The Bankwatch

With only a few days left the people who manage money, banks and traders are essentially warning of a September 2008 scenario.

Fed under fire over default talks

They want to address contingency planning for a run on money market funds that hold Treasury bonds, the impact on capital and liquidity ratios if there are large inflows or outflows of deposits and the potential effect on short-term financing from any problems in the repurchase, or “repo”, market.

Brett King has a three part series of blog posts on Finextra that provide a good backdrop to state of startups in financial services.

I commented today with this, and wanted to expand on it after about the notion of disrupting banks.

I would take issue though that we are perhaps not yet seeing the ‘disruption of banking’.  As both a long time observer and market participant (disclosure – I am involved with CommunityLend in Canada) I see these startups carving a useful niche, sometimes profitable, sometimes not.  These niches are small and particular.  I believe Giles (quoted – from Zopa) when he states he has a better credit model and he is also particular in what he allows on the books.  Not to defend banks, but they have been under political pressure for decades to provide banking services to all.  It is also true they have been driven by quarterly targets to maintain stock market returns ( and employee bonuses).

This targetted versus generalist customer model view goes some way to explaining what we see in todays startups.  It might also go some way to describing what the future of financial services might look like;  a much more divided, niche, targetted set of providers numbering in the hundreds or thousands could well be an outcome.

We are yet to see a model that scales up the way a large bank scales however.  It is wonderful to see the start up activity that we see and I am happy to be part of that, but I include our own efforts in recognising that we are only nipping at the ramparts of the big banks, but we are hardly threatening to tear down those walls yet.

As a side note, in that future world of many startups providing financial services, I wonder how the regulators will act and what the impact will be of the first major catastrophe that affects thousands or millions of customers somewhere – a reality that will undoubtedly and unfortunately occur.

The idea of disrupting banks is something we all think about, but it is hard to do.  Part of the reason is that banks are the sum of very attractive component parts (deposit taking, lending, servicing fees) that requires them to be part of a restricted club run by the government, and the cost of entry to that club is very high.  Once you are in, you can operate on a very low capital base thus reducing cost of capital lower than other industries.  This makes banks attractive and it makes them resilient to disruption.

So start ups come along, see this barrier to entry and attack banks by picking one of the banks’ component parts, say lending (Lending Club) , or say servicing (BankSimple) and target that vertical amongst niche customer markets.  Sometimes this avoids regulation, sometimes not.  Just ask the P2P Lending folks in North America.

Going back to my comment on Bretts post this has not yet shaken any banks or required them to shift strategy in response.  In fact one of the problems with banks is that while everyone complains about them, almost everyone trusts them with their money, largely due to the implicit government guarantee even beyond deposit insurance limits.

The magic will come some day when a start up is able to satisfy the aspects of trust and superior service or even better , make some aspects of banks’ irrelevant by displacing some core aspect of their model with sufficient volume to matter.

The General Accounting Office (GAO) in the US as requested by the The Dodd-Frank Wall Street Reform and
Consumer Protection Act directed GAO to conduct a study of person-to person lending.

Their report is now released at http://www.gao.gov/products/GAO-11-613

It provides a comprehensive look at how Lending Club and Prosper work, the challenges P2P Lending presents to the regulators who are based on pre-internet business models.

This report addresses
(1) how the major person-to-person lending platforms operate and how lenders and borrowers use them;

(2) the key benefits and risks to borrowers and lenders and the current system for overseeing these risks; and (3) the advantages and disadvantages of the current and alternative regulatory approaches.

A headline that is eerily reminiscent of September 2008 when markets dried up overnight following the bankruptcy of Lehman Brothers.

Collateral demand rises for interbank lending

By contrast, lending between banks without the backing of collateral has ground to a near standstill for any loans of more than a week’s duration, as fears of bank insolvency rise due to continuing uncertainty over Greece and its emergency loan payments.

The background here is that small euro banks are implicated in this for now.  The question will be what happens next and what other banks will be involved.  The changes since September 2008 are quite limited to future capital requirements. 

Much is being made about the distinction between sovereign liquidity and sovereign solvency recently.  This is a distinction made by journalists and amateurs.  Both liquidity and solvency refer to the ability to meet short term liabilities.  The corollary to ‘solvency/ liquidity’ is best described by ratios such as debt/ equity or debt coverage (ratio of cash flow to debt payments).  This applies to companies, banks and governments.  It is not rocket science and is simply the ability to repay debts over time. 

Going back to the situation now with the requirement for collateral for short term lending between banks.  This requirement is based on lack of confidence.  The loans being repaid in this situation are not long term loans to fund capital assets.  These are loans to fund working capital, ie liquidity.  In normal times banks are prepared to do this because they know the counterparty and are confident in their ability to make good the next day. 

The desire for collateral for such working capital loans is a sign of lack of confidence between banks.  This is an ominous omen. 

There is nothing in the new regulations suggested by Basel 3 that mitigates this liquidity and confidence risk between banks.

This is a hair trigger situation for the worlds banks over the coming days/ months.

We know the US financial markets are skewed because of QE2 providing financing for government borrowing from themselves, but this analysis shows just how deep the government support of capital purchases has become in US.

State is now dominant force in US capital markets

But the dirty secret behind this rhetoric was that government-backed institutions such as Fannie and Freddie were playing an important role in the modern financial system, even before the credit crisis erupted. And what is remarkable now, given that the role of Fannie and Freddie has swelled, is just how little debate this patter continues to generate. After all, with the US remaining wedded to free market ideals, it is uncomfortable to admit that “capital markets in the US have become reliant on government guarantees”, says Viral Acharya, an economist and co-author of a thought-provoking book.*