THE EFFECTS OF CRYPTOCURRENCIES ON THE BANKING INDUSTRY AND MONETARY POLICY
Section I: An Introduction and History of the Modern Banking Industry and
Monetary Policy
The modem banking system has a rich and complex history. The idea of what
banking should be, compared to what it actually is, has gone through many
transformations for better and for worse over the centuries. This section will be a brief
history of what the banking system is and why it is this way, as well as about monetary
policy and how it has evolved over time. This section will also go into some of the
pitfalls of the banking industry with special focus on the Federal Reserve. It's important
to understand that entire national economies and their citizen's social well-being are
balanced on the foundational need for a strong financial system (Beck, T. & Levine, R.
2008). If these systems are threatened or are faced with extreme change,
those economies
can be rearranged and either create new levels of prosperity or new levels of ruin for
every entity involved in the economy.
Original Purpose of a Bank
Before the Gramm-Leach-Bliley Act of 1999 there was two types of banks that
served two distinct purposes: commercial banks and investment banks. This distinction
was mandated by the Glass-Steagall Act of 1933 making it so that large banks had to split
into separate entities to specialize and only do one of the two distinct jobs based on the
individual banks' business model. First, let's break down what these two types of banks
are and what they do. A commercial bank is what most people think of as a traditional or
normal bank that functions to accept deposits and proved loans (Singh, J. 2014). These
banks make loans, take in deposits by offering checking and saving accounts, they
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THE EFFECTS OF CRYPTOCURRENCIES ON THE BANKING INDUSTRY AND MONETARY POLICY
generally use deposits to make loans, and offer other traditional banking services. An
investment bank doesn't deal with traditional banking but instead is limited to capital
markets. Capital markets are financial markets for buying and selling long-term debt or
equity backed securities. These banks are great at channeling the wealth of many savers
and lending it to entrepreneurs, governments, and corporations who can put those savings
to long term productive use.
The reason these banks were forced to form separate business identities is because
otherwise the banks would be allowed to take in an individual's money,
money that those
individuals thought was safe and secure in a checking or savings account, and take
greater risks with that money in the capital markets. If a bank made too many risky
investments and over leveraged themselves, all the people who thought their money was
safe in the bank suddenly found themselves broke or outright bankrupt. To help further
protect American's savings, F.D. Roosevelt also signed the Banking Act in 1933 creating
FDIC to help safely guarantee up to two thousand five hundred dollars in deposits and the
number has grown to two hundred and fifty thousand as of 2016. However, this only
protected citizens who put money into insured banks. To put it simply, investment banks
are for people who want to store their money with the goal of seeing a larger return on
investment, in exchange for the guaranteed safety of their money that they would expect
from a commercial bank with FDIC insurance.
Commercial banks do offer some loans to businesses and individuals but these
loans are relatively small compared to the large volume loans investment banks deal with.
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THE EFFECTS OF CRYPTOCURRENCIES ON THE BANKING INDUSTRY AND MONETARY POLICY
To put this into perspective, commercial banks would generally have their larger loans be
a couple hundred thousand for mortgages and less than a hundred thousand for car loans
or personal loans. Compare that to an investment banks that might make loans that are as
large a couple hundred million. Commercial banks get the money needed to offer their
loans by using the savings of other customers that the bank guards. Not only do
commercial banks offer loans to people like aspiring homeowners and car owners but this
bank will offer a warehouse function for all of its customers (Donaldson. J. 20 I 6). A
warehouse function is the function of the bank safely store and guarding your money in
their vault and offer convenience services like online banking, checking and savings
accounts, checks, and ATMs. Many of these services may cost a fee. So customers are
giving up on the ability to earn a higher return on their money in exchange for the safety
and convenience of their money.
All of this changed in 1999 when the Glass-Steagall Act was overturned and
individual banks were able to merge and perform both functions of being an investment
and commercial bank (Barth, J. et al, 2000). Suddenly one single bank could offer the
perceived safety and security of putting money into a commercial bank and highly
leverage themselves in the capital markets. A bank that customer thought was safe and
thus trusted their money to the bank, may not be as safe as the customer thought. These
banks are able to take far larger and riskier gambles with consumer's savings than just
offering relatively small loans to people who want to buy a house or car. Now people's
savings are in capital markets. Banks are able to advertise that consumers can have safety
with their money and earn higher interest on it as well
once it was legal to perform both functions, "too big to fail" was born (Sorkin, A. R. 2010). If banks lose
big in the capital markets, the tax payers would bail them out and protect consumer
savings with FDIC insurance. There was no incentive for these banks to rein in risky
lending. If they won these gambles in capital markets and risky personal loans, they won
big. If the lost, the tax payers would protect them and their customers deposits thanks to
FDIC insurance. This created a moral hazard.
Some people might feel that since consumers are protected by FDIC insurance
and too big to fail banks have the Federal Reserve, aka the Fed, as a lender of last resort,
then why is there a problem? The problem is that, like any firm in an economy, incentives
will drive their behavior. If the government tolerates banks having high-risk behavior
because of tax payer backed insurance on customer deposits, then the banks will push
that tolerance to the max. If the government wants banks to act fiscally responsible, they
don't need to regulate banks, they need to change the banks incentives (Leonard, T. C.
2008). FDIC insurance robs the tax coffers. The funds go into the pockets of banks that
took on massive risk and thus it takes away from other programs that could have used
those funds to better help tax payers. The Fed can be a lender of last resort but if it
continually has to keep bailing out banks, how and when will it even gain the money
back it loaned out? The Fed will have to tum to the printing press and causes an increase
in inflation that harms everyone in the entire economy. The Fed is a massive drag on the
U.S economy, on citizen's prosperity, and arguably not worth the cost for what few
perceived benefits it provides to big banks (Rothbard, M. N. 1994). Before getting too
far, let's break down the history and role of the Federal Reserve.
The Federal Reserve
The Fed was established through The Federal Reserve Act of 1913. This however
was not the first incarnation of the Fed. The first idea of a centralized bank was
immediately after America's founding after the revolutionary war called the First Bank of
the United States (Cowen, D. J. 2000). Jefferson was opposed to a central bank and
Alexander Hamilton was in favor of one. Hamilton was in favor of a bank because he felt
the U.S needed a strong central force to help handle the post-war economy, which was
nearly in shambles from war debt (Syllat R. 2009). He felt it could bring stability to the
country's new monetary system through being a credit provider to both private and public
needs. Jefferson was opposed because he felt a central bank would undermine democracy
(Flaherty, E. 20 10). The First Bank was established in 1791 and only charted for a twenty
year period during this time Jacksonian supporters, of soon to be President Andrew
Jackson, maintained a high level of hostility towards the bank and in 1811 thanks to their
efforts the bank failed to be renewed.
There was one more predecessor before the Federal Reserve called the Second
National Bank of the United States. Like the First Bank of the U.S. the Second Bank was
born out of the war debt and inflation from the war of 1812 (Paul, R. 2009). Due to the
unstable economic times and war debt,
nationalists wanted a strong central banking force
to help the economy. So in 1816 the Second Bank of the United States was charted for
twenty years. The Second Bank would be modeled and perform much like the First Bank.
Also like the First Bank, the Second Bank would fail to renew its charter at the end of the THE EFFECTS OF CRYPTOCURRENCIES ON THE BANKING INDUSTRY AND MONETARY POLICY
twenties years largely thanks to Andrew Jackson. This put a brief end to the pursuit of a
centralized bank until The Federal Reserve Act of 1913.
Also like both of its predecessors, The Fed was created because of war. Except
this time the central bank was made before the war began instead of in the aftermath of a
post-war economy. World War I was started in 1914 and the Fed was instrumental in
America being able to finance and join the war that was looming over Europe (Koning, J.
P. 2009). The reason for this is that war is very costly because it could only be financed
through bonds, borrowing, and direct taxation. Using a central bank to utilize inflation
makes it politically easier to finance a war.
The Fed's mission per its congressional mandate from 1977 is to maximize
employment output, stabilize prices (fight inflation), and moderate long term interest
rates. The Fed fulfills its duties in four ways as listed on the Fed's official website (2016).
Firstly, by conducting the nation's monetary policy by influencing the monetary and
credit conditions in the economy. Secondly, by supervising and regulating banking
institutions to ensure the safety and soundness of the nation's banking and financial
system and to protect the credit rights of consumers. Thirdly, by maintaining the stability
of the financial system and containing systemic risk that may arise in financial markets.
Lastly, by providing financial services to depository institutions, the U.S government,
and foreign official institutions, including playing a major role in operating the nation's
payments system.
The reality of the situation is that the Fed literally creates money out of thin air
using fractional reserve banking instead of 100% reserve banking (Solman, P. 2012). The
Fed also does this by using their own special techniques and tools like open-market
operations, changing reserve ratios, and discount policy to manipulate interest rates in
order to control the money supply. In fact, although part of the Fed's mandate is to
stabilize prices and fight inflation, the Fed and its chairman feel that inflation is actually
good for an economy. This is shown from remarks by Governor Ben. S. Bernanke before
the National Economists Club in Washington, D.C on November 21, 2002. "The U.S
government has a technology, called a printing press (or, today, its electronic equivalent),
that allows it to produce as many U.S dollars as it wishes at essentially no cost. By
increasing the number of dollars in circulation, or even by credibly threatening to do so,
the U.S government can also reduce the value of the dollar in terms of goods and
services, which is equivalent to raising the prices in dollars of those goods and services.
We conclude that, under paper-money system, a determined government can always
generate higher spending and hence positive inflation" Central planners like Mr.
Bemanke, and their belief in artificially manipulating the banking and monetary system,
cause harm to the economy and weakens the dollar. But what alternative is there to the
fiat paper money system that can be manipulated on a whim of a bureaucrate?