You Ask, I Answer: Why Is Banking So Unstable?

In today's episode, Alex asks the very interesting non-marketing question. Why is the banking system such a hot mess? Why don't we just um deposit and withdraw directly from the U.S. Treasury? Okay.

This is a complicated question. Extremely complicated question. The banking system as it is today is relatively stable compared to how it's been over the last few centuries. Originally, banks were purely private enterprises. There was no such thing as the FDIC, the Federal Deposit Insurance Corporation.

There was no such thing as, you know, regulations like Dodd-Frank. And as a result, banks were incredibly dangerous places to store your money. If your local bank got robbed, everybody, you know, by train robbers or whatever. All the depositors lost their money at that bank. There is a reason why robbing a bank was the easiest way to get money for illicitly for a long period of time.

What has happened, you know, banking as an industry has always tried to figure out ways to be profitable. If you are a purely depository institution, meaning people just go there to save money, uh to store money, uh uh you don't make much money. It's not very profitable to just hold on to other people's money um until they need it. Where the money is made in banking is on the investing side. Issuing loans, right?

Letting someone borrow money for a mortgage or whatever, and they pay it back with a certain amount of interest. Uh investing in equities, in all sorts of stuff, heck, you know, in Bitcoin, whatever. Um, that's how banks make their money. They they take the money that they have and they reinvest it. The reason why the banking system keeps getting into all kinds of trouble is because this is fundamentally commingling of two things that shouldn't be mixed.

Give this some thought. Suppose that you stored all your money in a jar, right? Which is a terrible idea. Well, let's say you stored all your money in a jar, you got your rent and all that stuff. And let's say you're also an avid casino gambler.

Is it a smart idea to put your rent money, your food money, and your casino gambling money all in the same jar? No. It really isn't. It's a really bad idea. You should partition that keep it separate, say, you know, this is as much I'm willing as I'm willing to risk at the casino this week, the rest of this money is set aside, you know, for specific purposes.

Banking uh uh has found itself in trouble many times over the years because they don't do that, right? Um banks, even just with basic lending, are essentially taking the money that depositors have given them given them and giving it to other people with the expectation that those other people would pay that money back with interest, right? That again, this is how banks must make money. The challenge is you can only loan a dollar for any currency um a certain number of times before it gets dangerous, right? If I have 10 dollars or 10 euros or 10 pounds or whatever, and I put that in the bank, my expectation as consumers I can go to the bank anytime and pull out my $10, right?

And for the most part that's true. Except when everybody at the bank says they want their $10. Why is that a problem? Because banks don't hold on to all the money they're given, right? They lend it out.

There are regulations, at least in the USA, and certainly all around the world in other banking systems, which say that banks may not lend out a more than a certain amount of their deposits, right? And a certain amount of their money. And in the United States, banks are required to have, I believe, 10% of the total deposits available at any given time, so that somebody comes and says they want their million bucks, you can give them their million bucks, right? Um that's how bank runs happen. When a bank has lent out so much of the deposits that it no longer has them, right?

No longer has that money's physically not in the building anymore, which means that the bank can't give you that money. It's simply not there. Um again, this might or might not be a showstop if it weren't for the fact that the concept of what this is is called fractional reserve lending. And that 10% requirement in the USA means that banks can loan out that same money over and over and over again to different people as long as they maintain 10% of their total deposits on hand. Think about what that means.

If I'm a bank and I have $10 of yours, I can loan Bob $10, I can loan Sue $10, I can loan Tamika $10, I can loan Jerry $10. And as long as they all make their payments, you know, they pay a dollar a month for 10 months, things are good. I've got I've got money coming in to replace what I've lent out, and it's coming in with interest, so I'm making money. If Bob can't pay his bill anymore, that $10 is gone, right? Because the loan goes bad, and you do as much as you can uh to recover it, but at some point you have to write it off and say, like, yeah, we're just not getting that $10 back from Bob.

If that happens enough, you wipe out your deposits because you don't have that money anymore. And so that's how the banking system manages to get itself in trouble an awful lot. Now, what the banking system has been lobbying to do, and uh thankfully the the folks who are in power have thus far been smart enough not to do it, is essentially want guarantees on the deposits so that they don't have to hold on to that money. Um they can lend it, you know, willy-nilly and face no consequences if the loan goes bad because the government will underwrite it. The government will say, well, we'll show up with a bag of money and bail out bail out everybody.

This is kind of what happened in 2008 during um the the Great Recession. In 2023, uh a similar, smaller program is happening, but at a much more reduced scale, and a much more smartly run program where depositors are saying, you know, the government tells depositors, yes, we will make you whole, we will guarantee your deposits, uh, but we will absolutely let the bank fail. We will absolutely let the bank go out of business. Um, all the investors on the the gambling side, because all investments are gambles, um, they're gonna lose all their money, right? They lose they lose it all.

And that's as it should be because investments are not guaranteed. Uh investments are a gamble. The way to fix this to prevent this from happening more is to continue to to segregate, to push banks to have their deposits on hand and to not use that money to go gambling with, right? In the same way that if you're trying to get your house's finances in order, you would tell you know your yourself, okay. I'm gonna set this money aside for gambling, and I'm not gonna touch any of the important money that I'm gonna need for later on.

The likelihood of this happening is very low because banks are for-profit institutions. Um they are uh very, very, very well uh funded uh and they spend a lot of money on lobbying politicians. Um they have been trying to overturn key provisions of uh a series of laws, including the Dodd Frank Law, over um for years, years now, ever since the law was passed, because it makes it harder for banks to make money. Uh it makes it harder for them to be profitable because of things like you know, fractional reserve lending limits and saying, hey, you have to have 10% of your deposits on hand. Uh before the Great Recession, that percentage used to be much lower.

Some banks it was down to one percent. And of course, those big banks imploded uh and the government did bail a good number of them out. So that's why the banking system is such a hot mess. And the way to constrain it and and reduce those risks is more regulation, which is never uh, you know, you never want more regulation if you can avoid it because it's just extra overhead. It's it makes things more complicated.

Generally speaking, you try to let the market work for itself, but there are cases where you have groups or people or industry sectors that are just so profit-driven, so so greedy, that they will behave irresponsibly and and harm their own long-term interests, but in doing so also harm a whole bunch of people, right? I have no problem with companies wanting to make money. My company wants to make money, right? Um, your company wants to make money. There's nothing wrong with that.

There's nothing wrong with being profitable and earning good money. There is a problem when your gambles don't pay off and you are gambling with other people's money that they did not give you permission to gamble with. That's where the problem is. So again, anything that can be done to separate out the deposit section of banking from the investment section, keep the safe money from the unsafe gambling, that's gonna it's gonna be a good thing. Anything trying to weaken that wall, but that you know that very thin wall that exists right now is generally a bad thing, right?

Because this is a sector that genuinely trusted, which is ironic, because we give them our money to hold on to it. Anyway, that's a very long answer to a very complicated question. And we still have not touched on most of the major issues because well, that could take days. But it's a very good question, and it's an important question. It's worth discussing.

Get to know finance law and wherever it is you're based, whatever your jurisdiction is, whether it's you know uh a country in Africa, a country in Asia, a country in North America. Learn the laws of what corporations are and are not allowed to do specific to banking. You will be surprised at just how many loopholes there already are and uh how many how many people are trying to take advantage of them. Thanks for tuning in. We'll talk to you soon.

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