Can Fractionalized Banking Survive 21st Century Technology?
Every bank lives in fear of a bank run. No matter how profitable, a bank engaging in fractionalized banking can be brought down by a bank run. As Caitlin Long told Ash Bennington on Real Vision, “Every bank has the proverbial sword of Damocles hanging over the head. That if there's a rumor of a bank run, now we know within hours, the bank could go down. That's not new, that's always been there. What's new is that it's just sped up because of phones.” What took weeks in the case of Washington Mutual less than two decades ago, took just hours in the cases of Silicon Valley Bank, Signature Bank and First Republic.
Ms. Long is attempting to disrupt the banking and crypto worlds with Custodia Bank in her native Wyoming. She is a Wall Street veteran, graduate of Harvard Law School and is jousting with the Kansas City Fed to obtain a Fed master account.
What she knows is as the world has gone from paper to digits “bank runs clearly are speeding up. And the impact of that is it's revealing that the traditional banking system-- it's always been fundamentally unstable. But it's even more unstable than folks had realized. And banks in general, as a result of the fact that the liabilities can be withdrawn a lot faster, are going to need to hold more cash.”
Murray Rothbard warned decades ago that fractionalized banking was fraudulent and unstable. Bankers are, as Long describes, “playing this three card monte game of, well, I'll tell everybody that they can have their deposits back on demand. But I only keep seven cents of the deposits in cash. So if more than 7% of the demand deposits get withdrawn in a short period of time, I'm in trouble. And that's exactly what happened to all the banks that failed.”
Responding to Long’s comments, Bennington made the point that today’s bank runs are not your grandpa’s. “I mean this is a really fundamental critique that you've just leveled right now against fractional reserve banking, against the current structure of liquidity transformation, as it's called in the business. This idea that basically the banking system that we have is no longer fit or suited for the 21st century. That is a profound critique of where we are today.”
Depositors are moving money to the large too-big-to-fail banks, but as Long explains, “the deposits at the cash at the large banks is only about 10 cents. So the Delta, if you will, between the smaller banks is seven cents versus 10 cents at the larger banks, you're not getting that much more safety, because the large banks aren't sitting on that much more cash than the smaller banks are. It's fundamentally an issue of fractional reserve banking to your point. I think this is just going to continue to haunt the regulators in the coming years.”
She believes regulators will “be playing Whack a Mole against this, because everybody has an expectation of internet speed user experience. And as they try to push everybody back to a bank run, talk to a 20 year old-- a 20 year old has never been in a bank run and never written a check.”
The solution in Long’s mind are specialized payment banks or gateway banks that handle these payments, but cannot lend and have to hold 100% of their cash on deposit at the Fed. That's the solution. Matt Levine wrote for Bloomberg Opinion about narrow bank TNB USA Inc. that received a provisional banking charter in Connecticut and set itself up as a bank to do what Long describes. But, when TNB went to the Fed in 2017 asking to open a reserve account, the Fed said no. TNB has sued the Fed, arguing that the Fed’s rules require it to open an account for any qualified bank, and that it is a qualified bank. TNB is mystified about why the Fed said no, but it apparently went all the way to the top: The New York Fed declined the account “reportedly at the specific direction of the Board’s Chairman,” Jerome Powell. The Fed has not said what its objection is.
Stijn Van Nieuwerburgh, the Earle W. Kazis and Benjamin Schore professor of real estate at Columbia Business School, who by the way believes banks are severely under capitalized based upon decreased asset values, told Mr. Bennington in another Real Vision interview that regulators may have to allow banks to slow depositors from being able to withdraw demand deposits for certain amounts of time when banks are under stress. That was known as a bank holiday which FDR instituted when he took office in 1933.
Of course the creation of the FDIC was to stop all the bank holiday nonsense. However, the deposit insurer is having trouble keeping up with skittish tech savvy depositors armed with cell phones who will move funds first and ask questions later. “Capital controls for demand deposit withdrawals is something that is freaking people out,” Bennington said, responding to Van Nieuwerburgh.
If Scott Rechler’s prediction comes true lots of people will be freaking out. The chief executive officer of real estate giant RXR and a Federal Reserve Bank of New York board member says 500 to 1,000 smaller banks could disappear because of insolvency or consolidation.
Gavriel Kahane, a managing partner at Arkhouse Fund, wondered on a Zoom call, writes Patrick Clark, “If lenders can hold on long enough for borrowers to find their next mortgage. The problem comes when lenders are forced to realize current values. In other words, when they stop pretending and can’t keep extending. ‘What happens then is really scary,’ he says.”
Scary indeed, because depositors are one click away from running.
