It’s a wonderful life for a banker — until the bank run
As a kid every single holiday season inevitably I would watch “It’s a wonderful life” on cable television before my 2 week vacation had ended. The bank run scene is great to watch as a primer for how fractional reserve banking works.
You’re thinking of this place all wrong. As if I had the money back in a safe. The money’s not here. Your money’s in Joe’s house, right next to yours. And in the Kennedy house, and Mrs. Macklin’s house, and a hundred others. Why, you’re lending them the money to build, and then, they’re going to pay it back to you as best they can. Now what are you going to do? Foreclose on them?…Now wait…now listen…now listen to me. I beg of you not to do this thing. If Potter gets hold of this Building and Loan there’ll never be another decent house built in this town … he wants to keep you living in his slums and paying the kind of rent he decides … Don’t you see what’s happening? Potter isn’t selling. Potter’s buying! And why? Because we’re panicky and he’s not … Now, we can get through this thing all right. We’ve got to stick together, though. We’ve got to have faith in each other.
Never before had banking’s fractional reserve system been painted in such a positive light. Frank Capra makes the Bailey Brothers’ Building and Loan seem like a hero in the community. When community banking is embodied by the struggles of George Baily the audience becomes won over to the idea that, so long as everyone gets to own their own home, fractional reserve banking doesn’t seem so bad.
But insurance is also a fractional reserve system, yet there is no Frank Capra to defend the practices of insurance companies. Instead we get movies like The Rainmaker and villains such as Great Benefit Insurance Corporation who mercilessly deny claims with the potential for bankrupting the corporation.
At the end of It’s a Wonderful Life the townspeople of Bedford falls are crowdfunding the 8,000 dollars that was lost to keep the Building and Loan in business. At the end of The Rainmaker the company is bankrupt with no monetary victory awarded to the victims who were unfairly denied their insurance claims.
Both banking and insurance are similar in that they are fractional reserve systems. There is no reason to think that people can’t have warm fuzzy feelings about insurance carriers also. But in order to do that we really need a protocol that can enforce the fair payment of claims. In this blog post we discover how transparent fractional reserve systems might work in insurance architectures and in the next blog post we will apply this specifically to Bancor.
Insurance is not a full reserve system
Full-reserve banking is a proposed alternative to our current fractional-reserve banking system in which banks would be required to keep the full amount of each depositor’s funds in cash available for withdraw. The only way for insurance to be a full reserve system is to hold one liquid dollar of capital for every dollar that a policy might be required to pay in the immediate term. The concept that the average uninitiated policyholder has is that there is one dollar available for every dollar a company might be required to pay but a certain portion of those funds are “invested” somewhere. This means that although the funds for claims are not entirely liquid all the money to pay all the claims is still “somewhere.” If this were a requirement it would be unlikely that any insurance company would have sufficient funds to underwrite enough policies to make the business profitable. Each policy underwritten would quickly deplete the funds reserved for future claims in a full reserve system until eventually no policies could be created.
Holding a liquid dollar in reserve for every dollar of max claim coverage a policy could possibly be required to pay is not merely inefficient but impractical. This is why we have actuaries to tell us the probable value of all claims within a given period so that money isn’t sitting idle in a reserve fund. Since insurance is not a full reserve system this must mean that there is a chance that there will be more claims outstanding than reserves. Given a crisis in either liquidity or solvency one of the following must be true:
- Claims that are expected to be paid in days are paid out over months
- Claims won’t cover the full value of the policyholders loss
- Valid claims will be outright denied
- The process will become pointlessly difficult to discourage valid claims
Given the above 4 options the following is unacceptable:
- Unfairly denying a valid claim
- Meaningless friction created to discourage a claim (i.e. paperwork)
Solvency is not absolute but relative
A policy failing to collect and hold sufficient premiums to pay a claim is similar to Greece asking the EU to take a haircut on the value of the loan they are being required to repay. The borrower would like to repay their lender but would like the lender to accept less than what was originally promised. In the context of potential insolvency the following are acceptable but only in relative terms. Relative to an insurance company becoming insolvent it might be ok if every outstanding claim took a haircut in either of the following ways:
- The time taken to pay all outstanding claims is equally extended.
- The claim awards for all outstanding claims are equally reduced.
The Bancor protocol simply makes explicit what is already implicitly true. It states that the value of an individual claim award is relative to the reserves needed to pay all outstanding claims. The payment a valid claim is eligible to receive is relative to a specific ratio. This is the ratio of all currently valid claims and the current funds held in reserve. This is given in the following equation so long as the value on the left cannot exceed 1.
If the value on the left is greater than 1 then in the policyholders view everything is as promised. If however the value on the left is less than 1 then the policyholder will be taking a haircut of some sort. To avoid this we need the proper incentives for everyone to do the right thing.
But a full reserve system would still be better right?
No. The cost to have money sitting somewhere waiting for a claim is passed on to policyholders. Policyholders are similar to borrowers, who must pay interest for the privilege to borrow money. Money waiting for a claim is therefore not free. Money held as reserves has a cost associated with it.
Bancor enforces fairness via the protocol
If you are unfamiliar with the Bancor protocol please read the whitepaper it is essential to understanding this series of blog posts. To understand how one would use Bancor to enforce the ideal insurance architecture we need to separate a claim award from a claim payment.
- A claim award: Policyholders being told that their claim is eligible for receiving a claim payment.
- A claim payment: Paying a claim to the extent of a policyholders loss given the insurer’s proportionate ability to pay it i.e. is there sufficient funds to pay relative to the outstanding claims.
The first concern people have about peer-to-peer claims has to do with identifying eligibility for an award. In this situation people care about the unfair denial of claims. The second concern people have about peer-to-peer claims has to do with the conditions under which payments are made. In this situation people care about fraud mitigation. It is very important to distinguish that awarding a claim is separate from paying a claim. In awarding a claim you are required to consider the claimant’s request under the best possible light. In paying a claim you are required to protect the interests of existing policyholders by maintaining the health of the premium pool from fraudulent claims.
Bancor is the only protocol that allows you to differentiate between a claim award and a claim payment using a fractional reserve protocol. Without Bancor there is no possible way that you can create a fractional reserve escrow that pays insurance claims. This feature makes it a very special protocol with special properties that make it easier to administer insurance coverage. In our next post we will see how we can set up transparent fractional reserve architecture using Bancor.
The next blog post will dig into the fundamentals of how to use the Bancor formula to pay claims.