The Bankwatch

Tracking the consumer evolution of financial services

The right idea for the times | UncrunchAmerica

The Canadian government, and governments in many countries remain concerned about consumer lending.  At the same time there is great concern about bank capital reserves, and ability to cover future loan losses that are expected to escalate.  

This results in an impossible combination of mutually exclusive sets of activities.  Banks can either lend, or recapitalise, but its a fiction that they can do both.  This places banks in the position of being asked the impossible.

What got me thinking about this was this site – uncrunchamerica.org which is listed here on change.org (and accepting votes too – feel free to vote).

This from change.org

Our idea is simple: unlock these resources, enable the people who have the money to lend it directly to creditworthy people who need the money through a new (yet tested over the last couple of years) mechanism called social lending: people lending money to each other at fair interest rates. With this aim in mind, we have created Uncrunch America (www.uncrunch.org), to give us a chance to help each other out.   

Several companies have already joined us in putting together the banking infrastructure necessary to make it happen (credit reporting, authentication, funds transfer, bank account verification, regulatory framework including lending licenses and SEC clearance, etc.) and have already committed to lend $1MM through Uncrunch America.

Uncrunch America is a non profit organisation with several supporters who all support new and alternative lending, including LendingClub.  The premise is that the economy needs lending markets tol be freed and that this can only occur through bring lenders and borrowers together directly through a trusted and regulated platform that offers an alternative to banks without being a bank.  While the supporters of uncrunch are “for-profit” the message being promoted through UncrunchAmerica is a good one and the right idea for the times.

This got me thinking about economics 101 and the multiplier effect of money.  This from wikipedia summarises the effect of a $100 purchase.  As that amount is received and deposited to a bank, that bank holds its reserve, in this example $20) and lends out $80.  The $80 is deposited, and so on.  The additional money created by that first transaction was $357.05, with the other $100 retained as bank reserves.

moneybankingreserves1

 
Going back to the original premise of the impossibility for banks, this is the illustration of that effect.  To the extent banks hold greater amounts back for reserves, then the drag on slowing the economy is greater. At a 50% reserve requirement, no new money is created.

fractional-reserve_banking_with_varying_reserve_requirements-1

From the same wikipedia article, we can see the higher that banks retain reserves, their is a dramatic effect on money created.

 

Relevance to bankwatch:

The position taken by uncrunch.org is a masterful one.  Never have we had so much cash sitting on the sidelines, and at the same time, borrowers with concern for availability of credit.  The masterful part is that when we look at the multiplier effect of money, there is no reserve impact in the uncrunch model.  The lending flows straight from lenders to borrowers, through the trusted platforms.  That offers ability to increase the velocity of money, and support the GDP is limited only by purchasers willingness to buy things – the money is always available.

Here is why this works.  In the case of  banks 100% of the borrower risk is centred in the banks, so they must hold capital reserves to cover losses.  In the case of social lending, first the risk is spread across many borrowers, so no lender is exposed to 100% borrower risk.  Secondly the capital reserve is with each lender personally, and sits with how they determine to allocate risk across their investment portfolio, including but probably not solely social lending loans.  They will have a basket of investments from cash, securities, GIC/CD’s and social loans.  Their personal appetite for risk determines their investments and reserve approach.

Some will argue that the multiplier effect will be reduced as borrowers take loans to repay credit cards, and the money velocity stops.  However that is only applicable at moments of absolute consumer confidence disappearance, and while we are close to there now, that will be temporary.  Those credit cards are now available again, and the instant that confidence returns they can be re-used.

UncrunchAmerica offers one simple and clear idea that is the right one at the right time, and I wish the participants well in their change.org voting.,

Written by Colin Henderson

December 30, 2008 at 16:38

5 Responses

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  1. I love the entrepreneurial spirit of this activity (I had been an active lender at Prosper for quite a while).

    If you think about banking in its simplest terms, it hasn’t changed since the 1700’s when banks facilitated the saving/borrowing function between neighbors. What has changed is the amount of losses (in the worst case, fraud) that has created the need for expensive regulations, which still don’t protect the banks, consumers or businesses.

    While this concept is great, what happens when fraud is introduced to individuals lending to individuals and losses begin to mount? As the risk of losing an individual’s savings grows, the peer to peer lending will also experience liquidity constraints and/or exorbitant interest rate pressure to justify the investment.

    I hope this kind of lending continues to grow (competition is good), but since most people work towards their own self interest, let the buyers beware.

    Douglas

    December 31, 2008 at 09:34

  2. I think the main issue these sites can help with is trust. No-one now trusts the loan originators to check for fraud, or creditworthiness, or, in some cases, death. Even if they did, the ratings agencies have completely discredited themselves, so the ABS couldn’t be sold. If Uncrunch & co. offer an audit-able loans pipeline, the actual credit worthiness is secondary.

    IFAIK your argument about reserves is somewhat outdated.
    http://www.hussman.net/html/fedirrel.htm

    Douglas is right, the tide is going back out to sea for everyone. But a return to 1970s levels of consumer lending can’t be that bad. Historically households have only used credit for extremely large durables (houses&cars) or emergencies, with substantial deposits.

    Thomas Barker

    January 3, 2009 at 07:16

  3. @Thomas … RE: reserves: that argument in the Hussman piece is relevant only if Banks want to lend and in a relatively risk free environment are seeking ways to lend. The issue here (imho) is that banks want to build reserves notwithstanding what the Central Banks wants. They know they have and will have more of loan losses, so they need the reserves.

    Otherwise yes, I agree with your other thoughtful points.

    Colin

    January 4, 2009 at 00:55

  4. I think the fundamental question is whether a better appreciation of risk and return can be achieved by a small number of professionals at banks or by a large number of relatively inexperienced yet sometimes more intimate lenders.

    I don’t think it’s a black/white question and it will take time to find the right balance, but I think our government bodies should encourage social lending experiments such as UncrunchAmerica instead of making the lives of social lenders difficult (see SEC action). While some banks are too big to fail, social lending are too small to cause pain.

    Guillaume

    January 5, 2009 at 21:40

    • @Guillaume – while there are borrowers and lenders, the other [important] variable is the social lending platform. The degree of quality analytics, consistency of process, consistency of credit presentation, and accuracy of identity verification offerred by the platform(s) will be an essential component in what could otherwise be a chaotic environment. These will be essential components in finding the balance you rightly speak of.

      Colin

      January 5, 2009 at 23:14


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