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CHIP Banks
This idea of a time-based complementary currency has much to recommend it. It would seem to hold its value well over time. And it would be a great way to standardize the measurement of value in other commodities. But could it really be possible to establish a new type of money like this without the force of government and a powerful monopoly to run the whole thing?
In order to avoid disruptions to the economy, it would be important to phase such a system in gradually over a period of time. For example, it would be nearly impossible to have everyone just switch over to using CHIPs on a certain start date. And we wouldn’t want to force anyone to use a particular kind of money anyway.
Ideally, people would begin to use CHIPs when they want, and only because they want to. Similarly, in order to have CHIP banks, there would also need to be a natural, economic incentive to start one. It too would have to be a viable way to make a living for the person owning and operating the bank.
Ideally, a CHIP bank would be a small business. Due to the current, complex regulations on money, it is nearly impossible for a small entrepreneur to own a bank today. There are instinctive reasons why you might not want to deal with a bank that is a small business. But this is mostly a concern over putting your deposits into some institution that might become insolvent at some point in the future. That would not be an issue when taking out a loan.
The primary qualification for starting a CHIP bank should be pledging a sufficient amount of owner equity to reasonably back up the loans the company will create. Obviously, it will be important to keep crooks and charlatans out of the business. To succeed, a CHIP bank must responsibly evaluate the borrower’s earning power, properly evaluate the value of his collateral, and then fairly represent to the rest of the world, the value of the CHIP credits he is obligated for.
In our current economy, many have come to rely on government regulation to keep banks operating according to a standard set of ethical and performance standards. Unfortunately, this has met with only limited success.
In spite of the fact that banks are so tightly regulated, we witnessed massive lapses of responsibility and ethics in the run-up to the 2008 financial crisis. So there is no evidence a business will be responsible or ethical simply because it is large or is regulated by the government. In fact, the exact opposite may well be true.
As businesses get bigger, they are often more subject to pressures for profit, regardless of moral values. And it appears that government regulation of the banking industry has not assured us good ethics either. But regulation has virtually locked small business entrepreneurs out of the banking industry, leaving it to big banking businesses that are well connected to government and can get big tax payer funded bailouts whenever things go wrong.
The Internet has shown us how many things can now be done more efficiently using technology. Ebay is one example of a trading community that has been developed without the need for government to regulate the integrity of its participants. Today it is possible for two people who have never met, and will likely never meet, to complete a fair and beneficial transaction as buyer and seller.
Even though there are a few crooks operating on Ebay, this problem is minimized because potential trading partners can quickly and easily determine the other person’s reputation. When a trader engages in unethical transactions, his disgruntled victims have the power to file unfavorable reviews on the site. Soon the bad player is not trusted by anyone else on the platform.
So we see, government operated regulation is not the only kind of regulation that can work. And it is probably not the most effective one either.
Given a reliable framework for establishing and publishing a reputation, it should be possible for any set of peers to learn about each other’s trustworthiness in advance of any set of contemplated transactions. Possibly, such a framework could even be established world-wide where individuals certify their credit on a peer-to-peer basis. But that is not what is being suggested in this section. Under this construct, you would only have to prove your credit worthiness to your own CHIP bank. And the CHIP bank would take care of establishing its own reputation with its peer organizations.
In order for a CHIP bank to be trusted by other similar institutions, a number of things would be necessary: First it would have to adhere to valuation standards published and agreed to by its associated banks.
During the development of the Internet, we saw how peers cooperated, without government regulation, to develop and adhere to standards such as the communication protocols we use today for data transfers across millions of different users and thousands of different software providers. Similarly CHIP banks can work together decide on such things as reasonable loan-to-value ratios, fractional reserve standards and recommended fee structures.
Then CHIP banks would publish their internal metrics so they would be subject to the scrutiny of the public. Every CHIP bank would have full access to see exactly how much in assets, liabilities, and equity are held at any given time by every other associated bank. All such metrics could be rolled together into a composite fitness score that would give a quick indication of the overall fitness of each member bank. In this way, consumers could make an informed decision about where they would most like to take their credit business.
Outside auditing firms could be retained by the association to perform independent audits to verify published metrics. Member banks could also audit each other in various ways to keep the system honest. Consumer advocacy groups and even individual citizens would be able to perform audits on the system as well.
In order for any bank-based monetary system to work, potential trading partners need to have the cooperation of their respective banks. For example, if I want to buy something from you using a check, you have to be able to deposit that check into your bank, even if I bank at a totally different institution. These transactions are completed using a process called “credit clearing.”
During any given day of business, each bank will have a large number of transactions take place. Some transactions will be between two different customers at the same bank. In this case, the bank just debits the account of the payor and credits the account of the receiver. No physical money moves anywhere–they only need to change account values in a computer.
But banks also perform transactions which require transfers to or from a variety of other banking institutions. Some of these are incoming and others are outgoing. This can amount to a large number of separate transactions. Much of the activity will net out to zero, leaving just a balance in one direction equal the sum of all the transactions.
At the end of each day, each bank will have a net transfer of credit to or from every other bank with which it has transacted business in that day. Again, this can be done simply by entering numbers in a computer because money is debt and debt is money. No one has to carry a bag of gold across town from one bank to another.
Moving money from one bank to another simply means that one bank owes money to another one. That net debt, or money will land exactly where it needs to in order to satisfy the transactions executed by bank customers in that day. And the money will remain in existence until it is extinguished, or redeemed by the people who back the debt with their own labor.
Banks would not be able invent new money out of nothing, because each CHIP needs to be backed by an actual credit customer and their collateral property. Since all metrics are public, any malfeasance would not pass the muster of public scrutiny. That much cannot be said for the present Federal Reserve system.
In essence, the task of establishing the CHIP system is reduced to a technical one. For example, computers need to assure that a debt transfer from one bank to another is entered in the same way on each end of the transfer. What is a debit on one side must be a credit for the exact same amount on the opposite end. Otherwise, there is an opportunity for a bank to fraudulently accumulate money that does not have legitimate backing.
Here we would employ two methods: one is to learn from those who have already developed crypto currencies such as Bitcoin. Using modern public/private key algorithms, it is possible to do two things: verify the validity of a publisher of information, and ensure that only the intended recipient can receive it. In this way, daily clearinghouse transactions could safely and accurately be transmitted between participating CHIP banks.
According to the publishing standards mentioned above, peer banks would be able to audit the transaction logs of their competitors, comparing the results to their own books. Anyone fiddling with the numbers in their books could be reasonably detected and exposed. Once caught, an offending institution’s reputation would be forever tainted and they would be hard pressed to ever engage in the bad behavior again. So the incentive would be to cooperate and to do it honestly or face expulsion from the CHIP community.
A further incentive for good and ethical dealing would be an equity standard. In order to get a good fitness score, a CHIP bank would have to have a good equity ratio. Equity is the capital contributed by the people who own the business. So the equity ratio is the amount of wealth the bank owners and operators have put at risk, in comparison to the amount of CHIP loans they maintain and service.
So maybe you would like to start a CHIP bank. It sounds like a great deal to be able to make loans to people with money you don’t even have and then earn interest on it, right? In order to do that, you would have to put up some collateral of your own.
This is just like the reserve requirements in our fractional reserve system of banking today. So let’s say you want to make loans in the amount of 1M in your brand new startup CHIP bank. It might be very difficult to get a good fitness rating because you will be a brand new player in the market and people won’t know how to evaluate your reliability. So because you have no existing reputation, you will have to put some money or property up as security.
Let’s say you own a commercial building currently valued at 50,000 CHIPs and it has no existing debt against it. You start by putting that on the balance sheet as the equity capital of your bank. As part of your charter, a lien is recorded against your building in favor of the bank. This will provide additional security for associated banks who will be trading credits with you.
Finally you open your doors to your first customer who has a home valued at 20,000 CHIPs (20 KC), has a good reputation in the community, is healthy and has been employed at a good paying job consistently for the last 10 years. So you lend him 15,000 CHIPs (15 KC) and record a first position lien against his house.
Your 15 KC loan represents a 75% loan-to-value ratio on the home that is worth 20 KC. So you are well collateralized. In addition, you have a solid customer who seems capable of working to pay off the debt. So you make the loan.
No additional money of your own is required because you will be creating it in the act of making the loan–just like our current banking system. All you need to do is make the appropriate entry in the bank books to reflect what has happened. The 15 KC loan becomes a debit to the assets section of your balance sheet, under loans receivable. There is also an offsetting credit for 15 KC under liabilities, customer deposits.
You now owe your customer 15 KC in credits and he owes you the same amount in loan repayments later. The net worth of your new bank hasn’t changed at all. You just have more assets and more liabilities in an equal amount.
You also make an entry in your computer, but not on your accounting books. This reflects the current valuation of your borrower’s home at 20 KC so other associate banks can see you have been careful to properly secure your borrower’s debt.
Now imagine your borrower wants to use some of his newly created CHIPs to buy a new car. He shows up at an auto dealership where cars can be purchased with CHIPs and he flashes his newly issued CHIP debit card. Like a check, the card does not cost anything other than a very minimal processing fee. And like a regular debit card, it will only be honored if the computer says there are sufficient funds to back it up.
Next, the computer at the dealership’s CHIP bank automatically sends an inquiry to your new CHIP bank’s computer. Using secure and encrypted protocols, the inquiring bank is able to determine several things about your new CHIP bank:
- Your composite fitness score and rating.
- The amount of collateral you have on hand to back up your issued credits.
- The amount of equity you have pledged as a bank owner to further guarantee your issued credits.
Since you are a new CHIP bank, you will not score very well on the experience rating. This might trigger a more in-depth query involving other readily available information such as:
- The identity and reputation of the appraiser who valued your commercial building and the identity and reputation of his insurer.
- County records regarding your borrower’s home which was pledged as collateral.
- County records regarding the commercial building pledged as owner equity.
Ultimately, it is clear you have sufficient collateral and equity well in excess of the liabilities on your balance sheet. So your borrower’s transaction is approved and the funds are transferred.
Once completed, your books will now show an obligation to the dealership’s bank. Liens will exist on your equity collateral as well as your customer’s collateral. Because of your bank’s obligation to the dealership’s bank, they will have a legal pathway to collect value under those liens if it is ever necessary. Everyone’s debts will be fully secured.
Now let’s assume something bad happens. Your borrower gets in a car accident on the way home and is killed. His earning potential looked so good just hours ago and now your hopes for repayment are dashed. What had looked like a great store of value, backed by human earning potential didn’t turn out well.
But in reality it’s fine. Your small contribution to the money supply is still intact. Everyone is going to remain whole. Even your bank equity is not yet at risk.
The reason is, you still hold the house as collateral. So over the coming weeks, you commence a foreclosure action. One of two things will happen: either your borrower’s estate will have other assets and will pay off the loan completely along with fees and accrued interest. Or you will take over the asset and sell it. Either way, your bank will be made whole and you will be able to satisfy all its obligations.
Now let’s assume something else bad happened. In the months following your borrower’s death, new technology suddenly emerged relating to the production of homes. It became cheaper to build a home than it had ever been before. Because of this, when you attempted to sell the foreclosed home, you were not able to get the full 20 KC.
If you were able to get at least 16 KC, all is well. You can still pay off the note and return a little bit to your customer’s estate. But if you only get 14 KC, now you have a problem. You have created money in the amount of 15 KC but you only have 14 KC of actual value to back it up.
This is where your equity comes in as a final stop-gap. Now the world of CHIP banks have a potential claim on your commercial building for 1000 CHIPs. And you will have to do better business on other loans to make up the difference before your equity becomes clear again. The money in the system is still good and it will take a lot more misfortunes like this before all your equity is used up.
The keys to this system are:
- Loans must be made at responsible loan-to-value ratios
- Appraisals must be fair and accurate
- Bank owners must pledge sufficient amounts of equity which will be at risk if they manage the bank irresponsibly
- The whole system must be transparent and subject to public inspection and scrutiny
Another important factor has to do with the ongoing value of collateral properties throughout the term of the loan. It would be ideal if the loan-to-value ratio did not degrade over time.
Because we are accustomed to valuing real estate in dollars, we have come to think such investments always appreciate, or become more valuable over time. But in a market not artificially skewed by systematic inflation, this is not generally the case.
Certainly in cases where land is becoming scarce, we would expect the value of that land to increase in real terms. But when much of the value in a real property is due to structures constructed on the site, we would expect that value to decrease, or depreciate gradually over time. Buildings and other improvements degrade over time and must eventually be replaced. As they wear out, they become worth less and less. Should a CHIP banker have to worry about his collateral losing value through the term of the loan?
Just like a regular loan in dollars, CHIP loans should gradually get paid down over time. As long as the loan term is less than the expected life of the improvements on the collateral, things should work out pretty well. As the collateral becomes less and less valuable, the loan balance is also being gradually reduced. It should be part of a solid loan underwriting strategy to make sure this dynamic is kept in the proper balance. Periodic appraisals throughout the loan term can be done to make sure this is the case.
But there is an even more important revelation that becomes evident as soon as we begin to value collateral in terms of hours instead of dollars. The value of land will purely be a factor of supply and demand. How badly do people want to own a particular location? In other words, how many hours would a person be willing to work to become the owner of a particular parcel of ground?
But when it comes to constructed improvements such as a building, the valuation process is much more straightforward. How many man-hours would be required to build the structure? That’s it. A building, a road or a parking lot is worth exactly the number of hours it would take to reproduce it. It never appreciates. And other than gradually wearing out, it never really loses value.
CHIP loans have the potential to be more reliably secured than dollar loans because the method of valuing the collateral is more predictable. Risk is reduced for the lending institution so the chances of failure are reduced.
But what if everything goes wrong? Your borrowers all die, your collateral is not worth what you had hoped, and your equity is not enough to cover the remainder. If responsible practices are followed, this would be very rare indeed. But let us consider it anyway.
In our current central banking system, a bank fails when federal regulators declare it insolvent. If depositors are at risk to lose money, the federally managed bank insurance fund is used to make up the difference. Then the failed bank is either liquidated or sold off to another bigger bank.
The result is, smaller banks go out of business and larger banks can buy them up with the losses being covered by the Federal Government. This means big business gets bigger, small business is filtered out by ever more complex banking regulations, and irresponsible banks are taught that if they fail, the tax payers will step in to cover the loss.
But with a CHIP network, banks can be continually monitored by other member CHIP banks making it possible to detect a weak or failing bank long before it becomes completely insolvent. It would be possible for association members to agree in advance that failing banks will submit to an association-managed foreclosure any time their metrics drop below a predetermined level.
As mentioned, entrepreneurs who want to get into the CHIP banking business would have to pledge enough personal capital to meet association standards. Like any other business venture, they would put that capital at risk in exchange for the opportunity to be successful and make money. If they succeed, there will be one more successful and profitable CHIP bank in a growing association. If they fail, their equity will be sacrificed. Tax payers will not be forced to cover the loss and bail out the failed business.
The failing bank’s assets and liabilities would be absorbed by the rest of the CHIP network, the value of the monetary system would be protected, and all the CHIPs in circulation would retain their integrity and hence their value.
