Haves and have-nots are the basis of the financial industry, that is financial institutions are mediators between those who have excess money and those who need it. The industry takes the excess money with a promise to repay it all and a little bit more. It gives that money to those who need it with an expectation that they’ll repay it back with a little bit more. As long as the little bit more that the borrower returns is greater than the little bit more they promised the saver (and operating expenses), the FI makes a profit. It’s a business model that has existed successfully for millennia. But that business model is beginning to erode. To understand why, let’s take a wander through an admittedly simplified history of money.
######Clear the Way in the Old Bazaar
I believe in the Innesian theory of the origin of money rather than the apocryphal economies of barter that we get from Smith. Innes argues that money is fundamentally a brokerage of the economy of credit; whereas according to Smith if I wanted to buy a pair of shoes from Ahmed at the bazaar, I had to show up with two geese for immediate barter. But there is little evidence that this direct barter system ever existed.
Instead, imagine that I bought those shoes from Ahmed on credit. Before money as we know it, parties determined the value of a credit at issue and then (I assume) often renegotiated at the time of redemption. You have a chit that shows that I owe you the value of one pair of shoes (value at issue). If I come back two months later and attempt to pay that credit by goose, we will negotiate how many geese are equivalent to one pair of shoes. If I come back and attempt to pay with a pig, we’ll need to negotiate a different rate of exchange (value at redemption). This system of credits and debits (purchases and sales) gave rise to fairs and bazaars so that “holders of debt could match credits and debits together [to] clear their accounts.” 1
This system of account makes much more sense as soon as we involve more than two people. Why? Well, if that shoe vendor, Ahmed, owed Jabbar the local brewer for a few too many pints, we can surmise that Ahmed could negotiate to pay Jabbar via the debt I owe him. So now, rather than paying Ahmed the shoe vendor, I need to pay Jabbar the brewer. In the confines of a local economy, there is enough trust (or social sanction) for this to work. When trade and commerce expand outside the circle of trust, transfer of my debt becomes understandably awkward: if I’ve never met Jabbar before he comes looking for repayment, neither of us trust each other. Ahmed and I had a trust relationship that allowed him to extend me the credit. Jabbar and I have no relationship. When it comes to negotiating the value at redemption, we’re both at a disadvantage. More importantly, Jabbar might be a traveling merchant and may not want to wait around for me to have assets of sufficient value to cancel our account, or have any use for livestock. So what’s a burgeoning businessman to do? Money.
######Money, Money, Money
“As a medium of exchange money facilitates trade, encourages greater specialization and productivity, reduces transactions costs, and allows for the further flowering of capitalism. It also serves as the beginning of the banking system. As metals become the preferred medium of exchange, banks are created to store and manage these wealth holdings. The coining of metal by state governments facilitates this process by standardizing weights and degrees of alloyed purity. The bankers then issue receipts describing the amount of gold stored or deposited on its premises. Over time, bankers realize that these gold receipts are circulating as money. They also realize that only a fraction of their holdings are called for on any given day. Thus, they can make loans at interest and issue gold receipts far in excess of their actual holdings. “ 1
So as metal coinage became the primary method of exchange and of settling accounts, financial institutions solidified their position as the primary facility for storage and management of accumulated wealth. Since the negotiation of value at redemption is only possible if you have an innate sense of the value of the goods, banks couldn’t determine if the value of one pair of Ahmed’s shoes was equivalent to one or two of my geese. But they could weigh the various pressures of supply and demand, and the risk of default of the debtor. This allowed them to broker gold credits that a businessman could use to settle their own account. The reason that banks have been able to succeed as a business model is because they make it their business to learn how to value various business transactions and how to quantify the risk of default of the debitor. But at their core, they need to have money on deposit to lend.
From the origins of money all the way to the end of the last century, we have exchanged goods for money and money for goods. We based the value of the money on an agreed value of purity and weight of the base metals we based the currency on. But as the last millennium ticked to an end, money first came to have a higher face value than its intrinsic value. Somewhere, thought, currency issuers (i.e., governments) were still expected to have enough precious metal under management to backstop the face value. Then governments stopped carrying enough actual precious metal to backstop issued currency. Essentially, money no longer represented a certain value of precious metal, it was once again only a unit of account.
######Come, Mister Tally Man, Tally Me Banana
Today, of course, we don’t use tally sticks and shubati tablets to track our units of account, we have digital money. This digitalization of money occurred slowly, but the rate of change is increasing exponentially. At first, this change didn’t change the fundamental nature of financial institutions. What does it matter that the credit on deposit came in by electronic transfer, or that the debits go out the same way? The financial institution still has more assets on its books than it needs on a daily basis and can, therefore, continue to lend. But current economic times are making even this increasingly difficult. The government (and the market) set rates that are compressing the margin between lending and borrowing to almost nil. Treasury analysts everywhere are finding creative ways of making the most of it, but fundamentally this core business of financial institutions is eroding.
Moreover, the fundamental purpose of financial institutions is eroding. Banks started as a safe place to store and manage your gold – your physical gold. They base their business model on the fact that people amass wealth for use in the future. This accumulation of assets is fundamental to their business. But if you think back to the bazaars of old, the point was to get what you need and leave with a “clean slate”. It wasn’t about amassing a positive net asset position, it was about having what you needed and being net neutral. There are probably a thousand reasons why societies moved to currency-based systems. But it is important to remember that banks are a symptom of that move, not fundamental to the development of society in the first place.
And so, as money digitized (and probably more importantly, as payments digitized), as a society we moved further and further away from seeing money as a stored and managed physical thing; we are moving back to money being a unit of account. The advent of the credit card further pushed us down this road by providing a tally stick of credit without any collateral. The widespread rise of leasing is another symptom of this change from asset building to cash flow management. What if, as a society, people are no longer looking to amass a large bank balance, but rather to leave the market with a clean slate? What if rather than trying to “save” their positive account, they’re looking to “do” something with it?
######The More Things Change
On the small scale, this doesn’t work. Individuals still need credit to buy homes and need savings for retirement. But with the digitization of money comes the democratization of money. The stock market used to be exclusive, but mutual funds opened the door for everyone. At first this meant that money that used to be long-term savings is now placed in a bank’s wealth products. But then that democratization comes to its logical conclusion as companies like WealthSimple use data and algorithms to manage that money better and cheaper than any bank. Money that was on deposit for use in daily transactions now sits in a Starbucks account so people can pay with their smartphone. Where people used to only spend using the money they had, they now use ubiquitous credit. All these things erode the cash on hand banks need for their business model. It is the digitization of money and the scale available through the worldwide democratization of money that make all these things possible.
Similarly, when you need to buy a car, you can lease from the manufacturer no money down. When you want to finance a business, you launch a Kickstarter. When you want small credit to help with cash flow (an operating line), every single big box merchant offers an unsecured credit card. Even if banks had lots of money on deposit, their core business of lending is eroding.
And perhaps this is the core of the issue. The trust that people once had in banks as the steward of their money is eroding. Disrupters – those people who use modern technology to speak to the digital, globalized tribes that people are increasingly attaching themselves to – are earning that trust instead.
######Are we Obsolete?
So, Risk and Reward. The risk is obvious: society is shifting in a way that, if unchecked, will make the business model of the bank obsolete. Big banks already know this and have developed much broader business lines: leasing, wealth products, small business advisory services, payroll, and many others. But fundamentally banks are, and are regulated to be, deposit-taking institutions. If society moves to a place where that is no longer required, eventually the industry will seem as antiquated as the slave markets: a profitable industry that society moved passed.
But with every risk comes an opportunity. What must banks be doing in 15 years so they remain viable? Well, it comes back to trust. Simon Sinek talks about the golden circle of safety or trust that forms the foundation of society. Leaders are those who earn special privilege because they maintain the security of those inside the circle. The old town fair was like that: credit was extended and accounts were balanced because the entire economy operated inside the circle of trust. Banks started with the fact that people needed physical security for their gold. They earned the right to leverage those assets for a profit on the condition that they kept the gold safe. The shift that is occurring, though, is changing what they need to protect.
Today people want assurance that their identity is safe. Today people want assurance that they’re protected from fraud. Today people want assurance that their investments are worthwhile. These are transactional concerns, not asset concerns. You don’t earn the privilege of a profitable business model (i.e., as a leader in finance) by keeping deposits safe. You earn it by allowing people to interact in the modern, digital, global economy while ensuring that they are safe from harm.
######A Circle of Trust
So how does a modern financial institution do that? They don’t guarantee deposits, they guarantee the safety of your identity. They don’t protect their interests with credit analyst expertise; they protect their customers’ interests with fraudulent transaction expertise. They don’t expect long-term deposits that they can lend; they find ways to allow people to use any positive balance on their slate by safely investing it in other members within the circle of trust. Effectively, a modern financial institution should facilitate the unit of account economy inside the circle of trust and protect its members when they, necessarily, venture out into the wilds outside the circle.
The reward for being the leader of a society and keeping them safe was the growth of your society and prosperity for all. The only true path to success in the future for financial institutions is to live that leadership. Financial institutions must build their circle of trust and must learn to protect the right assets. Fundamentally that means abandoning the core business the industry was built on.