Tag Archive | Crowdfunding

Blurry banks’ future is











Here’s Deloitte own version:




Deloitte Margin Compression


Two kinds of financial innovation

Paul Volcker famously said that the only meaningful financial innovation of the past decades was the ATM. Not only do I believe that his comment was strongly misguided, but he also seemed to misunderstand the very essence of innovation in the financial services sector.

Financial innovations are essentially driven by:

  • Technological shocks: new technologies (information-based mostly) allow banks to adapt existing financial products and risk management techniques to new technological paradigms. Without tech shocks, innovations in banking and finance are relatively slow to appear.
  • Regulatory arbitrage: financiers develop financial products and techniques that bypass or use loopholes in existing regulations. Some of those regulatory-driven innovations also benefit from the appearance of new technological and theoretical paradigms. Those innovations are typically quick to appear.

I usually view regulatory-driven innovations as the ‘bad’ ones. Those are the ones that add extra layers of complexity and opacity to the financial system, hiding risks and misleading investors in the process.

It took a little while, but financial innovations are currently catching up with the IT revolution. Expect to change the way you make or receive payments or even invest in the near future.

See below some of the examples of financial innovation in recent news. Can you spot the one(s) that is(are) the most likely to lead to a crisis, and its underlying driver?

  • Bank branches: I have several times written about this, but a new report by CACI and estimates by Deutsche Bank forecasted that between 50% and 75% of all UK branches will have disappeared over the next decade. Following the growing branch networks of the 19th and 20th centuries, which were seen as compulsory to develop a retail banking presence, this looks like a major step back. Except that this is actually now a good thing as the IT and mobile revolution is enabling such a restructuring of the banking sector. SNL lists 10,000 branches for the top 6 UK bank and 16,000 in Italy. Cutting half of that would sharply improve banks’ cost efficiency (it would, however, also be painful for banks’ employees). It is widely reported that banks’ branches use has plunged over the past three years due to the introduction of digital and mobile banking.
  • In China, regulators have introduced new rules to try to make it harder for mainstream banks to deal with shadow banks in order to slow the growth of the Chinese shadow banking system, which has grown to USD4.9 trillion from almost nothing just a few years ago. The Economist reports that, by using a simple accounting trick, banks got around the new rules. Moreover, while Chinese regulators are attempting to constrain investments in so-called trust and asset management companies, investors and banks have now simply moved the new funds to new products in securities brokerage companies.
  • Apple announced Apple Pay, a contactless payment system managed by Apple through its new iPhones and Watch devices. Apple will store your bank card details and charge your account later on. This allows users to bypass banks’ contactless payments devices entirely. Vodafone also just released a similar IT wallet-contactless chip system (why not using the phone’s NFC system though? I don’t know. Perhaps they were also targeting customers that did not own NFC-enabled devices).
  • Lending Club, the large US-based P2P lending firm, has announced its IPO. This is a signal that such firms are now becoming mainstream, as well as growing competitors to banks.

Of course, a lot more is going on in the financial innovation area at the moment, and I only highlighted the most recent news. Identifying the regulatory arbitrage-driven innovations will help us find out where the next crisis is most likely to appear.

PS: the growth of cashless IT wallets has interesting repercussions on banks’ liquidity management and ability to extend credit (endogenous inside money creation), by reducing the drain of physical cash on the whole banking system’s reserves (outside money). If African economies are any guide to the future (see below, from The Economist), cash will progressively disappear from circulation without governments even outlawing it.

Mobile Money Africa

Crowdfunding, naivety and scandals

John Kay wrote an interesting article for the FT yesterday, titled “Regulators will get the blame for the stupidity of crowds.” He argues that, despite crowdfunding and P2P enthousiasts blaming regulators for being too slow and too cautious, this new market will eventually crash and trigger calls for more advanced regulation as well as the setup of compensation schemes. Desintermediation firms would then reintermediate lending and effectively transform into… banks.

I partly agree with Kay. A collapse/crash/losses/fraud/scandals is/are inevitable. And this is a good thing.

I have already written about the importance of failure in free market financial systems. New financial innovations need to experience failures in order to end up reinforced, to distinguish what works from what doesn’t work. This is a Darwinian learning process. The system then becomes ‘antifragile’. Consequently, the state should refrain from intervening in order not to postpone this necessary learning process and resulting adjustments. When crowdfunding crashes, the state should resist any call for intervention/bailout/regulation. This is the only way crowdfunding can become a mature industry.

I however also partly disagree with Kay, who I believe does not see the bigger picture.

Kay argues that investors (in this case ‘crowds’) are naïve. That intermediation has benefits and non-professional investors lack the ‘cynicism’ to assess the risk/reward profile of those investments.

Where Kay is wrong though, is in considering P2P lending as “a substitute for deposit account.” It is not. P2P lending is an investment. Unsophisticated retail investors can also lose much of their money by investing in various stocks. Or by betting on the wrong horse. I don’t believe investors mistake crowdfunding for bank deposits…

I think that what Kay also fails to see is that, if historically many start-ups and young SMEs have struggled to grow and eventually failed, it is partly because they lacked the funds required to grow. Some start-ups ended-up collapsing or selling themselves to larger competitors simply because funding became scarce at the second or third round of funding. This funding gap was particularly prevalent in some markets such as the UK (less so in the US). Some other markets, such as France, on the other hand, lack first round financing (seed funding, mainly provided by ‘Angel’ investors).

When the supply for loanable funds is scarce relative to the demand, demanded return on investment is high. Many new firms, particularly in non-growth markets, find it hard to cope with this situation and are pretty much avoided by venture capital investors. What equity crowdfunding and P2P lending do is to increase the supply of loanable funds, reducing the average required rate of return. Refinancing risk mechanically recedes, guaranteeing the success or the failure of an SME on its business strategy and execution alone.

In addition, crowdfunding multiply investment opportunities, making it easier to diversify a portfolio of investments. Historically, venture capital funds could not diversify too much if they wanted to maintain appropriate levels of returns.

Scandals are inevitable, but the learning mechanism inherent to the market process must be allowed to run its course. Learning, combined with the increased supply of loanable funds, would reduce the probability of scandals occurring in the long-run and make crowdfunding a solid industry.

Could P2P Lending help monetary policy break through the ‘2%-lower bound’?

The ‘cut the middle man’ effect of P2P lending is already celebrated for offering better rates to both lenders and borrowers. But what many people miss is that this effect could also ease the transmission mechanism of central banks’ monetary policy.

I recently explained that the banking channel of monetary policy was limited in its effects by banks’ fixed operational costs. I came up with the following simplified net profit equation for a bank that only relies on interest income on floating rate lending as a source of revenues:

Net Profit = f1(central bank rate) – f2(central bank rate) – Costs, with

f1(central bank rate) = interest income from lending

= central bank rate + margin and,

f2(central bank rate) = interest expense on deposits

= central bank rate – margin

(I strongly advise you to take a look at the details here, which was a follow-up to my response to Ben Southwood’s own response on the Adam Smith Institute blog to my original post…which was also a response to his own original post…)

Consequently, banks can only remain profitable (from an accounting point of view) if the differential between interest income and interest expense (i.e. the net interest income) is greater than their operational costs:

Net interest income >= Costs

When the central bank base rate falls below a certain threshold, f2 reaches zero and cannot fall any lower, while f1 continues to decrease. This is the margin compression effect.

Above the threshold, the central bank base rate doesn’t matter much. Below, banks have to increase the margin on variable rate lending in order to cover their costs. This was evidenced by the following charts:

Rate floor

Rate floor 4

As the UK experience seems to show, banks stopped passing BoE rate cuts on to customers around a 2% BoE rate threshold. I called this phenomenon the ‘2%-lower bound’. I have yet to take a look at other countries.

Enter P2P lending.

By directly matching savers and borrowers and/or slicing and repackaging parts of loans, P2P platforms cut much of banks’ vital cost base. P2P platforms’ online infrastructure is much less cost-intensive than banks’ burdensome branch networks. As a result, it is well-known that both P2P savers and borrowers get better rates than at banks, by ‘cutting the middle man’. This is easy to explain using the equations described above, as costs approach zero in the P2P model. This is what Simon Cunningham called “the efficiency of Peer to Peer Lending”. As Simon describes:

Looking purely at the numbers, Lending Club does business around 270% more efficiently than the comparable branch of a major American bank

Simon calculated the ‘efficiency’ of each type of lender by dividing the outstanding loans of Wells Fargo and Lending Club by their respective operational expenses (see chart below). I believe Lending Club’s efficiency is still way understated, though this would only become apparent as the platform grows. The marginal increase in lending made through P2P platforms necessitates almost no marginal increase in costs.

Wells vs Lending Club

Perhaps P2P platforms’ disintermediation model could lubricate the banking channel of monetary policy the closer central banks’ base rate gets to the zero bound?

Possibly. From the charts above, we notice that the spread between savings rates and lending rates that banks require in order to cover their costs range from 2 to 3.5%. This is the cost of intermediation and maturity transformation. Banks hire experts to monitor borrowers and lending opportunities in-house and operate costly infrastructures as some of their liabilities (i.e. demand deposits) are part of the money supply and used by the payment system.

However, disintermediated demand and supply for loanable funds are (almost) unhampered by costs. As a result, the differential between borrowers and savers’ rate can theoretically be minimal, close to zero. That is, when the central bank lowers its target rate to 0%, banks’ deposit rates and short-term government debt yield should quickly follow. Time deposits and longer-dated government debt will remain slightly above that level. Savers would be incentivised to invest in P2P if the proposed rate at least matches them, adjusting for credit risk.

Let’s take an example: from the business lending chart above, we notice that business time deposit rates are currently quoted at around 1%. However, business lending is currently quoted at an average rate of about 3%. Banks generate income from this spread to pay salaries and other fixed costs, and to cover possible loan losses. Let’s now imagine that companies deposit their money in a time deposit-equivalent P2P product, yielding 1.5%. Theoretically, business lending could be cut to only slightly above 1.5%. This represents a much cheaper borrowing rate for borrowers.

P2P platforms would thus more closely follow the market process: the law of supply and demand. If most investments start yielding nothing, P2P would start attracting more investors through arbitrage, increasing the supply of loanable funds, and in turn lowering rates to the extent that they only cover credit risk.

The only limitation to this process stems from the nature of products offered by platforms. Floating rate products tend to be the most flexible and quickly follow changes in central banks’ rates. Fixed rate products, on the other hand, take some time to reprice, introducing a time lag in the implementation of monetary policy. I believe that most P2P products originated so far were fixed rate, though I could not seem to find any source to confirm that.

In the end, P2P lending is similar to market-based financing. The bond market already ‘cuts the middle man’, though there remains fees to underwriting banks, and only large firms can hope to issue bonds on the financial markets. In bond markets, investors exactly earn the coupon paid by borrowers. There is no differential as there is no middle man, unlike in banking. P2P platforms are, in a way, mini fixed-income markets that are accessible to a much broader range of borrowers and investors.

However, I view both bond markets and P2P lending as some version of 100%-reserve banking. While they could provide an increasingly large share of the credit supply, banks still have a role to play: their maturity transformation mechanism provides customers with a means of storing their money and accessing it whenever necessary. Would P2P platform start offering demand deposit accounts, their cost base would rise closer to that of banks, potentially raising the margin between savers and borrowers as described above.

It seems that, by partly shifting from the banking channel to the P2P channel over time, monetary policy could become more effective. I am sure that Yellen, Carney and Draghi will appreciate.

Izabella Kaminska gets confused on 100%-reserve banking, or collateral, unless it’s… wait, I’m confused now

Meanwhile, Izabella Kaminska in the FT had an interesting (as usual), but very confused and confusing, blog post. I asked whether or not she was reading my blog given that some of her claims pretty much reflect mine (she calls the shadow banking system a “decentralised full-reserve banking system that just happens to run parallel with the official fractional system we are used to.” Compare that with my “[…] parallel 100%-reserve banking system. The shadow banking system is effectively some version of a 100%-reserve banking.”). But the similarities stop here. She sounds very confused… She gets mixed up between various terms, principles and concepts and tries to hide it behind quite complex wordings.

She mixes collateralised lending with 100%-reserve and uncollateralised lending with money creation. They are in fact totally unrelated. A bank or shadow bank can be fractional-reserve-based or 100%-reserve-based, which simply relates to whether or not a bank lends out a share of its deposits or if it maintains them in full in its vaults. Collateralised lending is, well, just lending provided against collateral (which can be almost any type of assets). Both fractional and 100%-reserve banks can lend against collateral in order to minimise the risk of loss in case of default. 100%-collateralised lending is not 100%-reserve.

True, 100%-cash collateralised lending could be thought of as some form of 100%-reserve banking as the cash reserve at the bank would virtually never depart from the deposit base amount. For example, if a fractional bank collects USD100 in deposits and lends out USD90, it only keeps 10% of cash deposits in reserve. If, though, it lends out USD90 collateralised against USD90 of cash, then it ends up with USD100 in its vault, the same amount as the deposit base (although there will be limitations on the liquidity of the cash as the collateral will likely be ‘stuck’ until repayment or default). But, following her claim, a mortgage bank would be a 100%-reserve bank as the value of the housing portfolio on which lending is secured is worth more than the amount of lending. This is obviously wrong. Unless houses are now a generally-accepted medium of exchange?

Then she claims that “the official banking sector, for example, has the capacity to make uncollateralised investments in growth areas it feels are promising regardless of whether borrowers have collateral, or whether they can be fully funded.” Not really. First, banks usually collateralise between a quarter and more than 100% of their lending. Second, “uncollateralised investments in growth areas it feels are promising regardless of whether borrowers have collateral” is called venture capital and is clearly not what banks do. Venture capital funds, business angels, and some crowdfunding and P2P platforms are here for that (you could also probably add the junk bond market to the list). She then adds that, in contrast to banks, “the shadow banking sector’s strength, of course, is that it is prepared to service those entities (whether directly or indirectly) the official banking sector is not prepared to service, thanks to a greater emphasis on collateral or funding.” As I just said, this is not the case. Venture capital-type investments cannot accept collateral as… there is none! This is why they are high-risk.

According to Izabella, there is a reason why shadow banks cannot create money: their use of collateral. While it is true that (most, probably all) shadow banks cannot create money, it is not because they lend against collateral as described above. A lot of shadow banks don’t lend against collateral: think most money market funds, P2P lending, hedge funds, mutual funds, payday lenders…or simply the bond market! But they don’t create money either! They only transfer cash.

In the comment section she also seems to claim that fractional reserve banking is an innovation of our modern banking system. Where did she get that? Fractional reserves have been used since antiquity: the use of the ‘monetary irregular-deposit’ contract in classical Roman law gave rise to fractional reserves as deposits were mixed with other ones of equivalent nature (as opposed to the mutuum, or monetary loan contract, which is similar to what we could describe as today’s mutual funds for example). Despite the illegality of lending out irregular-deposits, some bankers took advantage of the fungibility of money, and of the fact that many irregular-deposits were rarely withdrawn, to lend out a part of their deposit base. The ‘bank’ of Pope Callistus I (see photo) failed as it was unable to return the irregular-deposits on demand. Other examples of failed banks exist at this period but fractional reserves really took off from the late middle ages in Europe.

Callistus 1

Not everything is wrong in her article as I mentioned at the beginning of my post. She’s right to claim that regulation would only displace risk to another corner of the financial system that shadow banking is merely a response to the regulatory-incentivised under-banked part of the economic system, and that P2P lending is a kind of shadow banking. But too many confusions or misunderstandings around collateral, money creation, bank funding, bank reserves, etc., obfuscate the topic.

Financial innovation is back with a vengeance

What didn’t we hear about financial innovation throughout the crisis? Whereas innovation in general is good, financial innovation on the other hand was the worst possible thing coming out of a human mind. Paul Volcker, former Chairman of the Fed, famously declared that the ATM was the only useful financial innovation since the 1980s. Harsh.

True, some financial innovations are better than others. In particular, those used to bypass regulatory restrictions are more dangerous, not because they are intrinsically evil or anything, but simply because their often complex legal structure makes them opaque and difficult for external analysts and investors to analyse. This famous 2010 Fed paper attempted to map the shadow banking system (see picture), and usefully stated that not all shadow banking (and financial innovations) activities were dangerous (but those specifically designed to avoid regulations were). Ironically (and typically…) one of the first innovations to ever appear within the shadow banking system was money market funds. What was the rationale behind their creation? In the 1960s and 1970s in the US, interest payment on bank demand deposits was prohibited and capped on other types of deposits. The resulting financial repression through high inflation pushed financial innovators to come up with a way of bypassing the rule: money market funds became a deposit-equivalent that paid higher interests. Today we blame money market funds for being responsible for a quiet run on banks during the crisis, precipitating their fall. It would just be good to remember that without such stupid regulation in the first place, money market funds might have never existed…

Shadow Banking

The last decade has seen the growth of two particularly interesting innovations within the shadow banking system: one was relatively hidden (securitisation) while the other one grew in the spotlight (crowdfunding/peer-to-peer lending). One was deemed dangerous. The other one was more than welcome (ok, not in France). What had to happen happened: they are now combining their strength.

Various types of crowdfunding exist: equity crowdfunding, P2P lending, project financing… Today I’m going to focus on P2P lending only. What started as platforms enabling individuals to lend to other individuals are now turning into massive gates for complex institutional investors to lend to individuals and SMEs. Given the retreat of banks from the SME market (thank you Basel), various institutional investors (mutual and hedge funds, insurance firms) thought about diversifying their investments (and maximising their returns) by starting to offer loans to individuals and companies they normally can’t reach.

Basically, those funds had a few options: developing the capabilities to directly lend to those customers, investing in securitised portfolios of bank loans, or investing in securitised portfolios of P2P loans. The first option was very complex to implement and the required infrastructure would take a long time to develop. The second option had already existed for a little while, but was dependent on banks lending to customers, which current regulations limit due to higher capital requirements on such loans. The third option, on the other hand, allowed funds to maximise returns and attract more potential borrowers thanks to the reduction of the cost of borrowing by disintermediating banks. And funds could also strike deals with those still tiny online platforms that would have never happened with massive banks.

While securitisation sounds scary, it is actually only a simpler way of investing in loans of small sizes (the alternative being to invest in every single loan, some of them amounting to only USD500… Not only many funds don’t have the capability of doing such things, but many have also restrictions about the types of asset class and amounts they can invest in). Securitisation also bypasses Wall Street investment banks: funds directly invest in P2P loans, package them and sell them on to other investors while retaining a ‘tranche’ in the deal, which absorbs losses first. Now some entrepreneurs are even talking of setting up secondary markets to trade investments in loans, pretty much like a smaller version of the bond market.

Is this a welcome evolution for the P2P industry? I would say that it is a necessary evolution. It is once again a spontaneous development that merely reflects the need for funding of the P2P industry, which small retail investors cannot fulfil (unless all investment funds’ customers start withdrawing their money to directly invest in P2P, which is highly unlikely). Many start to think that large institutional investors will end up crowding out small retail investors. Possibly, but as long as regulation remains light, keeping barriers to entry low, new platforms only accepting retail investors could well appear if the demand is present.

All this is fascinating. Not only because technology and the internet enables new ways of channelling funds from savers to borrowers, but also because this is the growth of a parallel 100%-reserve banking system. The shadow banking system is effectively some version of a 100%-reserve banking. And it keeps growing through those various innovations. As I argued in a previous post, this may well have implications for monetary policy that current central banks and economists don’t take into account. A 100%-reserve banking system does not have a deposit multiplier and consequently does not have an elastic currency to respond to a sudden increase or decrease in the demand for money. However, such a system perfectly matches savers’ and borrowers’ intertemporal preferences, limiting malinvestments. Nonetheless, we for now remain in a mix system of 100% reserve (most of shadow banking) and fractional reserves (traditional banking). It would still be interesting to study the possible policy implications of a growth in the 100%-reserve part of the economy.

Spontaneous finance at work

The FT reported today that non-bank lending to SMEs was at its highest level since 2008 in the UK, whereas bank lending had been declining constantly since the start of the crisis, despite politicians’ and central bankers’ actions to revive it (such as the BoE’s Funding for Lending Scheme).


What kind of non-bank lending are we talking about? Personally, I would call this ‘shadow banks lending’, even though some other economists and analysts may have a different definition of shadow banking. To me, it comprises the less-regulated non-bank entities, from hedge funds to peer-to-peer lending platforms.

This is spontaneous finance at work: while the bloated, politically connected and over-regulated banking system does not seem to be able to channel resources (private savings) to smaller-than-large corporations, private actors, from investment funds to private individuals, step in to respond to their funding needs. This phenomenon has two sources: banks’ lending rates are often too high (blame regulatory capital requirements) and banks’ offered savings rate too low (blame too high inflation vs. BoE rate). And blame banks’ too high operating costs for both. As a result, there is a mismatch between what savers expect and what companies expect.

The solution? Bypass banks. Various investment companies (from hedge funds to more traditional mutual funds) are now setting up funds to gather savings and lend directly to companies that need them. Peer-to-peer and crowdfunding platforms basically act the same way by disintermediating all financial institutions: individuals directly lend to other individuals or firms. We also now see funds investing through P2P platforms (reversing the disintermediation process). Through those shadow banking channels, both savers and borrowers get better rates than they would do at a bank. At the time of my writing, savers can earn from 4% to 7% on their savings (even some hedge funds would love to get such steady returns). Rates vary for borrowers, but are on average lower than that of banks.

Lending volume is still pretty small as the wider public isn’t yet aware of those funding opportunities. In the UK, Funding Circle has only lent slightly less than GBP170m so far to small businesses (this compares to banks’ SME lending which stands at around GBP170…bn). But it’s growing quickly: it was only launched in 2010. Moreover, other shadow banks had lent around GBP17bn as of June (yes, a lot of 17 something, just a coincidence).

As this City AM article highlighted today, as usual, the main risk to those financial innovations is over-regulation, preventing their development and potentially leading to the creation of much riskier and opaque financial products. Regulators wish to ‘protect’ savers. I argue that savers do not need to be protected: they need to learn to invest responsibly and to understand the risks involved. Protection distorts risk-taking and capital allocation.

More worrying is the fact that some peer-to-peer industry actors are now even lobbying to be regulated… They claim that regulation will reassure potential investors. I claim that regulation will mainly protect the established firms by making it more difficult for new competitors to enter the market and offer competitive products to savers and borrowers. A brand new financial system is building before our eyes. It is important not to repeat mistakes that led to our current ineffective banking system.

Photograph: govopps.co.uk


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