Crowd Financing Is Not Banking

Op-ed in Mint Magazine

October 6, 2015

I have lived through enough financial cycles to be wary of the claims made of financial innovation. It is likely that there has been little financial innovation since grain futures contracts were struck several thousand years ago in the Indus Valley. Most of what passes for innovation is just a new way of doing the very old thing of adding more debt and less down payment, reserve, or equity to traditional borrowing or lending contracts. The more opaque the additional leverage, the more the bankers charge, the more the leverage is raised to excess, and the more likely it ends up in financial boom and bust. I am equally suspicious of the claims of new technology in finance: M-Pesa is real but Bitcoin is a scam. The computer revolutionaries think they have found a way to liberate money from banks because like all teenagers, they think they know everything. They think they know that banks only push money around expensively in creaking computer systems. They do not know that money is created by banks and that global anti-money laundering rules mean that existing money is no longer anonymous, removing Bitcoin's remaining reason to be.

While past mirages have given financial innovation a bad name, we do need real innovation. Today, banks are in the business of collateralized lending: loans secured on a motor bike, car, home, factory, or office block. When they are not securing their loans with something worth more than the loan, they are offering overdraft and credit card facilities that, to put it generously, are charged at a rate that funds ample reserves against the incidence of nonpayment. This seems wrong to many. They urge banks to provide unsecured loans to small local businesses, to subprime borrowers and to charge less—until there is a banking crisis. Then, often the same people chastise the banks for recklessness. There is much that is wrong in banking and financial regulation, but because banks are critical to the credit creation process and the payments system, they cannot be in the business of risky lending. Risky lending needs to be done by somebody else.

If the added riskiness of a project is due to the length of the term of loan repayments, then regulation needs to change so that life insurers and pension funds could provide the finance. If risk is caused by the size of the loan or uncertainty with regards to the timing of the repayment, and if the social benefits are large, then there is a role for state-backed financing. But once you cut away the marketing, politics, and corporate social responsibility, the traditional financial institutions of banks, life insurers, pension funds, and even credit unions and government agencies do not really have a capacity to lend to what's left, often small startups with no track record, less collateral, and operating beneath the radar of corporate law. Moving to the next level of social and economic development depends on these borrowers getting through. Currently, they finance themselves by skipping sleep and moonlighting, by racking up credit card bills, or by begging friends and family. It's a heroic filtering system. Those that get through are glamorized in print and screen. But few do, and new anti-money laundering rules may mean even fewer do in the future.

At the same time, economists and businesses are continually surprised over the success of cash-based activities in poor communities. Think mobile phone carriers in Africa. Remittances are only part of the story. A large part of the problem of financing development is not the absence of cash but an inability to mobilize it. The solution may be crowd financing platforms like New York-based Crowdnetic, led by Luan Cox, Srikanth Goteti, and Rob Reoch. These are kinds of digital credit unions that use technology to match untraditional borrowers with untraditional lenders and provide opportunities for diversification and other forms of risk and information management.

Regulators are nervous. They wonder if crowd financing is backdoor banking. But regulating crowd financing platforms as a bank and not an exchange would not only undermine the point of it but also create systemic risks. Crowd financing is not banking if the platform shifts all of the credit, market, and liquidity risks to the investors. Ask them to carry capital and they will start holding on to some of these risks. Investors will need to understand that this is an investment over a fixed term, not an overnight cash deposit. They will need to appreciate that they could lose everything, that there is no deposit insurance, or access to central bank liquidity. Investments cannot be used as collateral for other loans. The marketing departments of these platforms will want some fuzziness on these matters because most people understand banking more than investing, but regulators will have to ensure there is no blurring of the line. They should insist that the platforms drop bank-like terms such as "marketplace lending" and "deposits." Crowd financing is a bit like a running tap of preference shares in entities too small to issue actual preference shares and where the shares are sorted into different maturities and credit history. Once regulators help to make it clear what it is, crowd financing could play a critical role in bridging the financing gap.