Monday, December 08, 2008

Reinventing the Wheel of Finance

National Bank of the Republic, Salt Lake City 1908Image via WikipediaOne of the ideas batted around every so often during the financial crisis is whether it would simply be easier and cheaper to create new banks and leave the old ones to die. On and off I’ve been thinking what this would mean. Which lead to the question of “are the current financial institutions the best way to manage capital?”

Banks have three primary roles: 1) store money 2) transfer money and 3) lending dormant money. Storing money is to the consumer the main view of banks. They store your money for you until you need it to pay bills and purchase stuff. Transfer money is what allows you to get your money from storage to where you needed it e.g. an ATM or to pay a bill online. Banks aggregate deposits and then lend this out of businesses and individuals to buy assets. It is this process that keeps money circulating and supports wealth creation.

There is no reason why these various roles need to be contained in one institution. We could in the future have one type of institution that stores money, another focused on transferring money and another on lending. What would happen if we separated these roles? For a majority of day-to-day banking tasks not much would outwardly change. The institution that stores your money would outwardly look like an existing bank with branches, debit cards and bank accounts. The transfer role is already there to an extent through various interbank agreements. Broadly, you won’t notice much.

Separate roles with be very noticeable in lending. Banks aggregate deposits and lend this out to individuals and businesses to buy assets (property, machinery etc.) Banks keep a percentage of deposits for people to use to pay bills and buy stuff. This works with the assumption that all the depositors are not going to need their money all at the same time. This process gives banks access to very cheap money which they can then lend out.

By separating the roles banks wouldn’t do the aggregation and lending. Instead those that lend would need to develop various ways to aggregate deposits from companies that store money in order to fund lending.
It is fair to ask whether this system would be more effective for society. I don’t know but it is worth exploring the idea. The advantages that I can see are:

  • Reduce conflict of interest between storing money and lending
  • Competition among deposit aggregators will produce a sustained increase the interest paid to depositors
  • It opens up the financial utility system for horizontal innovation and competition leading to better delivery of financial services
The existing banks and financial institutions will cry bloody murder as it attacks the status quo and potentially their profitability. However, they really haven’t demonstrated keen management of one of society’s key utilities. A potential more important issue is that individuals will be personally confronted with the idea that not all of their money is in their account. The existing illusion of your bank account actually having all your money ready to go will be stripped away as individuals have to decide how much of their account to lend to the aggregators. The removal of the illusion is very likely to create problems as people adjust to reality.

Separating the roles isn’t something that needs to be forced on existing players. Instead the various regulatory bodies should reform regulations to allow companies to step up and fulfil each role. Unleashing innovation in the delivery of financial utility (rather than in financial instruments) to society will do much to resolve the financial crisis.

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