Why are banks failing? Are there challenges to the dollar as the global reserve currency and the U.S Hegemony?

How Fintech, AI, and united commitment to American values can empower America to Overcome the interconnected challenges of the European War, Banking Crisis, Pandemic Losses, Crypto threat, and CBDCs

HI FINTECHTALKERS, (follow me on Twitter for lively discussions on these topics @PADDYRAMANATHAN)

The Political context

During and towards the end of World War II, Nazi Germany dropped propaganda leaflets on enemy lines to encourage troops to surrender. We are often told to study history as it will likely repeat or rhyme. I think we are seeing some of it now. In a made-for-TV/social-media moment, the President of China openly proclaimed to the President of Russia “that changes are coming that are not seen in 100 years”. That’s not it; there was another made-for-TV and social media moment where China is seen attempting to broker a peace deal between Russia and Ukraine and long-standing rivals Saudi Arabia and Iran.

There is a brutal war in Europe - some say a proxy war between nuclear powers, the United States and Russia. China has risen over the past two decades and is seeing the opportunity to challenge U.S. hegemony and the prominence of the U.S. dollar since the World wars almost a century back.

In this article, I elucidate that despite real risks and setbacks, the United States will ultimately succeed if it comes together and adheres to fundamental American principles that have made its system exceptional.

The Economic context

The globe is just coming out of a Pandemic that slowed down productivity and real income and shifted wealth to a handful in the biotech, pharma, and some tech. Forbes in 2021 reported a record 493 billionaires joined the list of billionaires from around the world, propelled by a red-hot stock market and unprecedented economic stimulus. Among those newcomers are at least 40 new entrants who draw their fortunes from companies involved in fighting Covid-19.

The Federal Reserve Bank in the United States responded by reducing interest rates and printing unprecedented amounts of money; the latter they are still at it. The total assets held by the Federal reserve at the time of writing is about $8.7 Trillion, and the European Central Bank is close to €8 Trillion (to put in perspective, the same number was around $2 Trillion during the 2008 financial crisis). This unprecedented amount of money created a bubble in the public equity markets, real estate, and startup valuations in 2021 when everyone felt rich. The low productivity from Covid lockdown coupled with unprecedented Fed stimulus created a hyper-inflationary and recessionary environment that the Fed is trying to soft land by raising interest rates. It has raised them to about 5% in a year. At the same time, Federal Debt held by the public (DHBP) in the United States has reached a record high of $31.4 trillion as of February 2023, almost 120% of GDP, which is also unprecedented.

The DHBP rise is likely for the Government to be able to fund the war without raising taxes which could be coming next. High DHBP is correlated with less money for private activity.

All-in-all, the economic reality and management are sub-optimal at best and seem to have triggered a banking crisis. You don’t say!

First, it was Silicon Valley Bank, then Signature Bank (although more related to its crypto adventures), Credit Suisse, and now CapitalOne and Deutsch Bank. There seems to be a run on these banks for multiple reasons, including some local problems like at SVB, essentially consumers and businesses don’t see any reason for them to park their deposits in these banks when the Treasury is offering high rates and equity holders of the banks are also exiting concerned about the viability of the business model despite various central banks and other supports.

Financial institutions such as SVB and Credit Suisse offered complex financial products that resembled the collateralized debt obligations (CDOs) of 2008.

For instance, SVB provided venture debt to startups on the condition that they keep all deposits with the bank, while Credit Suisse's Securitized Product Group (SPG) investments were co-mingled with customer deposits. This strategy resulted in substantial leverage, and for the model to succeed, an IPO or M&A was often necessary.

In the absence of such exits, the bubble is now bursting, and some of these debts will need to be reorganized. In SVB's case, the absence of interest rate hedging was a contributing factor as well. I wrote about it earlier here. SVB has yet to be auctioned off to a new owner as the stakeholders evaluate the real value of some of the assets and, more importantly, the viability of the business model.

The emergence of Bitcoin as a safe haven and store of value during times of debt crisis is a new factor that the Fed may not have accounted for in its playbook, leading to resistance towards Bitcoin and crypto-friendly banks like Signature and enforcement actions against crypto companies like Coinbase and now Binance. Despite some libertarian proponents advocating for Bitcoin as a hedge against the debt-fueled economic cycle, their understanding is incomplete. Bitcoin does not offer a full solution for replacing the USD and the Central Bank function. However, it can serve as a hedge similar to gold and other commodities. Policymakers may take measures such as a ban or taxation and enforcement (as we are already seeing) to limit its growth, as evidenced by discussions around taxing the energy used in Bitcoin mining and also a recent ban in China citing environmental concerns.

The bottom line: an abundance of money at banks with non-commensurate economic activity to lend to, hyperinflation, and high interest could further spiral things out of control. We may see more Bank failures or consolidations and further lower equity and real estate prices. Commercial real estate with lower occupancies in places like San Francisco is a bubble waiting to pop with a contagion effect on many balance sheets.

How are the political and economic contexts connected?

Two and more years of pandemic productivity losses and years of sanctions for some countries have decimated economies, which is partly maybe the reason for the war in Europe. China has risen as a powerful force in the globe in the last 20 years, and some alliances have been in the works like the BRICS (coined by Goldman Sachs it represents Brazil, Russia, India, China, South Africa), representing the emerging economies as a challenge to G7 and the dollar-dominated global financial system (USA, Canada, U.K, Japan, Germany, France, Italy, and the EU). It should be noted China is no longer an emerging economy.

Funding a proxy war requires resources, and one way to do this is by diverting funds from public programs, raising taxes, or cutting spending. However, these measures can also pressure interest rates, which would normally be expected to go down in response to a weak economy. In the case of France, for example, cuts to pensions to increase military spending have led to unrest and riots. The proletariat seems to be revolting against the ruling class' policies of austerity to fund the war. Spending cuts and/or tax increases on this side of the pond here in the U.S. seem inevitable if the war drags on.

This brings me to my opening of the propaganda that we see playout. It is essentially the emerging economies, led by Russia and China, attempting to create a narrative for an alternate financial system that is not dependent on America and the USD and also a political powerhouse driving Middle East and European policy akin to projecting that there is a new sheriff in town. What better time to seed the narrative than now - when banks in the G7 seem to be collapsing, and there is political unrest in some parts. Russia wants to use the Yuan to settle its energy trade with countries in Africa and Asia. Maybe they want to try the digital yuan (which China has piloted).

While there are some harsh realities and risks, here is why I think none of this will happen.

Despite aberrations and transitory challenges, the United States system is the most sound.

The United States hegemony and the USD as a reserve currency for the world are not just because of it being a super-power. It is because of the system and values that back it.

Free speech, free enterprise, meritocratic system where immigrants succeed, an independent judiciary and a central bank, and civilian rule over the military, among others that the other systems don’t posses. A proven system of checks and balances that evolves and self-corrects.

However, recent times have seen some breaks in the American way, with intertwined interests resulting from globalization. They question the importance of freedom of speech, press, and the inherent checks and balances in the Constitutional republic. In a recent WSJ opinion piece, Trevor Kiefer of Chapman University says During the Cold War, the stark contrast between the American way of life (individual liberty and free markets) and the Soviet system (political oppression and state control of the economy) made it easy for Americans to rally around our ideals and oppose our enemy. The same can be said about our national attitude toward Hitler’s Germany and Imperial Japan. But that dynamic doesn’t apply to America today, as the public debates whether such ideas as free markets, limited government, and individual liberty are even worth defending.

In spite of the difficulties, I hold the belief that American principles will ultimately triumph over the current economic and political turmoil. The situation may necessitate the emergence of new unifying leaders at every echelon who embody the fundamental ideals that underpin American greatness: the right to free speech and a free press, the promotion of free enterprise, and the implementation of checks and balances across all levels of government. Additionally, American ingenuity, which has been demonstrated across generations, will once again come to the fore, this time through the shrewd application of fintech and artificial intelligence.

Wait, what. How can Fintech and AI help with this political and economic crisis

Over the past twenty years, fintech has transformed financial services distribution. Developments in Artificial intelligence technology are at a seminal point that has the potential to have an impact comparable to an evolutionary leap. I wrote about some of the developments in AI here recently.

In these challenging times, the big opportunity for fintech is to provide consumers and businesses with options, increased transparency, financial education, creative debt, and wealth management solutions. We are seeing some of this already: The always agile fintechs quickly deployed solutions to increase deposit insurance after the SVB fallout (Mercury and Brex offer $5 to $6M insurance over the traditional $250k offered by FDIC through various sweep account mechanisms). Another fintech, Pipe has an alternative to venture debt (the venture debt bubble is arguably one of the reasons for SVB’s collapse) that converts future revenue into upfront capital without dilution. We will see more creative and situationally appropriate fintech solutions.

I foresee a surge in autonomous financial services or financial service agents powered by AI, akin to having your personal or business banker with AI embedded in your daily workflows. These AI-powered bankers will aid in cash management, wealth management, and ecosystem access. This transformational development will not only help alleviate the current crisis but also promote financial inclusivity by eliminating obstacles to capital and debt accessibility for all. Unfortunately, minority-led startups have received inadequate support from Silicon Valley in the past, but with the advent of AI-based service agents, this burgeoning segment can be better served. AI will contribute much-needed productivity enhancements to the economy and offset the productivity losses caused by pandemic policies. As a result, new job opportunities will emerge, driving us into a new growth cycle once we smoothly navigate out of the present one.

AI can boost productivity, foster job creation, and provide previously underserved founders and businesses with access to sophisticated financial services such as startup fundraising and revenue-based debt.

In conclusion, the confluence of fintech, AI, and traditional American values and unity will not only enable us to navigate this crisis seamlessly, but it will also keep the dollar's role in the global economy. This optimism reminds me of the final scene in Roberto Benigni’s movie Life is Beautiful. The scene depicts Joshua after the end of the last battle of World War II upon seeing a liberating American soldier in a tank exclaiming è vero or It’s true in Italian, as his dad had described how the game would end. Later on when he is reunited with his mother, an elated Joshua exclaims. “We won. We’re taking the tank home, we won" Just like Joshua elatedly took the American tank home victorious, everyone around the world can feel safe with their dollars.

Paddy Ramanathan
Founder of iValley (www.ivalley.co) and
Host of the FINTECHTALK™ Show

(follow me on Twitter for lively discussions on these topics @PADDYRAMANATHAN)

Thank you to chatgpt for suggestions.