the demise of the department store
The story of the big commercial banks over the last forty years is sort of like that of the department stores, only in slow motion. In the case of the latter, entrepreneurs targeted the most profitable “departments” of the cumbersome retailing giants and competed against them with freestanding specialty store chains offering a wider selection, trendier products and lower prices. Toys, consumer electronics, jewelry, household goods, cosmetics, and, of course, various types of apparel were all targeted.
The financial world, for some bizarre reason known only to itself, calls this process “disintermediation.” It has been underway for almost a half-century.
Consider what a bank does for a living:
in the simplest terms, it borrows money from some people, paying, say, 2% interest, and lends it to others at, say, 8%. It uses the difference (the spread) to cover costs and make a profit.
money market funds
The first big disintermediation came in the 1970s, with money market funds. These substitutes for bank checking or savings accounts take deposits from customer and make short-term (meaning a few months) loans to governments and corporations. The entire spread, less expenses, goes to the money market shareholder. So in normal times, money market funds pay considerably higher interest than banks. The banks’ only advantage has been government deposit insurance.
The emergence of the money market fund produced a massive shift of customer deposits away from banks.
The second was junk bond funds. The first junk bonds were “fallen angels.” That is, they were issued with low coupons by companies whose businesses subsequently deteriorated. As a result, their bond prices had dropped sharply (and therefore the bonds’ yields had risen to high levels). Careful credit analysis would turn up either companies that were on the cusp of a favorable turn in their fortunes or others where the market had considerably overestimated the chances of default.
As they become popular, junk bond funds soon faced a shortage of suitable bonds to buy. This led to the creation of an original-issue junk bond market–or junk bonds as we know them today. These bonds were direct competitors to the corporate lending operations of banks. However, junk bond issuers offered lower interest rates plus fewer restrictive covenants to borrowers and they delivered the entire spread, less expenses, to the fund shareholders.
Again, there was a massive shift of profitable business away from banks.
We’re in the early days of a third big disintermediation. Peer-to-peer lending is, I think, will end up replacing banks as makers of small personal and commercial loans.
As things stand now, P2P lenders are simply internet-based intermediaries. They do credit analysis to determine an interest rate for a given loan, put potential lenders and borrowers together and take a fee. As I see them, they’re very much like the creators of money market funds or junk bond funds, only targeting a different “department” of the banks. In the junk bond case, though, the “department” quickly morphed into something else. That could easily happen with P2P, as well.
What’s most interesting about peer-to-peer to me is that the leading firms are preparing to go public by issuing common stock.
More when IPO dates are closer.