The Banking System vs. Bitcoin

In a recent conversation with a friend, he referred to the U.S. banking crisis, and to that, I had to say, “Which one?”

I genuinely did not know whether he was referring to the 2008-2009 Great Financial Crisis or the recent U.S. banking crisis (which doesn’t seem to have an official name yet).

The recent U.S. banking crisis involving Silicon Valley Bank, Signature Bank, and Silvergate Bank is still playing out. There are some key differences between the Great Financial Crisis. But they are both indeed banking crises.

Silicon Valley Bank was the 16th largest U.S. bank by assets (with approximately $200 billion). The recent banking crisis is not just contained to the U.S. Credit Suisse was stressed to the point that regulators orchestrated a weekend buyout of the bank, with significant government guarantees provided to the buyer (UBS) as part of the deal.

The scale of this latest banking crisis is thus far smaller than the Great Financial Crisis. But even so, it raises certain questions when you witness a top 20 U.S. bank find itself a victim of a bank run or a global systemically important bank (G-SIB) with over 1 trillion Swiss francs in assets in need of finding a (government-supported) buyer on a weekend.

It leads one to ask: why do banking crises continue to happen? Why do they continue to happen despite assurances from the people supposedly tasked with ensuring they don’t happen? After all, in 2017, Janet Yellen (now somewhat famously) said she does not believe there will be another financial crisis in our lifetimes. Additionally, why is it that a crisis can happen to a bank so quickly? Why is it that a bank can appear healthy and safe one day, and then, just weeks or days later, the bank’s solvency is in question, or it has failed? Why don’t non-bank corporations experience this same type of immediate onset of a crisis? What could be a real solution to address these continued crises?

These may even lead you to ask deeper questions regarding whether the goal of the Federal Reserve and any financial regulator is their stated goal. If you pretend for a moment that their actual goal is “to keep those with control over money in control,” do their actions begin to make more sense?

Let’s do a brief post-mortem of how and why the recent/current U.S. banking crisis happened, specifically focusing on Silicon Valley Bank (SVB). This will by no means be an exhaustive review of what happened, as these types of situations can be analyzed for years on end if one really wants to. But this summary should provide a broad picture of what happened.

The first thing to keep in mind is that in the current financial system, your money is not actually sitting in a bank, nor do you really own it.

When you deposit your money in a bank, the bank lends it out in various ways, primarily via loans and securities such as corporate loans, real estate loans, treasuries, mortgage-backed securities, municipal bonds, etc. The bank only holds a small portion of cash on reserve. The loans and securities become the bank’s assets, and your deposit becomes the bank’s liability to you. When you “deposit money into the bank,” it is more accurate to say that you “lent money to the bank.”

When a bank operates this way, it is counting on two things: 1) that a significant amount of their depositors do not withdraw funds at the same time, and 2) to the extent that depositors do withdraw assets, the bank believes it holds enough in high-quality liquid securities which can be sold to satisfy the withdrawals without calling into question the solvency of the bank.

Silicon Valley Bank did a poor job managing both of the above items.

On #1, their customers, on average, were substantial in size, which led to more risk on the deposit side. If a bank has 100 customers with $1,000 in deposits each, that would be significantly more risky on the deposit side than a bank with 1,000 customers with $100 in deposits each. This is especially true when you consider the fact that in the U.S., we have FDIC deposit insurance up to $250k, which means that customers are less likely to withdraw deposits that are < $250k from any FDIC-insured bank, while customers are more likely to withdraw deposits that are < $250k if they believe a bank’s solvency is in question. SVB had a concentrated deposit base and a significant percentage of uninsured deposits (i.e., above $250k).

On #2, the majority of assets owned by SVB were a mix of cash, treasuries, municipal bonds, mortgage-backed securities, commercial and industrial loans, and real estate mortgage loans. When interest rates rise, as they did in 2022 at one of the fastest paces in history, the prices of fixed-income securities go down. This means that the fixed-income securities SVB loaded up on in 2020-2021 — when rates were very low — were now trading at much lower prices (perhaps SVB actually believed the Fed’s dot plots in 2021 which implied that interest rates wouldn’t rise materially, until 2023 or 2024. The price decline due to interest rate increases is not an issue if you can hold the securities to maturity (assuming the securities' issuers can pay back the bond’s principal).

But when you have depositors asking for their money immediately, you cannot wait years for treasuries/mortgage-backed securities to mature/pay down. SVB also owned loans, which are far harder to value at any given time, given they do not trade in as liquid and observable of a market as treasuries or mortgage-backed securities do. We now know that First Citizens Bancshares acquired SVB’s $72 billion of loans at a 23% discount. This means that wherever SVB’s loans were valued on their own books was likely not a realistic level where they could have sold the loans to other buyers if they needed to sell. And when you have depositors pulling billions of dollars, that certainly counts as a situation where you need to sell. 

SVB and the FDIC eventually saw that there was going to be no way SVB would be able to survive the combination of:

1. Depositors withdraw funds from the bank by the billions in a matter of days.

2. Securities held by SVB are trading at significant losses.

3. Loans held by SVB likely being marked down significantly if they had to be sold to another buyer. 

If the process were allowed to play out, eventually, SVB would have sold all its assets and would have run out of funds needed to satisfy depositor withdrawals. 

Once there is an obvious banking happening involving bank runs and bank failures, everyone, of course, agrees there is a problem. However, how people believe the problem can be solved and avoided in the future differs wildly.

The proposed solutions can generally be grouped into the following buckets:

A. The same system but more regulation — proponents believe the current banking system is generally okay but that we just need to tweak our regulatory framework, create more regulatory bodies, and appoint better regulators to oversee and manage the system.

B. A new system with near complete government control — proponents want retail bank accounts to be replaced by accounts held directly with the Federal Reserve. Your bank deposit is no longer a liability of a commercial ban. It is now a liability of the Federal Reserve, which can never have a bank run because it can always create more new units of money. This is effectively a Fed money or Central Bank Digital Currency system.

C. Bitcoin — proponents want to disconnect the government, the banks, and human judgment entirely from the process of “backing money,” determining the supply of money, and the cost of borrowing money. They instead want to replace it with a finite, supply, self-custodial monetary asset that can be easily and cheaply held, sent, and verified from peer-to-peer without banks or governments.

Here is a short analysis of options A, B, C: 

There are three primary risks associated with money: 

1. Risk of nominal loss of funds (due to loan defaults / bank mismanagement / bank runs)

2. Risf of debasement of funds through inflation of the money

3. Risk of censorship of being able to use the money for desired purposes

Proposed solution (A) is essentially our current financial system. It leaves you exposed to all three risks. 

Proposed solution (B) is a new system with complete government control. It leaves you exposed to risks #2 and #3. Crucially, the only reason this system can protect you from #1 is by engaging in and exacerbating risk #2, inflation and debasement. And you don’t need to be a hardcore libertarian to acknowledge that the risk of censorship increases materially if the system is entirely controlled by a centralized government.

Proposed solution © is Bitcoin. It is the only proposed solution that addresses all three risks. When you hold Bitcoin, you actually own the asset rather than having a liability that is (hopefully) backed by a bank’s loans and other securities. With Bitcoin, the nominal value of your Bitcoin cannot “go poof” due to loan defaults, interest rate rises, or bank runs. Bitcoin’s supply is finite, so it cannot be debased. And Bitcoin is far less likely to be censored than any system where banks and/or governments are the gatekeepers because there is no single party in control of which transactions get approved or rejected.

To be fair, Bitcoin still involves the risk of theft and loss, but this is a risk that comes with owning anything, regardless of whether it is monetary, non-monetary, physical, or digital.

While it stands to reason that Bitcoin is the only option that actually addresses the issues plaguing our system, the reality is the current system is quite entrenched. It is unlikely that the current system can or will migrate to either of the alternatives described in B or C above. It is far more likely that, in the near term, the “solutions” will come in the form of tweaks to the current system.

One of the likely outcomes in the U.S. banking system will become more consolidated and centralized. There was already a trend towards consolidating small banks into bigger banks, and the recent baking crisis will accelerate that. Based on the response thus far to the crisis, there is now effectively a two-tiered banking system in the U.S. Large banks with tons of treasuries and mortgage-backed securities can now pledge those securities at par to the Fed for a loan if they need it (this is the BTFP — Bank Term Funding Program).

Banks with other assets, such as corporate or real estate loans, cannot do this. If this policy is left in place, large banks will be seen as a relatively safe place to put deposits compared to small banks, where deposits have a more realistic shot of being lost in a bank run.

It’s also worth noting that without option C (Bitcoin), there is a difference of opinion about whether fractional reserve circulation credit should or will exist on top of Bitcoin. In other words, there is total agreement within the Bitcoin community that Bitcoin as a base layer monetary asset should and will be fixed in supply. However, within the Bitcoin community, some people believe there should be or will be a fractional reserve circulation credit on top of Bitcoin. And some think that this is a good thing. Recall that fractional reserve circulation credit is the equivalent of creating new units of money out of thin air when loans are made. So to believe that this is a good thing, one must think of some version of “we need to create new units of money out of thin air to achieve economic growth. I am firmly against this line of thinking. If you are interested in reading more about this topic, please see this piece initially published in Swan Private Insight.

Continuing on the topic of fractional reserve circulation credit on Bitcoin, there are two separate questions: should and will fractionally reserve circulation credit ever exist on top of Bitcoin, as alluded to in the prior paragraph? The article linked above mainly addresses the question of whether fractional reserve circulation credit exists on top of Bitcoin. Whether a fractional reserve circulation credit will ever exist on top of Bitcoin is worth an article on its own. However, for now, if self-custodial base money can be held, sent, or verified easily and cheaply, it removes nearly all of the reasons and incentives that led to fractional reserve circulation credit becoming so dominant in our current system. Ask yourself the following question:

“If precious metals could have been held, sent, or verified easily and cheaply, how many market participants would have said, “I don’t want the gold or silver. Give me fractional reserve bank credit money instead”?

Regarding the proposed solution B above, a CBDC, there are additional critical outstanding questions: Who will control the money supply? When will it increase? Who will be the recipients of the new money?

The short answer is bound to be… “the 'experts, ' of course!”

If you want to hear firsthand someone who is a proponent of solution B above, I would encourage you to listen to the podcast episode of Odd Lots from March 23rd with Saule Omarova as the guest.

As background, Saule Omarova is an academic and public policy advisor. In 2021, she was the Biden Administration’s nominee to head the Office of the Comptroller of the Currency (OCC). Omarova’s nomination was eventually withdrawn after significant Congressional opposition.

Here are a few snippets: 

• Co-host Tracy Alloways asked what happens with deposit rates in the Fed money/CBDC system, which Omarova described and promoted. 

Omarova’s answer: “one of the beauties and opportunities that this system offers is that ‘rate on various deposits can be established in a much more tailored, more finely managed way depending on a variety of public policy needs by the Fed.’

• Alloway asks if rates might differ for individuals and companies.

Omarova: yes, “if that makes sense. For example, if a particular occurrence or dynamic in the economy may necessitate channeling more liquidity into a particular sector of the economy by increasing the rate on deposits.”

• And it’s not just about centrally manipulating interest rates. Omarova clearly states that the outright sending of new units of money to certain groups would be part of such a system: 

Omarova: “If the need is, in a pandemic, to send money to low-income families, that can be done much faster and much more easily.”

It only takes a little imagination to see how those in power might start to use (i.e., weaponize and exploit) this type of system for their own political or financial gain.

But I do believe such a system can potentially lead to good outcomes. All we need is for the “experts” managing the system to be both omnipotent and benevolent. That’s all.

Answering this question could be an article or a book of its own. But for now, I’ll say that I believe the biggest reasons for pushback against Bitcoin are its non-state nature and its fixed supply. 

Many people in traditional finance, academia, the media, and the government believe strongly in these two flawed narratives: 

1. “Managing the currency and monetary system must be done by the state.”

2. “Creating new units of money is necessary to achieve economic growth.”

If you believe these narratives, option C (Bitcoin) is off the table. You are left debating how the new money should be created, who should create it, and who should receive it. This is, unfortunately, the current Overton window for mainstream debates on the monetary system. It is often a tactic of those in power to allow for discussion within a narrow Overton window to give the appearance of free-thinking, whereas the reality is that free thinking outside the window is not permitted.  

“The smart way to keep people passive and obedient is to strictly limit the spectrum of acceptable opinion but allow very lively debate within that spectrum…” - Noam Chomsky

Bitcoiners do not wish to debate how new money should be created, who should create it, and who should receive it. But instead, Bitcoiners reject such a system entirely. Thank goodness Bitcoiners can think for themselves and see past the artificially constructed limits of mainstream debates.