When HRH Queen Elizabeth famously said during the height of the financial crisis in 2008 “If these things were so large, how come everyone missed them?”, an honest reply would have been “because banks have been around for so long that we see them as the inviolable heart of the financial system — even though it’s crazy for money, and the payments system, to be provided by highly leveraged institutions, whose weaknesses are simply patched up each time there’s a new crisis!” If HRH asked the same question today, she could be told that blockchain technology has now developed to the point where we can still have pounds and dollars and euros, but no longer need them to be built on the shaky foundation of multiple credit expansion by banks.
Early banks operated with what in modern parlance would be called a 100% ratio of (largely unsubscribed) capital to deposits. In other words, the shareholders had an unlimited liability to protect depositors. If bad loans on the asset side of a bank’s balance sheets were so large as to swamp the subscribed equity and thus threaten to make it unable to repay their depositors, then the poor shareholders were on the hook to put in sufficient extra capital to make sure that the depositors were whole. The classic example was Sir Walter Scott, the Scottish novelist, who held bank shares (as a trustee for someone else) and had to write many extra books to pay the money owed to depositors when the bank’s loans went bad.
This arrangement was marvellous for protecting depositors, but didn’t exactly encourage people to subscribe for equity capital in banks, nor did it inspire bank mangers to take too many risks in the loans that they made. In short, it wasn’t a good arrangement for providing the growth in money and credit needed as the UK moved into an accelerating industrial revolution in the second half of the nineteenth century, with the US, Germany and others keen to follow. That was when limited liability companies were introduced, both for industrial entities and for banks.
Limited liability is often seen as one of, if not the, crucial building blocks that allowed the explosion of capitalist development in the western world. So far as industrial and commercial companies are concerned that seems fair, but for banks, it was just a patch-up. How on earth could limited liability for a bank be reconciled with the idea that bank deposits were money — by far the largest class of money in the whole economy — a money that could just get wiped out if domino bankruptcies in real-economy companies caused catastrophic losses to banks?
The solution, of course, was another patch-up: the invention of modern central banks. They took on a trio of responsibilities to make the patch up work: first, imposing rules about the minimum capital banks had to hold; second, trying to smooth out the credit cycle so that loan losses didn’t get bad enough to exhaust that capital buffer; and third, acting as a lender of last resort if it did get used up. It was a kind of public-private partnership, the central banks not providing an explicit full underwriting of potential losses, but nevertheless taking responsibility for any that might become systemic.
The 2008-9 financial crisis reminded us just how unstable this system was, and it could be argued that the jury is still out on whether we have really escaped from that. The central banks did indeed underwrite the banks, and did indeed stimulate the credit cycle, and tightened up the capital rules.
But tightening capital rules is just another patch-up that brings its own problems. The UK has ring-fenced the domestic operations of its banks into retail units that hold low-risk assets and high capital. Inevitably, this low-profitability model chokes off competition, often hitting smaller businesses and troubled individuals with high charges. New “challenger banks” were meant to address this but their failure to gain much traction in such an unattractive business area is hardly surprising. Australia has entrenched much the same model. None of this should be surprising: when you have a system that is fundamentally unfit for purpose, each regulatory or structural change that addresses one problem simply throws up another.
And now, we have a new technology that offers an escape. The functions of money creation, payments systems and major credit provider, currently bundled together in the banks, can now be separated. The patch-up can be replaced with a brand new system that is designed from bottom up to fulfil the functions needed for a modern economy. Stablecoins fully backed by CBDC will take over the role of money currently played by bank deposits. Public blockchains like Ethereum will take over the payments systems currently operated by banks — and throw in automated stock, derivatives and commodities markets, and much else. And the credit provision function of banks can be partly left with them (funded by bond issues rather than deposits) and partly migrated to carefully regulated decentralised loan markets on public blockchains. The muddled conflation of functions in highly leveraged entities that led to HRH’s question will be eliminated.
All this is great. There is just one problem: how do we get there from here? Orchestrating a stable transition that sees bank deposits and loans being run down, at least in relative terms, while stablecoins and decentralised lending grow, will be difficult. So much so that until recently, central bankers have shied away from contemplating it.
But as the new technology has gathered momentum, and started to take on a life of its own, not just with cryptocurrencies but now also with rapid growth in stablecoins, the decision point has suddenly become much nearer. Central banks and governments have to decide whether they are going to embrace the new technology, with its promise of a new system that is not only much cheaper, quicker and more secure than the present, but also eliminates the inherent instability of a system built on money that sits on the liability side of highly leveraged bank balance sheets — and accept the challenge of making that very difficult transition. Or, they have to try to freeze it out and stop it — a task that itself brings deep inherent risks, as the public becomes more familiar with the new technology and starts to find ways round any barriers to its use.