How Blockchain Technology Could Stop Bank Runs


SElicon Valley Bank (SVB) suffered the largest and fastest bank operation in history: customers withdrew $42 billion from SVB in a single day, leaving the bank with a negative cash balance of $1 billion. That’s $4.2 billion per hour, or over $1 million per second for ten straight hours. To understand the extent of this phenomenon, the previous largest bank operation in modern US history occurred at Washington Mutual in 2008, totaling $16.7 billion over the course of 10 days.

Withdrawals in SVB unfold at a pace enabled by digital banking and were likely to be affected by the viral panic spreading on social media The run likely grew first from social media – across platforms and private chat groups.

This prediction brings to mind the Federal Reserve Bank of Richmond’s 2018 paperwhich states “Banking activity is viewed as inherently fragile – that is, prone to runs. A run occurs when too many depositors deposit their funds to avoid losing those funds if a bank becomes insolvent.” In particular, a run can occur whether or not the bank is insolvent—that is, the fear of a run can be sufficient to produce one. In other words, the rumor becomes a self-fulfilling prophecy. She goes.

A bank run as described in the 2015 Chicago Booth Review is the result of a liquidity issue. paper – This is a mismatch between assets (loans) and liabilities (deposits) – more specifically, a mismatch of short-term assets versus short-term liabilities. If the bank has only a portion of the cash deposits (i.e., Reserve Ratio, a Fed Requirement) – as all banks do – would be nearly impossible to accommodate withdrawals of all (or most) deposits at the same time.

Running a bank is nothing new, and spreading rumors on the stability of a financial institution or an organization is nothing new either. But the magnitude of the run and the speed it’s on because of digital banking and social media means it can spiral. Advances in technology may have worked to the disadvantage of SVB, but technology can also be used to provide real-time and transparent information to prevent the spread of social media rumors and such incidents. potentially be reduced.

How can we accommodate advances in technology and cultural changes to prevent or at least minimize the next bank run from happening? Here, we look at two different possible solutions, one proposed by the New York Fed and another that relies on blockchain technology.

Solution One: Reducing the risk of runs on uninsured deposits: Minimum balance at risk

aim of Minimum Balance at Risk (MBR) A compromise has to be made between the liquidity of investments and their risk: to maintain the liquidity which investors withdraw at the cost of greater risk to their principal; This reduces the incentive to make tradeoffs.

The basic mechanics of the MBR are as follows: a small fraction of each depositor’s uninsured deposit amount (the amount that exceeds the FDIC-insured amount per depositor), called the minimum balance at risk, will be available for withdrawal only if there is a delay.

For example, the MBR may be 10 percent of the depositor’s maximum uninsured deposits in the last thirty days. Assuming you had $1 million of uninsured deposits with you during the last thirty days, you would be able to withdraw all but $100,000 (10 percent) of your uninsured deposits immediately. The remaining $100,000 will only be available to you after a delay of, for example, forty-five days.

To further reduce the incentive to withdraw, a portion of your MBR will be subject to deposits from those who did not withdraw. If you requested the withdrawal of all your uninsured deposits, but another customer left all of their uninsured deposits with the bank, you would receive your $900,000 while 10 percent ($100,000) remained in the bank for those forty-five days; But during that time period, your $100,000 will be subject to another client. In other words, if the bank fails during that period, you’ll absorb up to $100,000 of your losses before another customer loses a dime.

This secondary deposit structure greatly reduces the incentive for any bank customer to act as a first mover, as they will always be at a loss. If nobody wants to be the first mover, we might end up with no sudden withdrawals and thus stop the bank run. MBR can be a laudable solution, but it lacks transparency especially relating to the liquidity risk position of the bank in real time. Bank customers’ decisions are still based on rumors and outdated information.

Blockchain technology can provide the transparency that is needed to better assess the assets and liabilities of an organization, be it a financial organization or an organization. What if transactions could be recorded on a transparent immutable ledger, providing real-time accounting information of the balances of an organization’s assets and liabilities? tapestryx is developing such a solution using blockchain technology, but you can take it a step further with tokenization.

Solution Two: Tokenization for Liquidity Risk Management

Liquidity risk management within financial services organizations can benefit from tokenization. The SVB case illustrates this advantage. Its failure had several underlying issues, one of them being related to the “liquidity gap” – the bank’s customers had no real-time information on the bank’s liquidity position. If there were checks and balances that were transparent for customers to see, mitigation actions could have been taken in time.

In the case of SVB, the bank’s available information on the balance of its assets and liabilities was out of date, as it reflected the fourth quarter of 2022. If everyone could see the balances of the banks in real time, then the viral rumors on social media may not have had any impact on SVB’s position.

Flagging both assets and liabilities would show the bank’s reserves and capital on hand and assure customers in real time that the bank was not insolvent and not susceptible to undue leverage, which might have prevented a social media panic. Was.

Following the collapse of FTX, there has been a spurt in efforts from several centralized crypto exchanges to provide proof of reserve. Proof of reserves only shows that a firm has some assets to repay its debts; It does not provide any information on the liabilities of the organization. If a company can transparently demonstrate that it has $1 billion in reserves/assets, but if its liabilities are not clear for everyone to see (for example, if it had $10 billion in liabilities), then Its solvency will come under question.

Therefore, showing “evidence of a going concern” would be more useful. If both the assets and liabilities of an organization can be tokenized, then on-chain analytics can be used to understand whether the organization has enough assets – short term and long term – to meet its liabilities. . In other words, it answers and verifies whether an organization is a “going concern” and whether it will meet its financial obligations when due.

Furthermore, it will provide real-time information about the risk and leverage that the organization is faced with. In the case of SVB, it would have clearly informed customers that the bank had no bad loans or any excess leveraged exposure, therefore, rumors of the bank failing were at best baseless.

People can still spread rumors on the solvency of a financial organization. But we can reduce the risk of bank run and the possibility of future bank failure with the adoption of blockchain technology solution.

The views and opinions expressed here are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Source link