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Regulating Fintech: Getting the Response Right

Recent developments in finance challenge regulators around the world. Fintech companies are on the rise, and it is not clear what kind of new rules are needed. To shed light on these issues, one of the authors behind Jonathan McMillan gave a speech at the GovKnow conference on “The Future of Financial Services – Governance, Regulation and Accountability” in London.

Mind the regulatory gap between traditional banks and fast moving Fintech companies. (Photo: i am jae)

Mind the regulatory gap between banks and fast moving Fintech companies. (Photo: i am jae)


First of all, I’d like to thank you for this opportunity to discuss some perspectives on financial regulation in the digital age. In my view, this is a topic that has not yet received the attention it deserves. So let’s get right into it.


This April, I visited the LendIt conference in New York, the get-together of the marketplace lending industry. The panelists and presenters left no room for doubt: the industry is trying to take over Wall Street and the city. The tech gurus working there use smartphones, algorithms, social networks, and the Blockchain technology to take down the dinosaurs of the industry: traditional banks.


The rise of Fintech sparks a hope: the hope of modernizing the financial system with cutting-edge information technology to make the life of both borrowers and lenders better.


Misguided optimism


This hope has already spread among economists. Some expect Fintech to cure many of the diseases our financial system is suffering today, such as opacity, complexity, lack of competition, poor business culture, or high operational costs. To give you some first-hand insights on this matter, I let the experts speak for themselves. I have collected a few quotes from fellow economists:

Economists got excited about financial innovation before.

Is the enthusiasm for Fintech new?

Does anyone know who said this? I must admit, the quotes are not from our time:

Economists got excited about financial innovation before.

No, economists got excited about financial innovation before.

I collected quotes from the wrong decade, because I wanted to highlight that economists formulated the same optimistic viewpoints on Fintech already 15 years ago. Back then, it was just called differently: financial innovation.


Between then and now, we have experienced the worst financial crisis since the 1930s. When we look at the quotes today, they seem as absurd as a passed soundness assessment of the Fukushima reactor right before the Tsunami in 2011.


I am not showing these old quotes to expose the mistakes many economists made in interpreting the “Great Calm” before the storm of the financial crisis. These quotes should demonstrate that the financial world has already seen a major wave of financial innovation, a wave that started with the digital revolution in the 1970s, 1980s. Also back then, experts around the world hoped that these innovations would play a positive role for the financial system. Unfortunately, this was not the case.


Blind regulators


But at least, today we can draw from historical experience to come up with an adequate regulatory response to this rapid pace of financial innovation and technological progress we see again in the Fintech industry. Let me be frank: neither the regulators in the UK nor elsewhere are taking this experience sufficiently into account. Their regulatory approach will fail to cope with the rapid pace of innovation we see in finance today.


It is not that financial innovation is a bad thing per se. To the contrary!


The potential of technology to transform our financial system for the better is tremendous. It provides us with tools with which we can build a much more stable, efficient, and transparent financial system than we have today.


On this, I share the enthusiasm with many Fintech proponents.


But for some reason, virtually all financial innovations since the 1980s contributed to “mass financial destruction” instead of improving our financial system as a whole. Why is this? To answer this question, I need to get into a bit of further detail.


“Carrot and stick”


Finance is a very distinct animal. The key difference to other industries is the unique regulatory framework around banking.


This framework is best understood as a “carrot and stick” combination. The carrots are public liquidity and solvency guarantees, implemented to deal with the fundamental fragility of banking. As banks extend loans while offering deposit contracts, they essentially create money out of credit. Creating money out of credit is the defining activity of banking. This activity exposes banks to liquidity risks; if too many depositors demand immediate withdrawal, banks have to liquidate assets at a loss, and eventually become illiquid and insolvent. Such a situation is called a bank run, or if more severe, a banking panic.

A bank run happening in Berlin, Germany, in the 1930s. (Source: Bundesarchiv, Bild 102-12023 / Georg Pahl / CC-BY-SA)

A bank run happening in Berlin, Germany, in the 1930s. (Photo: Bundesarchiv / Georg Pahl / CC-BY-SA)

Guarantees can prevent banking panics. They have a great track record, but they come with an undesired side effect.


Play the game


Let me use a small example to demonstrate this side effect. Let’s say you take a trip to Las Vegas. Now I want you to imagine two scenarios. In the first scenario, all the money you take with you is at your own risk. In the second scenario, you take only 200 of your own pounds with you, and borrow another 5’000 pounds from a really nice guy who does not claim it back if you lose it. In which scenario will you behave like a reckless gambler, and probably have more fun?


It’s a classic case of moral hazard. Guarantees incentivize excessive risk taking. So regulators have to prevent that banks transform into reckless gamblers who put taxpayer money at risk. This is where the buzz-word of banking regulation – capital requirements – enter the stage.


Capital requirements are the stick that accompany the public guarantee carrot. Bankers are just like everyone else. They love the carrot. But they hate the stick. Because of the public guarantees, bankers do no longer want to put their own money at risk. They would do almost anything to minimize the impact of capital requirements


Banking is virtual


It goes without saying that it is difficult to implement regulations if the regulated industry gets infuriated about them. It’s a problem that appears in many industries Pharmaceutical companies will always complain about more stringent medicine approval procedures, and chemical plants will fight costly health regulation proposals that eat too much into their profits. But there is one aspect within banking that makes the difference:


It is an entirely virtual business.


In the industrial age, before the first wave of financial innovation – or Fintech, as it is called nowadays – the problem of imposing undesired banking regulation was manageable. Back then, banking took place on one balance sheet. Each and every transaction had to be recorded, confirmed, and reconciled with pen and paper. Trading and price calculation were very cumbersome. Back in the industrial age, regulators just had to closely follow everything that happened on the balance sheet to ensure that banks did not ramp up excessive risks to exploit the public guarantees.


But with the digital revolution, things changed drastically.

Steve Jobs and Steve Wozniak discovered the power of information technology – and so did bankers. (Source: blakespot)

Steve Wozniak and Steve Jobs discovered the power of information technology – and so did bankers. (Photo: blakespot)

Information technology enabled banks to slice, dice and redistribute money and credit across balance sheets and jurisdictions at high speed and low costs. The digital revolution mobilized credit. Banking increasingly took place outside the balance sheet of banks. The virtual nature of the financial industry combined with information technology, made it exceptionally difficult to impose effective capital requirements.


Capital requirements failed…


When the first generation of capital requirements were introduced in the 1980s, such as Basel I, banks had to maintain a minimum equity-to-asset ratio on their balance sheet. So banks searched for a way to move assets away from their balance sheet, while still being exposed to the risk/return.


A Fintech innovation called securitization came in handy to achieve this task at hand. The economists I quoted before, they misinterpreted this move away from the traditional bank lending model to the new securitization lending models as a blessing for transparency and efficiency. But actually, it was quite the opposite.


Securitization was used to disguise risks from regulators.


As such, it undermined the first generation capital requirements. So what did regulators do? They revised their regulations.


… and failed again


After the turn of the millennium, regulators started to implement the second generation capital requirements, such as Basel II. These moved away from simple equity-to-asset ratios. Instead, they were based on sophisticated internal risk management systems. The new approach was to make capital requirements dependent on the “true” market, credit, and operational risks banks are running.


In theory, this approach made a lot of sense. In practice, it did not work. And again, regulators did not account what financial technology, or Fintech, can achieve in the hands of creative bankers. After the turn of the millennium, bankers had unlimited Fintech tools at their disposal to circumvent undesired capital requirements.


This time, Risks were distributed into an even more complex chain of shadow banking. Loans were repackaged into Asset Backed Securities (ABS), Collateralized DEbt Obligations (CDO), and second order derivative structures. Progress in electronic pricing and trading technologies enabled banks to weave an inextricable web of derivative transactions.


According to the measures calculated to determine second generation capital requirements such as Basel II, it seemed these financial innovations removed almost all risks away from bank’s balance sheets. As a result, banks decided to distribute dividends rather than to build up a capital buffer for the storm that was about to follow.



The rise of shadow banking


We know by now how this episode ended. The Fintech of these days, innovations like ABS, CDOs, and CDS did not made risks go away. Instead, these products created a financial web that regulators – and actually many financial practitioners as well – could no longer understand. The financial innovation praised by Hubbard, Dudley, Greenspan, and Lacker was not the harbinger of efficiency and transparency; it was used to disguise regulators, to circumvent regulations and to empower bankers to take excessive risk at the taxpayers’ expense.


Such motives make it unlikely that financial innovation can play a constructive role. Let us have a look at how complex and opaque the financial system has become. What you see here is a tiny bit of Pozsars famous graphic on shadow banking.

This is only a small snipped of the shadow banking system (Source: Pozsar et al. (2010))

This is only a small snipped of the shadow banking system (Source: Pozsar et al., 2010)

Looks complicated…


Well, this is how the entire picture looks:

The shadow banking system in its entirety (Source: Pozsar et al. (2010))

The shadow banking system in its entirety (Source: Pozsar et al., 2010)

What happened in the financial services industry is the opposite of what happened in many other service industries, for example, accommodation, catering, or transportation. Just think of how simple renting a room, choosing a restaurant or taking a taxi ride have become with innovative companies such as AirBnB, Yelp or Uber. Innovation has made life much easier and services much more transparent.


Not so in the financial sector: Innovation made the financial system much more complex, opaque, inefficient, and fragile.


Nothing has changed


So, let’s fast forward to today. Has anything changed in the basic regulatory setup I described before? No. both public guarantees and banking regulations are still in place. Banks are still trying to eat the carrot and avoid the stick. Still, banks find tools to circumvent capital requirements. The main contribution of the third generation capital requirements was a further increase in complexity.


Up to now, we have not devised, let alone implemented, a regulatory framework that is adapted to the digital age.


So will financial innovation in the form of Fintech be used for good this time?


We would be a fool to think so. Financial innovation today is still driven by the same motivation; and it will have the same effect. Consequently, Fintech will eventually further increase the complexity and inefficiency of the financial system.


The new Fintech wave


I admit: all of this is a pessimistic viewpoint.  But the most recent developments in the most mature Fintech industry – marketplace lending in the US – unfortunately very much underscore our perspective.


It used to be called peer-to-peer lending, because it was the ingenious idea of connecting borrowers and lenders directly. This form of lending finally got rid of the middle man Dudley and Hubbard were talking about already back in 2004.


With peer-to-peer lending, all balance sheets between lenders and borrowers were cut out. This form of lending was fully transparent how credit risks were distributed, and it all took place in a lean and efficient setting. Peer-to-peer lending was a form of finance we should strive for, but it is already dead in the U.S.


Shadow banking 2.0


What happened? institutional investors such as hedge funds, banks and asset management firms have taken over the investor side of marketplace lending. Some of these institutional investors have access to public guarantees, or receive financing from institutions with government guarantees.


For example, Citi has provided a $150 million credit facility to Varadero Capital, a hedge fund that in turn invests the money in marketplace loans from Lending Club. This way, funds like deposits at Citi, which benefit from public guarantees, finds their way to marketplace loans.


More complex structures are already under way.


Investment banks discovered marketplace loans as viable raw material for their securitization machines. And the same rating agencies that awarded AAA-labels to securitized products before the last crisis now gladly provide high ratings to securities backed by marketplace loans. Second generation marketplace lending platforms like SoFi very much exemplify how the securitization machine is taking up speed again.


Hedge funds or investment banks can buy asset backed securities (ABS) that were built around marketplace loans and use them as collateral for borrowing money on the money market – that is, borrowing money from banks enjoying deposit insurance or from money market mutual funds enjoying implicit government guarantees.


In the end, we are back to shadow banking as we have seen it during the financial crisis of 2007-08. It might soon be the case that a systemically relevant institution will have the brilliant idea to insure the repackaged marketplace loans, that is, sell credit default swaps (CDS) on marketplace loan ABS.


It is the same pattern again. I have to say, it even surprised me how fast this transformation occurred. When I was on my way to the Lendit conference, I was really excited and eager to learn more about all these innovative Fintech companies. But I quickly realized that the vibe has become very similar to what I am accustomed from Wall Street.


A financial innovation starts very promising. But the regulatory framework with the juicy, tasty carrot and the stick that is by now nothing more than a toothpick turns financial innovation bad. Instead of promoting transparency, marketplace lending is again used to disguise risks from regulators. Instead of making finance more lean and efficient, it assists banks to take excessive risks at the taxpayers expense.


What should be done?


The carrot and stick approach to regulate finance might have worked in the industrial age. But in the digital age, this framework motivates destructive financial innovation; innovation that leads to complexity, opacity, excessive risk taking, and to recurring financial crisis.


The first step to make things better is to admit mistakes.


Since the digital revolution, we have never been able to implement effective banking regulation. We will never be able to implement effective banking regulations. Banking institutions will always find ways to get to the carrot while avoiding the stick.


Once we admit that banking regulation does no longer work, we have to acknowledge that we can no longer deal with the undesired side-effects of public guarantees. Banks will always abuse Fintech to get the most out of public guarantees, fuel unsustainable bubbles, and pass the bill on to taxpayers if they get caught by another crisis.


Consequently, no way leads around removing the public guarantees that transform banks into reckless gamblers. If we simply remove the public guarantees and force our government to let banks fail during panics, we might successfully reinstate market discipline. But we would have bank panics over and over again.


So we have to deal with the fragility itself. We need a financial system that is no longer vulnerable to runs and panics. The source of this fragility is the creation of money out of credit, and the inherent liquidity risk that comes with it. The source of fragility is banking. Only ending banking will remove this fundamental vulnerability and enable us to get rid of the public guarantees.


End banking? Don’t we need banking to channel resources from savers to borrowers? How can we supply credit to the economy without banking? Is economic stagnation the price for stability? What about those critical functions banks perform for our economy?


Making good use of Fintech


Let us have a look at the textbook functions: Banks are required for pooling and diversification, because borrowers need large loans, while savers have only small amounts at their disposal, which they want to invest in a diversified manner. Peer-to-peer lending demonstrates: pooling and diversification is possible without banking. Electronic platforms pool savings of many people into one mortgage, and lenders can invest their savings in a diversified manner.


The textbooks also say that we need banking to overcome information asymmetries. Well, we live in the information age and we have already developed countless ways to effectively address information asymmetries on an agency basis. Platforms such as TripAdvisor or Yelp have revolutionized the hotel business, the gastronomy business, and many other service industries. The same can happen within finance.


Last but not least, it is often said that banking is required to provide liquidity. This surprises me. In an era where everything can be bought and sold at low spreads on electronic platforms we still need banks for liquidity? Even Victorian Oil lamps have become a liquid asset in the digital age – just have a look at eBay. Standardized electronic markets supported by trading algorithms can replace the liquidity banks offer today.


That covers all the textbook functions of banks. Fact is: We have no longer any reason to hold on to banking. The digital revolution has freed our society from the need of banking.


Adapt the basic framework


To no longer need banking is one thing. But how do we actually end it? We propose a systemic solvency rule that basically requires all companies to finance the financial assets they hold on their balance sheet with equity. This rule will ban all companies, not just banks or financial institutions, from abusing their balance sheet as a vehicle to create money out of credit. It will enforce a radical disintermediation of our financial system.


No more public banking guarantees, no more costly and ineffective banking regulation.


Instead of letting banks use Fintech to avoid the stick and eat the carrot, let us use Fintech to get rid from the carrot and the stick. Let use implement a regulatory framework that is fit for our times, so we can finally advance into the digital age of finance.


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