Banking 2.0

Image Credit: from 401(K) on Flickr

Image Credit: from 401(K) on Flickr

Since the financial crash in 2008, I’ve been thinking a lot about how to do a disruptive startup in the finance sector.  It’s much better karma to work on how to make existing players irrelevant, than it is to just moan “that’s not fair”.  This is the nature of entrepreneurship, you look for opportunities to disrupt existing markets, because as the small guy you rarely get to compete fairly within the existing rule-set.

While the banks are a very suitable Goliath to play David against, it’s hard to achieve disruption because of their Unfair Advantage.  If you’re not aware, banks have been employing something known as Fractional Reserve banking, which in the UK we’ve been using since we left the Gold Standard in 1931.

In a nutshell, Fractional Reserve allows the bank to lend out more to borrowers, than they have in reserves – often a lot more.  At the moment this is around 8-9x more.  So for every £1 they have in a saver’s account, they can lend out £9 to borrowers.

Hopefully you already knew that, but if you didn’t then you’ll find this cartoon pretty informative, which goes way beyond the simple explanation above.

At the moment I still believe that the competitors ability to print money, is a major impediment to anything we can do in the with disruptive business models; I expect no one’s surprised that the money-elite have set up the system this way.  Without being able to disrupt at scale, then you’re left with a niche, similar to “green” options in other sectors, where you appeal to people with a conscience at a premium.

So yesterday two things happened, that got me thinking about banking again.  Firstly I was over at my mate Steve’s and he showed me this video of a 12 year old girl, schooling the Canadian finance sector, on how to improve things…

And secondly, the most excellent AVC posted an article on their P2P lending startups panel discussion at LeWeb last week.

The business plan of the P2P startups, is pretty much what I was kicking around in 2010 – getting people with money to lend it to people who need money, broker the transaction and offer suppliers to do credit-checks, legal and heaven forbid repossessions etc.

What is interesting is of course that they are actually doing it, so some of my assumptions are being put to the test.  One of the surprises to me, is that the average borrowing rate from Lending Club is 11%, which is substantially lower than I would have expected, given that all their loans are 1:1 (for each $1 someone lends, someone receives $1).  One day I may do a financial model, that looks at whether there is really 8x profit from making 8x the loans, but today is not that day.

Of course, as we have seen over the past 5 years, lending is a long-term-game.  It’s all very well looking at your returns in the good years, but the ebbs and flows of macro-economics take place on time-scales far greater than that.  None of these P2P lenders will be able to socialise their losses, in the way the too-big-to-fail banks have been able to.  If the lenders have not put enough buffer into their interest rates for the bad years, they will be gone too; I do suspect that this is the case at the moment.

Anyhow when I fired up WordPress, it was to talk to you all about fractional-reserve, and whether it’s a benefit or a hazard.  If you made it to end of the 1st video, you will have seen many of the downsides – it is a high price to pay, but is it worth it?

It comes down to the size of the money supply.  With fractional-reserve it is an almost infinite money supply, the only control on the tap is a central bank controlling interest rates to keep inflation at a “low” rate (if you think for a minute about exponential growth, then you too will probably want to put “low” in quotes, when its target is as high as 2%).  Ultimately fractional-reserve has allowed anyone to have money who wants it, so long as someone else has said they’ll cover any downside of the loan going bad.

The interesting thing about inflation, is that is measured on “a basket of goods“.  As anyone who has to buy their own shopping knows, stuff has been going up recently by way more than the 3% that we are currently told our inflation rate is.

This is because of two things.  One of them is the work we’re doing in the tech sector, bringing down prices through technological innovation, and the other is the outsourcing of manufacture to Asia.  Both of these have managed to bring down the prices of many of the items in the basket, so that the ones that have gone up have been offset.

However do note, that we’re getting to the point now where Asia is no longer as competitive as it once was.  Just this week we saw that Apple’s bringing some of its manufacture back and they are not alone.  While the cited reasons vary, the conclusion has to be that the total cost of being in Asia is just not as advantageous as it once was. In other words, this anchor on inflation will not be permanent.

Now to get back to the options of fractional-reserve or not, the alternative of going back to the gold-standard is a different problem.  Here we are now dealing with an issue of constrained supply (and a Bitcoin economy would be the same, but that’s another post).  Where there is constrained supply, then the price will fluctuate to balance supply with demand.  In other words, interest rates will rise and production will slow.  As a believer in innovation, I find that a tough pill to swallow.

It is interesting, that the first video and the little Canadian girl do end with pretty much the same third alternative.  In fact reviewing the materials again for this post, I suspect that she based her talk on the 1st video, and just added “cute factor” – but if you’ve got it, flaunt it!  However, while it is an exciting possibility, now what we’re talking about is a political change, and that is far out of the scope of anything we could do with a disruptive startup!

Where I think I’ve had a bit of a change of heart, is the premise that fractional reserve is all evil.  It certainly has had its use, fuelling this massive period of technological innovation that we’ve been living through.  Really I need to be re-evaluating my premise, that no startup is going to be able to achieve leverage in order to compete; maybe there IS a way to do that, which has just not come to light yet.

I do still feel there is likely a “solution” out there to disrupt this status quo, that’s brought the world to its knees, but for the moment I don’t have it. Am definitely continuing to search and would love to hear any of your thoughts in the comments. -A

  • Ian Norris

    Some reading material:

    I don’t currently hold out much hope of us seeing change any time soon though, the bankers have too firm a grip on the political system to see any kind of shift in policy.

    I’m very much in favour of the policies described by Positive Money, they are a great starting point to a more stable and balanced economy.

    • Andy Yelland

      Hi Ian, welcome to yellandSHOUT and thanks for the links, although my 20x article limit’s up on the telegraph right now :-s

      The first one’s interesting, and if I were in control of _all the pieces_ could be an improvement. However I’m not, and for me anything that requires regulatory change is not a move that I personally can make.

      Instead this is about bringing a battle, they are not expecting to fight – a rerun of Napster vs. the music industry but in banking etc. (except more like Google vs. Microsoft ’cause I would play to win, if I did this!).

      The current system only sucks if you’re not the banker

      • Ian Norris

        I agree, but I’m quite pessimistic about being able to do anything about the problems from the private sector too. I imagine that just like with Napster, the largest corporations will either legislate against, buy out and destroy, or sue anything that threatens their tight grip. To see real change I’d expect you’d first need to get the lobbyists out of government (good luck with that). They don’t want to compete, they want to dominate.

        I see it that the banking system is just one of the many symptoms of a system thoroughly infiltrated and corrupted by corporate interests. The bottom of the pile is unrestricted lobbying. Get rid of that and we might start to see some change over the following decades.

        • Andy Yelland

          That is all very well, but that is not within the tools at my disposal. However disruptive startups are. Sean Parker did alright out of Napster, and the entrenched music business did not. Lessons were learned.

          I’ll go add a post “Tech startups – replacing the middlemen with machines” to my drafts folder. If you’re not a producer, or a consumer, you will be replaced in the next handful of years by online matchmaking; it’s what computers excel at.

    • Andy Yelland

      Silly me, I could just change browsers to read the Telegraph…
      So yes, these plans are all one and the same give or take, the end of the “Money as Debt” video, the little girl and both of these links.
      Colour me sceptical, but while we have The Remembrancer sitting in parliament, I can’t see the UK leading the way here…

  • Paul Hilton
%d bloggers like this: