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Banks are in the business of making loans. Is that the right model?
Before answering, please consider the model of Lending Club.
Lending Club is an online financial community that brings together creditworthy borrowers and savvy investors so that both can benefit financially. We replace the high cost and complexity of traditional lending with a faster, smarter way to borrow and invest.
Here is the initial process straight from the Lending Club Website.
- You decide you want to borrow money
- You go to the Lending Club website
- You enter the amount
- You specify what it is for
- You answer a question regarding your credit
- Lending Club evaluates the information with no impact on your credit score, determines an interest rate and instantly presents a variety of offers to qualified borrowers
- If accepted, you can prepay at any time with no penalty
Lending club claims borrowers substantially reduce their rates over those offered by banks.
Exploring Lending Club
Bloomberg columnist Mat Levine explores the issue in Lending Club Can Be a Better Bank Than the Banks.
There are a lot of ways in which [Lending Club] is not a bank, but the big one is that basically all (95.6 percent) of its liabilities are "notes and certificates," that is, just unsecured structured notes tied directly to specific underlying loans.100% Equity-Funded Bank
Banks, on the other hand, are funded mostly by deposits and repo and other short-term senior borrowing.
- Lending Club's assets and liabilities are perfectly matched in duration: Those notes and certificates mature when the corresponding loans mature. A bank, on the other hand, is in the business of borrowing short to lend long.
- Lending Club's assets and liabilities are perfectly matched in loss bearing: Every dollar that a borrower doesn't pay back to Lending Club is a dollar that Lending Club doesn't pay back to note holders. The note holders know going in that they bear the entire risk of loss on the underlying loans. A bank depositor expects to get her money back even if the bank makes some bad mortgage loans.
This takes, in round numbers, all of the risk out of Lending Club's balance sheet.
In any useful sense, Lending Club is a 100 percent equity-funded bank: Every dollar that it lends comes from long-term, loss-bearing investors.
Lending Club is effectively a 100% equity-funded bank with 0% lending risk!
Ironically, Lending Club does not make loans. Instead, it facilitates matching borrowers with creditors and takes a fee for its efforts.
So, what's not to like?
Unfortunately Levine jumps off the deep end with his next set of statements.
First: You wouldn't want all banks to be like Lending Club. People like having checking accounts. Even beyond checking accounts, people like having liquid risk-free money-like claims. Banks exist to turn risky investments -- loans to people and businesses! -- into risk-free money-like claims, whether those are checking accounts or certificates of deposit or repo agreements....
For starters, the idea that banks can turn risky investments into risk-free claims is preposterous. Second, the idea that checking accounts would disappear is preposterous. Third, I certainly would prefer lending banks to be legitimately risk-free operations like lending Club.
- Lending club does not print money into existence
- Lending club does not offer loans of mismatched duration
- There is a zero percent chance of a run on the bank with lending club
- Investors in Lending Club take a risk in return for the opportunity to earn interest
- There is no legitimate need for FDIC
- Lending Club itself takes no lending risk, instead investors willing to lend money take a risk
Lending Banks vs. Safekeeping Banks
For all intents and purposes, Lending Club is the ideal risk-free lending bank. Given that it does not lend money, no bank-associated financial crisis is possible in such a model,
Does that mean checking accounts cease to exist? Hardly, and Levine should know better.
All that's needed is a separation of duties (lending vs. safekeeping): Safekeeping banks don't make any loans or facilitate making loans, ever. All checking accounts (demand deposit accounts) would reside in safekeeping banks.
In return for safekeeping, banks charge fees (just as they do now - ATM fees, transaction fees, checking account fees, etc.) There is no need for FDIC as no money is lent.
In this separation of duty model, lending banks would facilitate lending exactly as does Lending Club. Want to earn interest? OK you pick a loan you like, for a duration you like, and you invest in it.
Such loans would be term-duration loans, not FDIC guaranteed (and that is an added bonus, not a drawback). Those lending money for interest should logically assume some risk.
We might see some changes such as the end of cheap 30-year mortgages. Some might see that as a drawback, but that too is an advantage. Cheap, easy loans contributed to the housing bubble and a near financial collapse. If 10- or 15-year loans became the standard, so much the better. Houses should primarily be a place to live, not a speculative plaything.
Printing money into existence is at the forefront of every financial crisis, and it also helps explain the growing income inequality problem.
I am not against loans. Rather I am against borrowing money into existence, FDIC, duration mismatches, etc.
I suggest it's time to change the model to a 100% reserve system that eliminates duration mismatches, does not allow printing of money into existence, and also stops runs on banks without FDIC.
A distinct separation between lending banks and safekeeping banks appears to be a great starting point for discussion, not that peer lending itself is the perfect solution.
Note: I revised the last statement to make it clear that I am after a 100% reserve system model, not a peer lending model per se.
Mike "Mish" Shedlock