Tag Archive | Financial Innovation

The bank branch is dying. Some politicians don’t seem to get it

Technology is both a curse and a blessing for banks. It usually starts as a curse and ends up being a blessing (at least for the banks that eventually managed to master technological disruptions). I’ve personally argued several times during BarcampBank debates that the branch was outdated. The rebuttal I usually got (especially from French financial actors and entrepreneurs, probably a cultural thing) is that customers want to ‘feel’ some humanity, and not interact with some faceless system. I don’t disagree, but I would argue that they are massively overestimating the ‘humanity’ factor. What people want is convenience.

‘Humanity’ is just an inefficient way of providing convenient services to customers. When your services and IT systems aren’t convenient and instinctive enough for customers to use easily, they will naturally seek human help and reassurance. Does it mean customers necessarily want ‘access to other humans’ for most of their banking transactions? No. What it does mean it that banks don’t have straightforward enough and easy-to-use systems.

Mckinsey 2 Internet banking

So here I reiterate: branches are outdated. And, once again, it is both a curse and a blessing for banks. For now, it is a curse: the retail banking business of most (large) banks is plagued by an unsustainable cost/income ratio (often around 70%+ when it should be closer to 50). The internet revolution led banks to open websites but not to close branches: branches were still the primary medium through which they could attract depositors (hence funding). Having a branch near potential customers’ home was crucial in order to both obtain funding and revenues. Internet obviously changes everything. But with a lag. Young people quickly get used to utilising internet websites for shopping and banking, but don’t have the financial resources that drive banking revenues. On the other hand, older customers are much slower to keep up with the trend. Some of the very first internet banks, like UK’s Egg, were not as successful as expected as a result.

McKinsey retail banking

Now that mainstream internet use has been among us for around 15 years, much more customers use online services, including banking, and former early adopter but resource-poor students are now working professionals. Smartphones have compounded the trend. Brett King has extensively described the possible functions of a branch in the 21st century and documented the various trends in customer preferences in his Bank 2.0 and Bank 3.0 books. Mobile banking is booming and banks are at last starting to react. Over the last year, banks have followed each other in announcing reductions in their branch network, something that would have been unimaginable just a few years ago. In the US, banks are axing branches, the latest in line being Bank of America. In the UK, Barclays referred to branch closures as a ‘necessity’ at the end of last year. RBS and HSBC have also announced branch closures. In the rest of Europe, the trend is the same (see Belgian and French banks for instance). The other part of the curse is that banks do have to heavily invest in IT to catch up with the trend. And I am not even mentioning unions’ rejection of the branch axing plans, which indeed involve jobs cutting.


The blessing part of the story is that, while banks are constrained by increasing compliance costs and fall of revenues due to new regulations, smaller branch networks also means reduced cost bases. Bankers, desperate to improve their single-digit RoE can only welcome the change in the medium-term. More profitable banks also mean more flexible and more robust banks.

But. Some (most?) politicians don’t seem to get it. The UK’s Labour party came up with a brand new ‘brilliant’ idea to end the dominance of the largest retail banks of the country: a cap on the number (market share) of branches. As they are saying:

We are not asking whether existing banks might have to divest themselves of a significant number of branches. We are asking how we make that happen.

Well, you know what guys? It’s already happening. 21st century technological disruption does not require 20th century reasoning. Yet many professional politicians seem to have been blessed with the very skill of thinking using ‘previous century logic’. Politicians, please back away and let technology implement more efficient measures than anything you would have ever been able to plan.

PS: One of my (unrealistic at the moment) proposals was that alternative and independent interbank ‘superbranches’ could appear, gathering services/ATMs from all high-street banks under the same roof. This place would effectively be for banks what UK-based Carphone Warehouse and its competitors are for mobile phone providers. Banks would be a big step closer to being virtual service-providers and customers could potentially switch almost at will, intensifying competition. That would be a revolution.

PPS: Other technological disruptions I didn’t mention in the post were P2P-lending and associated services. This is also a big challenge but requires different responses, although some of the issues are interlinked.

China as a spontaneous finance Frankenstein

China is an interesting case. Underneath its very tight government-controlled financial repression hide numerous financial experiments aimed at bypassing those very controls. The Chinese shadow banking system is now a well-known financial Frankenstein, with multiple asset management companies, wealth management products and other off-balance sheet entities providing around half the country’s credit volume. The more the government tries to regulate the system, the more financial innovation finds new workarounds and become increasingly more opaque.

Frankenstein shadows

Bitcoin is following this typical mechanism. China was one of the world’s most successful Bitcoin markets as local retailers and customers attempted to avoid government control and manipulation. In short, Chinese users liked that Bitcoin had fixed rules that could not be twisted by some corrupted officials. Bitcoin allowed them to transfer currency internationally almost without restriction. Its Chinese supporters felt free. Indeed, freedom and facilitation of transaction and saving is what drives most spontaneous financial innovations. Nonetheless, the love story couldn’t last as I have already described and the government launched a crackdown on Bitcoin in December.

Nonetheless, Bitcoin is coming back, the Frankenstein way. The FT reported today that local Chinese Bitcoin exchanges are now finding ways around new government rules. Surprising? It shouldn’t be. Governments around the world, a simple message: don’t underestimate your citizens. You’ll always run after them. Never ahead.

The issue is now that all those rules are pushing Bitcoin and other innovations even more into the shadows, making the whole system even more opaque and hard to analyse. For instance, while Chinese banks are now forbidden to clear Bitcoin transactions, a local platform route the money through its founder’s account. Some others have started to use voucher systems, essentially transferable claims on RMB accounts for people who want to buy and sell Bitcoins. Those vouchers effectively become claims on claims on money, or some sort of money substitutes redeemable on money substitutes (bitcoins) redeemable on money (USD)…

I personally don’t really welcome such evolutions. Government should stay away and not add further systemic risks to innovations already trying to figure out what their own limits are. As I recently said, learning is intrinsic to any system and should not be suppressed.

Statism and the ideological war against Bitcoin

While the US Senate provided some support to Bitcoin and other digital alternative ‘currencies’, most of central banks and regulatory authorities around the world seem to have declared war against them. Yesterday, Alan Greenspan, the former Fed Chairman, said that Bitcoin was a bubble and that it had no intrinsic value. Although his track record at spotting bubbles is rather… poor.

Bitcoin Price

China’s central bank, the PBoC, banned financial institutions from doing any kind of business with it. Is it surprising from a country in which citizens are subject to financial repression and capital controls and who as a result see Bitcoin as a step towards financial freedom? It was very unlikely that China would endorse a medium of exchange over which it has no control. This is also true of other central banks. Today, Business Insider reported that the former Dutch central bank president declared that Bitcoin was worse than the 17th century Tulip mania. FT Alphaville continued its recurrent attacks against Bitcoin. The Banque de France also published a very bearish note on the now famous digital currency. The title couldn’t be more explicit: “The dangers related to virtual currencies’ development: the Bitcoin example”. What’s striking with the Banque de France note is that it pretty much sums up all criticisms (misplaced or not) against the virtual currency.

They start with the fact that Bitcoin is “not regulated.” Horror. Well, not only it is the goal guys, but it‘s not even completely true: Bitcoin’s issuance is actually very tightly regulated by its own algorithm, which replaces the discretionary powers of central banks. They add that Bitcoin provides “no guarantee of being paid back” and that its value is volatile. Yes, this is what happens when we invest in any sort of asset. To them, Bitcoin’s limited growth and resulting scarcity was intentionally introduced by its designer to provide it with a speculative nature. Not really… The design was a response to central banks’ lax use of their currency-issuing power. Moreover, Bitcoin’s value is the “exclusive result of supply and demand”! I guess that, for central bankers, this is indeed shocking. For classical liberals like me, or libertarians, this is the way it should be.

I think the ‘best’ argument against Bitcoin is the fact that, as it is anonymous, it can be used in criminal and fraudulent activities and money laundering. Wait… isn’t central bank cash even more anonymous? Hasn’t central bank cash been used in fraudulent activities and money laundering for decades, if not centuries? Are central banks involved in Know Your Customer practices? Finally, another argument of the Bank de France is: there is no authority safeguarding the virtual wallets, exposing them to hackers and other potential threats. True, there is no example in history of ‘authorities’ stealing, debasing or manipulating the reserves of media of exchange they were supposed to ‘safeguard’…* The central bank harshly concludes that Bitcoin’s use “presents no interest to economic agents beyond marketing and advertising, while exposing them to large risks.”

As I have said several times, Bitcoin is surely not perfect. But neither are our current official fiat currencies. I am neither for nor against Bitcoin or any digital currency. I am in favour of letting the markets experiment and pick the currency they judge appropriate. I am against a central authority forcing the use of a certain currency.

Let’s debunk a few other myths.

First, Bitcoin is not money. It is at best a commodity-like asset, such as gold, or a very limited medium of exchange. But it is not a generally accepted medium of exchange, the traditional definition of money. Perhaps someday. But not at the moment. Current institutional frameworks also make it very difficult for it to become generally accepted: legal tender laws, taxation in official currencies, and central banks’ monopoly on the issuance of money severely slow down the process.

As a result, the complaints that we keep hearing that its value is volatile and doesn’t allow for stable prices and economic efficiency through menu costs is completely misplaced. For a simple reason: apart from a few exceptions, there is no price denominated in Bitcoin! When you want to buy a good using Bitcoin, Dollar or Euro (or whatever) prices are converted into Bitcoins. Because Bitcoin has its own FX rate against those various currencies, when its value against another currency fluctuates, the purchasing power of Bitcoin in this currency fluctuates and prices converted into Bitcoins fluctuate! Prices originally denominated in Bitcoin would not fluctuate however.

What happens when you are an American tourist visiting Europe? Your purchasing power is in USD. But you have to buy goods denominated in EUR. As a result, your purchasing power fluctuates every day as you use USD to buy EUR goods. It is the same with Bitcoin. For now Bitcoin effectively involves FX risk. Either the consumer bears the risk of seeing its purchasing power fluctuates, or the seller/producer bears it, knowing that his own input prices were not in Bitcoin. At the moment, in the majority of cases, consumers/buyers bear the risk. Perhaps a bank could step in and start proposing Bitcoin FX derivatives for hedging purposes to its clients? Actually, a Bitcoin trading platform actually already offers an equivalent service.

Something that is really starting to annoy me every time I hear it is that Bitcoin is not like traditional fiat money, as it is not backed by anything and thus has no intrinsic value. Sorry? The very definition of fiat money is that it is not backed by anything! And none of the efforts of some Modern Monetary theorists, chartalists, or FT Alphaville bloggers will manage to convince us of the contrary. They claim that fiat money has intrinsic value as it is backed by “the government’s ability to tax the community which bestows power on it in the first place. This tax base represents the productive capacity of the collective wealth assets of the US community, its land and its resources. The dollar in that sense is backed by the very real wealth and output of the system. It is not just magic paper”, as described by the FT Alphaville blog post mentioned above. Right. This all sounds nice and abstract but can I show up at my local central bank and redeem my note for my share of “the productive capacity of the country”?**

A fiat money isn’t backed by anything at all but by faith. The only thing that gives fiat money its value is economic agents’ trust in it. When this trust disappears the currency collapses. It happened numerous times in history but I guess it is always convenient for some people to forget about those cases. A recent example was the hyperinflation in Zimbabwe: despite legal tenders laws and the fact that taxes were collected in Zimbabwean Dollars, the population lost faith in the currency and turned towards alternatives, mainly USD, EUR and South African Rand. People could well lose faith in advanced economies’ official currencies and start trusting Bitcoin (or any other medium of exchange) more. At that point, Bitcoin would still be fiat but become effectively ‘backed’ by the faith of economic agents and could well trigger a switch in the money we use on a day to day basis.

Another (half) myth is that Bitcoin is only a tool for speculation that diverts real money from real ‘productive purposes’. It is true that, as an asset, Bitcoin will always attract speculators. But it doesn’t necessarily divert money from the real economy: 1. when Bitcoins are sold, they are swapped for real money, money that does not remain idle but then can be used for ‘productive purposes’ by the new holder (or his bank) and 2. as a medium of exchange, Bitcoin can actually facilitate trade and hence ‘productive activities’. Don’t get me wrong: this does not mean that there are no better investment opportunities than Bitcoin. Investors will decide, and if the digital currency is destined to fail, it will, and the markets will learn.

There are other problems with Bitcoin, one of which being that it provides an inelastic currency as its supply is basically fixed. However, in a Bitcoin-standard world (as opposed to a gold-standard), we could probably see the emergence of fractional reserve banks that would lend Bitcoin substitutes and issue various liabilities (notes and deposits mainly) denominated in Bitcoin and redeemable in actual Bitcoin (which would then play the role of high-powered money). This mechanism would then provide some elasticity to the currency (and therefore to the money supply) to respond to increases and decreases in the demand for money.

Bitcoin seems to enrage central bankers, regulators, Keynesians (particularly post-Keynesians), chartalists, Modern Monetary theorists and other statists. Consequently they resort to myths and misconceptions in order to threaten its credibility. As I have already said, my stance is neutral. Alternative currencies will come and go. Some will fail. Others will succeed. Markets will decide. I argue that alternative currencies contribute to the greater good as they all of a sudden introduce monetary competition between emerging private actors and traditional centralised institutions. If alternative currencies can eventually force central banks and states to better manage their own currencies, it would be for the benefit of everyone.

To end this piece, let me quote Hayek:

But why should we not let people choose freely what money they want to use? By ‘people’ I mean the individuals who ought to have the right whether they want to buy or sell for francs, pounds, dollars, D-marks or ounces of gold. I have no objection to governments issuing money, but I believe their claim to a monopoly, or their power to limit the kinds of money in which contracts may be concluded within their territory, or to determine the rates at which monies can be exchanged, to be wholly harmful.

Well said mate.

* This was irony, for those who didn’t get it.

** The spontaneous development of alternative local currencies (such as this one) by individuals lacking balances in the official currency of the country but willing to trade goods or to propose services, is another example of a non-state issued money (and not collected to pay taxes) that facilitate economic output and the generation of wealth, in direct contradiction to the state theory exposed above.

Chart: CNN

Cato Institute’s 31st Monetary Conference – Was the Fed a good idea?

About two weeks ago, the US-based think tank Cato organised its annual monetary conference. Great panels and very interesting speeches.


Three panels were of particular interest to me: panel 1 (“100 Years of the Fed: What Have We Learned?”), panel 2 (“Alternatives to Discretionary Government Fiat Money”), panel 3 (“The Fed vs. the Market as Bank Regulator”).

In panel 1, George Selgin destroys the Federal Reserve’s distorted monetary history. Nothing much new in what he says for those who know him but it just never gets boring anyway. He covers: some of the lies that the Federal Reserve tells the general public to justify its existence, pre-WW2 Canada and its better performing monetary system despite not having a central bank, the lack of real Fed independence from political influence and……the Fed not respecting Bagehot’s principles despite claiming to do so. In this panel, the speech of Jerry Jordan, former President of the Federal Reserve Bank of Cleveland, is also very interesting.

In panel 2, Larry White speaks about alternatives to government fiat money, counterfeiting laws and state laws making it illegal to issue private money. Scott Sumner describes NGDP level targeting. Here again, nothing really new for those who follow his blog, but interesting nonetheless (even though I don’t agree with everything) and a must see for those who don’t.

In panel 3, John Allison provides an insider view of regulators’ intervention in banking (he used to be CEO of BB&T, an American bank). He argues that mathematical risk management models provide unhelpful information to bankers. He would completely deregulate banking but increase capital requirements, which is an original position to say the least. Kevin Dowd’s speech is also interesting: he covers regulatory and accounting arbitrage (SPEs, rehypothecation…) and various banking regulations including Basel’s.

Overall, great stuff and you should watch the whole of it (I know, it’s long… you can probably skip most Q&As).

PS: Scott Sumner also commented on the Pope’s speech on “evil incarnate”. Reminds me of the vocabulary I used

News digest (Krugman and deregulation, central banking for Bitcoin…)

A looooooooot of news since the beginning of the week. So I’ll just quickly go over a few of them. Guys please, next time, spread your news more evenly over time. There was nothing to comment on recently!

Not new news but the Swedish bank regulators are thinking of increasing RWAs on mortgages to fight a growing housing bubble. Well, raising them to 25% (from 15% floor…) would still not change much: they would remain below most other asset classes’ level and securitisation (RMBS) would allow banks to bypass the restrictions.

Meanwhile, Yves Mersch, member of the Executive Board of the ECB, spoke about how to revive SME lending in bank-reliant Europe. His solutions involve: strengthening banks, securitisation and… banking union. Any word of capital requirements/risk-weighted assets? Not a single one. When I told you that central bankers don’t seem to get it…

But the UK government wants to ditch the household lending side of the Funding for Lending Scheme! They now only want to provide cheap funding to banks if they prove that they lend to SMEs. Why not, but I doubt it would really work for a few reasons: 1. demand for loans remains quite low, 2. market funding remains cheap (it was cheaper than FLS), 3. banks haven’t drawn much on it anyway, 4. RWAs are still in place! Mortgage and household lending will still attract most of lending volume as it is more profitable from a capital point of view.

Meanwhile (again), SME financing from alternative lenders not subject to RWAs and other stupid capital rules, keeps growing in the UK. However, it is still tough for those lenders to assess the health of the companies that would like to lend to.

Erkki Liikanen, the Governor of the central bank of Finland, told us about his ideas to improve financial stability. Surprise: they haven’t changed. So macroprudential policy starts interfering with macroeconomic policies and financial regulation, with possibly opposite effects that don’t seem to bother him much. Look at that slide, which is the very definition of a messy policy goal, with multiple targets and interferences:

Liikanen Macroprudential

A very strange piece in the Washington Post: Bitcoin needs a central banker. Wait a second. No, it’s definitely not the 1st of April. First, the author asserts that Bitcoin’s wild changes in value make it difficult to be adopted as a currency. This is extraordinary. Does the author even understand FX rates? If the author wishes to purchase his coffee using Euros, despite the coffee being priced in Dollars, will he also declare that the fact the Euro’s value is unstable (making the effective Euro price of its coffee volatile) makes the currency improper for use? When prices are originally denominated in Bitcoin, the change in the value of the digital currency won’t affect them. When prices are actually denominated in USD, but converted into Bitcoin, then yes, changes in the value of the digital currency will affect them. But this is hardly Bitcoin’s fault… Then he gets mixed up with ‘menu costs’, ‘hyperinflation’, ‘money demand’, etc. Wow. Just one last thing: has he even understood that Bitcoin was designed to be free from central bankers and government intervention in the first place?

Izabella Kaminska in the FT wrote a new piece on Bitcoin and other alternative electronic currencies. She complains about the multiplication of such currencies that nothing backs and pretty much only see speculative motivations underlying them. I am not going to comment on the whole thing, but whether right or wrong, she should ask herself why there is such frenzy about those currencies at the moment. My guess is that, governments’ and central banks’ manipulation of their own currencies have unleashed a beast: people afraid to hold classic currencies started to look for alternatives, pushing up their prices, in turn attracting speculators. The process is similar to ‘bad’ financial innovations (the ones designed specifically to bypass restricting regulation): they often start as a benign innovation for the ‘common good’, but the surprising demand for them and large profits attract speculators until the market crashes. Not the fault of the innovation, but the fault of the regulation that triggered them…

Paul Krugman thinks that “the trouble with economics is economists”, and that mainstream economics is not to blame for the financial crisis. I partly disagree: 1. there are various schools of thought within mainstream economics that often disagree with each other altogether and 2. most (all?) of them cannot fully explain the crisis anyway. But, and this is where Krugman shows his limited knowledge of banking and therefore the limit of his reasoning, he declares that “the mania for financial deregulation, for example, didn’t come out of standard economic analysis.” I’m sorry? Which mania for financial deregulation? The international banking sector had never been as regulated in history as on the eve of the crisis! (even taking into account of the few one-off deregulations) I need to come back to this in a subsequent post. Really, Paul, you have to revise your history. And your reasoning.

On Free Banking, George Selgin urges Scots to ‘poundize’ unilaterally if ever they declare independence from the UK. And “if the British Parliament refuses to cooperate, so much the better. Who knows: Scotland could even end up with a banking system as good as the one it had before 1845, when Parliament, which knew almost as little about currency then as it does now, began to bugger it up.” If only Scotland could enlighten the world a second time and get back to a free banking system!

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

French entrepreneurs open a 100% reserve bank

Alright, I wasn’t planning to blog today but I suddenly got overexcited… I don’t know how I missed this news, as it’s been in the French media since June at least, but, well, I did miss it.

While the French government doesn’t like financial innovation, two French entrepreneurs just launched a 100% reserve bank… And this isn’t a tiny event. It’s reported everywhere in the media, for a simple reason: the bank’s cash and dealing machine will be located at the local…….tobacconist.

Yep, that’s right. We all knew that French people liked to smoke, but now, they will even be able to bank while buying cigarettes. A new revolution, I’m telling you.

This new bank is called ‘Compte Nickel’ and will open on the 1st of January 2014, pushed by the national tobacconist federation. The website was launched today. How does it work? Well, it simply works like any 100% reserve bank: it’s some kind of safe in which you deposit your money. Tobacconists open for you a payment account and provide you with an associated debit card. You can transfer money, pay your bills, withdraw money all around Europe and get your salary paid in the account. It’s virtually like a normal bank current account/demand deposit.

compte nickel

What’s the difference then? A (fractional reserve) bank lends out the money deposited in it by its current account customers or invests it in liquid securities to generate interest income. It then often pays an interest on the account as a result and there is no or little charge to maintain the account. Interest rate is usually very low on demand deposits, and virtually non-existent in France. Compte Nickel on the other hand really acts like a safe: the money is not lent out nor invested anywhere. It is simply deposited in Compte Nickel’s Banque de France account.

Consequently, Compte Nickel does not lend. There is no overdraft allowed, no credit card and no credit facilities available. As I said, it is an electronic safe. As the bank still has operating expenses, customers will be charged to maintain the account. This cost is expected to be around EUR34 per year.

It will be a pretty interesting experience to see how people react to that new type of banking, especially given the well-developed anti-bank sentiment in France. 100000 people are expected to sign up during the first year.

If ever this is a successful experience that leads to full reserve banking becoming more widespread, it will raise other questions though: what happens to lending volume in a 100% reserve banking world? It would necessarily decline. I am not saying that this is necessarily a bad thing, and many authors, including Friedman, Rothbard and Fisher have considered the benefits of such a system. On the other hand, other authors (I’m mainly thinking about the so-called ‘Free Bankers’ here), have argued that every time a 100% reserve bank was set up, it always eventually became a fractional reserve one… They also argued that, given the choice between the two models, people would go for a fractional reserve bank. How would the monetary system respond to an increase in money demand? What happens to central banks’ monetary policy? Central banks aren’t required in a full-reserve world…

Banking theorists and historians, get ready!

Update: There might be a few reasons why such an account could indeed attract French customers. As I said above, anti-bank sentiment is one. Many French people think that banks are casinos playing with their money. A second one is that French people already pay a lot of banking charges. French law actually prevented banks to pay interest on current accounts until 2005. There have traditionally been a lot of charges to maintain a current account as a result, which have not disappeared. Yes, once again another regulatory distortion… Therefore, it might not bother customers to be charged for a full reserve bank account (and it does look like normal banks charge more than Compte Nickel!). A simple reason why such a bank might take a while to take off is…. that French customers are often quite conservative and want proven business models.

Photograph: PFG/SIPA


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