Rajesh Jayaraman

Can we have a financial system without banks?

Bloomberg Businessweek published an interesting interview with Marc Andreessen today in which he says that technologists can reinvent the entire financial system. He discusses in depth two areas: Unbundling of credit intermediation with credit underwriting using new/different/big data and Bitcoin. Any such discussion about “disrupting” finance always comes down to the question of what happens to commercial banks 1. Can we have a financial system without banks as we know them today?

Before we answer that question, lets revisit the definition of what a bank is and what it does. This Investopedia article is sufficient to give us the lay of the land. Banks perform four essential functions: Payment settlement (or liquidity provision), Credit intermediation (borrowing from depositors and lending to borrowers), Maturity transformation (providing immediate funds to depositors while making long maturity loans to borrowers), and money creation.

Of these, the money “creation” function has been debunked by James Tobin as far back as the 1960s.

The payment settlment piece is a franchise monopoly provided to banks by the Federal reserve via access to the ACH and FedWire systems. It is easy enough to look to the UK where non-bank parties can access the BACS payment system. The Fed could become enlightened and allow others into this club. This is simply a network effect play like Facebook and it is the hardest to unseat (Bitcoin notwithstanding) without providing access to non-banks to these networks.

The most interesting changes that technology can bring about is in credit intermediation and maturity transformation. These two functions were necessary in an era when only a bank could serve the needs of depositors (who wanted immediate at par funds) and borrowers (who wanted long maturity loans). Many things have changed in the financial and technology landscape in the last 150 years. There are now financial assets that span the gamut of maturity, risk and liquidity profiles for investors to place their excess cash in - treasury notes, bills and bonds (risk-free, highly liquid, maturity profiles from few days to 30 years), commercial paper/corporate bonds (low to medium risk, highly liquid, multiple maturities), marketplace loans ala Lending Club/Zopa/Prosper (high risk, low liquidity, long dated). There are also equities that investors can place their cash in. On the technology front, the Internet and cheap computing have made it possible to a) enter and exit asset positions in a very automated fashion and b) access liquidity round the clock via electronic payments.

We can now match the risk appetite of investors/savers with the riskiness of the underlying assets with technologies like marketplace (p2p) lending, liquid bond & equity markets with fully electronic trading. This obviates the need for the credit intermediation function of banks. We can also match the liquidity preference of investor/savers with the maturity & liquidity characteristcs of the underlyind assets because of a wide variety of electronically tradable securities. This obviates the need for maturity transformation.

This really leaves us with what to do about demand deposits. The answer was given by John Cochrane in an excellent paper titled “Toward a run-free financial system”. Here he advocates for backing demand deposits by treasury securities - the US has more than enough debt and a rock solid credit rating to sate all the risk-free appetite of the country’s depositors. It is entirely possible to build a debit card that is backed by treasury bills - every time you buy a mocha at Starbucks appropriate amounts of t-bills are traded on electronic exchanges.

So, the answer to the original question is: Yes. We can have a financial system without banks.

  1. Investment banking is a different matter altogether. It definitely provides scale advantages for investment banks to be together with commercial banks but there is no inherent reason that they need to be together. We have had a period of 60+ years (1932-1999) when Glass-Steagal was in effect where investment banks and commercial banks were separated. In this post we will use the term banks to refer only to commercial banks and not investment banks. 

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