Crypto, Fractional Reserve Banking, and Home Loans

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As a result of the recent run of bank failures, fractional reserve banking (FRB) has been a hot topic of late. In case you aren’t familiar with the term, FRB is the system in which banks are required to hold only a portion of their customers’ deposits as reserves, while the rest can be lent out to borrowers or used for other investments. This is the basis for most modern banking systems and plays a critical role in facilitating economic growth by enabling the expansion of credit and promoting investment.

But as we’ve all just witnessed with banks like Credit Suisse and Silicon Valley Bank, FRB also has some inherent risks and drawbacks. One significant concern is the potential for bank runs, where a large number of depositors simultaneously attempt to withdraw their funds, fearing the bank’s insolvency. Since banks only hold a fraction of their deposits in reserve, they may not have enough liquid assets to meet all withdrawal demands, leading to a loss of confidence in the system and potential economic instability.

So why do we have FRB in the first place? Part of the answer could be that it emerged as a result of certain limitations of our financial system. A system that requires banks as trusted intermediaries to custody our funds and process transactions. But now that the advent of crypto has made it possible for us to no longer have to use trusted third parties, the question is, do we still need fractional reserve banking?

While many crypto supporters see FRB as anathema to their worldview, I don’t think we can have a properly functioning modern society without it. Again, one of the major benefits of FRB is that it enables the expansion of credit and facilitates greater economic activity.

But there is also the question of what would happen if the entire world suddenly stopped using fiat money, which is inflationary, and replaced it with a fixed supply cryptocurrency like eCash? Some believe that if the purchasing power of a currency is going to only increase over time, no one will ever use that currency. Instead, holders will become hoarders, wanting to hang onto their coins as long as possible. This is basically Gresham’s law at work. The idea that good money will drive out bad, because everyone will want to keep their good money, while getting rid of their bad money. But there must come a point when there is only good money left, and the hoarding will have to end. The question is, will people be willing to put their money to work, or hold their coins until they die? Many think the latter, because why would you let go of an asset that will only continue to increase in purchasing power over time? But I disagree. I think there are plenty of reasons why someone might choose to invest or lend their coins rather than merely hoarding them.

Whether it’s to diversify risk across different asset classes rather than hanging onto a single currency, to seek higher returns by investing in new businesses, real estate or other assets, or to generate passive income in the form of interest payments or invest in projects that align with one’s personal interests such as helping the environment, I don’t see crypto leading to the end of credit, though it may change the face of it.

Something we must consider is that simply expanding the credit supply doesn’t automatically guarantee everyone benefits. We’ve seen how an extended period of 0% interest and the easy money policies it creates can lead to negative side effects such as increased malinvestment and even predatory lending practices. Excessive credit can also lead to rising prices that are both irrational and unsustainable and can have severe consequences on the greater economy. I believe that many of the economic problems we are facing today, as well as the usual boom and bust cycles we’ve experienced throughout history, is because we’ve had no choice but to rely on a money that is inferior, unsound, and centrally planned.

But by fixing our money, by empowering the people to no longer be forced to rely on banks and other financial institutions, we can instead force the institutions to compete for our trust and our deposits. This will create an environment where the banks that will succeed are the ones that perform their proper due diligence and generate yield, not through Ponzi schemes, but by investing in sound individuals and businesses deemed creditworthy.

The bottom line is I’m not concerned that a world that runs on cryptocurrencies will mean the end of FRB. Whether it’s to diversify their assets, generate passive income, or invest in businesses seeking a higher return, there will always be people looking to contribute to innovation and growth, as well as individuals who may not always be driven by a profit motive but are looking to lend their capital to projects that align with their values.

Now let’s take a look at a specific example where fractional reserve banking plays a big role in our lives: home loans. Without FRB, many would be unable to secure the capital to purchase their own home. And indeed, the global adoption of crypto could have a huge impact on how home loans will work in the future.

For example, interest rates in a fixed-supply cryptocurrency environment might be higher due to the potential for deflation, incentivizing people to hold onto their assets rather than lend them. Lenders would need to be compensated with higher interest rates to encourage them to provide loans. They may also need to adopt more stringent risk management practices. This could include diversifying their loan portfolio, adjusting loan-to-value ratios, and actively monitoring the value of the collateral to ensure they are protected in case of borrower default. Compare such policies to the conditions that led to the 2008 global financial crisis, where banks acted as enablers and encouraged people to buy more house than they could afford. Under a new crypto paradigm, homes would arguably be purchased more responsibly leading to a healthier and more stable real estate market.

In addition, cryptocurrencies could also radically change the home loan industry by leveraging their technological capabilities. For example, in a cryptocurrency-based system, peer-to-peer lending platforms could gain prominence. Borrowers and lenders could transact directly without the need for traditional banks as intermediaries. Smart contracts could be employed to facilitate the loan agreement, ensuring that the repayment terms, interest rates, and collateral requirements are automatically enforced.

The traditional way we assess an individual’s credit may no longer be applicable in this new paradigm. Alternative methods of assessing creditworthiness, such as analyzing transaction history on the blockchain or using decentralized identity solutions, could be used to determine a borrower’s ability to repay the loan.

Cryptocurrencies would also make it possible to tokenize real estate and enable fractional ownership, allowing multiple investors to collectively finance a property. Borrowers could purchase a fraction of a property with their loan amount and gradually acquire more ownership over time.

In summary, home loans in a financial system running on a fixed-supply cryptocurrency would likely be very different from the model we have today that could potentially have huge benefits to society.

In much the same way, I believe crypto can have a similar effect on fractional reserve banking. For example, one of the major criticisms of traditional banking is the lack of transparency. Banks have historically maintained a high degree of secrecy, leading to concerns about trust and systemic risk. Cryptocurrencies, however, possess a decentralized, transparent ledger called the blockchain. By integrating blockchain technology into the fractional reserve banking system, banks can make their reserve holdings publicly accessible, fostering increased trust and confidence among depositors.

Cryptocurrencies also reduce counterparty risk and settlement times. Transactions no longer have to involve multiple intermediaries, which adds complexity, cost, and time to the process. Cryptocurrencies enable direct, peer-to-peer transactions with no need for a middleman so fractional reserve banks can streamline transactions and lower counterparty risk.

Finally, one of the most significant benefits of cryptocurrencies is their potential to increase financial inclusion. With a large number of unbanked and underbanked populations worldwide, cryptocurrencies offer a viable alternative to traditional banking systems. By integrating crypto-based services into fractional reserve banking, banks can extend their reach to previously underserved communities, promoting financial inclusion and driving economic growth.

In conclusion, cryptocurrencies and blockchain technology continue to mature and gain widespread adoption, the potential for transforming fractional reserve banking becomes increasingly apparent. Using cryptocurrencies, fractional reserve banks can evolve to offer greater transparency, reduced counterparty risk, more efficiency, and increased financial inclusion.