Reconceptualising Financial Intermediation in the Age of FinTech
Vincenzo Bavoso - The University of Manchester
-- This blog post provides some initial reflections on a research question that matured from the interplay of two converging themes, presented at CUHK's recent Machine Lawyering conference. The first one relates to the expansion of market-based channels of finance since 2014, and more specifically the rebranding of what was once termed shadow banking into resilient market-based finance (see Bavoso 2018). The second theme is the expansion and regulation of P2P channels of lending, which increasingly appear to be supplementing commercial banks in the supply of credit to the economy (see Bavoso 2019).
What became quite interesting in developing these research questions, especially from a theoretical standpoint, was the conceptualisation of financial intermediation in light of the shifts highlighted in the referred papers, namely as a consequence of the further disintermediation from banks. More specifically, I found that in order to fully appraise the move from bank-based towards market-based finance, it is crucial to look back at the traditional role performed by banks in the intermediation and allocation of finance, and how this has evolved over time. This line of enquiry allows firstly a reconceptualisation of the social and economic role of banks; and secondly, the positioning of alternative lending channels in the wider context of financial intermediation and financial markets.
The reconceptualisation proposed in this research is grounded on three theoretical layers, which represent different views of how banks operate. The first theoretical model revolves around the proposition that banks act as financial intermediators between depositors and borrowers. In doing so they accomplish a vital economic function, which is reflected in a) the creation of liquidity on their balance sheet (namely the funding of illiquid loans through liquid deposits); and b) the creation of a particular type of debt that is considered “panic-free” (also information insensitive) and thus equivalent to cash, namely demand deposits. Importantly, this concept of banking rests on the belief that bank loans are premised on deposits, and that the capacity of individual banks to create credit is constrained by reserve ratios.
The second theoretical model of banking takes stock of the structural changes that shaped the business model of banks over the past two decades. These prompted shifts in the two key functions identified in the previous paragraph. Specifically, modern multifunctional banks create market liquidity off-balance sheet (instead of funding liquidity on-balance sheet) as they engage in the process of securitising assets. Likewise, the creation of information insensitive debt takes place through market-based, off-balance sheet channels, and it is represented by securitised debt. This new type of debt is pledged as collateral in repo transactions and thereby considered a panic-free money claim (albeit not as information insensitive as demand deposits). The critical aspect of this model is that unlike the previous one, its channels of intermediation never received public backstop in the forms of deposit insurance protection and lender of last resort regulation. This inevitably made them vulnerable to panic and crashes, as it is well documented by the events of 2008.
The third theorisation of banking questions the intermediation and allocation functions traditionally attributed to banks. This view was much strengthened by a recent paper by the Bank of England that clearly explained how commercial banks create credit ex nihilo, and that, contrary to conventional belief, it is loans that create deposits and not vice versa. In essence, whenever banks originate new loans, they increase both sides of their balance sheet, adding the same entry both on the assets side (as loan) and contextually on the liabilities side (as deposit). This reality begs fundamental questions, as this view refutes the concept of intermediation as well as the limit on banks’ credit creation traditionally attributed to reserve ratios.
In light of this reconceptualisation of banking, it appears that P2P finance represents a new form of disintermediation, and at the same time it encompasses a number of functions that seem to be consistent with the intermediation model explored earlier.
Unlike banks, P2P platforms do not hold client money, and do not leverage up their balance sheet when extending loans. As a result, the credit risk originated on the platforms is retained by investors. Moreover, platforms are heavily engaged with the secondary market, often through the securitisation of P2P loans. The immediate questions as a result are whether platforms are capable of correctly monitoring the credit risk that they originate (as banks are traditionally presumed to do), and whether they transfer risks to other segments of the financial system.
It is important to recognise that the P2P sector is not recipient of any public backstop (such as deposit insurance protection, lender of last resort, or resolution schemes) even though some form of regulation (chiefly in the area of investor protection) and some voluntary arrangements do amount to some degree of private backstop. The question is whether this level of regulation is sufficient to screen the industry from a crash, or from the systemic effect of it. Can in other words increasing defaults in the P2P market create a systemic shock?
In addressing these questions, it needs to be remembered that the sources of interconnectedness between the P2P market and wholesale channels have been neglected by recent regulatory reforms. This is at odds with the increasing engagement of P2P platforms with the securitisation market and the ensuing interlinks with capital markets. This also means that while platforms create market liquidity, liquidity risks are not adequately monitored, as was the case before 2008.
Ultimately, there is still much to be asked about the nature of P2P finance, and whether platforms are supplementing something that banks don’t do – and perhaps are socially expected to do. If financial intermediation is something that retains fundamental social and economic value, are we sure that it is appropriate for these functions to migrate to market-based channels? There is no concluding evidence after all suggesting that intermediation and allocation functions are better performed through alternative, market-based channels. As defaults in P2P loans are increasing and more draconian investor protection measures are being implemented, it is perhaps time to question whether reinventing banking along more traditional and simple models is the best way forward to ensure intermediation and allocation functions.