A look at systemic risk of leveraged fractional reserve and new banking using CBDC

This is a long essay in which we elaborate on a simple thesis: Central Bankers are unlikely to be able to understand and regulate digital banking, where 40 billion dollars of deposits can rush out in 6 hours. Money, credit (leverage), and trust are related in finance, and the market discovers new methods faster than regulators can understand or manage.

The essay is lengthy because we provide context and links to bring readers with different levels of awareness to the same level of facts or data. Please skip sections that you are familiar.

Added a 11 minute NotebookLM Audio overview which is quiet good and teases nuances out. Here is link. May need you inside a google account

Suggested reading sections:

1 Synopsis

My personal bank run experience and suggestion on a new digital bank different from fractional banking and too big to Bail and too small to Fail banks.

2 Risk management

We can assume main drivers for bank runs in March 2023 were:

• Poor Risk management by an Individual bank or banks
• Dis-loyal or ‘bad’ customers.
• Poor macroeconomic policies. ZIRP for decades?
• Regulation and regulators failure. Sleeping on the wheel and inadequate appreciation of a sharp increase in interest rates

Basel III and Dodd-Frank approach post-2008 GFC regulation considerably tightened risk management in individual banks. There are many comments on basic mistakes in asset-liability matching and concentration on some dodgy industries like VC & Startups or crypto. The discussion also needs to consider if central bankers have tools to fight inflation dominated by the supply chain, and the threshold rate should be higher at 3% for USA. In sections below we quote

El-Erian chief economic adviser at Allianz SE Raghuram Rajan ex-Governor RBI and Professor of Finance at Chicago Booth

G N Bajpai ex-Chairman of the Securities and Exchange Board of India and Life Insurance Corp of India

3 Regulation and Regulators may dominate in creating systemic risk

A list of points:

• Archaic computer back-ends have a 4 PM cutoff, which prevents them from sending emergency loans of 20 billion to SVB before its closure.
• Since late 2021, there have been around 20 supervisory staff members at SVB. There have been notices of poor management by summer 2022, but no action was taken.
• FAS 157 mark-to-market was abandoned in March 2009, so FASB/IFRS allowed HTM (held-to-maturity) losses in footnotes. Many banks switched from Available-for-Sale (AFS) to HTM to hide rising losses.
• Risk-adjusted solvency and liquidity stress tests forced harmonization across banks, leading to more system-level fragility.
• Aggressively raising interest rates could have a much greater impact on banks than a hammer blow.
• Surprisingly, the existing stress test of the Fed may have still passed SVB as being compliant in February 2023.