“We need banking. We don’t need banks anymore.”
If you were to guess when Bill Gates said this, I bet that many people would think this could be a quote from last week or last month.
But in fact, this quote is over 30 years old.
The death of banking by technology has been predicted for a long time but never seems to actually happen. Many people in finance and banking like to point to this fact to show that banks will actually be around forever and the dangers are overblown…
But I don’t think that’s the case either. I think the really important question to ask is:
What is it that banks do today that no one else is able to do?
Gates was saying that once technology companies are able to provide the core services of banks, we really don’t need banks anymore. But what most people get wrong about this is what they think banks actually do.
If you take a quick look around in the marketplace, it’s easy to say that we have all of these new technologies now that look kind of like bank services, so therefore we can live without banks.
- You can convert foreign currency for free with Revolut or Transferwise
- Get a loan through SoFi, LendingCircle, or Alibaba
- And send a payments using various different cryptocurrencies
… so immediately many people jump to the conclusion that we just don’t need banks anymore.
But these services aren’t the real value that we get from banks. Banks give us something deeper than just making payments. They give us trust, scale, and alchemy.
And no new technology or FinTech start-ups have come close to offering the same combination yet. But once they do, we might finally see the end of days for banks.
Many people might disagree and say, of course I don’t trust banks after the financial crisis.
But it’s not really whether or not you think the big banks are doing what’s right for society or if they are making the global economy less stable — this is a question of who do you trust with your money.
And the simple truth is, that regulated banks are insured up to a certain amount in most countries, giving you full confidence that the money you put into a bank is going to come back to you no matter what happens.
This is simply not something that an FinTech company can offer, unless they apply for a banking license.
This also applies to cryptocurrency. If your bank gets hacked into and they lose millions of dollar, your account is still insured even if the bank takes such heavy losses that they are forced to close their doors.
On the other hand, if you are holding your money in a cryptocurrency exchange and those coins disappear — good luck getting them back.
And the trust that we have in banks goes even further than the basics of getting our money back if it is stolen. It’s also about knowing that your money won’t go towards financing drug cartels, terrorists, human rights abuses, and all other kinds of illicit activity around the world.
True, many banks have had their failings in preventing money laundering, but at least they are accountable to governments who have the right to impose strict penalties if they are found to be breaking the law.
You may be a libertarian who is OK with facilitating illicit financial activity in the name of privacy — but this is still a big differentiator for banks. And in fact, many FinTech companies still rely on infrastructure from banks and the AML/KYC checks that they perform.
The second value that banks provide is scale, and what I mean by this is that you can take your debit or credit card and go around the world and make payments or withdraw cash from most shops or ATMs.
And not only that, you can do this at nearly the same time as everyone else in the world and all of these transactions can be processed instantaneously. In fact, Mastercard alone processes nearly 160 million transactions per hour with the average transaction taking 130 milliseconds to process.
Now this type of scale is something that can be replicated, as you can see companies like WeChat and Alibaba in China that have over 100 million customers and are processing massive amounts of transactions at scale.
But in order to build this amount of scale, these companies had to build enough trust in their platforms, and a big part of this was actually by getting banking licenses and becoming banks themselves.
Many finance insiders look at the Silicon Valley tech companies as some of the biggest potential rivals to banks in the future, since they have large existing user bases and would be able to realistically scale up to handle the kind of transactions involved.
But the last few months have not been kind to the reputations of Facebook, Google and others, and it is questionable whether a big tech company can really earn enough trust to take on any meaningful amount of banking services in addition to the services they already perform.
And when you look at blockchain and crypto solutions, this has always been a key sticking point — will it ever be possible to match Mastercard’s 160 million transactions per hour?
No doubt there are good efforts, with one technology claiming 1 millions transactions per minute. But reaching this level while maintaining 100% reliability is still a major challenge for blockchain solutions.
The last of these is probably the hardest to replicate and the least obvious. This is what former Bank of England Governor Mervyn King dubbed “alchemy”, essentially creating money from thin air.
Banks are able to do this with what is technically referred to as “fractional banking”.
Here’s how it looks in practice:
- A Bank has $100 that individual customers have deposited into their checking accounts
- The Bank takes this $90 from this and makes loans to businesses
- $10 is kept in reserve by the Bank to pay back any customers who want to withdraw funds or to cover the losses from bad loans that don’t get paid back
And as a result of this process, the bank has just created this $90 out of thin air! The money is in two places at one once: Depositors feel that they can always access their money, yet there are also loans that have been paid out to people needing credit.
This is a bit of a precarious system and during a crisis everyone wants to take their money out at the same time. When everyone wants their $100 of deposits all at once when the bank only has $10 to pay out, that is a bank run!
There have been efforts by regulators to make the system more stable by increasing the amount of reserves banks are required by law to hold. (say from $10 up to $15) But this is a different topic for another day.
The main point is that no FinTech solutions are able to effectively replicate the value that banks create here.
People could argue (very fairly) that this is a house of cards and that the system should be changed — maybe, but if all of the money that banks have created was taken out of the economy now, we would not have the credit required to keep businesses going and many would be forced to close.
And this is one of the main drawbacks to all of the new technical solutions that are out there today:
- If you enter into an Ethereum smart contract, you lose my money in the meantime and cannot access it. Your ether is essentially locked into that smart contract and cannot be used for something else.
- If you loan money to someone on a P2P lending platform like Lending Circle, you can only access that money when the loan is repaid or if someone else agrees to buy that loan from you. (not easy to do in a crisis when loans are not being paid back)
But if you deposit your money in a bank, they can loan it out and you can still have access to all of your money. That’s alchemy, and like it or not, the current economy is built on it — and any new solution will have to compete with that.
These are tough problems to solve
FinTechs have already solved the easy problems that are out there with banking. Everyone knows that banks are not user friendly and that FinTechs can create better front-end experiences — that’s not hard!
But banks have the trust of customers to hand over their money. They have the scale to execute transactions around the world with no downtime. And they are able to create money from thin air to keep the global economy running.
And if you are building a solution that is really and truly looking to replace banks, you have to be thinking about how you can replicate these three things.
Otherwise, you are just a fancy front-end with banks doing the heavy lifting in the background.