How a Trillion-Dollar Market Remains Hidden in Plain Sight
techcrunch.com
techcrunch.com
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.
> 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.
So if most lending moved to market lenders we would see a collapse in the money supply.
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.
> A $100 deposit generates slightly less than $1K in loans
If that were true, the amount of money in circulation would be infinite, because loans also end up as deposits.
Edit: More to the point, look at actual numbers in bank balance sheets. The amount of loans tends to be roughly equal to the amount of deposits (the precise ratio varies with bank business models).
This is precisely how banking works, at least in countries that have fractional reserve requirements.
>If that were true, the amount of money in circulation would be infinite, because loans also end up as deposits.
Nope. It would only be infinite if the reserve requirement were 0%. Look at the chart I linked to. This goes on all day, every day at banks around the world. New money is created through credit, subject to the limitations imposed by each country's reserve requirements.
Furthermore, check out countries without reserve requirements. Do they have an infinite amount of money in circulation?
Yes, banks create new money through credit. However, this is not limited by reserve requirements (if the empirical evidence still doesn't convince you, please read up on how the central bank will always lend the required central bank money to banks when they need it, i.e. the lender of last resort function of central banks). You have to look at capital requirements and general borrower demand and quality to understand what's going on.
None of these banks has lent out more than 90% of their deposits, yet the money has multiplied. Of course, most banks will never be able to get to 90% because demand for loans from qualified borrowers isn't high enough. But this is how the system works.
nhaehnle has a deeply flawed understanding of how the principles underlyingmodern banking, and is confusing different funding sources. Do not accept what he says at face value.
Even if I take a charitable interpretation of what downandout writes, they still contradict themselves. First, they wrote:
> A $100 deposit generates slightly less than $1K in loans
In the latest comment, they wrote:
> Bank A receives a $100 deposit and lends $90. That $90 goes into bank B. Bank B lends $81 of that money. That goes into bank C. Bank C lends $72 of that money, and that goes into bank D. > > None of these banks has lent out more than 90% of their deposits, yet the money has multiplied.
I suppose this shows that they are aware that deposits are roughly equal to loans. But then why write that 100$ of deposits generates roughly 1000$ of loans? The two statements are clearly contradictory. [0]
The second point is this: Perhaps this is a confusion about where deposits actually come from? Today, most deposits are usually made electronically, but even if you actually go ahead and deposit physical money at your bank, that physical money at the bank has previously been withdrawn from a bank account somewhere.
But even if 100$ of physical money were to appear by magic in your wallet and you then went ahead and deposited those at your bank, this would not cause an increase of loans by 1000$. There is just no process in modern banking where anybody at the bank says "Oh look, our deposits have increased, let's go loan to somebody". That just doesn't happen - go talk to actual bankers!
The truth is that the level of loans in the economy is primarily determined by (a) how many people/companies apply for loans and (b) how creditworthy they are. [1] The amount of loans given out by banks might additionally be limited by capital regulations.
However, at no point anywhere does the amount of deposits determine how many loans a bank makes. If anything, it's the other way round, because the level of loans determines the level of money which determines the level of deposits.
I know that your story is the one that a lot of laypeople (and even economists!) perpetuate. Unfortunately, it's just not true.
[0] I honestly fail to see how one could fail to see this. My only explanation is that you people were told this story from when you were children, that you accepted it unquestioningly and it was never pointed out to you.
Edit: Perhaps, to spell it out and make the contradiction more obvious: You assume 100$ entering exogenously as new deposits. You now apply the statement "100$ of deposits generate 900$ in loans". Fine. Those loans become deposits, so now you actually have 1000$ of deposits additionally to the starting point, 900$ of which you have not yet applied the statement "100$ of deposits generate 900$ in loans" to. You now apply this statement 10 times, meaning that 9000$ in loans are generated. Ad infinitum. It just doesn't make any sense even disregarding how the banking system really works.
[1] Note that this is a good thing, because it means that the economy is free to grow quickly!
Edit: Downandout isn't wrong, it's the GP userbmf that is, since he/she said that market lenders aren't banks and "cannot use fractional reserve banking", which is a ill-defined statement. I erroneously assumed that the two users were the same. My apologies.
Did I say that it didn't apply to p2p loans? It, of course, applies to any money that can be a new deposit. And how exactly am I wrong? The concept of the money multiplier is pretty well documented. There's even a chart that I linked to.
When I borrow $100 from p2p lending then loan it out to you through p2p lending I no longer have that $100 until you repay it to me, at which point you no longer have it. So we are simply passing $100 around without any multiplier effect.
edit - can't reply to you as the reply limit bottomed out - your response doesn't have enough info. You didn't address the demand deposit vs timed loan difference.
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.
Note, however, that lending is subject to unrelated constraints, in particular the capital requirements that I've mentioned.
This is what I meant by saying that even if a bank fails to borrow from other banks to satisfy its reserve requirements, it can just go to the central bank to get the required money, and that therefore reserve requirements are not a constraint on lending.
By the way: In case you haven't heard of it, read the Modern Monetary Theory Primer here: http://neweconomicperspectives.org/modern-monetary-theory-pr... It's very long, and there are a lot of macroeconomic statements in there that can be disputed, but their description of how the monetary system actually works is spot on and well organized.
(Money multiplier is the inverse of the reserve requirement)
Banks have two sets of inputs:
(1) Equity (i.e. the owners of the bank put up capital. This is great because it requires them to have 'skin in the game')
(2) Incoming debt (i.e. depositors give them money.).
They have two outputs:
(3) Outgoing debt (i.e. the loans the bank makes out to people, in the form of mortgages, small business loans, lines of credit, etc.)
(4) Reserves (money they have to keep on hand)
Notice that as an accounting identity, we must have that (1) + (2) = (3) + (4).
Leverage limits essentially limit the ratio (2):(1). For example, a leverage limit of 9:1 means that a bank lends out $100 has to source at least $10 of that from equity, and at most $90 of that from incoming debt.
Fractional reserve limits essentially limit the ratio (3):(4). As "user downandout shows in a sister thread to this one, this can be used to determine a "multiplier" for the economy as a whole, since for a nonzero limit, there is a closed form fixed point solution maximum multiplier ratio in the economy as a whole. (Although in practice the "true" multiplier can be lower since people might stuff their mattresses with money, or have lots of loose change lying around, etc.).
Note that the fractional reserve limits are something that is enforced on banks by the government to limit the multiplier. This restriction doesn't exist on P2P lenders (as of yet), and so if any thing, it means that P2P lenders are even freer to do bad things (such as have no reserves on hand at all).
That's not entirely correct. Those $25 mostly comes from other banks with other business models, e.g. banks holding treasury bonds instead of loans.
That said, I really like how radmuzoom's comment contained the kernel of real-life data that should help people realize that the typical money multiplier explanation is just wrong: if you actually look at the sum of deposits and the sum of loans that banks have, you'll see that they are more or less equal.
Yet, if you believed the typical money multiplier story, the amount of loans would have to be at least 10x higher than the amount of deposits (even infinitely larger in countries where no reserve requirement exists!).
When you "lend on" money you yourself borrowed in peer2peer lending at this point you cede access to that money. Unlike when you save with a bank where your money is lent out (except the 10% reserve) yet you have a demand deposit for the full amount. Hence the multiplier effect.
I think your description above is totally wrong. Banks in the UK had leverage at over 20 times assets to capital. It was precisely this high level of gearing which meant that our banks collapsed very quickly when there was a shift in the economy.
Banks lend most of the money out back out based on the probability that most loans won't default. Your 1+2 isn't correct.
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?
When did disruptive innovation devolve into reviving old shady businesses?