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Will the Internet ever change the face of Finance?

By : Ziad K. Abdelnour| 5 June 2013
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I certainly hope so….We don’t need giant banks as small banks do much more lending than big banks.

It is a fact that smaller banks are stepping in today to fill the lending void left by the giant banks’ still much hesitant to make loans. The only reason I believe that smaller banks haven’t been able to expand and thrive is that the too-big-to-fail banks – fully backed by the might, faith and power of Big Brother – have decreased competition.

As big banks struggle to find a way forward and rising loan losses threaten to punish poorly run banks of all sizes, smaller but well capitalized institutions have a long-awaited chance to expand…..Indeed; at a recent congressional hearing on small business and the economic recovery economist Paul Merski, of the Independent Community Bankers of America, a Washington (D.C.) trade group, recently told lawmakers that community banks make 20% of all small-business loans, even though they represent only about 12% of all bank assets. Furthermore, he said that about 50% of all small-business loans under $100,000 are made by community banks…

The importance of traditional financial intermediation services, and hence of the smaller banks that typically specialize in providing those services, tends to increase during times of financial stress. Indeed, thecrisis has highlighted the important continuing role of community banks and the smartest finance people out there all agree that the big banks aren’t really focusing as much on the lending business as smaller banks. For example, less than 10% of Bank of America’s assets come from traditional banking deposits. So a shutdown by banks is really far from cataclysmic.

While banks once dominated business lending, today nearly 80% of all such loans come from nonbank lenders like life insurers, brokerage firms and finance companies. Banks used to be the only source of money in town. Now businesses and individuals can write checks on their insurance companies, get a loan from a pension fund, and deposit paychecks in amoney-market account with a brokerage firm.

Specifically since Glass-Steagall was repealed in 1999, the giant banks have made much of their money in trading assets, securities, derivatives and other speculative bets, the banks’ own paper and securities, and in other money-making activities which have nothing to do with traditional depository functions. They are only loaning to the biggest players and those who don’t really need credit in the first place.

Many community banks have thrived on the other hand because their local presence and personal interactions give them an advantage in meeting the financial needs of many households, small businesses, and agricultural firms. Their business model is based on an important economic explanation of the role of financial intermediaries–to develop and apply expertise that allows a lender to make better judgments about the creditworthiness of potential borrowers than could be made by a potential lender with less information about the borrowers.

A small, but growing, body of research suggests that the financial services provided by large banks are less-than-perfect substitutes for those provided by community banks…..Plus the fact that the “too big to fails” are actually stifling competition from smaller lenders and credit unions, and dragging the entire economy down into a black hole.

So who really needs these giant gamblers such as JP Morgan, Citi, Bank of America, Goldman Sachs or Morgan Stanley?

Thankfully a new way of borrowing money has come to the fore — peer-to-peer lending — and it offers an opportunity for both borrowers and investors alike.

Peer-to-peer lending appeals to lots of people. Americans already lend more than $89 billion to friends and family every year, according to Federal Reserve estimates. Nearly 75 percent of Brits said they’d consider using a peer-to-peer website to borrow or lend, and some estimates suggest the global market for peer-to-peer lending will grow to more than $10 billion by 2015.

While cutting out the middleman may be instinctively attractive to many people, it can have an economic advantage too. Compared to credit cards, peer-to-peer lending offers borrowers really attractive interest rates—often half what they might expect to pay Visa or MasterCard.

And peer loans are often structured more fairly. A debt can be paid off in installments, unlike with credit cards, which can trap borrowers under debt that snowballs every month. For lenders too, these loans offer a higher rate of return than what they can earn on savings accounts. Interest is after all key to small lenders.

It is that goal—getting capital to people who need it at reasonable rates—that creates a strong sense of purpose and community in social lending. The sites promote personal ties between lenders and borrowers. And with the global reach of theInternet, borrowers no longer need to know someone with money to secure a loan. By the same token, lenders often feel they’re helping a real person get through a bad patch or realize a dream.

Traditional bankers have a hard time seeing it that way. For them, “Why would anyone lend money to strangers?” The banking establishment, after all, considers itself expert at evaluating the risks involved in lending money. But banks also have a vested interest in remaining the middleman, and they’ve never been quick to adapt to change. The success of the online bank ING Direct, which caught brick-and-mortar banks unprepared, and say peer-to-peer lenders may have a similar effect.

So let’s ask once again the question from a different perspective:

Why do we need banks – what are they for?

Loosely speaking, banks [through the Federal Reserve system] make money. Banks are not the only entities that do this, but they are the ones whose purpose it is to do this.

The other thing that banks (but again, not only banks) do, is to record and execute monetary transactions. In return for transaction fees, they hold and manipulate the data relating to people’s accounts with them. We are all either debtors or creditors of banks and we need to have accounts at banks because the trust system that banks represent is the required medium for nearly allfinancial transactions. When I transfer a sum of money to you, I simply instruct my bank to initiate a sequence of entries in its books and those of your bank.

Which brings us to Bitcoin

Launched a few years ago and still in its infancy, it calls itself a peer-to-peer virtual currency.

This means that instead of a bank, the collective network of users maintains a complete encrypted record of bitcoin (“BTC”) transactions and how many BTC each user has.

Payments involve a public-private key exchange so that only valid identities can participate and each BTC can only be transmitted once. Because both parties have the complete data set, no external trust system is required. It’s a mechanism that removes the need for us to transact through banks.

The BTC system, like any other currency, allows credit creation through fractional reserve banking. The BTC money supply could therefore exceed the number of BTCs in issue. However, without a BTC central bank, the imprudent lender may well go bust. It will be interesting to see how regulators deal with mainstream banks that acquire significant assets and liabilities in BTC. They might outlaw the BTC operations of regulated entities, but could they really close down an unregulated global user network?

There are some fascinating possibilities here that would create not just a digital currency but a digital currency exchange as well as.

So why on earth do we need banks at all? Banks are lenders. They provide credit. Everything else is “window dressing”.

You think banks provide safety? Wrong. That is the government and FDIC…. So why do you go to a bank? Because your brain has been trained to believe that you can trust them. You assume that their risk management is better than yours, and therefore will protect your money and enhance its value.

What if that assumption is wrong? What if we cannot trust banks to protect and enhance our assets? We would be left with one function for banks: lending money or providing credit. If we could replace that credit function, or if we believed that our own risk management was better than the bank’s, then we could do without banks.

I sincerely hope and strongly believe that one day technology and the internet is going to provide this.

Sound farfetched? It is not. In fact, the financial world has been evolving in this direction for a while. We just chose not to pay attention.

Today, you can open an E*Trade account and do all your brokerage online for less cost than going through a bank. You can transfer money using Paypal. You can trade currencies through endless online options from EasyForex and SaxoBank for experts to eToro for novices. Think you need advice on investments or consumption patterns and fees? Forget your banker and try Seeking Alpha or Mint.com.

Which brings us back to lending. There are numerous efforts around Peer to Peer lending from Zopa to Prosper. There are other nascent efforts around commercial lending (which anyway the banks are not doing now). Essentially, startups can use the web to provide risk management tools and investment opportunities that disintermediate banks and thereby make credit available to borrowers.

One of the things that got banks in trouble with mortgages was that they were divorced from their borrowers. The FDIC has a long procedure around “Know Your Customer” regulations, but banks do not really know them or their customers’ creditworthiness. They were buying sliced and diced mortgage paper at a distance (which is why some community banks are in better shape – they really knew their customers).

Banks use technology for risk management and asset allocation. Why can’t we put those tools in consumers’ or business’ hands? Are banks really experts? Are they bigger experts than crowd-sourced wisdom on creditworthiness or risk management? I seriously doubt it.

One of the other roles banks play is they intermediate between the government (Treasury) and consumers and businesses to keep liquidity flowing in a risk-managed way….but in the age of the internet, why can’t consumers buy currencies directly from governments/central bank or currency trading platforms and access that liquidity directly? Businesses could as well. It is just a technology question. As always in creative destruction, it will happen from the bottom. Tools like Peer to Peer lending will grow up and become full-fledged lending platforms with appropriate risk management that might disintermediate obsolete banks entirely.

The banks have simply become a filter that robs us consumers of 90% of our money…..Let’s get rid of them once and for all.

If we cut out the giant banks as financial middleman, we might have a much more efficient economy, pay less in interest, fees and penalties, and restore a functioning political system and the rule of law.

The rise of peer-to-peer lenders such as Zopa and Funding Circle – which directly match up firms in need of cash with investors – and so-called crowd-funding, where small amounts are raised from a large number of funders, will hopefully challenge the nation’s major financial institutions forever.

I see major opportunity knocking for finance….. Hopefully, the growth of peer-to-peer lenders and those involved in crowd-funding will help solve the problems we have with lending for small and medium enterprises once and for all… The banking middlemen may in time become surplus links in the chain.

IT has changed every other industry like film, music and even football clubs so why not Finance?

While Big Brother is hostile to any challenge to the hegemony of the big banks, I think it is high time for a revolution in finance.

Just like Junk bonds changed the landscape of finance in the ‘80s… I am looking forward for the Internet and the smartest people behind it to do the same – the sooner the better – before big banks now controlling over 70% of the country’s assets end up one day controlling all.

After all, if government backed Wall Street is granted a monopoly on the use of money to achieve their goals, history shows that power is always abused….. Every single time.

What do you say?…Share your thoughts.

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