“Bank runs are a common feature of the extreme crises that have played a prominent role in monetary history. During a bank run, depositors rush to withdraw their deposits because they expect the bank to fail. In fact, the sudden withdrawals can force the bank to liquidate many of its assets at a loss and to fail. During a panic with many bank failures, there is a disruption of the monetary system and a reduction in production.”
— Bank Runs, Deposit Insurance, and Liquidity (Diamond & Dybvig)
Deposit insurance schemes and moral hazard
Deposit insurance schemes are implemented in over 140 countries (International Association of Deposit Insurers). They are designed to protect bank depositors from losses caused by a bank’s inability to pay its debts when due and to promote financial stability. Additional systemic measures that foster stability include a central bank that can act as a lender of last resort and rules and regulations aimed at curbing risk for deposit owners.
Deposit insurance requires oversight of deposit-taking institutions in order to protect deposit customers, and contain issues of moral hazard.
Moral hazard is commonly associated with financial safety nets like deposit insurance. Minimizing moral hazard, while preserving the benefits of deposit insurance, involves promoting good governance for banks, while ensuring sound regulatory, supervisory and legal frameworks exist to deal with excessive risk-taking by banks.
“The size and severity of the 2008 financial crisis has been tied to excessive risk-taking by banks, enabled by the poor incentives that arise under limited liability and public deposit guarantees. Under limited (single) liability, bank shareholders may take excessive risks because they receive all upside gains from risky projects, but their downside exposure is limited. The provision of deposit insurance further encourages bank risk-taking since it decreases depositors’ incentives to monitor and constrain bank risk.”
— Reducing Moral Hazard at the Expense of Market Discipline (Anderson et al.)
How does ‘Fractional-Reserve Banking’ play a role?
Banks (through a process called fractional-reserve banking) are allowed to create money as debt.
How does this work?
Fractional-reserve banking requires banks to hold just a fraction of deposit liabilities in actual reserves. Many products and services of banking institutions increase the company’s risk exposure — as well as the risk exposure of their depositor customers — since they are lending more than the assets they have in reserve.
When excessive lending occurs (e.g., housing loan crisis in 2008), excessive debt for companies, individuals and families is also created. Customers may begin defaulting on their loans in systemic volumes, brought about by macroeconomic changes like rising job loss, inflation, etc. As was the case in 2008, defaults can lead to banks becoming insolvent, which causes governments to turn to taxpayer-funded bailouts for the too-big-to-fail banks and public austerity measures, like spending cuts, tax rises, and a reduction of household income. All of which can further increase defaults.
Banks do not, as too many textbooks still suggest, take deposits of existing money from savers and lend it out to borrowers: they create credit and money ex nihilo — extending a loan to the borrower and simultaneously crediting the borrower’s money account
— Lord Adair Turner, formerly the UK’s chief financial regulator
The difference between e-money and bank deposits
Unlike bank deposits, e-money issued by Monerium is safeguarded separate from any other financial activities, such as lending. Instead, customer funds are invested in a segregated portfolio of high-quality liquid instruments along with Monerium reserves. The structure is similar to a high-grade money market fund with a minimum capital contribution by the fund administrator that serves as a buffer against losses .
The e-money framework is defined in the Electronic Money Institution Directive (Directive 2009/110/EC of the European Parliament and of the Council of 16 September 2009). The Directive provides an alternative scheme for guaranteeing funds. As an electronic money institution (EMI), Monerium must safeguard customer funds and guarantee Monerium customers have priority claims in the event of bankruptcy.
If an EMI would default, the e-money holders have the highest priority of claims against the bankruptcy estate (Act No. 21 from 1991 on Bankruptcy). Monerium customers have direct rights to the funds that are received and safeguarded in exchange for e-money.
The directive is clear on how EMIs should safeguard customer funds. Customer funds can only be kept on a deposit account with a bank or in a portfolio of secure, low-risk assets, such as government bonds. In order to reduce counter-party risk, Monerium intends to safeguard funds in low-risk money market accounts.
It’s time to refactor the financial system.
By Jon Helgi Egilsson (co-founder) & Jon Gunnar Olafsson (counsel), Monerium
“Leaving the payments system in the hands of big banks means that we’re all at risk from their lending activities, and banks have to be propped up by the taxpayer to avoid economic collapse. People who don’t have access to bank accounts are excluded. … A ‘digital cash’ system would remove a need for the Government to back up ‘too big to fail’ banks, because money stored at [a central bank] would be risk-free. By increasing the number of companies which are able to provide current accounts, it would reduce the concentration of economic power in a few large institutions.” PositiveMoney.org
About Monerium
Monerium is a financial technology company with the mission of making digital currency accessible, secure, and simple to transact. Using Monerium e-money, individuals and non-financial enterprises can store and send digital currency without going through traditional financial institutions. Monerium was founded in 2015 by a team with diverse backgrounds, including central banking, finance, blockchain, and cloud services. The company has raised $2M in funding from ConsenSys, Crowberry Capital, Hof Holdings, and private investors.
