Co-authored by an investment banker and an academic macroeconomist, “The End of Banking” proposes a fresh makeup for the financial world. The book’s central premise – that banking must come to an end – hinges upon the existence of a viable replacement. That solution, in the eyes of the authors, is the rapidly expanding, supremely efficient and endlessly flexible collection of online alternative finance providers. We caught up with one of the book’s creators to learn more.
You’ve recently published a fascinating book: “The End of Banking”. Can you give us an elevator pitch – briefly explaining its key themes and purposes?
Hi Ryan, thank you for giving me the opportunity to present “The End of Banking”, which I have written together with an investment banker. I am happy to give you an elevator pitch.
The book is basically about the rise and fall of banking. Banking was essential for economic development in the industrial age. But with the digital revolution, it got out of control. Information technology allowed bankers to circumvent regulations, rendering them by and large ineffective. On the bright side, however, information technology allows us to organize a financial system that no longer needs to build on banking. Well, to put it into one sentence: “The End of Banking” shows that a financial system without banking is both desirable and possible in the digital age.
For me, the most intriguing part of the book is the section entitled “Banking is No Longer Needed”. Many people see the alternative finance space as complimentary to traditional banking services, but your book suggests that peer-to-peer lenders could in fact entirely replace the banks – is that right? Can you describe your vision of a better financial services sector?
We envision a financial system that is better in supporting the real economy. Of course, it should also be resilient against systemic crises, and the new financial system should offer more convenient services than the banking system we have today.
To achieve this, we propose to disintermediate the financial system, that is, to set it up such that borrowers and lenders interact directly with each other. This establishes transparency and effectively distributes financial risks widely across the economy.
This is where the digital revolution enters the stage; information technology is critical for a disintermediated system to be viable.
Peer-to-peer lending, for instance, allows diversification and pooling without an intermediating bank balance sheet. Thanks to information technology, we can organize a payment system outside the banking system. Moreover, business models like the one of eBay demonstrate that there are new ways to deal with information asymmetries in the digital age. Finally, market liquidity has increased across the board, and with trading algorithms many processes in the disintermediated lending industry can be automated.
The focus on technology distinguishes us from other financial reform proposals such as the one propagated by Positive Money. We acknowledge that banking was a technology that was useful in the industrial age. We would have refrained from prohibiting the bank business model back then. But the digital revolution turned out to be a game changer that calls for the end of banking.
Taken together, the alternative finance space could support a financial system that offers everything banks offer today, just more efficient, stable, and convenient.
I think it’s fair to say that the peer-to-peer lending industry hasn’t yet evolved to the point where the financial system that you propose could function properly. A highly liquid secondary market, for example, is one of the key missing ingredients. How does the industry need to develop from here for your theory to become a reality?
You are right, some of the institutions we describe in the book are not yet fully established today. But technology and businesses are developing at an astonishing speed. Let us discuss market liquidity, for example. First, note that the basics for a liquid secondary market are all there. Most peer-to-peer lenders are very transparent about loan quality and their credit scoring models. These are critical pre-requirements for secondary markets, as information asymmetries can lead to a breakdown of markets.
What is lacking at the moment for a thriving secondary market is scale. Although the growth rates of peer-to-peer lending are truly impressive, the overall market size is still small compared to other financial markets such as equity, currency, or fixed income markets. With larger market size, however, liquidity will increase too.
What we need to see is that peer-to-peer lenders can share one market place to increase market liquidity. It is interesting, for instance, that Lending Club and Prosper in the US use the same company, Folioinvest, to organize their trading platforms. Maybe they will, at one point integrate, their markets to pool liquidity further. Both companies would benefit from such an integration.
Also in the other spaces we discuss in the book, a lot is happening these days. For instance, companies such as Orchard Platform have started to automate the investment process. They have developed algorithms, and provide valuable information to investors. Such companies will play a critical role in deepening secondary market liquidity for peer-to-peer loans. Separately, they also might evolve towards effective watchmen over the lending standards of peer-to-peer platforms, because they will have considerable influence over where investors channel funds.
We do not think fundamental technologies are missing to make the financial system we envision work. The real obstacle is the outdated regulatory framework.
What do you mean by this? What are your thoughts on regulating the alternative finance space?
The biggest problem the alternative finance space faces is that they are heavily disadvantaged against banks. Banks have access to deposit insurance, too-big-to-fail guarantees and Federal Reserve liquidity. The alternative finance space does not have any of this.
When a financial crisis happens, marketplace lenders will suffer losses while lenders to banks are protected by the government. As such, the current regulatory framework effectively prevents alternative finance companies from competing against banks on equal levels.
The most the alternative finance space can achieve in this framework is to complement banks. But banks will remain the dominant players. There is even the real threat that alternative finance companies transform into something bank-like, and thereby lose their potential to disrupt the financial system for the better.
Can you elaborate on this further, how can peer-to-peer lenders become banking institutions?
Well, to be fair, some peer-to-peer lenders have already started to move in this direction. Zopa with their “safeguard fund”, for instance, is moving away from disintermediation and towards banking. In addition, Lending Club started to attract companies that securitize peer-to-peer loans. The securities created can then be used to obtain short-term funding. Effectively, peer-to-peer lending could become a part of shadow banking this way.
So, what are your proposals to prevent banking from reappearing? What should the alternative finance space do about this?
The alternative finance space has to become vocal about this situation. They should raise the awareness of regulators and the public that the current regulatory framework severely inhibits the potential of modern finance. The industry has to demand a paradigm change of similar magnitude as the one after the Great Depression.
In the book, we develop an intuitive reform proposal that effectively ends banking. As said, a new financial system requires a change in the regulatory framework. Basically, we only need to redefine the concept of balance sheet solvency. Under the proposed new accounting rule, alternative finance companies get the level field they require to establish a functioning financial system for the digital age.
Do you truly believe that this system will materialize? And, if so, when do you imagine that it will take hold (speaking in very rough terms, of course)?
The functionality of the current banking system is severely impaired and the current situation is unsustainable. This has been disguised by the massive bailouts undertaken after the failure of Lehman brothers, without which the whole financial system would have melted down.
More and increasingly complex banking regulation is implemented day by day. But given the unlimited potential of information technology, bankers will always be faster in finding new loopholes. In the meantime, supported by too-big-to-fail institutions, derivative markets have grown larger than ever before. And we are not just talking about the western world. In China, for instance, we can observe a similar mortgage boom as the one in the U.S. prior to the crisis.
In our current banking system, another major financial crisis is just a matter of time away. Triggered by turmoil on derivative markets, collapsing prices on Chinese real estate markets, or something else. Thinly capitalized banking institutions taking excessive risks will eventually make another bailout necessary to keep the system afloat.
Sooner or later we will find ourselves in the same situation as in September 2008. The last crisis has taken us by surprise, and we were forced to bail out banks. If enough citizens and politicians acknowledge the transformative potential of the digital revolution, chances are good that we do not kick the can down the road once more. So let us stop trying to “fix” banking and, instead, start to prepare for the end of it.
If you're keen to learn more, the "End of Banking" may be purchased by following this link.