EconomicsBanking is dead,
long live banking
An anonymous investment banker explains why the banking system is just big enough to fail, and will collapse soon, to be replaced by peer-to-peer networks.
It’s not every day you sit down to interview two people speaking with one voice. Last week however, I found myself in that unusual position during an in-depth phone discussion with “Jonathan Macmillan”, a pseudonym employed by two anonymous Swiss banking experts who published a radical critique of the current global financial system late last year called The End of Banking.
Both have drawn on decades of experience analyzing and working in the financial services industry to inform their polemic, contending that our banking system is fundamentally unstable, inefficient and unlikely to survive for much longer. The book articulates the broad outline of a completely different, totally algorithmic financial system that its authors believe has the power to make banking, as we know it, a relic of the past. Our discussion ranged from the history of banking and the Great Depression to the most recent financial crisis in 2008, while also sketching out what an alternative system might look like.
Throughout our discussion, “Macmillan” stressed that the book’s point of view is optimistic. He believes the instability of the financial services industry stems from its resistance to the kinds of technological progress that have made formerly complex and inconvenient industries like tourism and travel bookings so much more streamlined and transparent. The book, he said, is fundamentally about using foresight to imagine ways recent developments in digital technology (such as the launch of Facebook Messenger's new fund transfer abilities) could be used to build a new, better system from the ashes of the old the next time it breaks down.
H&F: Who is Jonathan Macmillan? It's a composite that was created by the anonymous person to whom I'm speaking and another person, correct?
Jonathan Macmillan: Yeah, so the other person is an economics editor at a newspaper in Switzerland. He has a PhD in Economics. He's the guy with the theory. He wrote about banking and banking regulation in his PhD thesis.
H&F: And the anonymous person to whom I'm speaking right now is a banking analyist.
Jonathan Macmillan: Yeah, I’m an investment banker. I worked in London before and now I’ve been working in New York for a year. I have the practical background and knows about all the fancy investment bank products, like derivatives.
H&F: Why is the name of your book "The End Of Banking"?
Jonathan Macmillan: Many people have a misconception of banking; they think that we take money from depositors and give it out for mortgages, for small business loans, for student loans. But in reality, banking is the creation of money out of credit. So when we extend a loan, it's not that we take existing money from someone else and give it to a borrower; it's really the creation of new money from credit. And when we talk about the end of banking, we are saying that this model no longer works. And that's because we have had a digital revolution, and that means ... we can no longer control or regulate banking, and we don't need it anymore.
H&F: So when you say the digital revolution changed this banking model that had existed for decades, what do you mean? What changed?
Jonathan Macmillan: In the Industrial Age, as you can imagine, everything had to be recorded on paper. So when you extended a loan, the whole bookkeeping process was all done on paper. And that kind of constrained banking had a very simple setup. So you had one bank, with one book, and one balance sheet. And they had the loans on the one side, and deposits on the other side. But with the digital revolution, we have electronic communications, we have electronic networks, we have a lot of computational power. So this constraint was lifted, and banking could detach itself from the bank balance sheet.
Macmillan explains that financial assets and information can now be transferred across dozens of networked balance sheets, which allows traditional banking operations to be carried out by many different companies and institutions, and makes the whole industry much more difficult to regulate. Like most large-scale businesses today, a great deal of previously centralized activities are now “outsourced” to other partners. For that reason, financial regulation is much more difficult and complex. For example, the Volcker Rule, a critical part of Obama’s 2010 financial reform bill designed to limit banks’ ability to make risky investments, struggled to be implemented because their scope affected so many different companies beyond the simple category of “banks”.
H&F: How did digital technology bring about this change?
Jonathan Macmillan: Imagine you have to repackage one thousand loans. How do you calculate the credit risk, how do you ultimately come up with the price for these packages? You need computational power to do that.
When you look at shadow banking, which is banking that doesn't take place in traditional banking balance sheets, there's a graph in our book that shows that this segment starts to grow in the '70s, when computers began to proliferate.
H&F: Why does an increase in computational power make the system less stable, rather than less prone to human error?
Jonathan Macmillan: We have to go back to the concept of banking to understand that. Banking is the creation of money out of credit. Now, this model is inherently extremely unstable, because there is always this possibility of a bank run. Because on one side you have depositors, who can withdraw their money at any time. And on the other side you have borrowers who get their loans for maybe three, four, five years. And the bank cannot just call them up and demand their money back when their depositors come and request withdrawals. And that's why we saw bank runs over and over again in the 19th and 20th centuries. Depositors panicked, asked their cashiers for their money, and very often that led to bank failures and to economic and financial crises.
The Great Depression in the 1930's was a typical bank run. Several thousand banks had to close. Now of course, the government wanted to prevent that from happening which is why today we have a Federal Deposit Insurance Company, the FDIC, and we have the Federal Reserve, which can give emergency liquidity to the banks if such an event happens. This solves the problem of bank runs, but the problem is that when you get guarantees from the government, it kind of changes your behavior.
The banks started to take on more risk because they had a government guarantee. Now of course the government knows that. The regulators are not stupid. So they started to constrain the possibilities for the banks. They said 'Hey, you can't act like this is Las Vegas. You can only do safe and prudent activities as a bank because you have federal deposit insurance and you have access to Federal Reserve money.'
DIGITAL TECHNOLOGY'S IMPACT ON BANKING
Before computers, financial operations were recorded on paper, which made it complex to move assets from one balance sheet to another.
Analog communications meant companies had to negotiate specific terms when transferring financial assets between themselves.
Computational power changed that, making previously complex operations much faster
When banks had to operate within a traditional bank balance sheet it was very difficult to circumvent those rules. Regulators could easily keep track of what was happening on one balance sheet. But once digital tools allowed one balance sheet to be connected to various other balance sheets, so you could put things wherever regulators aren't looking, which means you can use this technology to circumvent banking regulations.
So basically, those technologies weren't used to make the existing system safer, they were used to circumvent banking regulation, while also making the most of government guarantees.
H&F: When you talk about peer-to-peer lending, do you mean something that would look a bit like Paypal?
Jonathan Macmillan: No, PayPal is more like an add-on for banking. Our proposal is really about dis-intermediating finance. Remove all the balance sheets between the ultimate borrower and the ultimate lender.
'End of Banking' argues that a financial system can be evaluated by three criteria: stability, equality and efficiency.
Vast salaries derived from government guarantees and bank bailouts prove the system produces inequality.
Resources are inefficiently allocated, such as the millions of houses that never ended up being used during the subprime mortgage bubble.
Macmillan describes a system whose interface would mimic the one we use today, but whose underlying structure would be completely different. One way to think about it is to recognize that money kept in a bank account is a kind of loan, which is why the bank accordingly pays interest to the account holder. So today, when you swipe your card in a shop, your bank debits the money you keep with them, and credits the shop’s bank account. The bank also creates new money by giving loans to business and individuals. Under Macmillan’s proposed system, however, money wouldn’t be held in a bank account, as banks would no longer exist. Instead it would be held in an investment account managed by algorithms, which would lend it out to hundreds or thousands of borrowers who need loans. When you took money out of the account, your loans would be automatically sold to someone else in exchange for cash, and then wired to the shop’s investment account, which would immediately reinvest that money once it arrived.
Macmillan believes that the three main functions of banks; pooling large amounts of money for loans, assessing creditworthiness of borrowers, and creating “liquidity” or a healthy supply of loans in the economy, can now all be done through automated computerized functions.
Jonathan Macmillan: There's nothing unique that banking has to add here, to supply the real economy with credit. Banking just makes full use of government guarantees without offering anything. We don't need it anymore.
H&F: Banking provides jobs to people who work in banking.
Jonathan Macmillan: Well, yes, that's maybe one reason for it, nowadays!
H&F: Do you believe your proposed system represents a purely idealized financial infrastructure or do you see it as somehow inevitable?
Jonathan Macmillan: I am convinced that if we don't disintermediate our financial system we will have financial crises over and over again and we will have further problems with rising inequality. The current status quo is totally unstable. So yeah, I'm convinced the only way forward is in our direction.
I believe 2008 could happen again at any time, and when it does happen again, within the next couple of years, I don't believe the system as it is today will survive.