After the credit crisis of 2008-09, former Federal Reserve Chairman Paul Volcker quipped that the only important innovation the financial industry had come up with in the prior 20 years was the automated-teller machine. Now almost everyone is walking around with a smartphone loaded with apps to manage personal finances, cryptocurrencies have become funding vehicles for everyone from cloud technology entrepreneurs to rappers, while big banks are pondering how to put their records and conduct transactions on decentralized blockchains.
Bloomberg View columnist and economics professor Tyler Cowen recently spoke with fellow Bloomberg View columnist Matt Levine, who spends a lot of time thinking and writing about the future of finance and its intersection with technology. Here is a lightly edited version of their online chat.
Tyler Cowen: Twenty years from now, when we look back, what do you think will be the biggest and most surprising way that fintech will have changed our lives?
Matt Levine: I am going to have a boring answer here, which is that I don’t expect anyone to experience financial technology as surprising or life-changing. The point of most innovations in consumer finance has been precisely to reduce its presence in our lives: Instead of talking to a bank teller to get money, you use an ATM. Instead of physically walking into a broker’s office to talk about which stocks to buy, you buy index funds through a web page. Or, now, you click to enroll in an app and it does all of your asset-allocating and stock-picking and tax-harvesting and so forth for you. I think that a lot of financial technology is heading in the direction of perfecting that vanishing act, so that in 20 years you’ll just think about financial things less than you do now.
Of course there are people with the opposite vision. There are, like, virtual-reality programs that let you visualize your stocks as buildings and walk through them like a city. If anything in financial technology looks like that in 20 years, then things will have gone horribly wrong. Or there are the cryptocurrency enthusiasts who think that everyone and everything will have their own currencies in the future, and that everyone will spend all day engaged in thinking about crypto-exchange rates. Again that doesn’t seem like an attractive or realistic vision.
That said, I think the possible surprise here lies in the connection between finance and identity. People are sort of inchoately aware of it now; we use the term “identity theft” to mean “someone using your name and Social Security number to get a credit card.” But most people don’t really think of their credit report as being central to their identity. Really ambitious proponents of blockchain technology, though, envision a world in which a lot of identity information — your citizenship and marital status and college degrees and employment and certifications and whatnot, maybe your fingerprints and retinas and DNA, as well as of course your credit information — are encoded on a blockchain and used in every aspect of your life. (India has a governmental system a little bit like this, and China is building one, though the blockchain vision usually involves decentralized non-governmental systems.)
I think that the idea that financial intermediaries should be the keepers of identity is pretty uncomfortable, but then, the idea that Facebook would be the keeper of identity seems like it would be uncomfortable, and in fact Facebook has quickly taken over a lot of the work of verifying identity, at least online. One thing that we might see in the next 20 years is a fight between financial institutions and social networks and decentralized blockchain builders over who gets to be the keeper and verifier of everyone’s identity.
TC: Perhaps I expect bigger changes than you do, so let me follow up on a few possible future scenarios. Here’s one to start with: Big data and algorithms will become so good that only the good credit risks will be able to borrow. Of course this will help many creditworthy people, but the social-insurance function of credit might disappear with large numbers of risky borrowers locked out of the loan market and perhaps some insurance markets too. In economic lingo, separating equilibria may replace pooling equilibria and it may become harder to protect against risk.
ML: This is not impossible, but the story of technological changes to credit so far seems to me to be pretty exclusively one of expanding access to credit. You have subprime mortgage lending, which is of course a mixed bag, but which certainly allowed people who were bad credit risks to borrow — not because algorithms were so good (or bad) at analyzing their credit risk, but because the borrowing was secured (and the algorithms were bad at predicting house prices).
But also the whole peer-to-peer and online lending space really expanded unsecured personal lending from being an afterthought at banks to being a real business. If your starting point is that average credits get loans at average rates, then better credit analysis driven by big data might hurt below-average credits.
But if the starting point was a market-for-lemons equilibrium where it was hard for anyone to get credit, then adding algorithms might improve access for almost everyone. I suspect that’s closer to the truth for a lot of lending products. Or there are the payment-processing companies (like Square) that are getting into small-business lending.
Again the story here is not that they have fancy algorithms that are better than the banks are at predicting which businesses will pay them back. The story is that they have privileged access to the businesses’ cash flows: They process payments for them, so they can just divert some of the payments to pay back the loans. The technological advantage is not in credit analysis but in getting really good security for the loans.
Quite plausibly that process is generalizable, and there’s a blockchain-and-smart-contracts story I could tell you here about how technology will make lenders feel more secure even when lending to bad credit risks. If the smart contract automatically pays you back, you just need to worry less about whether your borrower is a deadbeat.
(Obviously that has its own social-insurance-function negatives; part of the social purpose of credit is that you don’t have to pay it back in all states of the world.)
TC: And what do you think of this possibility? The shadow banking system will grow so large it will be impossible to either guarantee it all or regulate it safely. Life was easy when traditional commercial bank deposits were central to intermediation, but now non-guaranteed credit instruments, derivatives and off-balance sheet activities continue to grow. Won’t we return to a world with the periodic banking panics of the late 19th century, except they won’t be in banks narrowly construed? Maybe this one has happened already! Again, that could mean a lot more risk.
ML: Yeah, I think of that as out-of-scope, not a fintech story but something that happened already. Surely that picture of the world was truer a decade ago than it is now, when money-market funds have floating par values and more derivatives are on-exchange and shadow banking is subject to more regulatory oversight. Also, a big part of the fintech story is about distrust of exactly that situation. Peer-to-peer lending is a kind of equity-financed banking. And a lot of bitcoin enthusiasts don’t even believe in fractional-reserve banking!
TC: Here’s the final scenario I’d like you to consider, and do you see any chance of this outcome? Capital becomes truly mobile internationally, even for the little guy. Of course that would be great for many poorer parts of the world, at least if they have decent governance. Other poor countries could be sucked dry by capital flight. And might it pose a risk to middle America? What if I earn some discretionary income, and I can push a button lending it to a diversified portfolio of businesses in China, India and Brazil? For a higher rate of return of course. Are small to mid-tier American businesses going to do so well from this? What do you think?
ML: Sure, I think that is true and happening already. But going back to where I started, I am not really bullish on the idea of financial technology as leading to lots of regular people making individual investment decisions while bypassing financial intermediaries.
It’s just too much work; even if technology simplifies the mechanics of lending to Indian businesses, there is still a lot of mental energy that goes into deciding to do that. And the peer-to-peer lending platforms that actually exist are mostly not peer-to-peer, in the sense that it’s a lot of individual humans picking through individual loans or whatever. It’s aggregators and intermediaries, hedge funds and banks, who are making the investing decisions.
And so yes, I mean as a first cut I’ll put my money in an account at Chase, and JPMorgan Chase is a giant global bank, and for all I know it will lend my money to a diversified portfolio of businesses in Brazil to pursue a higher return than it could get in the U.S.. Or I’ll go to Vanguard’s web page and put some of my money in U.S. index funds and an increasing percentage into international index funds. So certainly my money will increasingly go to fund businesses abroad, but I think that is more about the growing size and international scope of the big financial intermediaries than it is about new disruptive fintech ideas. International investing via Vanguard is much easier than international investing via LendingClub.
Will it be good for small American businesses? One stylized story of the financial crisis is that people in other countries — China is often mentioned — had more money than they used to, and wanted to invest it in relatively safe ways, but there weren’t enough safe investments to go around. So some financial engineers in the U.S. — a traditional home of financial innovation — went and built new machines to transform risky assets into supposedly risk-free debt. The particular inputs that those machines used were mostly U.S. residential mortgages, and so that influx of global money was really good for U.S. homeowners (in terms of their access to credit and rising house prices), until, of course, it wasn’t.
But there was nothing inherent to the machines that required them to use residential mortgages as inputs. They could have used small-business loans. And in fact the CLO market — the commercial-lending analogue of the residential mortgage-backed securities that drove the financial crisis — is doing pretty well now. So if one dynamic of financial technology and globalization is that U.S. investors can get higher risk and higher returns by lending in emerging markets, another dynamic is that increasingly wealthy emerging-market investors will want to pursue lower risk and lower returns by lending in the U.S.
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