Disclaimer: The information provided in this article is for educational purposes only and should not be considered as financial advice.
In 2023, we have seen the collapse of a few banks that sent the economy into a spiral. First Republic Bank and Silicon Valley Bank come to mind, among others and experts have now foretold the potential demise of banks outside of the U.S., such as TD Bank in Canada, after having closed branches in the states and on Vancouver Island in the last couple of years.
Is fractional reserve banking the culprit behind these bank failures? How does it stack up against proof of reserve and self-custody banking?
Table of Contents
- Fractional Reserve Banking VS. Proof of Reserve Vs. Self-Custody Banking
What is Fractional Reserve Banking?
Fractional reserve banking is where a bank is only obligated to keep a fraction of the deposits made as a reserve and is free to utilize the remaining amount for loans and investments. The purpose of fractional reserve banking is to generate profits and earn interest for the bank.
How it Works – The Breakdown
How exactly does the fractional reserve banking system work? Let’s say a bank receives $1,000 in deposits and is required to keep 10%, which is $100 in reserves, then that means the institution just needs to keep $100 on hand and is free to use the $900 leftover for loans and investments.
Fractional reserve banking is the dominant banking system in many countries.
What is Proof of Reserves in Crypto?
Another type of banking is proof of reserve, or PoR. This type of banking is seen in crypto and aims to instill trust within the institution by providing transparency to clients. This system requires the bank to have 100% of the reserves.
In other words, financial institutions are not allowed to loan and invest any portion of the deposits.
Proof of reserves is commonly used in crypto firms and financial exchanges, any institution that relies heavily on building trust. Banks may provide proof of reserves held with digital signatures, hash functions, and zero-knowledge proofs (proof that does not reveal sensitive info).
What is Self-Custody Banking?
With crypto wallets, you have an option that provides more control over your assets. As it sounds, self-custody banking gives users full autonomy over their assets without the need for a middleman, bank, or custodian. How, you ask? With cryptocurrency, blockchain technology, and the use of smart contracts.
Investing in cryptocurrency and transacting on the blockchain is a form of self-custody banking. You would hold your own private keys, which are the only way to access your crypto wallets. Since decentralization is the primary consideration in the blockchain world, exchanges often rely on self-custody.
Fractional Reserve Banking VS. Proof of Reserve Vs. Self Custody
Fractional Reserve Banking:
Pros
- Allows banks to lend and invest a portion of the deposits they receive, thus creating more liquidity in the economy and income
- Increases the money supply, which in turn can boost economic growth allowing banks to earn interest rates on loans
- Creating new loans
Cons
- Can lead to bank runs (where many depositors withdraw at the same time), which leads to bank failure
- Insolvency and increased chance of economic instability if not properly managed
- Can result in losses for customers if the bank is unable to pay its debts
Proof of Reserve:
Pros
- More transparency, security, and stability
- Can reduce the risk of fraud, mismanagement, and insolvency
- Offers enhanced privacy and trust between individuals and bank
- Better risk management
Cons
- Limits the bank’s potential to boost economic growth and earn profits
Self-Custody Banking:
Pros
- More privacy and autonomy over assets and holdings
- Improved security measures
- More decentralization
- Often lower costs
Cons
- Has a steeper learning curve and technological know-how to use effectively
- Lack of consumer protection due to decentralization
Each banking model has its benefits and drawbacks. The key is to understand which is the best fit for your needs. What do you prize more, privacy and autonomy? If so, self-custody banking may be the way to go. If you don’t mind having the bank hold onto your assets, but you want proof that it remains in the reserve, then go with proof of reserve banking.
Conclusion
As we have mentioned, the fractional reserve system is the standard for many financial institutions across the globe. We have seen bank failures before and we seem to be witnessing it again in 2023, so is it time to opt for more transparency, security, and autonomy? While the future remains to be seen, we can say it has definitely spurred many investors and depositors to look into the alternatives.
Related Articles:
- Traditional Banking System Downfall – First Republic Bank
- Why Choose a Cold Wallet?
- What Happened to Cryptocurrency Exchange FTX?
