They say that actors really want to direct, and directors really want to act. We’re starting to see a similar grass-is-greener yearning in two of America’s most powerful industries. These days, banks want to become technology firms, and technology firms want to become banks.
The “fintech” boom has been on for a while now, and it covers a lot of categories. It started with efforts to disrupt the payment system, which in the United States is sclerotic and antiquated. PayPal, Stripe, Square and more recently ApplePay have tried to change that. Then there’s Betterment, one of several automated investing services that seek to replace financial advisors with an algorithm.
But peer-to-peer services like Lending Club and Prosper, connecting borrowers in need to lenders with ready capital, have generated the most attention. SoFi, another peer-to-peer lender, is now one of the country’s 30 largest banks by market capitalization, with $4 billion in mortgages, personal loans and student loan refinances.
Older tech firms, like PayPal, Square and Intuit, makers of TurboTax software, are plowing into the lending space, using their voluminous user data to contour offers to small businesses. Even UPS is partnering with an online small business lender named Kabbage. There are undoubtedly more on the way: Fintech firms raised $8 billion from venture capitalists in just the first six months of the year.
Wall Street is aware of the threat: As JPMorgan Chase CEO Jamie Dimon said in his annual letter to shareholders this year: “Silicon Valley is coming.” Financial firms have responded to these intrusions on their turf in several ways. First they’re buying up their own fintech companies to incorporate the technology and use their massive scale to compete.
For example, asset manager BlackRock picked up robo-investor FutureAdvisor last month. In January Capital One bought the spending tracker Level Money. And Goldman Sachs has entered peer-to-peer lending, in competition with Lending Club.
More recently, nine major banks (including Goldman Sachs, JPMorgan Chase and BBVA) have vowed to adopt the blockchain, a technology used in the bitcoin system to track payments over a computer network. Blockchain evangelists believe it has the potential to speed issuance of remittances, private shares and interbank payments. Blythe Masters, the former JPMorgan Chase executive known for developing credit derivatives who now runs a tech startup called Digital Asset Holdings, calls it “email for money.”
There’s a lot of potential in these innovations. The U.S. payment system really is bad, and could use some freshening up. Small business lending has faltered since the financial crisis, and competition could bring rates down and expand access. Opening the credit box to new types of entrepreneurs democratizes finance and increases the possibility to acquire wealth, no matter your station in life. And most users of these services praise their efficiency and ease of use. It’s not like traditional banking has such a sterling reputation that they couldn’t do with some competition.
But we should be careful in assuming that fintech represents much change from the status quo. Often the peer on the other side of your peer-to-peer loan is a private equity fund, asset manager or investment bank, all of whom have plowed money into these sites. There’s also an enormous secondary market for securities derived from peer-to-peer loans. Over the past year, Morgan Stanley, Goldman Sachs and BlackRock have issued hundreds of millions of dollars in peer-to-peer loan-backed securities.
There’s very little difference between this relationship and the one between investment banks and non-bank mortgage originators during the housing bubble. If fintech firms begin to rely on warehouse lending from Wall Street, and an increasing demand for peer-to-peer loans, inevitably underwriting standards will drop and defaults will rise. P2P lenders claim otherwise, that they are perfectly transparent about their loans and that they are engaged in “controlled growth.” I’m sure Countrywide said this at the beginning, too.
The other, related problem with tech firms plunging into banking is that the regulatory apparatus isn’t set up for it. Like “shadow banks,” Lending Club and SoFi exist somewhere outside the regulatory perimeter, and it’s questionable which of the various agencies have jurisdiction. Regulators around the world are starting to look at this issue, but by the time they figure it out we could be headlong into a credit crisis.
There’s a third point about data, which tech firms are leveraging to generate their loans. Profiling customers through data mining is no different than what predatory lenders do when they buy lists of low-income earners and tempt them with deceptive schemes. Questions of privacy and cybersecurity become magnified when financial matters get involved, and it seems terribly easy for all this Big Data to get mismanaged in ways that harm individual customers.
As for the blockchain, there are already other simple payment systems that leverage technology — the M-Pesa mobile payments in Kenya come to mind. The Federal Reserve has been looking into improvements for the payment system for some time, though the hype about blockchain could get them to move faster.
But I shuddered when hearing about one potential application: a company called Factom building a land title registry in Honduras off the blockchain. This is precisely what banks did with a private recordkeeping mechanism called MERS, evading public land recording fees while creating an electronic database for mortgage transfers. This ended up putting upwards of 60 million mortgages into the MERS database, accessible to thousands and with no double-checks or tracking whatsoever. The potential for human error to crumble the blind faith in technology is great.
Similarly, the need to screen and test payments and transfers would be given away to hope and trust in the blockchain system. As Stephen Cecchetti and Kermit Schoenholtz write, “the anonymity of the blockchain technology collides with the public’s legitimate right to thwart criminal transactions.”
We should not fear innovation. But we should wonder about the goals: to deliver better and cheaper financial services, or to sidestep regulation and rely on the vagaries of the free market? For those who think that the banks have ruined their reputations and that it’s time to trust Silicon Valley with their money, they might want to be careful what they wish for. And for those who think Wall Street can’t possibly mess up financial innovation again, well, I don’t think anyone is that foolish.