and expensive since it requires significant human resources to complete.

Within a centralized banking system, it is also easy to manipulate data, as seen in the Wells Fargo scandal in 2016. Employees at the bank had opened millions of fake accounts without customers’ consent so they could meet sales targets. The scandal resulted in a $185 million fine and raised questions about the bank’s internal auditing.

These limitations highlight the need for innovative solutions, such as DeFi protocols, to improve auditability and enhance transparency in the banking industry.

DeFi’s role in improving auditability for traditional financial institutions

Before we go into the details of what DeFi can bring to the banking system, it’s important to understand the core benefits of public blockchains, which is the infrastructure DeFi is built upon.

While the current banking system creates a strong asymmetry of information with the depositors and requires blind trust in how deposits are lent, blockchains are trustless and transparent.

Because blockchains are public ledgers, they provide transparent and open access to transaction data, recorded on the blockchain in a permanent and immutable manner. This transparency allows anyone to verify transactions, ensuring that there is no hidden manipulation or fraud. This is also why we say that these systems are trustless.

In contrast, traditional banking systems often lack transparency, with transactions being recorded and controlled by a central authority, creating information asymmetry and reducing trust.

In a utopian world where the entire banking system is built on blockchains, depositors will be able to view real-time reports around the distribution of assets and liabilities on a bank’s balance sheet.

Therefore, banks will be compelled to manage their risk more effectively to stop a bank run from the beginning since depositors can always view the bank’s financial state.

What DeFi and blockchain can do for the banking system

Now that we understand the core benefits that public blockchains can bring, the main question is: what types of assets should banks bring on-chain?

Tokenized assets

If the financial assets that banks hold are on-chain, customers can receive real-time reports on the distribution of reserves between cash and assets. Stakeholders can track the flow of funds and identify potential risks. Depositors could view them by using an explorer/ custom tool to inspect the blockchain. Tokenizing assets, such as securities or bonds, can also offer the following benefits for banks:

• Increased Liquidity: Tokenizing assets can potentially increase liquidity in the market by making them more easily tradable and transferable on blockchain-based marketplaces. Digital tokens representing securities or bonds can be traded peer-to-peer on a blockchain, eliminating intermediaries and reducing settlement times, which can enhance market efficiency and liquidity.
• Lower Costs: Tokenizing assets can potentially lower costs for banks by reducing the need for intermediaries, paperwork, and complex reconciliation processes. By leveraging blockchain’s transparency, programmability, and automation, banks can streamline the issuance, trading, and settlement of assets, resulting in cost savings in areas such as custody, clearing, and settlement.
• Enhanced Accessibility: Tokenizing assets can make investments more accessible to a wider range of investors. Digital tokens representing securities or bonds can be fractionally owned, allowing for smaller investment denominations and opening up investment opportunities to a broader investor base. This can democratize access to investments and potentially attract new investors to the market.
• Improved Auditability and Security: Tokenizing assets on a blockchain can enhance transparency and security. All transactions and transfers of digital tokens are recorded on the blockchain, providing an immutable and transparent audit trail. This can reduce the risk of fraud, improve trust among stakeholders, and enhance the overall security of asset transactions.

Tokenized liabilities – i.e. tokenized customer deposit claims

Tokenized liabilities refer to deposit claims against a licensed depository institution for stated amounts recorded on a blockchain. They are economic equivalents of existing deposits recorded in a novel form used to pay, settle trades between digital assets, and generally act as a store of value and means of exchange on blockchain ledgers.

Unlike stablecoins that are fully reserved and therefore bind up a lot of liquidity to fully back them, tokenized deposits can offer several benefits for banks and depositors:

• Improved Efficiency and Transparency:Tokenizing deposits can streamline the deposit process, reducing administrative overheads, and increasing transparency. Deposits represented as digital tokens on a blockchain can be easily transferred, verified, and settled in a more automated and efficient manner, reducing the need for manual processes, paperwork, and reconciliation.
• Enhanced Access to Capital: Banks can potentially leverage tokenized deposits as collateral for loans or other financial products, allowing them to access capital more efficiently. Tokenized deposits can provide a new source of collateral that can be verified, transferred, and traded on a blockchain, enabling banks to unlock liquidity from their deposit base.
• Access to Decentralized Finance (DeFi): Tokenized deposits on a public blockchain can potentially enable banks to participate in the growing ecosystem of decentralized finance (DeFi). Banks can leverage tokenized deposits to interact with DeFi protocols, earn interest, provide liquidity, and access a wide range of decentralized financial services, expanding their business opportunities.

If progress is made in tokenizing both – assets and liabilities, DeFi can complement the current model to improve transparency and auditability within the banking system.

DeFi could facilitate the reformation of banking (rather than a revolution)

To summarize, the recent bank collapses have led to questions about the viability of the fractional reserve banking system and the need for transparency and risk management.

Governments and central banks have been forced to step in with backstops, which have led to concerns about hyperinflation and a cycle of bailouts. One potential solution to address the asymmetry of information in banking and to rebuild customer confidence is to commit to effective auditing. However, there are limitations to auditing in the banking industry that need to be addressed.

Decentralized finance (DeFi) may also offer potential solutions to these problems, as it provides increased transparency and accountability. In reality, for progress to be made on this front, banks would need to start the arduous process of tokenizing all the different types of assets & liabilities that live on a bank’s balance sheet.

Antoine Scalia is the founder and CEO of Cryptio, which develops enterprise-grade accounting, audit and tax software for digital assets.

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• Source: https://thedefiant.io/how-defi-can-help-banks-manage-risk