A Financial Intermediary That Will Not Fail; and A National Financial System That Will Not Crash

Abstract

This chapter proposes a radically different model of financial intermediation—a decentralized, failure-proof lending platform—designed to avoid the systemic risks and contagion effects that plague traditional banking systems. It outlines how such platforms can operate without holding deposits, making loans directly, or being subject to national regulations. The chapter includes two Appendixes that show how cloud-based decentralized platforms can provide the full range of financial services that a person would need for their entire life.

Generic Causes of Financial Crises

Financial crises begin in two ways. The triggering event has sometimes been an event that causes a sudden spike or collapse of the price of some important good, such as corn. If the corn crop fails, the price of corn rises sharply. Then some businesses or households find themselves unable to make payments they had promised. They default, and then the entities they had promised to pay also default, because they, in turn, did not receive enough money to pay their commitments.

When one or two entities default, people rush to the banks to try to withdraw the money they deposited. If they arrive soon enough, they are able to withdraw their money. They then take it home and put it in someplace safe. They do not put it into another bank; the place that seems safest is to hide it in their house, perhaps in their mattress, or they put it in a box and then bury the box in their back yard.

The second way a financial crisis can begin is more spectacular and sudden. A financial institution discloses that it has made too many loans to a single borrower, or to a category of borrowers that cannot pay. When that happens, word travels fast and the demands for withdrawal pile up and the bank suspends withdrawals. Many financial intermediaries that looked solvent and healthy suddenly face demands for withdrawal. The crisis spreads.

A third way that a financial crisis can begin is when a government defaults on its bonds, as Russia did in August 1998, and as Argentina did in January 2002. When that happens, most banks in the defaulting country suspend payments. The cascade of defaults then spreads to banks in other countries.

A New Model: Financial Intermediaries Without Deposits

This chapter describes a way of creating a financial intermediary that will never suspend payments. The financial intermediary will not hold depositors' money. The proposed intermediary will never freeze customers' deposits. Also, it will never have deposits at other financial intermediaries, because it will not have any money, except small amounts that come from commissions.

The important difference between the proposed financial intermediary and traditional ones is that the new financial intermediary does not take deposits from customers, nor does it hold any money that is to be paid to customers. In consequence, it does not promise to pay any amount to any person who uses the intermediary, and it does not promise to return any amount on a specific date.

This new type of intermediary only arranges loans. It provides a venue where people wishing to borrow money post their requests, and where investors go to choose which proposals to support. It does not take deposits, cash checks, or initiate wire transfers.

How the Platform Works

The new kind of financial intermediary is not a bank. It is a meeting place where would-be borrowers meet would-be lenders. The meetings take place on a platform in cyberspace, not in any physical location. People who want to participate agree to follow the rules of the platform. They can then post requests for loans, or offers to sell shares in enterprises they are seeking to launch or expand.

For example, a farmer might seek enough money to buy a used tractor. The farmer sees enough fields in the immediate neighborhood to keep the tractor and its operator busy. The owners of the fields will pay the tractor owner to plough their fields. The price of the tractor is US$1,500 equivalent.

Lenders who visit the platform see the farmer's application and the computations that the farmer posts to accompany the application. These computations show that the income from operating the tractor will be sufficient to pay for the tractor over a period of 18 or 24 months. Lenders who decide that the loan will be profitable commit to invest an amount of money, for example US$25 or US$100.

Avoiding Contagion and Moral Hazard

The lending platform, in this simple form, does not handle money. It charges small commissions for each transaction, enough to pay Web hosting fees and the electric bill for its server. For each loan that an applicant proposes, the platform launches a "smart contract." That is a computer program that shows information about the loan request and about the applicant.

The crucial difference is this simple crowdfunding platform does not have any lending officer and does not have any entanglement with conventional financial intermediaries, nor with regulators. Lenders will not worry that a dishonest lending officer might make fraudulent loans. Lenders will also not worry that any country's financial regulators will close the Web platform.

Building Diversified Portfolios

A lender can go to several Web platforms to find loan opportunities that allow the lender to create a portfolio that is diversified with regard to the economic activities of the borrowers, with regard to the countries where the borrowers live, and with regard to the credit history of each borrower.

After a lender makes 1,000 loans of $50 each, the lender should have been able to create a sufficiently diversified portfolio. Even during a recession, if 15% of the loans fall into partial or complete default, the lender would lose part of the $50,000 invested but would continue to earn interest on a large part of it.

A Life Without Financial Crises

The lending platforms described here do not include every type of financial intermediary that exists now. These simple designs show that it is possible to implement financial intermediaries that do not collapse, and do not trigger bank runs that drag down other financial intermediaries.

These simple crowdfunding platforms would channel loans to borrowers who might have business talent, but little chance of obtaining loans from the traditional lending institutions that exist in their countries. These platforms would not compete with traditional lenders at first. If these platforms uncovered hundreds or thousands of people with business talent, and channeled important amounts of money to them, the traditional lending institutions might try to take action to block them.

At that point it would become obvious that the lending platforms are not operating within the legal jurisdiction of traditional lending institutions. Then the traditional lending institutions would investigate what they can do to block competition from these decentralized lending platforms.