This is part of a blog series Can Blockchain Save Our Financial System?
This blog examines how the blockchain adds transparency to the investment banking practices which could help avoid a repeat of the 2008 financial crisis.
To read the previous blog post about How Blockchain could have prevented the 2008 Crisis, click here.
To learn about how Bloxable is building the most advanced debt platform using blockchain and smart contracts, visit us here.
One of the main reasons that financial crisis of 2007–2008 took place was due to lack of transparency in the existing financial system at that time. A number of analysts had warned about the threat of subprime mortgage loans. However, they did not have access to exact data and their gloomy predictions were not backed by substantial information.
Looking back and analyzing the 2008 crisis tells us that if the blockchain technology had been around and used by banks such as Lehman Brothers, their investors would have seen the risks coming and put a stop to risky lending practices.
The 2008 Financial System
The one major flaw with the existing financial system is that everything is kept on private files with very limited access for potential investors and general public.
Take the mortgage lending industry. All the major investment banks maintain the databases of their investments and expected returns privately. While this method is certainly more secure it isn’t the most transparent and accessible.
In 2008, the regulators and investors did not have an open access to the investments of troubled financial institutions like Lehman Brothers. Regulators and other banks had to rely on the financial figures that Lehman Brothers provided them, and these numbers were often exaggerated and presented a rosy picture of the bank’s investment portfolio.
Other banks only started to realize how bad things had become at Lehman Brother’s when the investment bank kept asking for more and more loan for its debt financing. When the other banks shut their doors, Lehman Brothers went to the Federal Reserve.
The Federal Reserve similarly had no access to Lehman Brothers actual portfolio and chose not to bail out the bank. Lehman Brothers declared bankruptcy soon after this which shocked the financial world.
Bank Interconnectivity
A large number of other banks and financial institutes had advanced money to Lehman Brothers. When the major financial bank declared insolvency, these banks realized that they were going to lose significant amounts of their investments. Depositors and investors in these banks rushed to get their money out.
The banks stopped lending to one another and started calling back on their outstanding loans. No one knew which bank would be the next to fall. Confidence was completely shaken because there was no way to know the investment portfolio for other banks and how much risk everyone was exposed to.
Blockchain Transparency Advantage
The core feature of Blockchain is that it is a decentralized ledger system that is available online and can be accessed by anyone with proper authorization. If Lehman Brother’s portfolio of investments had been available online it would have significantly reduced the chances of the financial crisis.
First, the online ledger would have made it easier for investors to know how much risk Lehman Brothers had exposed itself to, long before the crisis began. Their lenders would have been able to demand that the bank should limit its risk exposure and cease its aggressive investment policies before things got out of control.
In case of non-compliance, other banks and investors would have been able to pull their loans out. This would have worked as a corrective measure to keep the bank in check.
The Blockchain-based ledger would have also made it easier for regulators to step in and monitor the situation. The real advantage of Blockchain is that it allows cross-functional teams to work together by allowing improved communication between stakeholders.
The mortgage lending industry is the backbone of the financial system. Implementing the Blockchain would add transparency to the system. It would also improve trust from investors and give them a better chance of safeguarding their interests.
The Blockchain would also allow the regulators to monitor the financial system and step in if things appear to be headed in the wrong direction. It could be the perfect platform to avoid a repeat of the 2008 situation.
To read the next blog post in our series, about Blockchain Mortgage Lending In the Shadow of 2008 Crisis, click here.
