We all crave certainty in an inherently uncertain world. But a promise of safety always comes at a price. For example, consider a typical investment portfolio: it could include funds targeting returns of 10 per cent sitting alongside cash deposits paying 0.5 per cent. The reason for the large difference in returns is that the cash offers certainty; the funds don’t.
We all assume that money in a bank account is risk-free. But let’s look at this more closely. Banks take in money from depositors and promise to keep it safe. The same banks then lend the money out in order to make a return. But lending money is an inherently risky business. The equation is fundamentally out of balance – banks are matching safe capital against risk assets. Like any system that is out of balance, something inevitably must give to restore equilibrium.
Much thought has been given to mitigating the effects of this imbalance. The usual way to do it is to regulate banks and require them to hold more capital. But a bank capitalised sufficiently to cope with, say, a one in 50 year event would still not be able to guarantee safety when a one in 100 year event arises.
Some would then suggest that banks hold even more capital, but where do you stop? Why not a one in 1,000 year event? The problem is that the cost of that certainty – the cost of ensuring safety – is too high for most years but not high enough for that one year when it matters most.
It is intuitively inefficient – and therefore value-destroying – for the whole banking system to be wrong one way or the other the whole time: too safe in the good times and not safe enough in the bad. And let’s be clear: we all pay for that inefficiency. Capital requirements amount to nothing more than a sticking plaster over a flawed system.
So what can we do about this? The logical way to address the problem is actually to stop deposit-based lending. Lending wouldn’t stop, as capital markets step in: marketplace lending exchanges which efficiently match risk-seeking capital with return-paying loans.
Crucially these markets, which already exist and are growing quickly, match risk capital with risk assets like loans: this results in a balanced system. Investors receive a direct share of the upside (or downside) from the investments in the form of fair returns. The tension of trying to guarantee safety against a risky asset simply doesn’t arise – the system is neater and cleaner as a result.
Banks would return to their original purpose of being a secure store for money, charging a transparent fee for that service.
This may initially seem like a radical idea, but it’s not as far-fetched as you might think. Banks already extract a price for certainty in the form of rock bottom interest rates for depositors. What’s more, the end of free in-credit banking is a distinct possibility. In the last decade we also saw banks withdraw in a major way from lending (particularly to SMEs). At the same time, more people are seeking better returns by investing through marketplace lenders.
By separating deposit-taking from lending – keeping safety away from risk – we can achieve certainty at a fair and transparent cost; and good returns for a fair level of risk. Both sides of the deal are happy: there is clarity and no broken promises.