Author: Marvin Barth Source: Coindesk Compiler: Shaw Golden Finance
We may be about to usher in a revolution in the field of monetary finance, which has been the dream of many famous economists for hundreds of years. Financial innovation is laying the foundation for this dream, and at the same time, the political and economic environment in the United States is changing to support this revolution. Once this revolution goes smoothly, it will have a significant impact on global finance, economic development, and geopolitics, and create many winners and losers. The transformation I am referring to is the "narrow bank" based on stablecoins.
The Origin of Fractional Reserve Banking
Our current financial system is built on the concept of fractional reserve banking. In the 13th and 14th centuries, Italian money houses and bankers began to realize that since depositors (rarely) would ask to withdraw their deposits at the same time, they only needed to hold a portion of the gold coins required for the deposits as reserves. This was not only more profitable, but also facilitated long-distance payments: Instead of transporting gold coins over dangerous roads, a member of the Medici family in Florence could simply write a letter to his agent in Venice instructing him to debit one account and deposit it in another.
While fractional reserve banking is lucrative and efficient in normal times, it has its drawbacks. Its inherent leverage makes the system unstable. An economic downturn can cause more depositors to withdraw their deposits at the same time, sparking rumors that the loans backed by the bank's deposits are about to default, leading to a bank run. Banks that cannot meet depositors' withdrawals will eventually go bankrupt. But under the fractional reserve system, more than just depositors' wealth is lost when a bank goes bankrupt. Because banks both generate credit and facilitate payments, economic activity is severely restricted when banks fail, as payments for goods and services are affected and loans cannot be obtained for new investment projects.
Governments have tried to fix their problems
Over the centuries, as banks became more leveraged and more important to the functioning of the economy, governments stepped in to try to reduce the risk of banking crises. In 1668, Sweden chartered its first central bank, the Riksbank, to lend to other banks experiencing runs. The Bank of England followed 26 years later. While this helped solve liquidity problems (those faced by banks with healthy assets but low cash), it did not prevent solvency crises (those faced by banks with bad loans). The United States created deposit insurance in 1933, designed to curb solvency-induced bank runs. But as many banking crises since then, including the 2008 U.S. subprime mortgage crisis, have shown, neither deposit insurance nor bank capital regulation address the inherent fragility of fractional reserve banking. Government intervention has simply reduced the frequency of crises and shifted their costs from depositors to taxpayers.
Economists Conceive a Better Solution
Around the time that Roosevelt’s administration introduced deposit insurance in the U.S., some of the then-leading economists at the University of Chicago were mulling a different solution: the so-called “Chicago Plan,” also known as “narrow banking.” The idea gained renewed traction among economists during the U.S. savings and loan crisis of the 1980s and 1990s.
Narrow banking solves the core problem of fractional reserve banking by separating the critical functions of payments and money creation from the function of credit creation. Many people believe that the central bank creates money, but in fractional reserve banking, that’s not the case: commercial banks are the money creators. The central bank manages the rate at which banks create money by regulating their access to reserves. But when banks make loans, they magically create deposits in the process, thereby creating money. This system and its chaotic deconstruction tied money growth to credit growth and, through the network effects of banks, to payments.
Split the Bank
The Chicago Plan separated the key functions of money creation and payments from credit activities by splitting banking functions into two. The “narrow” bank, which takes deposits and provides payment services, must fully back deposits on a one-to-one basis with safe instruments such as government bonds or central bank reserves. Think of this bank as a money market fund with a debit card. Lending is done by “broad” or “commercial” banks, which are financed with equity capital or long-term bonds and are therefore not subject to runs.
This segmentation of banking functions allows each function to be independent and non-interfering. Because the narrow bank is fully backed by high-quality assets (and central bank channels), it avoids runs. Narrow banking facilitates payments, and its safety removes risk from the payment system. Because money is no longer created by credit, bad lending decisions by commercial banks do not affect the money supply, deposits, or payments. Conversely, natural fluctuations in the economy's demand for money (boom or bust) and concerns about loan quality do not affect commercial bank lending because it is funded by long-term debt and equity.
Why Isn't This a Great Solution?
You might be asking yourself by now: "If narrow banking is so great, why don't we have it today?" The answer is twofold: the transition is painful, and the political and economic environment has never been supportive of legislative change.
Since narrow banking requires deposits to be 100% backed by Treasury bills or central bank reserves, a transition to narrow banking would require existing banks to either call in loans, thereby shrinking the money supply significantly, or to sell their loan portfolios to buy short-term government bonds if they can find non-bank buyers. Both of these actions would lead to a massive credit crunch, and a transition to narrow banking would create liquidity shortages and payment problems.
In terms of political economy, fractional reserve banking is highly profitable and creates a lot of jobs. Economists, by contrast, are a small group of people whose work is questionable. Anyone in Washington, DC will tell you that the American Bankers Association (ABA) is one of the most influential lobbying groups there. The same drama is going on in London, Brussels, Zurich, Tokyo, and elsewhere, but with different actors. So the continuation of fractional reserve banking is not a banking conspiracy, but simply because it makes political sense and is economically prudent.
Financial Innovation Meets Political Change
This may no longer be the case. Both the costs of transition and the political and economic environment have changed, especially in the United States. The development of decentralized finance (aka “DeFi” or “cryptocurrency”) and the simultaneous evolution of the US political economy, national interests, and financial structure have created conditions that make the US transition to a narrow banking system not only feasible, but increasingly, in my view, likely.
Over 90% of stablecoin transactions still involve on-ramps or DeFi transactions, but an increasing amount of transaction growth involves “real world” use. In countries with unstable local currencies such as Argentina, Nigeria, and Venezuela, person-to-person and business transactions have been the main source of growth, but one of the largest sources of growth has been the growing use of migrant workers in global remittances, which is estimated to account for more than a quarter of the total.
With the Help of Congress
As the Trump administration and the U.S. Congress move to institutionalize stablecoins, stablecoins are gaining acceptance and growth as an alternative payment system.
How do stablecoins maintain their value relative to a specific currency, such as the U.S. dollar? In theory, each stablecoin is pegged one-to-one to the currency to which it is anchored. In practice, this is not always the case. But U.S. lawmakers have defined what constitutes an acceptable high-quality liquid asset (HQLA), requiring a one-to-one peg and requiring regular audits to ensure compliance. Congress is thus creating the legal basis for entities that: (1) take deposits; (2) must fully back deposits with HQLA; and (3) facilitate payments in the economy.
Deja vu
Does this sound familiar? Isn’t that a “narrow bank”?
There are some missing pieces. Most notably, neither the GENIUS Act nor the STABLE Act grants stablecoin issuers access to the Fed, nor does it define stablecoins as taxable money. The lack of access to the Fed may reflect both necessary caution to avoid disrupting the fractional reserve banking system (too quickly) with direct competitors and lobbying by the American Bankers Association (ABA) to protect the banks’ monopoly. But even so, there are intriguing signs that the protection for banks may be temporary and only enough to transition to a narrow banking model: the HQLAs authorized for stablecoin issuers in both bills include access to the Fed’s reserves, which currently only banks have access to.
Shifting political winds
The Trump campaign’s turn to cryptocurrencies last year, and the push by both houses of Congress to normalize stablecoins, reflects a profound shift in the domestic political economy and its conception of the national interest. Bipartisan populist anger at banks and their relationship to Washington has lingered since the global financial crisis. The Fed’s quantitative easing and recent inflation policy mistakes have exacerbated populist anger. This is as much a part of the cryptocurrency phenomenon as FOMO.
But cryptocurrencies have also created enormous new wealth and business opportunities, creating a well-funded rival to the American Bankers Association (ABA). Even institutional asset managers are now at odds with their traditional banking allies and salivating over opportunities in the DeFi space. The combination of a popular base and economic strength is creating a political and economic environment that supports narrow banking for the first time.
New Financial Architecture
New Financial Architecture
The United States’ shift to narrow banking based on stablecoins will have huge economic, geopolitical, and financial implications. It will produce significant winners and losers both domestically and globally.
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