Banks are a crucial component of the modern economy. They facilitate financial transactions, provide loans, and create new money through fractional reserve banking. However, the traditional way of banking is facing challenges and disruption from the emergence of new technologies, payment platforms, and digital currencies.
The Transformative Impact of Digital Payment Giants and Cryptocurrencies on the Future of Banking
Digital payment giants and cryptocurrencies are transforming how people use money, and this revolution could have significant consequences far beyond the banking industry. The shift could impact consumer privacy, government power, and the stability of the entire financial system. As a result, it is worth considering what a world without banks would look like and whether we would even miss them.
For centuries, the fundamental principles of banking have revolved around the greatest magic trick of all – how to create money. Fractional reserve banking is the system used by banks to create new money. It began when banks stored gold for investors hundreds of years ago. They realized it was unlikely that everyone would claim their gold back at the same time, so they started loaning some of the gold deposits out to other people. This helped the bank earn interest and helped power the economy by allowing idle deposits to fuel new business and trade.
Fractional Reserve Banking: The Magic Trick of Creating Money and the Shift to Digital Deposits
Over time, banks began issuing banknotes or IOUs, rather than physically giving out gold. These IOUs started being traded in the economy, meaning the amount of money in circulation was much larger than the value of the gold held by the banks. As a result, the banks’ lending had created new money. Today, most money is digital, and when a bank makes a loan, it creates a new asset on its balance sheet and credits the borrower’s account with new funds, creating a new deposit. The fundamental principle is the same, and 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.
The ability of commercial banks to create money is crucial for the economy as it means banks can respond to demands for money in an economy, and that means 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, making 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 by printing the physical paper cash people carry around. Therefore, banks and central banks balance the need to create money between them.
The Shifting Role of Banks in Financing Business Growth in the Digital Age
The role of banks in financing important businesses is receding as an increasing number of businesses no longer rely on banks for loans. 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 stopped repaying. However, intangible assets like software cannot easily be posted as security for a bank loan. Therefore, if you want to get funding as a Silicon Valley startup, you’ll need to go to people who are equity investors, so they take a slice of your business in return for some money.
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 $16tn 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. This new digital payments ecosystem disregards nation-states and national borders, making it easier for people to transfer money and conduct transactions across the world.
The Threat of Tech Giants and Super Apps to the Power of Central Banks in the Global Economy
Facebook is also developing its own digital currency, and Amazon is working on financial services. Some worry that this could concentrate too much power in the hands of a few tech companies, while central bankers fear that these developments could cut the cord between the central bank and the economy altogether. The super apps in China started off just doing payments, and now they offer provision of loans, investment services, and insurance, providing all the services that banks do. Central bankers feel as though their ability to oversee and conduct monetary policy and oversight is fundamentally slipping away.
To address these concerns, some central banks have taken radical action by creating their own digital currencies to rival the tech giants’ payment systems, in the hope of securing their grasp on the economy. A central bank digital currency (CBDC) gives the consumer a direct relationship with the central bank, similar to digital cash. In theory, instead of keeping your money in a commercial bank, you could hold all your money in the Federal Reserve or the Bank of England.
The Rise of Central Bank Digital Currencies and Their Potential to Transform the Banking Industry
CBDCs are only being used or trialed in a handful of countries worldwide, but they’re growing fast. 80% of central banks are considering issuing them in the future, and 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. If everyone put their money into a CBDC, fractional reserve banks could potentially be out of a job, which could impact economic growth as they could not rely on consumer deposits to finance their loans.
There are also concerns about the potential for cyber-warfare, as if the servers that support the central bank digital-wallet system were taken down, it 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, and it’s easy to imagine that money in China could be programmed so that it can’t be used to pay for books or newspapers from foreign sellers.
Supporters of CBDCs claim they could lead to a world where more people have access to financial services, and it’s cheaper and easier to move money across borders. However, innovations like this could also disrupt the traditional banking system, and it is unclear what impact they will have on the global economy.
In conclusion, banks are one of the engines of the modern economy, but their traditional way of operating is under threat from tech-payment giants and digital currencies. The emergence of new technologies and payment platforms is transforming the way people use money, and this could have significant consequences far beyond the banking industry. A world without banks may be possible, but it would radically transform the economy and the way we conduct financial transactions. Central banks and commercial banks must adapt to the changing landscape and work to strike a balance between innovation and stability to ensure the long-term health of the financial system.