Crowdfunding: the end of banking as we know it?

Photo credit:   Banalities

May 20, 2014 // By: Tony Greenham

Last month the Financial Conduct Authority released a statement on crowdfunding outlining the parts of the industry they now regulate. Covering peer-to-peer lending and investment based crowdfunding, they list both the benefits and the risks of this relatively young sector.

With this increasingly mainstream presence, it’s worth thinking about just how crowdfunding is different to banking as we know it. And what could be on the horizon if, as is predicted, this industry continues to grow?

The end of banking as we know it

Most British high streets are still graced by the reassuring stone architecture of bank branches, even if you are increasingly likely to find pubs and wine bars inside them. One of the key marketing tools of early banks was to communicate their reliability, trustworthiness and professional prowess through the quality of their premises. Just leave it to us, they seem to say, we’ll take care of everything.

Now increasing numbers of individuals and businesses don’t want to hand their money over to bankers, however impressive their buildings, but would rather borrow and invest in virtual marketplaces directly with people they will probably never meet. The UK Crowdfunding Association defines three different types of crowdfunding: equity, debt (peer to peer lending) and donation or reward funding. The number of platforms is proliferating and the sector is predicted to raise $5.1bn globally in 2013.

Does the rise of crowdfunding, and the disintermediation of banks, mean the end of banking as we know it?

Disintermediation is an ugly word (particularly for intermediaries), and is defined by the Oxford English Dictionary as “reduction in the use of intermediaries between producers and consumers, for example by investing directly in the securities market rather than through a bank”.

But hang on a moment. The first building societies in England were surely no more than a sort of early crowdfunding scheme. Based not around the internet but the 18th Century technology of the Tavern: the first building society was founded in 1775 by Richard Ketley, the landlord of the Golden Cross Inn in Birmingham.

Or a return to the roots of banking?

So, crowdfunding could be seen as a welcome return to the roots of retail financial institutions. More to the point, surely crowdfunding platforms are intermediaries?

At the minimum they offer a meeting place – an online notice board to enable those seeking and offering finance to find one another – and the technology to carry out the transactions, including moving the money. Usually they offer much more than this. Peer-to-peer lenders check the credit ratings of potential borrowers, screen those deemed un-creditworthy, and band the rest into different risk tranches. Platforms increasingly offer a secondary market to provide liquidity for those wishing to cash in their investments early. UK crowdfunder BankToTheFuture even intends to apply for a full banking licence to extend its range of products.

Will banks be forced to try to follow suit with much more transparent products? Let’s hope so.

On the horizon

I predict that as soon as the crowdfunding industry takes a meaningful chunk out of bank balance sheets, then it is only a matter of time before we see big banks acquiring the larger players. So perhaps a more interesting question is: how might crowdfunding change the banking sector? Here are three potentially significant ways to think about:

  1. The core of crowdfunding is transparency and control. One could argue that the best of banking already achieves this – just look at the full disclosure by Triodos Bank of who it lends to. Ethical and social banks also give customers some control over how their money is used. But crowdfunding takes this to a whole new level, and this can only be good news for consumers. Will banks be forced to try to follow suit with much more transparent products? Let’s hope so.
  2. Greater transparency and control might lead to a shift in the nature of what gets financed. Will the decisions of millions of individuals, often motivated by social and environmental as well as financial returns, result in a much more positive overall impact for society than a financial system controlled by a relatively tiny elite?
  3. The most unpredictable impact is on the quantity of money in circulation rather than who lends it to whom. Deposit taking banks have the power to create money. Only bank lending can expand (or contract) the overall supply of money into the economy by creating new bank deposits. This is the essence of fractional reserve banking. We cannot easily predict the macroeconomic impact on the money supply of a shift from bank credit to crowdfunding.

A threat to fractional reserve banking?

There is a long history of eminent economists calling for the separation of the money and credit functions of banks, and hence the abolition of fractional reserve banking. In the US, the Chicago Plan proposed this in the 1930’s. It was never enacted by Congress, but one intriguing possibility of crowdfunding might be that the market succeeds where Congress failed - not the disintermediation of banks, but the end of fractional reserve banking as we know it.

This blog first appeared on the Future of Financial Services website

Issues

Banking & Finance, Democracy & Participation

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