John Gapper in a Financial Times article titled “US Banks Will Pay Dearly For Their Failure To Modernize” warns that the United States banking system is failing to modernize and is actually falling behind England, India, and Africa, as the private sector moves to separate deposits and peer-to-peer lending. These new P2P and B2B banking organizations are often referred to in the rest of the world as shadow banks.
Gapper concludes that “the US lags behind the rest of the world with no obvious way to solve its difficulties.” Although the United States pioneered digital private payment networks like PayPal and Popmoney for consumers, “It is strange that a country [USA] that often leads the rest of the world in consumer technology lags behind badly in the basic infrastructure of retail banking.”
Alternative lending strategies are generally referred to as peer-to-peer (P2P) lenders or the “crowdfunders;” these online lenders include names like Lending Club, Prosper, and Zest Finance. The other fast-growing group of lenders is the business-to-business (B2B) side of new banking called merchant funders, such as Merchant Cash and Capital, On Deck, and Fora Financial.
Since these new banking organizations can operate independently from a legacy bank’s combined asset and liability balance sheet structure, they are not subject to much of the existing regulatory system. But over time, the existing U.S. banks will need to get into the game or risk losing substantial market share.
Gapper makes an interesting comparison to how change takes place in the U.S. versus Europe. “Europe’s [shadow banking] lead reminds me of the period a decade ago when it was ahead of the US in the use of mobile phones.” European countries deployed quickly because government set one specific standard platform and told cellular companies to comply. But the United States let several firms compete for the market, and this allowed different platforms to be developed. This form of experimentation allowed U.S. mobile networks to take off and develop systems that eventually dominated over their European competitors.
There was a lot of pressure during the financial crisis to change the banking system from being allowed to have “fractional” leveraged deposits to a banking system that was 100% percent reserved without leverage. Known as “the Chicago Plan,” the proposal was put together by several economists at the University of Chicago at the bottom of the Great Depression in 1933. The Economist also published a recent write-up on June 7th.
The central idea of the Chicago Plan, called “narrow banking,” is that “any bank or bank-like entity, such as a money-market mutual fund, financing itself with short-term fixed-value liabilities could only invest in short-term debt issued by the Treasury or the Federal Reserve. Banks could still engage in other business, but they would be barred from using short-term debt to fund such activities.”
With U.S. banking now leveraged thirteen times deposits, banks are currently operating on 7.5% collateral versus their total loans outstanding. The Chicago Plan would require 100%, but it would deregulate almost all the activity since the U.S. Treasury would not be at risk of guaranteeing depositors from bank defaults and bank runs. Most economists thought this would wipe out 92.5% of lending, but this 100% reserve banking is exactly what crowdsourcers are already doing in much of the world.
Capitalist innovation and customer needs are already reshaping the structure of banking and financial services industry. Information technology systems behind this movement will continue to improve at a startling pace. Legacy banking systems will either shrivel over time as P2P and B2B begin to dominate or innovate to the next level.
The author welcomes feedback and will respond to reader comments.
From July 15th to July 29th, Chriss Street will be teaching “Entrepreneurship and Capitalist Business Strategy” at Ho Chi Minh University in Vietnam