In 1942, while Keynes was brand-new and all the rage, a contrarian Austrian immigrant coined a phrase that would come to define the core of American capitalism and economics over the next 70 years.
Joesph Schumpeter saw the disruption and eventual destruction of entire industries while he was alive. Modern farming, factory automation, transportation — amongst many examples — fundamentally improved the economy as a whole, while entrenched and inefficient businesses withered.
Case in point: We remember Henry Ford for his innovation and factory line productivity boosts, not for putting carriage drivers and saddleries out of business.
A mere six pages were devoted to his concept of creative destruction in his book, Capitalism, Socialism, and Democracy. As he put it, capitalism is “the perennial gate of creative destruction.”
Since then, American economic thought has elevated this concept to heights Schumpeter could not have conceived. It is a core tenet of what businesses try to do, what investors chase, and what we as a nation embrace.
So, if we idolize and rely on creative destruction to the point that it has become part of the American spirit and identity, why do we let a small batch of cronies stuck in the early 20th century act as gatekeepers to economic growth and prosperity?
A Flawed Patch
Following the Great Recession, a whole lot of people have been beating around the bush on this, unable to find an adequate solution — even in theory — to how to address the failings of entrenched brick-and-mortar, too-big-to-fail banks.
However, the free market started this process years ago through shadow banking. There was a need and there was a way… and money started to flow outside of the traditional holders of the purse strings.
Unfortunately, it didn’t deviate far enough from what it aimed to replace, and the system was intrinsically flawed because of it.
In the chase for returns, mortgage and asset-backed securities and credit default obligations flowed from shadow banks to traditional banks, then on to investors.
At the frenzied peak, banks themselves cut out the middlemen and created securities that were designed to fail out of the worst loans on their books, all for short-term profit. The alternative was corrupted by the original flawed version.
Shadow banking became swollen and bloated with big bank money, and the system failed. Bankers and businessmen came to Washington with their hats in their hands (or was it the other way around?), and we ended up where we started; but poorer and mired in stagnation.
Yet the fundamental need for money to flow from lenders in search of a return to individuals and businesses still exists. More than ever, banks can’t and won’t deviate from their modus operandi to resolve the problem they created.
The need for creative destruction of traditional banking and lending is greater than ever before.
Finance, from the Ground Up
We’re finally starting to see new models that provide an alternative emerge again. They avoid the intrinsic flaws of shadow banking while fulfilling this core tenet of modern capitalism.
The failed model, with its derivatives, securitization, and interdependencies, has been tossed out. Financing is being built from the ground up, and it couldn’t look more different from traditional banking models.
Venture capitalist Marc Andreessen is perhaps the most vocal proponent of bringing creative destruction to the stale and intrinsically flawed finance sector.
As he told Bloomberg Markets magazine in a recent interview:
You shouldn’t need 100,000 people and prime Manhattan real estate and giant data centers full of mainframe computers from the 1970s to give you the ability to do an online payment. You would not today, starting from scratch, invent any of these financial businesses in the same way. To me, it’s all about unbundling the banks.
It goes from how credit scores are tabulated and loans vetted all the way to the how payments flow from borrowers to lenders:
There is a growing idea in Silicon Valley that there are sources of data on consumer behavior we can use to predict creditworthiness. These will be completely different than the traditional approach to credit ratings, which are tremendously imprecise and ‘laggy.’ PayPal can do a real-time credit score in milliseconds, based on your EBay purchase history – and it turns out that’s a better source of information than the stuff used to generate your FICO score.
This growing idea Andreessen cites is already being tested, as small companies across the U.S. and Europe take the peer-to-peer, unbundled lending approach to undercut traditional banks.
They are using technology to quickly evaluate borrowers and match them to lenders, transfer money, and settle commercial transactions at a fraction of the time and cost traditional banks are used to.
Undercutting the Competition
A prime example of how this works can be found in U.K.-based Funding Circle Ltd. Five years ago, three university students decided to start a crowd funding web site over some beers at a London pub.
Today, Funding Circle is the top online matchmaker for small-business loans with an average of 1.5 million pounds in loans per day. It quickly grew from nothing while British banks withheld loans from worthy small businesses to shore up reserves.
In the first six months of this year, U.K. peer-to-peer lenders facilitated over 500 million pounds of loans, putting it on par for 1 billion for the year.
On our side of the Atlantic, the two biggest peer-to-peer lenders have just crossed $4 billion in total loans and nearly tripled loan volume in 12 months.
The appeal is undeniable. No loans are packaged and resold, yet risk is spread out. Lenders mitigate risk by choosing which loans to directly fund themselves in units as small as $25.00 each.
The interest on the loans ranges from 8% to 16% for this type of lending, making the returns greater for investors and the rate paid lower for borrowers than anything that would or could be offered by traditional banks.
As for the cost, sometimes it is an origination fee under 3% and sometimes it is 1% of the payments returned to investors. Regardless of the structure, it is pennies on the dollar compared to the cut banks take.
This is exactly the kind of creative destruction the financial sector direly needs in order to shake things up.
