How a Trillion-Dollar Market Remains Hidden in Plain Sight

http://techcrunch.com/2014/10/05/how-a-trillion-dollar-market-remains-hidden-in-plain-sight/

by funkyy • 12 years ago

40 37 12 years ago

techcrunch.com

JohnSz• 12 years ago

This reminds me of www.zidisha.org where you can make micro-loans to 3rd-world individuals.

rbinv• 12 years ago

I think kiva.org is pretty successful in this space, too.

kapitalx• 12 years ago

The OP is likely referring to prosper.com and lendingclub.com which are for profit businesses for peer to peer lending in the US.

narrator• 12 years ago

The market is really only here while cd interest rates are stuck at near 1%. That's likely to go on for a while. Right now the spread is big enough to make this work.

userbmf4• 12 years ago

Market lenders aren't banks. They cannot use fractional reserve banking. If they take in $100 they loan out $100. A bank takes in $100 having loaned out $10K to satisfy reserve requirements 10% (likely less but keeping it simple).

So if most lending moved to market lenders we would see a collapse in the money supply.

pbhjpbhj• 12 years ago

Don't we already have a collapse in the money supply?

I wonder if the huge number of people/organisations that can loan money but not set up a fractional reserve system (eg because of regulations) amounts to a smaller amount of money available. People making smaller loans may be less risk-averse too?

jackgavigan6• 12 years ago

If the bank's reserve requirement is 10%, wouldn't it only be able to lend out $90 of the $100 it had taken in deposits?

radmuzom• 12 years ago

Yes. But typically banks can leverage - for example, the bank which employs me typically lends out around $125-$135 for every $100 dollars in deposits. I guess the OP was trying to explain the money multiplier but got the example wrong.

(Money multiplier is the inverse of the reserve requirement)

downandout5• 12 years ago

Kind of, sort of, but not really. The $90 that was lent, at some point, winds up back in a bank, where that loan is now a new deposit. Then 90% of the $90 can once again be lent out. Now that original $100 deposit = $171 in loans. And on it goes, until that $100 deposit is roughly $1000 floating around in the economy. This is called the "money multiplier".

Here's a chart that shows the expansion potential of money at various reserve requiements: http://en.wikipedia.org/wiki/Fractional_reserve_banking#medi...

This also shows how banks make so much money, and why there are both laws and services designed to encourage people to keep their money in banks. A $100 deposit generates slightly less than $1K in loans. At only 5% interest, the banks will realize $50 in interest per year on the ~$1K in loans enabled by that single $100 deposit.

userbmf4• 12 years ago

oops missed a zero, but you get the point, there is an order of magnitude between FRB and peer-to-peer like lending.

nhaehnle7• 12 years ago

No. This is probably the most widely spread misunderstanding about banking.

A reserve requirement says the following: Sum up the amount of deposits of a bank (on the passive, debt side of the balance sheet), call that A. Then look at what the bank has in its account(s) at the central bank, call that B. Banks must ensure that on average, B must be greater than x% of A.

So, let's look at a simple example of a bank B that fulfills its reserve requirements exactly at the beginning of this story.

Let's say some client, C, receives an electronic transfer from somebody at a different bank to the amount of 100#. The bank updates their database to increase the number that C sees on their bank statement.

Around the same time, the sending bank S also makes an electronic transfer of central bank money of 100#. This typically goes indirectly via a clearing system, but in practice we can pretend that both banks have an account at the central bank, and central bank money is transferred between those accounts by the central bank updating its database. [0]

At the end of the transaction, bank B's liabilities have increased by 100# (more deposits), and so have its assets (more money in its central bank account).

Moreover, while B has gained 100# in central bank money, its reserve requirement has only grown by 1#, assuming a 1% reserve requirement. This means that according to the reserve requirement, bank B is allowed to have an additional 9900# in deposits.

One way that the bank can leverage this is to hand out a 9900# loan. Let us assume that it does so. That is, it gives some client a deposit of 9900#. Now the reserve requirement is fulfilled precisely again.

You will now probably think, well, the client is going to do something with those 9900#. True, and it becomes relevant if the client transfers this money to somebody whose account is with another bank (otherwise, everything happens locally to one bank and the reserve requirement does not matter).

In that base, bank B will have to send 9900# of central bank money to the receiving bank. However, it's reserve requirement is reduced only by 99#, so it will be 9801# short. Oops. Did the bank break the law?

No, because they are only required to fulfil the reserve requirement within a specified amount of time! During this time, the bank's interbank market traders will simply borrow the required amount of central bank money from another bank, using the bank's assets as security.

Most of the times even this is unnecessary [1], because other banks also make loans, and electronic transfers between banks cancel out.

Initially, this may now look as if the banking system as a whole could just create loans absolutely at will - and that is actually largely true. However, there are some limitations.

However, reserve requirements are not a limitation. If you think the above through, you might come to the conclusion that the banking system as a whole might at some point not have enough central bank money to satisfy the reserve requirements. However, this can never happen because of the central bank's mandate for interest rate stability.

What happens when the banking system as a whole creates a huge number of loans is that bidding in the interbank market would drive up the interest rate for short term central bank money. However, the central bank has a fixed target for this interest rate and will therefore lend out central bank money to the banks (thereby increasing the monetary base) to calm the bidding. [2]

The true limitation of bank lending comes from capital requirements, and for good reasons. When a loan defaults, this hits the banks profits, and when a bank makes losses, they hit the bank's capital - which is morally and capitalistically okay. Loss of capital is exactly what should happen when a bank makes bad lending decisions. So society requires a buffer of capital that is large enough relative to the amount of loans (not deposits!) that a bank has made. Naturally, the size of this buffer is a hotly debated topic, because the larger the buffer, the better for stability, but the smaller the buffer, the better for the bankers.

[0] This is simply a description of how inter-bank money transfers work, and really should be part of every school curriculum. I bet a clear majority of people has never even thought about how any of this works, even though it is a foundational fact about how our society functions.

[1] Actually, it is still necessary due to fluctuations, but the flows involved are much smaller.

[2] This is describing the "normal" situation outside of the liquidity trap scenario we are currently living in. It is important to note that in what I described, the expansion of the monetary base is not a decision of the central bank. It is endogenously driven by the commercial banks' lending decisions.

grayclhn• 12 years ago

No, you would need a larger monetary base to support the same size economy. But printing more money is easy.

Animats• 12 years ago

Peer to peer small lending is easy. Peer to peer small debt collection is hard. That's why the low end of lending is so expensive.

rgrieselhuber• 12 years ago

And, in many markets, a good deal of kneecapping is still involved. (Not a joke.)

justinsb• 12 years ago

I remember reading the T&Cs for one of these 'marketplace lenders'; they would do collections for the lender, if the borrower was 60 days late (which doesn't even seem that late). But the lender would get nothing, setting up a huge conflict of interest for the marketplace: they could make a lot more money on a loan in default than a successful loan.

Wild West indeed.

Edit: Yuk.. "Currently, Lending Club charges investors... 18% of the amount recovered if the loan is 16 or more days late and no litigation is involved". In other words: an automated-payment screws up, Lending Club sends a letter to the borrower, who fixes the problem: Lending Club takes 18% of the principal.

https://www.lendingclub.com/public/rates-and-fees.action

justincormack• 12 years ago

"5% of originations" er, thats not a sane margin. That is around where current banks charge, probably higher, but banks take credit losses in that, but this is pure intermediation.

freshflowers• 12 years ago

Yeah, because unlike taxis and hotels, loans aren't heavily regulated for good reasons.

When did disruptive innovation devolve into reviving old shady businesses?

7Figures2Commas• 12 years ago

Parts of this article gloss over important facts.

These new platforms are able to create a marketplace where lenders and borrowers can find one another and agree to terms, all without the involvement of retail banks or credit card companies.

Credit card companies provide revolving lines of credit; the author's "marketplace lenders" provide term loans. These are two different beasts.

While some folks do use term loans to pay off debt with a higher interest rate under a revolving line of credit, the non-professionals eager to finance consolidation loans would be wise to heed Mark Cuban's advice, "Always look for the fool in the deal. If you don't find one, it's you."

And instead of receiving 1% interest for keeping their money in a CD, active lenders on marketplace platforms receive, on average, an 8% return on their investments.

Most CDs are FDIC-insured. Casually comparing an FDIC-insured certificate of deposit to an unsecured note that has both credit and interest rate risk is insanely foolish.

Earlier this year my whitepaper on marketplace lending forecast that the sector has the potential to originate $1T in loans globally by 2025.

"Marketplace lenders" are absolutely here to stay, but the influx of capital to this space has a lot to do with ZIRP. The author doesn't acknowledge this, but when interest rates start to rise, which could happen within the next year, the environment for "marketplace lenders" is going to change.

How a Trillion-Dollar Market Remains Hidden in Plain Sight

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