Why Banks Are Doomed: Technology And Risk

Tyler Durden's picture

Submitted by Charles Hugh-Smith of OfTwoMinds blog,

It's not just that banks are no longer needed--they pose a needless and potentially catastrophic risk to the nation. To understand why, we need to understand the key characteristics of risk.

The entire banking sector is based on two illusions:

1. Thanks to modern portfolio management, bank debt is now riskless.

2. Technology only enhances banks' tools to skim profits; it does not undermine the fundamental role of banks.

The global financial meltdown of 2008-09 definitively proved riskless bank debt is an illusion. If you want to understand why risk cannot eliminated, please read Benoit Mandelbrot's book The (Mis)Behavior of Markets.

Technology does not just enable high-frequency trading; it enables capital and borrowers to bypass banks entirely. I addressed this yesterday in Banks Are Obsolete: The Entire Parasitic Sector Can Be Eliminated.

Unfortunately for banks, higher education, buggy whip manufacturers, etc., monopoly and propaganda are no match for technology. Just because a system worked in the past in a specific set of technological constraints does not mean it continues to be a practical solution when those technological constraints dissolve.

The current banking system is essentially based on two 19th century legacies. In that bygone era, banks were a repository of accounting expertise (keeping track of multitudes of accounts, interest, etc.) and risk assessment/management expertise (choosing the lowest-risk borrowers).

Both of these functions are now automated. The funny thing about technology is that those threatened by fundamental improvements in technology attempt to harness it to save their industry from extinction. For example, overpriced colleges now charge thousands of dollars for nearly costless massively open online courses (MOOCs) because they retain a monopoly on accreditation (diplomas). Once students are accredited directly--an advancement enabled by technology--colleges' monopoly disappears and so does their raison d'etre.

The same is true of banks. Now that accounting and risk assessment are automated, and borrowers and owners of capital can exchange funds in transparent digital marketplaces, there is no need for banks. But according to banks, only they have the expertise to create riskless debt.

It's not just that banks are no longer needed--they pose a needless and potentially catastrophic risk to the nation. To understand why, we need to understand the key characteristics of risk.

Moral hazard is what happens when people who make bad decisions suffer no consequences. Once decision-makers offload consequence onto others, they are free to make increasingly risky bets, knowing that they will personally suffer no losses if the bets go bad.

The current banking system is defined by moral hazard. "Too big to fail" also means "too big to jail:" no matter how criminal or risky the bank managements' decisions, the decision-makers not only suffered no consequences, they walked away from the smouldering ruins with tens of millions of dollars in personal wealth.
Absent any consequence, the system created perverse incentives to pyramid risky bets and derivatives to increase profits--a substantial share of which flowed directly into the personal accounts of the managers.

The perfection of moral hazard in the current banking system can be illustrated by what happened to the last CEO of Lehman Brother, Richard Fuld: he walked away from the wreckage with $222 million. This is not an outlier; it is the direct result of a system based on moral hazard, too-big-to-jail and perverse incentives to increase systemic risk for personal gain.

And who picked up all the losses? The American taxpayer. Privatize profits, socialize losses: that's the heart of moral hazard.

Concentrating the ability to leverage stupendous systemic bets in a few hands leads to a concentration of risk. Just before America's financial sector imploded, banks had pyramided $2.5 trillion in dodgy mortgages into derivatives and exotic financial instruments with a face value of $35 trillion--14 times the underlying collateral and more than double the size of the U.S. economy.

In a web-enabled transparent exchange of borrowers bidding for capital, the risk is intrinsically dispersed over millions of participants. Not only is risk dispersed, but the consequences of bad decisions and bad bets fall solely to those who made the decision and the bet. This is the foundation of a sound, stable, fair financial system.

In a transparent marketplace of millions of participants, a handful of participants will be unable to acquire enough profit to capture the political process. The present banking system is not just a financial threat to the nation, it is a political threat because its outsized profits enable bankers to capture the regulatory and governance machinery.

chart courtesy of Market Daily Briefing

The problem with concentrating leverage and moral hazard is that risk is also concentrated. And when risk is concentrated rather than dispersed, it inevitably breaks out of the "riskless" corral. This is the foundation of my aphorism: Central planning perfects the power of threats to bypass the system's defenses.

We can understand this dynamic with an analogy to bacteria and antibiotics. By attempting to eliminate the risk of infection by flooding the system with antibiotics, central planning actually perfects the search for bacteria that are immune to the antibiotics. These few bacteria will bypass the system's defenses and destroy the system from within.

The banking/financial sector claims to be eliminating risk, but what it's actually doing is perfecting the threats that will destroy the system from within. Another way to understand this is to look at what happened to home mortgages in the runup to the meltdown of 2008: the "safest" part of the financial sector ended up triggering the collapse of the entire pyramid of risk.

Once we concentrate risk and impose perverse incentives and moral hazard as the foundations of our financial/banking system, then we guarantee the risk will explode out of whatever sector is considered "safe."

Once you eliminate the "risk" of weak bacteria, you perfect the threat that will kill the host.

The banking sector cannot be reformed, for its very nature is to concentrate systemic risk and moral hazard into breeding grounds of systemic collapse. The only way to eliminate the threat posed by banks is to eliminate the banks and replace them with transparent exchanges where borrowers and owners of capital openly bid for yield (interest rates) and capital.

Bankers (and their fellow financial parasites) will claim they are essential and the nation will collapse without them. But this is precisely opposite of reality: the very existence of banks threatens the nation and democracy.

One last happy thought: technology cannot be put back in the bottle. The financial/banking sector wants to use technology to increase its middleman skim, but the technology that is already out of the bottle will dismantle the sector as a function of what technology enables: faster, better, cheaper, with greater transparency, fairness and the proper distribution of risk.

There may well be a place for credit unions and community banks in the spectrum of exchanges, but these localized, decentralized enterprises would be unable to amass dangerous concentrations of risk and political influence in a truly transparent and decentralized system of exchanges.

Of related interest:

Certainty, Complex Systems, and Unintended Consequences (February 14, 2014)

Our Middleman-Skimming Economy (February 11, 2014)

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buzzsaw99's picture

wrong wrong wrong. couldn't get past the first paragraph.

fonestar's picture

Banks are doomed.  Satoshi as the ultimate doomer.

forwardho's picture

There is nothing so dangerous to the status quo as a Man with the courage of his convictions.

Keep up the good fight!

fonestar's picture

fonestar is the way of the future.

Anusocracy's picture


Governments Are Obsolete: The Entire Parasitic Sector Can Be Eliminated.

NOTaREALmerican's picture

Re:  paging fonestar

It's like summoning Lurch in the Adam's Family.

It's amazing!

akak's picture

Yes, but at least Lurch had an engaging personality.

fonestar's picture

At least real pirates are utilizing Bitcoin and .torrent technologies.

akak's picture

And are 'useful idiots' for the NSA and NWO.

"Come track EVERYTHING I do, Big Brother!  Here is all is!"

fonestar's picture

How do they track it?  When fonestar comments on something he prefers to know what the hell he is talking about.

akak's picture

There's this little organization called the "NSA" --- go look it up.


PS: And while you are doing that, tell us all again how all the bitcoin exchanges are "perfectly secure" and "unhackable".

fonestar's picture

Using one time addresses and disposable wallets + coin tublers, tracking Bitcoin transactions becomes near impossible.  When you factor in tracking addresses to actual persons using the wallet, it becomes impossible.  There is no organization on Earth that has that capability.

Bitcoin is perfectly secure and unhackable.  And how would you know anyways?  You are clueless, probably never used or owned Bitcoin.

lordylord's picture

Bitcoin is perfectly secure and unhackable.  And how do you know Fonestar???

fonestar's picture

Bitcoin utilizes time-tested and secure technologies used in a myriad of other network services.

lordylord's picture

The brief history of the electronic age tells us that technologies are never secure.  All inevitably fail and are replaced in time.  Bitcoin will be no different.  The question is, what happens to all those people holding the bag?

fonestar's picture

Bitcoin is not being replaced for a very long time, and to suggest that it would be replaced overnight (network effect does not work like that) is just plain stupid.  Bitcoin is serving as a common channel for the altcoins and can take the better offerings from them into its own.  Pretty clear most of you have no clue what is going on.

TeamDepends's picture

The only things time-tested are gold and peoples ability to be duped by the next big thing.

fonestar's picture

Bitcoin and the cryptocurrencies are an epochal change.  You are never going to see the end of cryptocurrencies in your lifetime.

Thorny Xi's picture

I'm probably a little older than you, and I can envision an easy end to crypto-anything in my lifetime.  It all requires reliable global energy grids.

bcking's picture

How can this be the end when the entire field is in its infancy? This is just starting numskull.

Five paper rectangles for you! Spend them only where I allow you to do so.



LMAOLORI's picture



Too funny fonestar

Protect your privacy

Bitcoin is often perceived as an anonymous payment network. But in reality, Bitcoin is probably the most transparent payment network in the world. At the same time, Bitcoin can provide acceptable levels of privacy when used correctly. Always remember that it is your responsibility to adopt good practices in order to protect your privacy.


Understanding Bitcoin traceability


Bitcoin works with an unprecedented level of transparency that most people are not used to dealing with. All Bitcoin transactions are public, traceable, and permanently stored in the Bitcoin network. Bitcoin addresses are the only information used to define where bitcoins are allocated and where they are sent. These addresses are created privately by each user's wallets. However, once addresses are used, they become tainted by the history of all transactions they are involved with. Anyone can see the balance and all transactions of any address. Since users usually have to reveal their identity in order to receive services or goods, Bitcoin addresses cannot remain fully anonymous. For these reasons, Bitcoin addresses should only be used once and users must be careful not to disclose their addresses.



bcking's picture

fonestar is correct. Have you ever used Bitcoin? Do you have to have your mom do everything for you?

Crypto currencies will thrive and this is just the beginning. Even a great leader such as me, Kim Jong Un, can see the obvious advantages of Bitcoin.

Enjoy your poverty and the looks of disappointment from your family when they realize you are just another sheep.

Five paper rectangles for you!

Landotfree's picture

buzzsaw the article is stupid.

"The current banking system is essentially based on two 19th century legacies"

No, the financial system is same as it was when the banking systems imploded 1000s of years ago, before there were things called banks.    It's based on the requirement for exponential growth, which is been going on for centuries.   Expand, fail to expand, collapse and liquidation.  

The Architect - Your life is the sum of a remainder of an unbalanced equation inherent to the programming of the matrix. You are the eventuality of an anomaly, which despite my sincerest efforts I have been unable to eliminate from what is otherwise a harmony of mathematical precision. While it remains a burden to sedulously avoid it, it is not unexpected, and thus not beyond a measure of control. Which has led you, inexorably, here. 

Neo - You haven't answered my question. 

The Architect - Quite right. Interesting. That was quicker than the others. 

*The responses of the other Ones appear on the monitors: "Others? What others? How many? Answer me!"* 

The Architect - The matrix is older than you know. I prefer counting from the emergence of one integral anomaly to the emergence of the next, in which case this is the sixth version. 

*Again, the responses of the other Ones appear on the monitors: "Five versions? Three? I've been lied too. This is bull****."* 

Neo: There are only two possible explanations: either no one told me, or no one knows. 

The Architect - Precisely. As you are undoubtedly gathering, the anomaly's systemic, creating fluctuations in even the most simplistic equations. 

forwardho's picture

Did I somehow agree to backstop this BS just by being born in this country?

 To .gov I am nothing more than a cash cow. Until such time as I become an unfunded liabilty.

BLOTTO's picture

I believe the first banker's name was 'Lucifer'

rotagen's picture

Yeah, banks are doomed like a race track is doomed if you win your bet.

TeamDepends's picture

Free Richard Fuld!

NOTaREALmerican's picture

I like CHS, but he - like the socialists & libertarians, and other ISM idealists - forgets that the banks are just a single method used by the smart-n-savvy people to screw the dumbasses.

Somebody famous once said:  The sociopaths will always be with us.

Right now they run the banks, governments, and corporations.   If the banks disappeared tomorrow, the sociopaths would just start another scam.  

It's a survival of the fittest society.   That's what we've always had.   The most fit - the smart-n-savvy sociopaths - must win.

poldark's picture

I am. Bitcoin can be destroyed any time by the government if it wanted to.

viator's picture

There is nothing wrong with banks, they meet an important need and have done so for centuries.

The problem is TBTF banks, a recent creation brought to us by the government working hand in hand with crony capitalists.  The TBTF banks need to be broken up and the law changed to prevent TBTF banks from forming. Smaller banks are much safer, deal with smaller risks, have a fairly good record, are easy to liquidate, and the costs of liquidation can be covered by insurance which must be priced to cover the risk. I have dealt with banks for decades and remember fondly the old style local bank.

NOTaREALmerican's picture

All valid points.

But, you are forgetting - of course - the most important thing.

20 years ago, the Libertarians had Free Enterprise Orgasms when Greenspan - great Libertarian - told them the banks were self regulating because you didn't want the evil hand of gov'ment regulators messin' up the Free Enterprise system - the system which rewards the heroic risk takers, like bankers, who take risks and make this great-n-glorous country more great-n-glorious.

So,  if you bullshited the Libertarians and "conservatives" once, I'm sure it can be done again.   Apparantly, all it takes is a nice suit and a college term paper on Ayn Rand to establish Libertarian cred.

viator's picture

It was the Congress of the US and government regulators who created TBTF banks. It was progressive political action and shakedowns working hand and hand with government and political parties that forced the banks to make sub-prime loans of all kinds.

agent default's picture

Banks are doomed because they have put themselves in  a position of excess leverage, and the only way to survive is to increase their leverage.  This the core of the problem they are trying to sweep under the carpet.  Of course this is not sustainable, and the later it explodes, the louder the bang.

teslaberry's picture

charles hugh smith sometimes has clear good point, and sometimes clear communist nonsense.  ubt most of the time clearly good or stupid. this article , particularly with respect to the second point he is making about banks being 'obsolete' is in a grey zone.  charles hugh smith is not a technology expert. but even the famous paul volcker said the biggest innovation in thirty years of banking wasn't any new fandangled speculative instrument---but the ATM. despite the vague allusion to a truth at work here, charles hugh smith is out of line , vague and making a mocket of clear communication here. this is where i see him not as right or wrong, but just lazy and dumb. 


there is a lot going on in the payment world. however -----the underlying centralization and sophistication of technologically advanced applications----EVEN DISTRIBUTED APPLICATIONS LIKE BITCOIN-----leaves them in a precarious position of helping bring in one form of centralization for another. 


for if the banks fundamental function shall be replaced by a group of technologies owned by tech companies who rely on the ownership and cooperation of the major portals for the internet itself----------owned by the telecom companies in cooperation with major government control-----------------------than you are essentially applauding the obsolscence of the banks in favor of a new set of masters. 


the illusion that everyone gets to be a hippy homestead self sufficient farmer using the newest latest greatest technology is perhaps charles hugh smith's clearest mistake . and yet---there is a lot of interesting stuff going on in the world of payment technology, accounting technology, lending technology. and yes----the conservative banking institutions themselves know that the future path of competitive profits lies not in brick and mortar lending but in finding ways to achieve the same or more amount of TRUST without going through brick and mortar reality. 


the question of what happens when western governments around the world transition to 'cashless' society remains at large.  MANY differnt things will happen as they do this. many. gold silver bitcoin, various online credit-push systems. chase pay is already that. ---a wire transfer on steroids. paypall is developing its own version on dollar backed open source cryptographic systems. think bitcoin but with a register entry for where/with whom the federal reserve underlying note is registered. essentially derivative forms of currency ---dollar 2.0. 

people talk about bitcoin 2.0 all the time , mastercoin ultra coin, other 'coins' representing services based off a relationship of tradeability with bitcoin, or an explicity processing algorithm for linking tokens to bitcoin. either way ---the very same thing is already happening to the dollar itself. . 




Implicit simplicit's picture

I understand that you might not agree with him, however ,Charles Smith is neither dumb or lazy.

I Write Code's picture

A remarkably ignorant article.

Banks have traditionally had two roles, aggregating deposits (liabilities) so they could make loans (assets).

Risk was something to be managed.

Today, banks no longer give a rat's ass about deposits, and view risk as something to be monetized.  They can make money all day long "lending" only to the government, which is the next thing to riskless.

In other words, banks as they have ever been, have been obsolete for about thirty years, since they were disintermediated by the money market funds.  The ghosts of banks, the banksters, live by sucking blood from the living, whether individually or governmentally.  But of course they effectively *are* the government since the derivative explosion circa 2001, but certainly since 2008.  The "risks" revealed in 2008 are only the classic risks of greed and stupidity and the risks of monetizing risk rather than doing anything remotely related to actual banking.

lotsoffun's picture

keep writing code.  and learn something. banks had one role.  safe keeping of your money, so it won't be stolen by marauders.  or your coins (PM's).  you paid a fee.  at some point, they figured out that that they could 're-hypocate' your gold or paper and you would not notice.  then, they figured out how to do it levered (oh- and were allowed to) 10x, 20x, 100x.  bingo for the banks.  and then, they were alllowed to do it, with no downside.

games is over.  question is when.


wagthetails's picture

Big Banks are doomed.  I see a reversion back to many local community based banks (inlcuding credit unions) who might actually look out for the local community.  We'll always need high finance because simply, people and companies will always be willing to pay others to do some of the work.  But we must get the banks out of the marekts.  take deposits and make loans, and we'd be fine.   although if we could roll back the clocks, we could probably exist w/o banks at all.  But you could say the same for government...that ain't happening, unfortunately.

q99x2's picture

Start offering goods and services in MaxCoin.

Darkman17's picture

Yes the need for banks is going away. Out saving there earns negative interest due to inflation, and that charge people 400% what they give us. 20% vs .5% times 10 due to fractional reserve. I have been using lending club to lend money to others and would encourage you all to do the same.

bcking's picture

Banks are DOOMED. Goodbye losers. I will feed you and your families to the dogs!

Go Bitcoin!

pashley1411's picture

To me this might be the best ZH post of the year.

The flaw is that the author doesn't get into how ZIRP needless increases the leverage, and so buying power, of the financial sector, for both assets and influence.   Its ZIRP which is the real antibacterial agent; banks are just the carrier.

Griffin's picture

In Iceland we have a system where all businesses are issued a kind of social security number called kennitala (ID number).

The most popular form is EHF, with limited responsibility for owners.  You can, if you are clever, load it with debt, pay yourself bonuses and dividends, run it into the ground and then start a new company with a brand new kennitala, transfer all asset into the new company, leave the debts in the corpse of the old company and walk away.

Those who are the most ruthless do quite well, and those types are often the ones who like to invest in politics, to circumvent problematic laws and increase the size of the playing field.

Life becomes very difficult for honest business people in a environment like that, its almost like they are being systematically exterminated.

Every time there is a crash they pay the price, but the people who are not burdened with morals somehow always seem to come out on top.


lotsoffun's picture

this is the history of mankind. greed.  i often point out to friends how the british ruling family - topped the own family.  very often.  this is one example, but there are plenty.  however - what i mean to say is - if the one had let the other live, neither of these people are going starving by any means. 

so - if that's what the brit royal family does to each other - what do you think they have in store for us?  or any other these other 'leaders'.

Mary had previously claimed Elizabeth's throne as her own and was considered the legitimate sovereign of England by many English Catholics, including participants in a rebellion known as the Rising of the North. Perceiving her as a threat, Elizabeth had her confined in a number of castles and manor houses in the interior of England. After eighteen and a half years in custody, Mary was found guilty of plotting to assassinate Elizabeth, and was subsequently executed.

and that is why we've as citizens attempted to create a situation, where we limit the ability of others  to simply come into our cave, hit us on the head, and take everything we have.





much obliged's picture

quote: Concentrating the ability to leverage stupendous systemic bets in a few hands leads to a concentration of risk. Just before America's financial sector imploded, banks had pyramided $2.5 trillion in dodgy mortgages into derivatives and exotic financial instruments with a face value of $35 trillion--14 times the underlying collateral and more than double the size of the U.S. economy.

reply: America's financial sector had help in pyramiding $2.5 trillion in dodgey mortgages. President Jimmy Carter's "Community Reinvestment Act" required lenders to lend to sub-prime borrowers. President Bill Clinton provided penalties upon any financial institution that failed to honor the Community Reinvestment Act and lend to sub-prime borrowers.



I_KNOCKOUT_U's picture