Privacy & Security

Banks Will Soon Be Obsolete

Last week, social networking giant Facebook announced that it plans to create what it calls an “alternative financial system” based on a cryptocurrency called the Libra. The crypto will be backed by a basket of currencies to keep its value stable.

Pundits immediately pronounced that the Libra could represent the beginning of the end for traditional banking. But while Facebook’s plunge into this space is the most ambitious effort by a Fortune 500 company to profit from the crypto market, the company hasn’t exactly done a stellar job of protecting user data. That makes me skeptical of its ability to safeguard your money.

Last October, Facebook announced that hackers had compromised more than 30 million accounts by taking advantage of vulnerabilities that have now been patched. A month later, researchers uncovered a vulnerability in Facebook Messenger that hackers could use to reveal the identity of the people with whom you exchanged messages. And who can forget the seemingly innocent quizzes that were used to gain access to 50 million Facebook accounts in an effort to affect the outcome of the 2016 presidential election?

It’s one thing to load photos of your cat doing stupid tricks onto your Facebook account. It’s quite another to trust the company with your money. Although Facebook says that Libra’s governance model will ensure “separation between social and financial data,” I suspect Libra will appeal mainly to people who don’t have bank accounts and have no practical way to open them. Facebook cited a figure of 1.7 billion adults in this category, with nearly half of them living in Bangladesh, China, India, Indonesia, Mexico, Nigeria, and Pakistan.

Still, the launch of the Libra is a proverbial shot across the bow for the banking industry. And it couldn’t come too soon.

Our global financial system is built on the flawed foundation of a poorly understood concept called fractional reserve banking.

Five hundred years ago, if you owned valuables you didn’t want to store at home, you could keep them in a secure warehouse. You gave the warehouse-keeper a sealed bag and received a receipt for it. You paid the warehouse-keeper a fee for keeping the bag safe. So long as the warehouse-keeper didn’t run off with your valuables or let someone else steal them, your wealth was secure.

Not all depositors, however, insisted on receiving the same bag of valuables back from the warehouse-keeper. They were satisfied to receive back equivalent value. Depositors could now use the receipts warehouse-keepers issued as a medium of exchange.

Warehouse-keepers soon realized that not every receipt would likely be redeemed simultaneously. So they began lending out a fractional reserve of the stored valuables in exchange for interest payments. In this manner, warehouse-keepers evolved into interest-charging fractional-reserve banks.

The biggest risk of fractional reserve banking is, of course, the “bank run.” If a bank lends out too much of the funds on reserve and everyone wants their money at once, the bank won’t be able to pay everyone. Deposit insurance schemes evolved in the 20th century to shield bank customers from this possibility. As a result, bank customers in most countries treat their deposits, including those that are uninsured, as if they’re 100% backed by actual reserves.

Then came the 2013 Cyprus financial crisis and the collapse of the country’s banking system. In exchange for a €10 billion bailout from the European Central Bank, Cyprus agreed to force uninsured depositors to submit to a “bail-in.” Instead of getting their money back, depositors holding uninsured accounts that exceeded €100,000 received stock in the failed bank. Uninsured depositors at the worst-capitalized bank that failed lost all their money.

Bank regulators around the world quickly took notice, and by the end of 2014, decided to extend the bail-in model worldwide. Deposits in banks that are “too big to fail” will be “promptly recapitalized” with their “unsecured debt.” This avoids the taxpayer-funded bailouts that proved so politically unpopular during the 2008–2009 financial crisis.

And the largest chunk of unsecured debt is your bank deposits. Insolvent banks will recapitalize themselves by converting your deposits into stock.

Historically, in return for the risk you take by exchanging your hard-earned money for an IOU (and now, the threat of a bail-in), fractional reserve banks paid you interest. Three decades ago, for instance, you could earn 4% or more annually in a domestic passbook savings account.

Those days are long gone. You’d be hard-pressed to find a domestic bank that pays more than 0.5% on ordinary checking or savings accounts or a little more than 2% for a certificate of deposit. Indeed, many banks outside the US offer negative interest rates to customers. In effect, you’re paying the bank to lend out your money.

In other words, in return for very paltry interest (or even negative) payments, your bank lends out the money you deposit in your bank account for whatever purpose the bank (and the agencies that regulate it) deems acceptable. And if the bank makes enough mistakes, your savings could be bailed in.

Facebook’s Libra won’t fundamentally change this system, because customer deposits will be stored at traditional fractional-reserve banks. But many other organizations already offer alternatives to traditional banking. And if you look hard enough, you can often bypass banks altogether. Need a loan? You no longer need to go to a bank to borrow money; peer-to-peer services such as Lending Club instantly match borrowers with investors with money to lend. Need to make or receive payments without a bank account? You can use Bitcoin or other cryptos to do that; Libra will just be one more.

Indeed, an avalanche of product launches to woo depositors away from banks is coming. Management consultancy Bain & Company predicts that a banking service from Amazon could gain 70 million customer accounts within five years after launch. That would give it the market clout of Wells Fargo, America’s third-largest bank. Not to mention the rapidly growing market penetration of e-commerce platforms like Apple Pay and Google Wallet.

Facebook, Amazon, Google, and Apple haven’t exactly done a great job of protecting user data. But traditional banks aren’t doing much better – a recent study from security consultancy Positive Technologies revealed that more than half of banks with an online presence allow fraudulent transactions and theft of funds. But security is likely to gradually improve, and the tech giants will provide much-needed competition for what was for many years an effective payments monopoly by fractional reserve banks.

I look forward to the day when the fractional reserve banking system takes its last breath. If you’re tired of dealing with soaring banking fees, stifling compliance requirements, or the threat of “de-risking,” you have reason to smile. In the not-too-distant future, banks will be obsolete.

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