Beyond the Brink: Why Fixing Banking Requires More Than Just Stronger Walls

The Unsettling Déjà Vu of Modern Banking

In the world of finance, history doesn’t just rhyme; it often repeats with alarming precision. The recent tremors that shook the banking sector, sending giants like Silicon Valley Bank and Credit Suisse into a tailspin, have once again thrust a familiar debate into the spotlight: are our banks safe? The typical response from regulators and policymakers is a call for stricter rules and, most commonly, higher capital ratios. The logic seems sound—force banks to hold more capital as a buffer against losses, and the system becomes more resilient.

But what if this focus is a dangerous distraction? What if we’re meticulously reinforcing the walls of a house built on an inherently unstable foundation? A recent letter to the Financial Times by Kaleem Mirza succinctly captures this contrarian view, arguing that the endless “tweaks to capital ratios” miss the fundamental flaw at the heart of modern banking. The problem isn’t just the size of the buffer; it’s the very mechanism by which banks operate and create money.

This post delves into that provocative idea. We’ll explore why the conventional wisdom about bank safety might be flawed, unpack the controversial concept of money creation “ex nihilo” (out of nothing), and examine how the rise of fintech and blockchain technologies isn’t just a disruption, but a direct challenge to the banking world’s century-old paradigm.

The Capital Ratio Comfort Blanket: A False Sense of Security?

First, let’s demystify the regulators’ favorite tool: the capital ratio. In simple terms, a bank’s capital ratio measures its core equity capital against its risk-weighted assets. Think of it as the bank’s own money on the line compared to the loans and investments it has made. Regulations like the Basel III framework are designed to ensure this ratio is high enough to absorb unexpected losses without collapsing or requiring a taxpayer bailout.

On the surface, this makes perfect sense. A well-capitalized bank is a safer bank. However, this perspective treats the symptoms, not the disease. The core issue, as Mirza points out, is the fractional-reserve banking system itself. This system allows banks to lend out far more money than they hold in actual customer deposits. Focusing solely on capital ratios is like arguing about the thickness of a dam’s wall while ignoring the immense and volatile pressure of the water behind it. The system is designed for leverage, and leverage creates inherent fragility.

The 2008 financial crisis was a brutal lesson in this. Many banks that collapsed had capital ratios that were considered adequate by the standards of the day. The problem was that the “risk-weighting” of their assets was catastrophically wrong, and a sudden loss of confidence created a liquidity crisis that no capital buffer could withstand. The system’s fundamental architecture, not just its regulatory trim, was the point of failure. Beyond the Grid: What the FT Crossword Reveals About Mastering Modern Finance

The Alchemist’s Secret: How Banks Create Money “Ex Nihilo”

The most profound and often misunderstood aspect of modern economics is how money is created. Most people assume that banks act as simple intermediaries, taking in deposits from savers and lending them out to borrowers. This is a convenient fiction. The reality, as confirmed by central banks like the Bank of England, is that commercial banks create the vast majority of money in the economy when they make loans.

When you take out a mortgage, the bank doesn’t pull cash from its vault. It simply credits your account with the loan amount, creating a new digital deposit—and thus, new money—out of thin air. The loan is an asset for the bank, and the new deposit is a liability. This “ex nihilo” creation is the engine of economic growth, enabling investment and consumption on a massive scale. But it’s also a system built on confidence.

This model leads to a stark paradox that Mirza highlights: profits are privatized, but losses are socialized. During boom times, banks and their shareholders reap enormous rewards from the credit they create. When the cycle turns and bad loans cascade through the system, the risk of collapse becomes systemic, threatening the entire economy. At this point, governments and central banks are forced to step in with bailouts and liquidity support, effectively socializing the losses across the taxpaying public. It’s a game of heads-we-win, tails-you-lose, played with the stability of the global financial system.

The Digital Rebellion: Fintech, Stablecoins, and the Quest for Stability

For decades, there was no viable alternative to the established banking system. Today, that is no longer the case. The rise of financial technology is not just about slicker apps and lower fees; it’s a fundamental challenge to the banking monolith. More specifically, technologies built on the blockchain are presenting a radically different model for what money and finance could be.

Consider the concept of a fully-reserved stablecoin. Unlike a bank deposit, which is an IOU from a highly leveraged institution, a 100% asset-backed stablecoin (in its ideal form) is a digital token representing a direct claim on a real-world asset, like a dollar held in a treasury bill. There is no fractional-reserving, no “ex nihilo” creation. Every digital dollar is backed by a real dollar of safe, liquid assets. This offers a level of transparency and solvency that the traditional banking system simply cannot match. The rapid growth of the stablecoin market, which has ballooned to over $125 billion, signals a clear public appetite for more trustworthy digital money.

This shift represents a move towards what is known as “full-reserve banking,” an idea championed by economists for nearly a century but long dismissed as impractical. In this model, institutions that take deposits would be required to hold 100% reserves, completely separating the safe-keeping of money from the risky business of lending.

To clarify the distinction, here is a comparison between the two models:

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Imagining a New Financial Architecture

A transition to a financial system with full-reserve principles would be revolutionary. It could eliminate the need for deposit insurance and taxpayer-funded bailouts, ending the moral hazard that encourages excessive risk-taking in the stock market and beyond. Financial crises, while not entirely preventable, would likely become less frequent and far less severe.

However, the challenges would be immense. The most pressing question is: if banks can no longer create money through lending, where will the credit to fuel the economy come from? The answer lies in separating the monetary function of banking (safekeeping deposits) from its credit function (lending). Lending would have to be financed by investors—through peer-to-peer platforms, loanable funds, and other capital market instruments—who knowingly accept the risks in return for potential rewards. This would be a more transparent and perhaps more stable form of investing and credit allocation.

Central Bank Digital Currencies (CBDCs) are another avenue through which this separation could occur, offering citizens a direct, perfectly safe claim on the central bank and fundamentally altering the role of commercial banks in the financial ecosystem. The £100 Billion Lesson: What the HS2 Saga Teaches Every Investor and Business Leader

Conclusion: Time to Discuss the Foundations

The relentless cycle of financial crisis, regulatory tinkering, and eventual complacency is a dangerous one. While strengthening capital ratios is a necessary part of the conversation, it is far from sufficient. As long as we avoid a serious debate about the fundamental architecture of fractional-reserve banking, we are merely patching the cracks in a system designed for instability. The rise of new financial technology is no longer a niche experiment; it is a clear signal that the world is ready for a more transparent, resilient, and honest financial system. It’s time to stop arguing about the height of the walls and start inspecting the foundation they’re built on.