The flaws in the banking system and the dead end of DeFi


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Defects in the commercial banking system

Commercial banks are the product of the market economy. It is a financial organization formed to meet the needs of market economy development and socialized production. After hundreds of years of development and evolution, commercial banks have now become the most important fund distribution institutions in the economic activities of all countries in the world, and their influence on economic activities ranks first among various banks and non-bank financial institutions in various countries. Commercial banks are special financial companies that aim to maximize profits and provide customers with a variety of financial services. Profitability is the basic prerequisite for the creation and operation of commercial banks, as well as the internal driving force for the development of commercial banks. The profit model of commercial banks is actually very simple. First, they absorb deposits and then make loans from these deposits.

However, if calculated like this, the loan amount should be less than the deposit amount. But in fact, the loans that banks can release are far greater than the deposits they obtain. The total US money supply in August 2020 was US$18.412 trillion. However, the total debt of the credit market (the second quarter of 2020) was US$77.61 trillion, which is 4.215 times the total money supply. Regardless of the amount of money in circulation, 4.215 times is used for loan origination in the United States. Of course, all of this money is not held by the bank as deposits, but based on accounting rules, all this money is shown as “deposits” in people’s accounts. Therefore, loans must be issued on the basis of these deposits. If banks are allowed to use 90% of their deposits as loans, then 90% of US$18,412 billion can be issued in the United States = US$16.57 trillion. But US accounts show that total debt is $77.61 trillion. Therefore, I used the term “banking system flaws.” It would be better to say that the “partial reserve system” has its own flaws.

Defects of the partial reserve system

Without physical currency, banks naturally cannot lend more loans. But modern society divides money into two types:

Paper money

Digital currency

Please note that the digital currency here is not a digital currency such as Bitcoin and Ethereum, but a currency that exists in the banking system in digital form. It is the emergence of this digital currency that “the banking system has excess funds.” This is the result of a banking rule called the “partial reserve banking system.” According to this rule, the bank can use a part of the deposit (such as 10%) as a reserve, and then use the remaining 90% as a loan.

On the surface, this is a normal bank practice. Simply put, this rule allows banks to use our deposits to provide loans to people in need. Their reason is that the money (our deposits) is idle in the bank anyway. Therefore, they will use it for the following purposes: lending money to those in need, the bank can profit from it (loan interest), and the depositor (us) can also get interest from the deposit, which seems to be a win-win situation.

The problem is, this is only one side of the story. Few people talk about the shortcomings of the fractional reserve banking system.

Flaw 1: Because the person who made this rule is not a saint, they introduced this rule to simplify the loan procedure. The more money banks lend, the more interest they earn (the bank’s source of income). This rule is actually for the benefit of banks. Let’s make an analogy:

Suppose a bank has a deposit of 100,000 USD. According to the bank’s partial reserve system, the bank must retain 10% as a reserve. The bank can lend out 90% of the $100,000, or $90,000. Assuming the interest rate is 7.5% per year, the bank can get $6,750 from $90,000. This is the second defect of the partial reserve system: the ability to resist runs is extremely poor. According to this rule, the bank can provide a loan of 900,000 US dollars if the deposit does not exceed 100,000 US dollars. But we think that only US$90,000 can be used as a loan. The annual income of 90,000 USD is 6750 USD. Similarly, 7.5% of the revenue of $900,000 will be $67,500 per year. Through the implementation of a partial reserve system, the bank’s revenue has increased tenfold. This is why all banks in the world follow this model.

The biggest danger of this model is bank runs. A bank run is a situation where a depositor tries to withdraw cash but the bank cannot provide cash. This happens when the bank does not have enough cash to pay all depositors. However, under the partial reserve model, banks’ resistance to runs is much weaker than the traditional model.

Let’s take an example:

If we want to see the collapse of the money supply, it looks like this: demand deposits (savings + demand): 52.13 trillion yuan. Time deposits (FD/RD): 89.59 trillion yuan. Total deposits: 141.72 trillion yuan. Total bills issued by the People’s Bank of China: 8 trillion yuan. Economic cash is only 8 trillion yuan, while deposits are 141.72 trillion yuan, that is, deposits are 17.715 times cash.

All deposits over 8 trillion yuan are digital currencies. So it is certain that if all depositors want to withdraw cash, the bank will fail. In addition, the cash held by Bank of China does not exceed 10%, which means that of the 141.72 trillion deposits, only 14.72 trillion is available in bank lockers. Even if 1% of depositors are willing to withdraw cash, banks need 1.472 trillion in cash to pay. The bank doesn’t even have so much cash. This also explains why the financial reserve banking system is so risky. Everything is based on the assumption that more people will not need to cash in at the same time. This assumption is not biased. But its flaw lies in the number of times that digital currency has grown more than cash.

Banks are financial institutions approved to accept deposits and issue loans. Please pay attention to the order here-the deposit should be before the loan. But today’s banks do not operate like this. They have begun to operate like a typical “private enterprise organization.” They make money by issuing loans to the public, not by accepting deposits or printing banknotes. This is why the focus of the banks has become “issuing more and more loans.” This is why we always receive crazy phone calls from banks, asking for loans, credit cards, etc.

However, all loans must be backed by some deposits. however:

China’s total deposits: 203.7481 trillion yuan. Total debt repayment by banks: 231.1681 trillion yuan. Debt to deposit ratio = 1.13 Let us assume that 1.13 is the maximum ratio that the People’s Bank of China hopes to maintain at all times. But in the process of issuing more and more loans, our banks have issued 10% more loans than they are now. As a result, the loan amount soared from 23.11681 billion yuan to 25.42849 billion yuan. Now, the loan-to-deposit ratio will increase to above 1.13. Banks must increase the deposit level from 203.7481 trillion yuan to 225.03 trillion yuan. If banks want to increase the deposit reserve ratio, they can borrow money from the People’s Bank of China. The People’s Bank of China can lend to banks in two ways:

First: Banks can issue more and more loans. Just like the deposit reserve example we mentioned earlier, in modern society, this is how money is earned from debt.

Second: In a more traditional way of making money, the Bank of China can madly issue loans when banknotes are printed by the People’s Bank of China, and the People’s Bank of China can print money directly. Today, the main flaw in our banking system is the ease of making money. The fundamental reason is the partial reserve system.

Have you noticed that, no matter what, they can make money out of thin air, and you can only earn the money one by one, to increase the value of the money, and think about it, why do you do this? What?

Defects in printing money

Of course, I am not saying that the central bank is deliberately destroying the financial system. The morality of the Chinese central bank is beyond doubt. But the question is, what is the value of the banknotes printed by the People’s Bank of China? A piece of paper with numbers on it. The credit guarantees of the People’s Bank of China and the Chinese government make us believe that these numbers have value. The valuation is mainly based on trust. Before explaining, let me give a simple example.

If you want a personal loan of 400,000 yuan, the following facts will be verified: Income level: Assume 100,000 yuan per month. Assets: For example, a real estate worth 500,000 yuan. This person can easily get a 400,000 yuan loan because his income level is enough to cover the monthly repayment. In addition, there are backups of assets. If something goes wrong, the bank can confiscate the property. So the problem is that when we plan for debt, there will be a lot of cross-checks. But when the People’s Bank of China assumes debt (every banknote it issues is its debt), will it conduct fact-checking? I don’t think so. This is why I said that banknotes are too easy to print in our flawed banking system.

Let’s take a look at the assets and income levels of China’s banking institutions: Banking assets in the second quarter of 2020: 309.41 trillion yuan Banking liabilities in the second quarter of 2020: 283.93 trillion yuan debt ratio = 91.76%

An ordinary person with a small income has assets worth 1 million yuan. In the case of mortgage, how much loan can this person get? Assume 80% of the asset value (800,000 yuan). Using the same analogy, a bank with 33.04 trillion in assets can bear 80% of 33.04 trillion in liabilities (26.432 trillion). But how much debt does China’s banking industry bear? Is there really no danger at all in the face of financial institutions with such debt ratios? The simplest question is, if you apply for a mortgage loan from a bank, can you lend out 91.76% of the cash?

The status quo and the significance of diversified investment

What we see here is indeed worrying. We work to make money. We use money to buy goods and services. In exchange for money, others also give us their goods and services. But why would people agree to sell their goods in exchange for money? Because they think money is valuable. If our currency suddenly depreciates (as happened in Zimbabwe), we will not be able to buy any goods and services. This is called currency devaluation.

Our current banking system is flawed because it allows our currency to depreciate over time. The reason is not just inflation. The bigger evil is the way banks issue loans (partial reserve banking system). As ordinary people, we cannot completely rely on our banking system. We must diversify our investments: investments based on stocks and debt are examples of currency-based securities, while real estate, gold, etc. are all hard assets. One must always keep diversified investments, so digital currencies (BTC, ETH) are a good choice.

DeFi’s death

The flaws in the banking system made us think about and seek a better banking system. However, DeFi has gone to the other extreme-extremely conservative over-mortgage loans. Currently, there is generally a platform for pledged lending on the market, and the pledge rate is between 40% and 70%. However, the market demand for loans cannot be met by mortgage loans. Especially when DeFi is still in its infancy, the ever-increasing amount of funds can not only solve the problem of marginal cost, but also the key to making DeFi survive the ETH2.0 online.

The example of the real economy is easy to understand: when the economy runs at a high level of production capacity, prosperity will exist. In other words, prosperity will emerge when demand exceeds the existing capacity level. At this time, companies have good profits and the unemployment rate is also very low. The longer these conditions last, the greater the increase in production capacity and the greater the demand for credit. In an economy without credit, the growth of demand is constrained by the growth of production, which reduces the occurrence of boom-bust cycles, but also reduces the efficiency of high prosperity and severe deleveraging. Credit is like a lubricant for cars. With it, the car can exert its best performance.

However, DeFi still cannot solve these two problems: 1. Over-issued currency. 2. Generate credit.

The inability to solve the problem of over-issued currency stems from the inability to completely cut the general equivalent properties of digital currencies. Digital currencies are directly exchanged with fiat currencies and stable currencies linked to fiat currencies through the OTC market or through exchanges, so they are also affected by the over-issue of fiat currencies.

The inability to generate credit is due to accountability issues and moral hazard issues. Because of the anonymity on the chain, after the credit is issued, because the individual cannot be traced, and because the cost of default is low, the moral hazard of the borrower’s default is extremely high. This is also the reason why over-mortgage loans are popular.


The world of blockchain was created with its own romanticism: to create a democratic, transparent and perfect world. The existence and continuous innovation of DeFi let us see this hope. However, if the above problems are not solved, DeFi will eventually usher in its death.

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