Banks are one of the engines of the modern economy, but the way they work is under threat.
Tech-payment giants and digital currencies are revolutionizing how people use money. And this could have dramatic consequences far beyond banking.
It could affect consumer privacy, government power, and the stability of the entire financial system.
It is difficult to overstate sort of how radically different that world could be from the one that we live in now.
So what would a world without banks look like, and would you even miss them?
The fundamental principles of banking have been the same for centuries and revolve around the greatest magic trick of all – how to create money. It’s called Fractional Reserve Banking.
Here is how it started.
Hundreds of years ago, banks stored gold for investors. But they realized it was unlikely everyone would claim their gold back at the same time. So they began to loan some of these gold deposits out to other people.
This made money for the bank through interest and helped power the economy by allowing idle deposits to fuel new business and trade.
As time went on, the banks started issuing bank notes or IOUs – rather than physically giving out gold. And these IOUs started being traded in the economy. This meant the amount of money in circulation was much larger than the value of the gold held by the banks. So the banks lending had in effect created new money.
Nowadays, most money is digital. When the bank makes a loan it creates a new asset on its balance sheet and credits the borrower’s account with new funds which creates a new deposit.
The fundamental principle is the same. Every time the bank makes a new loan, it creates new money. In fact, 90% of money in the world is digital deposits that have been created by banks in this way. This is hugely important for the economy.
What it means is that banks are able to respond to demands for money in an economy. That means that the supply of money in the economy is very elastic.
There is no set amount of money in circulation so if the economy is booming and more goods are being created then thanks to fractional reserve banking the supply of money should also increase as people take out loans and make new investments.
The ease with which commercial banks can create money is largely controlled by central banks like the Federal Reserve, which set interest rates. If interest rates are high, banks pass those costs onto borrowers.
This makes it more expensive for them to borrow money to buy things and so banks create less new money. Central banks also supply money for use in the economy. They print the physical paper, cash people carry around and so banks and central banks balance the need to create money between them.
That sort of balance means that money can grow easily with demand but also the central bank has sort of a direct presence in payments and transactions.
But this delicate balance is under threat thanks to a revolution in the way people use money.
For a start, an increasing number of businesses no longer rely on banks for loan. This is because businesses, historically used to create concrete assets – like machinery, against which banks were happy to lend. They could always claim the assets if the borrower stop repaying.
But intangible assets like software can’t easily be posted as security for a bank loan. The world has shifted in a way that does makes it harder for banks to fund the sort of most innovative parts of the economy.
If you want to get funding as a Silicon Valley startup, in general you will need to go to people who are equity investors so they take a slice of your business in return for some money.
And it is not just innovative startups that are turning elsewhere for funding. Since the 1950s the share of bank loans as a percentage of GDP has been relatively stable. At the same time, non-bank loans and securities have risen sharply.
This means the role banks play in financing important businesses is receding. That’s not all. The way people move and spend their money is changing too – thanks in part to a new class of mega-apps from China.
One of the most popular is Alipay from Chinese tech giant Ant Group. It has over a billion users and handled $16 Trillion Dollars in payments in 2019. Rather than using bank cards to make payments, Alipay customers carry out transactions by loading money into digital wallets. They can then do anything from buying lunch to investing in stocks and shares – all without leaving the app.
And rather than paying expensive international transaction fees to their bank, Alipay users can also use the app overseas. We are already seeing this even in America, Walgreens in the States accept Alipay. This, sort of, new digital payments ecosystem sort of completely disregards nation states and national borders.
It’s not just Alipay, Facebook is developing its own digital currency and Amazon is also working on financial services. Some worry this could concentrate too much power in the hands of a few tech companies.
But, for central bankers, the problem is even more acute. They fear these developments could cut the cord between the central bank and the economy altogether.
The super apps in China, they started off just doing payments and now they do provision of loans, they do provision of investment services, and they provide insurance. They do all the things that banks do.
Central bankers feel as though their, sort of, ability to oversee and conduct monetary policy and oversight is fundamentally slipping away.
So some central banks have taken radical action by creating their own digital currencies to rival the tech giants payment systems in the hope this will secure their grasp on the economy.
Central bankers level of discomfort is potentially prompting them to act in changing this economy system, the monetary system that has underpinned modern economies for 250 years.
China is one of the largest economies leading the way by trialing a digital yuan. You might have heard of Bitcoin or rather digital money that is supposed to disrupt finance. But digital currencies issued by governments in this way might be even more radical.
Here’s how it works.
Most central-bank money is held by commercial banks as reserves against customer deposits. You can only access a small amount of this government made money via physical notes and coins as this physical cash is issued by the central bank. In the U.K., bank notes are even signed by the Chief Cashier of the Bank of England.
A central bank digital currency – or CBDC – is a bit like digital cash as it gives the consumer a direct relationship with the central bank. So in theory, instead of keeping your money in a commercial bank, you can hold all your money in the Federal Reserve or the Bank of England. CBDCs are only being used or trialed in a handful of countries worldwide, but they are growing fast. 80% of central banks are considering issuing them in the future.
The Bank for International Settlements which is a club of central bankers, says that within three years, a fifth of the world will live in countries that have this central-bank digital money.
This could change everything, if everyone put their money into a CBDC, then fractional reserve banks could potentially be out of a job. This could effect economic growth as they could not rely on consumer deposits to finance their loans.
And this would be particularly pronounced in the developing world where most lending still comes from banks. But that’s just the beginning.
There are also concerns about potentially cyber-warfare. Because if you can take down the servers that support the central bank digital-wallet system, then you could shut down an entire economy.
Digital currencies could also increase the potential for state intervention in everyday transactions. It becomes much easier for governments to completely block your ability to pay for something. It’s very easy to imagine perhaps you could program money in China so that it can’t be used to pay for books or newspaper from foreign sellers.
Supporters of CBDCs claim they could lead to a world where more people have access to financial services and its cheaper and easier to move money across borders. But innovations like this, could also disrupt the financial equilibrium and give governments far greater control over their citizens money and lives.
Although it’s possible for the first time in modern history to imagine a world without banks, you might just find that you would miss them if they were gone.