Why do banks exist? The conventional wisdom goes like this – depositors prefer to hold liquid risk-free assets and borrowers prefer to borrow for the long-term to invest in risky projects. Banks sit in the middle of this process and perform a sort of alchemy. By performing this alchemy, banks leave themselves open to the risk of bank runs – if all the depositors seek to withdraw their money at the same time, even a bank with otherwise sound loans as assets can go bust. This perceived risk of a bank run is why governments and central banks provide deposit insurance and liquidity facilities to the banking sector, a privilege that is not typically available to other financial intermediaries. In other words, banks exist for the purpose of maturity transformation.
Maturity transformation is a nice catch-all phrase but it subsumes some very different lending activities conducted by banks. For example, banks can help businesses to finance their working capital needs and provide financing against customer invoices. This function is as old as banking itself. It is what bankers did in the prosperous city-states in Italy in the 15th century. But most of these debts are short-term debts with a maturity of less than a year. This is not the heroic maturity transformation of the bankers whom Schumpeter viewed as the ‘capitalists par excellence’. There is no reason to believe that society does not have the risk appetite to take on the default risk of such short-term debt and as I shall show later, there is significant evidence of this already happening in the United Kingdom today.
In the modern era, banks also provide a range of short-term lending options to consumers such as credit card loans. Again this is short-term debt that forms part of a well-diversified pool of loans. For well over a decade, these have been amongst the most easily securitised parts of a bank’s balance sheet. Again, although this is also technically maturity transformation it is typically not what most of us think as the primary purpose of maturity transformation.
When most of us think of maturity transformation we think of banks’ ability to provide long-term loans (at least 3-5 years in maturity and as long as 30 years in maturity). Again this is not a homogeneous category. The most significant component of bank lending on such a long maturity in many countries is mortgage lending. Mortgage lending is undoubtedly an important part of the financial landscape. But very little of the maturity risk of mortgages actually stays with the originating banks. The interest rate risk is often hedged away with willing counterparties such as pension funds and life insurers and the credit risk is often securitised away.
What most people think of when they think of the role of banks is their role in providing long-term loans to businesses. The popular press is rife with the inability of banks to lend more to small and medium enterprises (SMEs) and how this is holding back economic growth. It is an obvious truth that banks make very few unsecured loans to SMEs on even a 3-5 year maturity, let alone a 30 year maturity. But does this matter? And did banks ever engage in such lending?
To understand the modern mythology surrounding bank lending to businesses, we need to study the history of bank lending to industry. In the United Kingdom, bank lending has never formed a significant component of business funding for growth investment even during the high-growth periods of the 19th century. To the extent that banks have provided such loans in the modern era, it has typically been on the back of security in the form of owners’ property, company property or personal guarantees from company directors.
‘Heroic’ maturity transformation was born in the economies of mainland Europe that wanted to catch up to Britain in the middle of the 19th century. The first such bank was Crédit Mobilier which was founded in France in 1852 to finance the railroads that banking had not touched till then. Although Credit Mobilier collapsed in the financial crisis of 1867, the innovation took hold in the form of other banks in France such as Crédit Lyonnais and spread across Europe.
The quintessential example of banks as long-term investment institutions arose in Germany between 1870 and the First World War. In an era when financial crises were frequent and banking was risky, German banks figured out how to profitably fund long-term investment projects without bankrupting themselves in the process. Instead of just arranging share issuances, they bought a significant chunk of the equity of firms they lent to. German banks owned a significant stake in German industry and proceeded to engineer German industry such that the risk to them was minimised. This involved using their ownership stake and financing power to push through mergers, cartels and backward/forward integration. In other words, they de-risked German industry. Bankers may have been the driving force of capitalism in 19th century Germany but they were not risk-takers.
After Germany, this model of banking and development has been copied by a number of countries – Italy, Russia prior to 1917 and pretty much all of East Asia (starting with Japan) since World War Two. There are many aspects of this model that are not relevant to today’s world – what worked in the mass-production, heavy-industry dominant period of capitalism when economies of scale meant that most successful businesses were large will most likely not work in the world today. But the critical problem with this model is that it is a model suited to accelerating catch-up growth. It is also a fundamentally low-risk, low-reward model of banking and economic development. In the developed world that is going through the ‘Great Stagnation’, this model will not work.
Now you may argue – so what if we don’t need banks to conduct heroic maturity transformation that funds long-term investment? Surely we need maturity transformation to fund the more mundane activities that I described earlier – invoice financing, short-term business loans, mortgages etc. Until a couple of years ago, this question was literally unanswerable. The only honest answer would have been – who knows? But the explosion of activity in the peer-to-peer lending sector now enables us to arrive at some preliminary conclusions.
Intermediaries that facilitate peer-to-peer (P2P) lending are subject to very little regulation in the United Kingdom (unlike the process of starting a bank which can take years and land you with a seven-figure legal bill). Unsurprisingly, there has been an explosion in the number of peer-to-peer lending platforms in the UK. Conventional wisdom would suggest that individuals who lend through such platforms would lend their money at higher rates than banks would. After all, they have nowhere near as privileged a position as banks do – no ability to create money ex nihilo, no access to the central bank’s repo window. But the reality is exactly the opposite. The lending rates in the industry are, if anything, too low. Individual lenders are falling over themselves to lend money to risky individuals and companies at rates far lower than what banks would lend to them at (to take just one example, take a look at the borrowing rates at Zopa).
And P2P lending is not just a niche phenomenon – there are platforms that handle everything from invoice financing, bridge loans, longer-term loans to individuals and businesses and mortgages. The last couple of years have in effect given us a controlled experiment in what a non-maturity transforming lending system would look like. And the answer is that rates would be lower than they would be in a maturity-transforming system. Maturity-transforming banking is redundant – it only gives us recurrent financial crises. The idea that in the absence of bank maturity transformation, lending rates would explode has been disproven.
This still doesn’t give us any answers as to what we can do to stimulate genuine disruptive and risky investment that can drag us out of the ‘great stagnation’. The answer is simple – we need to do more to promote equity investment in disruptive new enterprises. The conventional wisdom states that there isn’t enough risk appetite for all the equity financing that new high-risk businesses require for their investment needs. Again, the growth in equity crowd-funding is slowly disproving this myth.
A common argument against opening up the possibility of SMEs funding their equity requirements from the masses is that the masses are ill-equipped to evaluate the quality of the SMEs that seek their financing. This may be true but the “Kickstarter” approach is much worse in this respect. Recently there have been some significant Kickstarter-funded “failures”. I have nothing against the kickstarter approach. But it is insane to allow individuals to collectively donate millions of dollars to ventures without any ownership stake while at the same time barring them from funding the same projects and receiving an ownership stake in return.
Enabling equity crowd funding has another benefit that rarely gets mentioned. Left-wing critics of capitalism frequently criticise the “selfish” nature of capitalism. What the growth of the kickstarter funding model shows us that on the individual level there is much more to capitalism than simple monetary interest. Almost all the criticisms of capitalism are derived from the pathologies of institutional fiduciary capitalism. The fact that “capitalism in the large” is selfish is a good thing – fund managers and venture capitalists have a fiduciary responsibility to their investors to focus exclusively on the monetary prospects of their investments and this is exactly how it should be.
But when we invest our money directly in ventures that we care about, we are motivated by much more than just the prospect of riches. However we can do better than allowing individuals to donate money on a hope and a prayer. Expecting everybody to move to a ‘gift economy’ is unrealistic. But we can enable a genuine capitalism for the masses, where individuals can fund projects that provide them with a non-monetary payoff but with all the legal protections afforded by “corporate” capitalism. Institutional fiduciary capitalism is selfish by definition and design. If we want capitalism to become less selfish, we need to enable each individual to become a capitalist.
Note: Most of this essay is drawn from my experience in the financial industry but the portion on the growth of ‘heroic’ banking in Europe from 1850 till the First World War is mostly drawn from ‘The Oxford History of Modern Europe’ (pg 64 onwards). Chapter 7 of Davis Blackbourn’s book ‘History of Germany 1780-1918: The Long Nineteenth Century’ is also excellent on the German model.