Fractional Reserve Banking With Bitcoins

I recently got into an argument over on the Reddit Bitcoin boards where I held the position that fractional reserve banking with Bitcoins was not possible.  I’ve repeatedly made this claim before due to the fact that I think no one would accept receipts for Bitcoins (bank notes) over actual Bitcoins.  However, the argument on the Reddit boards led me to see the error of my previous logic.  What can happen is that a Bitcoin bank could use its deposited accounts as “receipts” for Bitcoins because the digital account balances could be detached from actual Bitcoin wallets.

A bank could keep a digital ledger of accounts and pool all their deposited coins into a single wallet that it lends from.  Obviously this is the most likely scenario anyways, since we see this same process with current Bitcoin exchanges.  So using a 10% reserve ratio as an example, a bank could have 100 Bitcoins in demand deposits while lending out 90 of those Bitcoins to other accounts.  It would be able to get away with this because of the digital account balances.  Those who deposited money in the bank would not see their balances decrease when the money is lent out unless the bank explicitly setup its system to operate this way.

This could lead to the unstable situation described in this Khan Academy video on fractional reserve banking:

The one thing that would NOT be possible under Bitcoin banking would be the creation of a central bank or FDIC type “insurance” scheme to backstop bank reserves.  This is because there is no way for new Bitcoins to be created other than the mining process and because people directly conduct transactions using Bitcoins themselves.  Obviously I find this to be a very healthy thing because it limits the fraud and forces individual bank depositors to be responsible for losses instead of tax payers.

The implications of this are that Bitcoin banks will be viewed with a high degree of skepticism by depositors.  Depositors will view depositing their money at a bank as taking the same kind of risk as they would view buying stock in a company.

In thinking about what prevents bank centralization in an all Bitcoin economy, it dawned on me that the use of Bitcoins in direct transactions is vital to preventing bank centralization.  Say if Bitcoin banks all operated on a fractional reserve banking system, in theory, bank centralization could occur in much the same way it did under the gold standard if Bitcoins were not used directly in exchange.

What really made bank centralization possible under the gold standard was the use of bank notes to represent gold, and the fact that gold was a physical item that could be easily seized.  Once banks got it in peoples’ heads that bank notes were “as good as gold,” the path toward monetary destruction was set.  The ability for people to conduct wire transactions anonymously using Bitcoins is a key component in preventing the centralization of banks under a Bitcoin system.

Hmmm…. This raises some more food for thought.  Let’s suppose a state tries to seize control of the banking system.  It could order all banks to freeze their accounts at gun point, and then order all banks to transmit their wallets to a central banking authority that would take control of all the Bitcoins in the banking system.  Peoples’ digital account balances would remain unchanged, but all the Bitcoins would be gone.

The only thing that would prevent the state from being able to get away with this is the fact that all the retail payment systems are setup to accept Bitcoins directly, rather than accepting ledger transfers from banks as they do today.  Keep this fact in mind when people start advocating for instant transfer mechanisms between banks and retailers that rely on ledger transfers rather than actual Bitcoins.  It could lead down a dangerous road.

It will be interesting to see how Bitcoin banks operate in the future.  I suspect people will be leery of banking with a bank that does not require time deposits for interest bearing accounts since this would be an obvious sign of fraud.

If I had to speculate, I think we might see banks operate with several various account choices.  A bank might offer a secure demand deposit account where it hosts an individual wallet for each account.  It might also offer an unsecured demand deposit option, which would allow for instant transfers of payment between bank members.  And then it might offer an interest bearing time deposit type of account that it would use to make loans from (depositor assumes risk as well as reward).   The risk of fraud to depositors would be if the bank started using its unsecured demand deposits to lend from or backstop its reserves.

This entry was posted on March 9, 2012 at 11:14 am and is filed under Bitcoin, Featured. You can follow any responses to this entry through the RSS 2.0 feed.