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Deregulate Peer to Peer Lending to Help Forestall Economic Crises

The major regulatory problem in our financial system is the danger of runs on banks. Commercial and savings banks engage in so-called fractional banking. They keep on deposit only a fraction of what they have outstanding in loans. Because banks do not hold enough in cash to pay depositors when many want to withdraw at once, a bank becomes fragile at the time of an economic downturn. And when one bank gets in trouble, depositors get worried about other banks, leading to more runs and a risk to the larger economy. This danger is the prime justification for the intense regulation of banks — more intrusive regulation than that of any other business, itself imposing substantial costs on financial transactions. And still worse, these regulations, as onerous and complicated as they are, often fail in preventing runs.

Thus, financial innovations that perform the same essential function as fractional banks without creating the same danger of economic meltdown are very welcome. One such innovation is peer to peer lending. In this business, an intermediary brings together people who want to lend directly with those who want to borrow. Think of it as the financial equivalent of Uber or Airbnb. Because these creditors are paid from the payments from the loans rather than interest from deposits, they do not create a danger of runs on the intermediary.

In order to get diversification the intermediary often also pools borrowers, and creditors then gets a contract guaranteeing that they will get payments from the pool. Unfortunately, the SEC is moving to regulate such contracts as securities. I will not get into the technical details of whether it is legally right to do so. My point is that as a policy matter it is a mistake to  extend the scope of securities law with its large attendant regulatory costs to an industry that may help solve one of the essential problems of financial system. The advantages from protecting investors, if that is what participants in peer to peer lending are, are quite marginal  particularly given their likely sophistication, but the cost of retarding innovation is substantial.  Bluntly, a score of ill-used investors are a small price to pay for accelerating the rise of a new kind of financial institution that may help forestall the next great recession.

There is a more general point here about regulation. If society confronts huge social problem like financial runs, we need reduce the regulations for other problems that make the more serious problem more expensive or impossible to solve. For instance, if global warming is as substantial a risk as many allege, nuclear energy deserves greater solicitude, because it does not add to the carbon footprint. To be sure, nuclear energy may have some other costs, but these must be weighed against the benefits in preventing the greater catastrophe of global warming. And this perspective is useful in testing sincerity of political advocates. When anyone tells you that the government must issue costly regulations to prevent a catastrophe, ask him what other regulations he would be willing to give up to make the catastrophe less likely.

Reader Discussion

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on April 30, 2018 at 11:53:23 am

Ok, they won't get runs....but if there's a significant uptick in the default rate, there's going to be a response to that from the loanees to the intermediary doing the peer to peer. Also, the intermediary has to provide some sort of implied "presentation of fitness" of the person getting the loan...no matter how much the intermediary say's he doesn't represent them (ie the loaner)....otherwise he's no better than Craigslist. And CraigsList had issues with people being robbed when the transaction happened.
Anyway, since the loaner needs vetting (and the peer to peer is in the best position to provide it economically), it would be in its best interest to vet using a standard. That standard could be an industry standard, not necessarily a government one. However, the standards have a tendency to drift.

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Allen
on April 30, 2018 at 12:43:57 pm

There is a more general point here about regulation. If society confronts huge social problem like financial runs, we need reduce the regulations for other problems that make the more serious problem more expensive or impossible to solve.

…and therefore we shouldn’t impose burdensome regulations on new financial arrangements such as Collateralized Debt Obligations and Credit Default Swaps! What could possibly go wrong?

Let’s get real. McGinnis is describing an investment bank: A firm that helps businesses issue debt (or equity) to investors, but doesn’t take deposits.

McGinnis compares these investment banks to Uber—and my response will be similar: I favor equality under law. Similarly-situated entities should be subject to similar regulation. The fact that McGinnis describes certain investment banks as cute or wholesome does not, by itself, render them differently situated than other investment banks. Now, maybe our current regulations are too stringent. Or maybe they’re too lax. Or maybe they’re just right. But whatever standard of regulation we pick, let’s apply it uniformly to all similarly situated entities.

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nobody.really
on April 30, 2018 at 12:46:59 pm

For instance, if global warming is as substantial a risk as many allege, nuclear energy deserves greater solicitude, because it does not add to the carbon footprint. To be sure, nuclear energy may have some other costs, but these must be weighed against the benefits in preventing the greater catastrophe of global warming. And this perspective is useful in testing sincerity of political advocates. When anyone tells you that the government must issue costly regulations to prevent a catastrophe, ask him what other regulations he would be willing to give up to make such prevention more likely.

The libertarian’s traditional concluding statement would be that it’s government’s role is to guard against market failures to ensure that all relevant costs get internalized (reflected in price), while it’s the market’s role to make the appropriate choice among alternatives. Thus, the appropriate regulatory framework would be to assess a Pigouvian tax on carbon—AND on the risks attendant to nuclear power—and then let the market make the appropriate choices.

But to the contrary, we have failed to adopt a carbon tax, or even a cap-n-trade system. And far from pricing in the risks attendant to nuclear power, the feds adopted the Price-Anderson Nuclear Industries Indemnity Act to (partially) shield the industry from liability for disasters—even disasters resulting from gross negligence and willful misconduct. The Cato Institute has been a regular critic of this policy.

In fairness, there are somewhat similar policies for hydro power and petroleum. And, of course, green energy technologies get various subsidies. So market distortions abound.

Notwithstanding the nuclear subsidy, nuclear plants are closing throughout the country, and only one new plant has been built in the past 20 years. To be sure, regulatory burdens play a role. But the nuclear industry is also suffering the same fate as the coal industry: alternatives are cheaper—or, at least, investors think that the alternatives will become cheaper before the investors would be able to recoup any additional investment in nuclear power. In particular, the three-headed knight of wind, solar, and storage/batteries currently threatens to vanquish all rivals.

In short, while McGinnis is correct that people who oppose carbon emissions should be open to all alternative sources of electricity that do not emit carbon, in practice it appears that nuclear power is no longer a competitive generating technology—whether or not carbon is considered.

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nobody.really
on April 30, 2018 at 13:40:08 pm

Hmmm! Perhaps you should talk to the Sierra Club. As of last year a number of their people were advocating that the US take a renewed look at nuclear power.

Also, you seem to imply that nuclear is dying due to costs. And while you mention regulatory burdens, would it not be fair to also mention the regulartory HURDLES that have time and again proven insurmountable and require almost two decades of bureaucratic encounters and incessant confrontations / demonstrations / disruptions by the eco-nazis. Additionally, some plants have closed, or are being closed, due to State interference (see NY) and or regulatory unwillingness to permit upgrades. Sadly, and just like subsidies, it all comes down to politics - AGAIN!

Other than that, agreed.
as the Soup Nazi said - "No subsidies for you!

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gabe
on April 30, 2018 at 13:43:42 pm

"Let’s get real. McGinnis is describing an investment bank: A firm that helps businesses issue debt (or equity) to investors, but doesn’t take deposits."

Agreed - I had the same thoughts re: investment bank.

Also it seems to me that if the proverbial excrescence should move into the path of the fan blades, NO improved "fractional reserve rate" is going to delay the fiasco - unless, of course, one wishes to impose a near %100 reserve requirement - then, I guess it would not be a bank - just a piggy bank!

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gabe

Law & Liberty welcomes civil and lively discussion of its articles. Abusive comments will not be tolerated. We reserve the right to delete comments - or ban users - without notification or explanation.