The risks of making loans

Crowd funding for unsecured personal loans is interesting in that it spreads the risk and potentially dangerous in that  it may attract investors who ignore the risk factor.  It is also unique in making loans that do not add to the money supply via fractional reserve banking.

An article in this week’s The Economist reports on some American firms that are making crowd sourced loans to individuals usually to consolidate and reduce the cost of credit card borrowing.  This model means borrowers get a cheaper interest rate and depositors get more on their deposits.  This is different from crowd sourced funding for business development although both involve risk.

CCBill_20120401When ever one makes a loan, either directly or though an intermediary (a bank deposit) one is transferring purchasing power to somebody else.  Mostly one hopes to get more purchasing power (interest or dividends) back.  There are three risks in doing this:  a government may decide to give you a haircut, the person may default or you may get caught by inflation.  We can try to protect ourselves from default by purchasing deposit insurance.  I don’t know how to protect ourselves from a haircut or inflation.  Maybe by supporting the Tea Party.  These risks will always be there no matter how bankers try to offload them.

As I understand it the crowd loan companies allow you to put a small amount of money into a number of loans.  Each amount is tied to that loan and your deposit is returned to you if, as and when the borrower repays the loan.  This allows you to spread your risk among a number of borrowers.  This may let lenders think they are reducing their risk but most business and financial models work well when the economy is growing and have problems when growth declines.  There is some probability our economy will continue to decline for some time to come.  Here is the risk statement of one of these companies.

I like that this way of funding loans does not involve fractional reserve banking and thus has a neutral impact on the money supply.

I fear that too many people will see the higher interest rates being paid on deposits and  ignore or not realize the risk involved.  If and when the risk becomes reality, there will be a lot of crying and screaming and possibly a lot of suffering.

It may be that the risk in crowd funding is no greater than with other forms of saving/making loans.  It is just a little more obvious. I still think that given the current economic situation the best investment is a market garden.

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A Chicago plan for reforming banks

This week I came across a couple of articles about the Chicago  Plan for reforming banks and I like it because it proposes changing the way in which we create money and gets rid of the evils of fractional reserve money.

This plan was proposed in the 1930s by some economists from  Chicago and suggests banks be reorganized into two separate identities.  One type of bank would only accept deposits which would be kept 100 per cent with a central bank.  This type of bank would probably have to charge fees for looking after the deposits but they would be safe (except from inflation which would probably be less of a problem – or haircuts.)  No more fear of bank runs.

bankThe second type of bank would be a financial intermediary in that it would make loans based on 100 per cent equity deposits of its customers.  As all deposits would be equity, customers would know there are risks of a loan not being repaid.

As most, if not all,  bankers would see immediately, this would be the end of outrageous Wall Street profits.  Under the current system bankers make huge profits by taking for themselves  the premiums from risky loans but when the risk becomes reality somebody else takes the losses because the money creation feature of banks makes them too important to fail.  People putting money into a loan making business would know the risks and expect the returns to compensate.  The end of fractional reserve money creation would also do away with the leverage which allows bankers the profits from creating money on which they charge interest.

According to the Chicago Plan governments would create the money supply at zero interest.  This would be good in that interest charges would not be built into money creation thereby  reducing the potential for inflation.       My concern is that governments make decisions for political rather than economic reasons.  To me a national LETS (local exchange trading system)  would be preferable way to create money because the amount of money in use would depend upon the collective decisions of individuals.  For the sake of price  stability it is essential that the money supply should be flexible up and down.

When I wrote my essay “LETS go to market: Dealing with the economic crisis” I didn’t put a lot of thought into how to organize banking with a national LETS money system.  I didn’t know it then but the creators of the Chicago plan had already done that.

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