A similar euphoria is gelling around the fintech, or financial technology, that intends to transform finance. One fintech company is SoFi, a San Francisco based company whose founder claims it will do to banking what Uber has done to taxis. You may have seen its Super Bowl 50 ad, “Great loans for great people.” Mike Cagney is one of SoFi’s co-founders. He met the others at Stanford business school where they discovered that fellow students had unusually low default rates on student loans. Cagney and friends developed their own model to assess students’ credit ratings instead of using FICO scores. Then they offered loans to those high credit students at an interest rate below that of the government student loan rate. Cherry picking the debtors with the least risk of default allowed them to earn a thin margin on the loans. Only 14 of 100,000 student loans have defaulted.
The company has since expanded to mortgages, personal loans, and wealth management as well as securitizing the loans to recycle the money. So far, SoFi has done 150,000 loans totaling $10 billion and generates a $1 billion monthly loan-origination rate. So what could possibly go wrong?
SoFi is young and hasn’t weathered a recession, yet. The financial media think that the failures of big banks like Lehman Brothers caused the recent Great Recession with their incompetent or immoral practices, but they’re suckers for the post hoc fallacy. The recession hit first and the banks were victims. Recessions cause default rates to rise and property values to collapse. The next recession will cut into SoFi’s already thin margins. That’s not as serious a problem for SoFi because most of its funding is equity. Without the 30:1 leverage that many banks employ, SoFi can survive some brutal storms. But it may lose some equity investors and that will cut down on the loans they can make.
Eventually, competition from imitators and from big banks will make life difficult for SoFi. I watched a similar business model in the early decade of this century. An entrepreneur figured out that he could buy bad credit card debt for next to nothing. The cost was so small that if the company collected anything on the debt it made a fortune. The company made millions until credit card companies grasped what they were doing and refused to sell their debt. The company died quickly.
SoFi avoids most of the problems of banking. It doesn’t have much leverage or suffer from banking regulations, such as the requirement that they make a lot of loans to people they know can’t even make the first payment. And they don’t take deposits. As a result, economist John Cochrane is excited about SoFi:
You have introduced run-free banking that solves all the financial-crisis worries that 90 years of bank regulation could not solve. Let this spread, and the army of bank regulators, lobbyists, lawyers, and associated politicians can all go, well, drive for Uber.Cochrane is saying that equity based lending, as SoFi does, rids us of the problems caused by fractional reserve banking that has caused boom and bust cycles for over 300 years. If equity based lending became the dominant model, it would certainly put the ABCT out of business. I just don’t think it will catch on.
The Dutch Republic tried 100% reserve banking for 200 years and still suffered booms and busts. Everyone knows about tulip mania, but there were others. Bills of exchange were the problem back then. They traded like money and businesses would issue more than they could pay back. So the volume of bills would swell to 30 times the money stock and cause the same problems as fractional reserve banking.
Hayek noted in Monetary Theory and the Trade Cycle that a practice similar to fractional banking takes place with whole life insurance and other industries. Hayek added that the practice is too lucrative. Someone will always be willing to take a chance on it. So companies like SoFi probably don’t show us, "if you peer through the fog, the future,"as Kessler wrote in his article. More than likely, the cherry picking of fintech will merely force banks to offer better rates to their least risky customers and further erode bank profits.
SoFi’s biggest problem may be the derivatives it creates by selling loans to banks that package and resell them as bonds. In the latest crisis, investment banks like Lehman were buying mortgages and other loans and packaging them as bonds. Money market funds would buy those bonds in order to boost their returns. But when the underlying asset, whether real estate or car loans, lost value in the recession due to higher default rates or collapsing real estate prices, the money market funds wanted their money back and launched an old fashioned bank run against the investment banks. Investment banks couldn’t give away the bonds. SoFi could see that source of financing blown away by the next recession.
Rather than innovation, fintech looks more like the increasing division of labor of finance into finer segments. As the general store of the 19th century got pushed aside by specialty retailers, finance has been dividing into specialty banking. But don’t look for any major paradigm shifts in finance. Deposits, and hence fractional reserve banking, are the cheapest source of finance for bank loans and will always have an advantage over other forms of finance. As a result, the business cycle will continue to afflict us for the foreseeable future.