The global financial system relies heavily on banks, but are these institutions really as solid as they seem? A closer look reveals that banks operate with surprising similarities to Ponzi schemes. By depending on new deposits to pay off withdrawals and investing in less liquid assets, banks create an illusion of stability that can quickly collapse under the right conditions. Conditions we’ve seen a lot of in 2023.
The Illusion of Liquidity
A Ponzi scheme; is an investment scam where returns are paid to existing investors from funds contributed by new investors, rather than from profit earned by the operation of a legitimate business. — Yes everything is a ponzi, but hear me out— Similarly to a Ponzi, banks take in deposits from customers and use them to fund investments and loans, often maintaining only a fraction of the total deposits as liquid cash reserves. This practice is known as fractional reserve banking.
When a customer requests a withdrawal, banks rely on new deposits or the reserves they hold to fulfill that request. In times of economic stability, this system functions seamlessly. However, when a large number of customers demand their money at once, the illusion of liquidity can quickly shatter, leaving banks unable to meet their obligations like we saw recently with SVB collapsing as well as a few others, but hey, who is keeping score.
Investing in Illiquid Assets
Banks don’t just hold onto the money that they receive from your deposits; they use it to make investments, often in bonds and other less liquid assets. While these investments can generate a return for the bank, they also contribute to the bank’s illiquid position. This can lead to serious problems if the bank needs to access its funds quickly in order to meet a sudden increase in withdrawal demands. Again, tying back to how SVB collapsed.
Bank Runs and Bankruptcy
A run on the bank occurs when a large number of customers, fearing the bank’s insolvency, rush to withdraw their money. Historically, bank runs were a physical event where customers would line up at the bank’s branches to demand their money in person. This would give banks some time, albeit limited, to address the situation and attempt to secure additional funds to meet the increased withdrawal demands. However, the landscape of banking has changed drastically with the advent of technology.
Today, the process of withdrawing funds has been transformed by digital banking, allowing customers to access their money instantly from the comfort of their homes or even through their phones. This has led to a new era of bank runs, where the rapid pace of withdrawals can escalate far more quickly than in the past. Instead of taking days for a bank run to unfold, it can now happen within minutes, leaving banks with little to no time to react.
This acceleration of bank runs creates a dangerous situation for both the banks and their customers. With little warning, a bank can find itself in a precarious position, as its cash reserves are depleted at an alarming rate. As a result, the bank may become insolvent, unable to meet all of its obligations, and potentially leading to bankruptcy.
Conclusion — Not your keys not your coins…
While banks are not inherently fraudulent like Ponzi schemes — we don’t have to go into examples of how Wells Fargo fraudulently made fake accounts for customers and charged them, or how HSBC was laundering money for drug cartels — , banks share some concerning similarities to Ponzis in their dependence on new deposits to pay off withdrawals and investments in illiquid assets.
How many more banks will fail this year? Lets find out.
Be well,
Xulian
follow me @KingJulianIam
