Overview Overview
This article will discuss the shortcomings of the commercial banking system and the dead end of DeFi.
Report report
Report report
Flaws in the Commercial Banking System
A commercial bank is a product of the market economy, and it is a financial organization formed to meet the needs of the development of the market economy and socialized mass production. After hundreds of years of development and evolution, commercial banks have now become the most important fund collection and distribution institutions in the economic activities of various countries in the world, and their influence on economic activities ranks first among various banks and non-bank financial institutions in various countries. Commercial banks are special financial enterprises that aim at maximizing profits and can provide customers with a variety of financial services. Profit is the basic premise for the establishment and operation of commercial banks, and also the internal driving force for the development of commercial banks. The profit model of commercial banks is actually very simple. First, they absorb deposits and then issue loans from these deposits.
However, if calculated in this way, the amount of the loan should be less than the amount of the deposit. But in fact, banks can lend far more than they can get deposits. The total US money supply in August 2020 was $18.412 trillion, however, total credit market debt (Q2 2020) was $77.61 trillion, or 4.215 times the total money supply. Regardless of the amount of money in circulation, 4.215 times of it was used for loan origination in the United States. Of course, all of this money is not held as deposits in banks, but based on accounting rules, all of this money shows up as "deposits" in people's accounts. So loans have to be made on the basis of these deposits. If banks are allowed to take out 90% of their deposits as loans, then 90% of the $18,412 billion that can be issued in the US = $16.57 trillion. But the US accounts show a total debt of $77.61 trillion. Hence my use of the term "banking system flaws". Rather, the "fractional reserve system" itself is flawed.
Disadvantages of the fractional reserve system
banknotes
digital currency
digital currency
Please note that the digital currency here is not a digital currency such as Bitcoin and Ethereum, but a currency that exists in the banking system in digital form. It is the emergence of this digital currency that makes "the banking system have excess funds." This is the result of a banking rule known as fractional reserve banking. Under this rule, banks can hold a portion of deposits, say 10%, as reserves, and then issue the remaining 90% as loans.
On the face of it, this is normal practice for banks. Simply put, this rule allows banks to use our deposits to provide loans to those in need. Their reasoning is that money (our deposits) sits idle in the bank anyway. Therefore, they will use it for the following purposes: lend money to those who need it, the bank can earn a profit (interest on the loan), and the depositor (us) can also earn interest on the deposit, which seems to be a win-win situation.
But the thing is, that's only one side of the story. Few people talk about the flaws of fractional-reserve banking.
Flaw 1: Because the people who made this rule are not saints, they introduced this rule to simplify the loan process. The more money banks lend out, the more interest they earn (the bank's source of income), and this rule actually serves the bank's benefit. Let's make an analogy:
Suppose a bank has $100,000 in deposits. Under the fractional reserve requirement system for banks, banks are required to keep 10% as reserves. The bank can lend 90% of $100,000, or $90,000. Assuming an interest rate of 7.5% per annum the bank can earn $6,750 out of $90,000. This is the second defect of the fractional reserve system: the ability to resist runs is extremely poor. Under this rule, banks can lend up to $900,000 on deposits of up to $100,000. But we think only $90,000 can be used as a loan. Annual income of $90,000 is $6750. Likewise, 7.5% of $900,000 in revenue would be $67,500 per year. By introducing fractional reserve requirements, the bank's income increased tenfold. That's why all the banks in the world follow this model.
And the biggest danger with this model is a bank run. A bank run is when depositors try to withdraw cash, but the bank is unable to provide it. This happens when the bank does not have enough cash to pay all depositors. But under the fractional reserve model, banks are much less resistant to runs than under the traditional model.
Let's take an example:
If we want to see what happens when the money supply collapses, it looks like this:
Demand deposits (savings + demand): 52.13 trillion yuan.
Time deposits (FD/RD): 89.59 trillion yuan.
Total deposits: 141.72 trillion yuan
The total amount of bills issued by the People's Bank of China: 8 trillion yuan.
Cash in the economy is only 8 trillion yuan, while deposits are 141.72 trillion yuan, that is, deposits are 17.715 times that of cash.
All deposits exceeding 8 trillion yuan are digital currencies. So it's safe to say that if all depositors wanted to withdraw their cash, the bank would fail. In addition, the Bank of China holds no more than 10% cash, which means that out of the 141.72 trillion deposits, only 14.72 trillion is cash available in bank lockers. Even if 1% of depositors were willing to withdraw cash, banks would need 1.472 trillion in cash to pay. The bank doesn't even have that much cash. This also explains why the financial reserve banking system is so risky. All on the assumption that more people won't need to cash out at the same point in time. This assumption is not biased. But its flaw is the number of times digital currency has grown compared to cash.
A bank is a financial institution licensed to accept deposits and make loans. Please pay attention to the order here - the deposit should come before the loan. But that's not how banks work today. They have begun to function like typical "private business organizations". They make money by making loans to the public, not by taking deposits, printing money, etc. That's why the focus of the banks has become "making more and more loans". That's why all the time we get crazy calls from banks asking for loans, credit cards, and more.
However, all loans must be backed by some deposit. However:
China's total deposits: 203.7481 trillion yuan.
Total debt repayment by banks: 231.1681 trillion yuan.
Debt to deposit ratio = 1.13
Let's assume that 1.13 is the maximum ratio the PBOC wants to maintain at all times. But in the process of making more and more loans, our banks are making 10% more loans than they are doing now. As a result, the loan amount soared from RMB 23,116.81 million to RMB 25,428.49 million. Now, the loan-to-deposit ratio will rise above 1.13. Banks must raise deposit levels from 203.7481 trillion yuan to 225.03 trillion yuan. If banks want to raise the RRR, they can borrow money from the People's Bank of China. The PBOC can lend to banks in two ways:
First: Banks can make more and more loans
Like our previous example of reserves, this is how money is made out of debt in modern society.
Second: Use a more traditional way of making money, with the People's Bank of China printing banknotes
Banks can make loans like crazy, and the People's Bank of China can print money directly. The main flaw in our banking system today is easy money. The root cause is the fractional reserve system.
Did you find out, no matter what, they can generate money out of thin air, and you can only earn the money penny by penny, adding value guarantee to the money, but have you ever thought about it, why would you do this Woolen cloth?
Drawbacks of printing money
Of course, I am not saying that the central bank is deliberately destroying the financial system. The morality of the Chinese central bank is beyond doubt. But the question is, what is the value of the banknotes printed by the People's Bank of China? Banknote A piece of paper with numbers written on it. Credit guarantees from the People's Bank of China and the Chinese government give us confidence that these numbers have value. Valuations are primarily based on trust. Before explaining, let me give a simple example.
If you want a personal loan of 400,000 yuan, the following facts will be verified:
Income level: assuming 100,000 yuan per month.
Assets: For example, a property worth 500,000 yuan.
This person can easily get a loan of 400,000 yuan because his income level is enough to meet the monthly repayments. In addition, there are backups of assets. If something goes wrong, the bank can seize the property. So the thing is, when we plan for liabilities, there's a lot of cross-checking. But when the People's Bank of China takes on debt (every banknote it issues is its debt), is there a fact-check? I don't think so. That's why I say paper money is too easy to print in our flawed banking system.
Let's take a look at the assets and income levels of Chinese banking institutions:
Banking industry assets in the second quarter of 2020: 309.41 trillion yuan
Banking liabilities in the second quarter of 2020: 283.93 trillion yuan
Debt Ratio = 91.76%
An ordinary person with a small income has assets worth 1 million yuan. In the case of a mortgage, what is the maximum loan this person can get? Let’s say 80% of the property’s value ($800,000). Using the same analogy, a bank with 33.04 trillion in assets can cover 80% of 33.04 trillion in liabilities (26.432 trillion). But how much debt has the Chinese banking sector taken on? Are financial institutions facing such a debt ratio really not at all dangerous? The simplest question, think about it, if you apply for a mortgage loan from the bank, can you lend 91.76% of the cash?
The Current Situation and the Significance of Diversification
What we're seeing here is really worrying. We work to make money. We use money to buy goods and services. In exchange for money, other people also give us their goods and services. But why would people agree to sell their goods in exchange for money? Because they think money has value. If our currency suddenly devalued (as happened in Zimbabwe), we would not be able to buy any goods and services. This is called currency devaluation.
Our current banking system is flawed because it allows our currency to depreciate over time. The reason is not just inflation. A bigger evil is the way banks make loans (fractional reserve banking). As a normal human being, we cannot fully rely on our banking system. It is imperative to diversify our investments: stock and debt based investments are examples of currency based securities, while real estate, gold, etc. are all hard assets. One must always keep diversified investments, so digital currencies (BTC, ETH) are a good choice.
DeFi's dead end
The flaws in the banking system make us think and seek a better banking system. However, DeFi has gone to another extreme-extremely conservative over-collateralized loans. At present, there are generally pledged lending platforms on the market, and the pledge rate is between 40% and 70%. However, the market's demand for loans cannot be met by mortgage loans. Especially when DeFi is still in its initial stage, the ever-increasing amount of funds can not only solve the marginal cost problem, but also is the key to enabling DeFi to survive until ETH2.0 goes online.
The example of the real economy makes it easy to understand: prosperity exists when the economy operates at a high level of capacity. In other words, a boom occurs when demand exceeds existing capacity levels. At this time, businesses have good profits and unemployment is low. The longer these conditions persist, the greater the increase in capacity and the greater the demand for credit. In an economy without credit, the growth of demand is constrained by the growth of production. This reduces the occurrence of boom-bust cycles, but it also reduces the efficiency of high prosperity and severe deleveraging. Credit is like the lubricant of a car. With it, the car can perform at its best.
However, DeFi still cannot solve these two problems: 1. Over-issued currency. 2. Generate credit.
The inability to generate credit is due to accountability issues and moral hazard issues. Because of the anonymity of the chain, after the credit is issued, because the individual cannot be traced, and because the cost of default is low, the moral hazard of the borrower's default is extremely high, which is why over-collateralized loans are popular.
Conclusion
risk warning:
risk warning:
Be vigilant against illegal financial activities under the banner of blockchain and new technologies. The standard consensus resolutely resists various illegal activities such as illegal fundraising, network pyramid schemes, ICO and various variants, and dissemination of bad information using blockchain.
