Lending won’t stop if banks go under.

The Journal has a story about a venture-funded alternative lender called On Deck Capital that extends credit to small businesses, many of whom don’t qualify for bank loans at the moment. Interest is high, at 18+ percent, but that sounds about right considering the risks of lending to small companies in this environment.

This business model reminds me of person-to-person loan companies such as Prosper Marketplace, Inc., where savers are matched with lenders through an auction process.

No fractional reserve lending.

The beauty of these lenders is that they can’t create money out of thin air like the banking cartel. Every penny they lend out was earned and saved by someone, either the investors in the venture fund that backed On Deck or the very individuals who find borrowers on Prosper.com. These companies do not create fake credit like banks, but simply fulfill the proper role of intermediaries.

No moral hazard.

The president of Chemical Bank, George Gilbert Williams, credited “the fear of God” for the bank’s continued ability to satisfy withdrawals with gold coin through the panic of 1857*. Without the FDIC or Fed to bail anyone out, lenders have to be very careful about each loan. In such a free-market system, lenders’ fear of losing their own money prevents bubbles from being blown. Without the explicit or implicit promise of bailouts, there is no need for them.

Market rates.

If all the fractional reserve banks in the world were to fail tomorrow, and the Fed and FDIC were abolished, all kinds of new lenders would crop up, offering everything from high-yield consumer credit to asset-backed trade loans to mortgages. The interest rates would be set by market forces, which is to say that they would be high at the moment to reflect risks. Only very strong borrowers could secure loans, and the weak would have to de-lever or fold.

Savings encouraged.

Without the fear of inflation, but with strong deflation, savings would be encouraged. More and more of those savings would be lent out as the bust ran its course and risks were better balanced against rewards, in no small part because asset prices would be much lower.

Unfortunately, nobody seems to understand such simple logic these days, and Bernanke’s models say that inflating away savings to prop up the insolvent is the way to prosperity. We’ll see who is right.

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*Page 112, Money of the Mind, by James Grant.

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4 thoughts on “Lending won’t stop if banks go under.

  1. Hey Guys, what do you think will happen when M2 plummets on lower total cash in the system? And do you think that deflation is actually a good thing?
    Finally, it seems to me that person-to-person loan market places survive because the average person doesn’t know that he doesn’t know how to accurately price risk and return – this is supposed to be why banks are necessary.
    I get your aversion to the moral hazard caused by federal insurance on savings accounts, but its a proven fact that stability helps markets to become efficient. Without things like financial bailouts and FDIC insurance in the US, when we have financial crises the markets would shut down- kind of like what happened in the great depression. By providing less capital for lending, the entire economy(through decreasing M2) it (the economy) would suddenly shrink, and people would be really … upset. And broke.

    Love from Basic Economics,
    Maja’s friend

  2. Hey man. Sorry for taking so long to answer this.

    Yes, deflation is a good thing. It wipes out the waste accumulated during the bubble and allocates assets to smarter hands who didn’t get caught up in the madness. This is creative destruction, and without it, an economy can get nowhere.

    The bailouts and moral hazard cause the instability to begin with. Without moral hazard, bankers would have to actually assess risk because if they didn’t, it would be their ass. The post below gets to the heart of the matter. It’s one of my favorites:

    http://sovereignspeculator.com/2008/09/06/greenspan-was-framed-blame-bankers-moral-hazard-not-their-lackey/

  3. Hi Mike,
    Is it possible that you don’t know what deflation is? I think you’re thinking of low levels of inflation rather than actual deflation. Do a google search for liquidity trap.
    In a recession with real deflation, interest rates on loans would become astoundingly high, causing people to stop borrowing. The problem with this is that most businesses are financed by debt – which would become too expensive under deflation. If this were sustained, we’d see most businesses shut down – because the only businesses that would remain would be those run and owned by people who have enough money to withstand the deflationary pressures. In other words, we’d see a widening of the gap between the haves and have-nots.
    The fact that you’re wishing for a deflationary environment means that you don’t fully understand deflation – again, I’m fairly sure that you’re thinking of low inflation.

    Once More,
    Maja’s friend

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