Being Better is not Enough: The Way Forward for Marketplace Lending

Finance concept. Dollars and bank building.

[Editor’s note: This is a guest post from Jonathan McMillan, who has published the book The End of Banking: Money, Credit and the Digital Revolution. The book explains why a financial system without banking is both possible and desirable in the digital age. The article is part of a two-part series. The first article explained why marketplace lending is disadvantaged in the current regulatory framework. The opinions expressed in this article are the author’s own.]

To ensure their survival in the long run, marketplace lenders have to tackle the privileges of banking institutions – such as government guarantees and the access to Federal Reserve liquidity. We made this point in a previous article. But what specific changes should the industry propagate to create a sustainable and fair regulatory environment for the financial system?

The Obvious Option: End the Unfair Advantage

The most obvious solution is to simply ban government guarantees and prohibit the Federal Reserve to provide emergency liquidity. Prominent libertarian politicians advocate this solution. Should the marketplace lending industry befriend the Tea-Party movement, demand to end the Fed, and pledge to throw the head of Treasury into jail if he bails out another banking institution?

In some cases, such as this one, the obvious solution is not the right one. The current financial system is vulnerable to unpredictable chain reactions. Just think about the repercussions of the bankruptcy of Lehman Brothers. Could you stick to a pledge not to bail out financial institutions if it means that the whole system goes bust, implying millions of people to lose their jobs and homes?

The government can only remove the unfair advantages for incumbent banking institutions if the financial system is immunized against these destructive chain reactions. Even the former chairman of the Fed, and the current chairwoman from the International Monetary Fund acknowledge that the too-big-to-fail problem has not been solved – despite many new banking regulations. We have to take another angle on enabling a modern and stable financial system.

The Intuitive Option: End Banks

Some financial experts – such as the chief economics commentator of the Financial Times – suggest that we should ban banks. Indeed, as we have discussed previously, banks are no longer needed in the digital age. So, when banks are no longer needed and cause so much trouble, shouldn´t we just shut them down?

This idea is enticing; many people have proposed to ban the traditional business model of banks, that is, to strip them from their power to create money out if credit. But the recent crisis suggests that the problem spreads beyond banks. The digital revolution allowed new forms of banking. The power to create money out of credit is no longer restricted to institutions called “banks.”

Money market mutual funds, special purpose vehicles, or asset-backed commercial papers conduits are just some of the institutions that performed banking. These institutions were at the epicenter during the financial crisis of 2007-08. Yet, while they created money out of credit, they are not “banks” in the narrow sense.

Looking at Fed Research on Shadow Banking (especially the graph on page 3) gives an idea how complicated our financial system in the digital age has become. The so-called “shadow banking” institutions created an opaque and inextricable daisy chain of financial commitments. As such, the financial system became highly fragile.

When only a few of the financial commitments fail – such as the subprime mortgages during the last crisis – the whole system falters like a house of cards. Banning banks would not have prevented the rise of shadow banking, the subprime mortgage crisis, and the Great Recession. Hence, banning banks falls short.

The Right Option: End Banking

An effective solution has to go further. With the rise of information technology, balance sheet items can be moved from one company to another with only a few mouse clicks. Any type of company can now participate in creating daisy chains of financial commitments that harm uninvolved third parties if they break down.

But how can one prevent those fragile daisy chains of financial commitments within the whole system? As we have seen, targeting institutions based on their label “bank” fails to do the job. We need to tackle the problem at the systemic level and target the activity of banking.

For this, we have to turn to the legal framework that sets the elementary rules for companies: corporate law and solvency rules. We propose a new, systemic solvency rule that prevents all companies with limited liability – not just banks or financial institutions – from banking intermediation.

The idea behind the systemic solvency rule is simple: Companies should be allowed to borrow money only for investing in productive assets such as machinery, factories or intellectual property, but they should no longer be allowed to use borrowed money to extend loans themselves. Such a rule prevents financial institutions from acting as banking intermediaries between the ultimate borrower and the ultimate investor.

The systemic solvency rule enforces a disintermediation of the financial system. Without a daisy chain of balance sheets that is prone to devastating chain reactions, we can finally get rid of government guarantees. Doing so will create a level playing field for the financial industry without risking major economic breakdowns. In our book, we provide a much more detailed account of the systemic solvency rule.

The beauty of the systemic solvency rule is that it is simple yet effective. Although it applies to all companies, it has barely any effects on non-financial companies. The systemic solvency rule has the potential to restore financial stability, to replace the lion’s share of today’s regulatory overhead, to end the unfair advantages for the incumbent banks, and to restore healthy competition on financial markets. What we propose is in fact a radical departure from the status quo; still, it is getting seriously discussed in the financial community.

Disrupt Politics Now

Banking got out of control with the rise of information technology, as demonstrated by the financial crisis of 2007-08. But there is good news, too. Marketplace lenders and other financial technology companies exemplify that we no longer need banking in the digital age. A simple change of today’s solvency rule ends banking and restores a functioning financial system for the digital age.

It does not matter whether you are an investor, a borrower, or an employee in the marketplace lending space, you should have a vital interest that we establish a modern regulatory framework. Otherwise, your money, your job or your access to liquidity will be washed away with the next financial crisis. If this happens, the failure of marketplace lending will be used as an example that there is truly no alternative, and Wall Street will once again successfully extort bailout money to keep a dysfunctional banking system alive.

So let us not wait for the next financial crisis. There is an alternative! Marketplace lenders have already shown that we can do better than banking. It is now time to push for regulatory reform.

  • Peter Renton

    Peter Renton is the chairman and co-founder of Fintech Nexus, the world’s first and largest digital media and events company focused on fintech. Peter has been writing about fintech since 2010 and he is the author and creator of the Fintech One-on-One Podcast, the first and longest-running fintech interview series. Peter has been interviewed by the Wall Street Journal, Bloomberg, The New York Times, CNBC, CNN, Fortune, NPR, Fox Business News, the Financial Times, and dozens of other publications.