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Fault lines in the Modern Financial System

It brings me grief when I hear people refer to CBDC as being just another form of digital money or just another mobile application for making payments when in reality there is a world of difference with CBDC being sovereign money (as is notes and coins) controlled and guaranteed by central bank and backed by assets, once upon a time gold itself,  in contrast to commercial bank money, that you and me hold in our bank accounts, which is spinned off by commercial banks in the form of 'credit' with little or no proportional backing of any reasonable magnitude, if otherwise we wouldn't have known what is a 'bank run'.

For starters - Commercial bank money is created when the banks give out loans (known as 'new credit'). When the borrower pays back the loan, the credit gets destroyed. The net result is the wealth the loan  helped to create - example a factory or a farm, and the interest the bank earned as profit. This is simple dynamics how economic machine runs. As a result, in a way, the 'quantity of money' in a given economy at any given point in time is the money that is waiting to be retracted into an existing loan. In essence, all money in existence today is a credit that spinned off sometime somewhere in the past, and hence we live in so called 'credit based economy'.

Where things go wrong is in a credit expansion cycle when credit that is spun off by banks knows no bounds - end result being erosion of value of this credit based money. The only measures that limit the amount of credit a bank can spin off is cash reserve ratio (CRR in India) and liquidity of these banks (in RTGS) for interbank movements to be maintained at the national central bank (both in central bank money).  While former is abolished in many advanced economies, latter demands banks to have only a miniscule of liquidity  roughly of a 1:10 ratio (due to netting, and other liquidity efficiency techniques in the central systems) to the actual money being moved.

While this is an unsettling fact, the truth is even worse that banks who fail to maintain even this miniscule reserve can borrow in the overnight market to fulfil the deficit (there is always one bank to lend who has excess reserves, where the loan landed as deposit). Also interestingly if the banks manage to loan out equally well then the obligations net out. (the secret why the banking system as a whole desires banks of equal sizes). Lastly now - In an event of stress where inter bank lending ceases, central bank loans off to the bank in deficit (ex. marginal lending in EU, discount window in US and so on), due to which any stress in banking system is seamlessly handled within this closed loop.   

One would normally expect the surplus to retract (and money gain it value back) in a credit contraction cycle, but in reality it doesn't. Further, banks which were heavily leveraged back in the expansion cycle now finds itself with mismatched balance sheet (when assets fall even slightly in value) bring them close to credit risk, liquidity risk and sometimes even insolvency risk, only aggravating the inter bank lending drama mentioned before.

In summary, the credit based money that is sloshing around has no as much credibility as one would normally think, in contrast to central bank money (which banks can obtain only by maintaining assets). The only form of central bank money that we (as public) can hold is physical bank notes and coins, which is now in the retreat unfortunately, however central banks are now offering the same in digital form - so would you want to hold on to it, or not? 

Even if one is to ignore all said above, just the fact that banknotes are considered Tier1 HQLA (high quality liquid asset) by  BASEL for meeting its norms (to know how well capitalised banks are in the event of crisis) is itself reason enough to know the digitised form of the same will be equally as valuable.

International Finance

The story of credit creation does not end within the domestic boundaries. Credit is spun off in the international market exactly the same way as in domestic markets (for global trade and remittances), except that it is done by just a few global banks in just a few global currencies, with no central authority to regulate or monitor, no reserve requirements. It is a international network of these banks (currency correspondents) providing liquidity to rest of the banks in the world. They lend money using different type of complex instruments (derivatives), mostly off the balance sheet. These banks could practically flood the market with money, or crush it, depending only upon their own profit interest at any given point of time.

Why International market never ceases, and nostro's are always drawn without checking the balance - magic lies in its this lending market. You can always find liquidity in the market so long you have assets to trade (doesnt matter if they aren't of high quality - one can exchange assets in markets to distil them up until you get to the point yo have them qualified enough to borrow liquidity). Just in case the inter-bank lending ceases due to any economic stress, there is always the central bank (respective currency)  coming for rescue with swap lines and etc.

Nobody really knows what is the leverage of these global banks (with derivative markets running in notional value in quadrillions see my article here) so there is not even a way to quantify the market. This is why Warren Buffet rightly calls derivates as 'financial weapons of mass destruction'. 

Last but not least, one thinks money that enters the system is clean and legal - for example USD comes from US domestic market when they pay out in dollars for international trade, but that's not really the case. Major source of the system is the offshore (shadow) banking centers where large amounts of tax evading illegal monies that is constantly washing ashore for safe and undisclosed storage. This money enters the international system easily for lending (to earn interest for depositors) though these global correspondent banks who happens to be well connected with the offshore banks, and then multiplies several times in the credit creation process, traversing through the veins of the financial system fulfilling its liquidity needs.

It is also my inference that International market doesnt have inherent ability to contract money supply as the money that has entered the system cannot easily leave (a hotel california situation). Example - when a country's bank receives an international USD payment, it receives no money in its bank ledger but a claim (account receivable) to the dollars held in one of these international global banks. Further transactions simply changes the holder of the claim from one to another, but it doesnt offload the dollars from the ledger of these global banks. The only possibility the money can leave is when it is absorbed by the US domestic market, or converstion to Treasury bonds, but both are small quantity compared to the size of the market.  

Summary -

The modern banking system has evolved exponentially with technology advancements, but its hard to ignore the fault lines that have developed for the one who look closer. I leave it here for your judgment. 

I sum up to say if common man gets access to central bank money then thats good thing in general, given all said above. The convertibility between bank notes and commercial bank money (in your account) is only delusional to indicate they are equal, whereas in reality the difference is as large as a Jaguar and a Toyota. 

There are as well contrasting views that the advent of CBDC will provide national governments with too much control on people, and that CBDC marks the end of democracy, however they are forgetting that we live in free market, market decides where people will drift to. If CBDC is really as claimed so it will die its natural death in the hands of free market, as has many such things as history shows.

Finally, It is not so hard to guess that a mass movement to CBDC is just one 'banking crisis' away !


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Shaju Nair

Shaju Nair

Payments SME, Product Manager


Member since

30 Jul 2008



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