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July 5, 2013

Could Anyone Be a Bank?

Posted by Rajashekara V. Maiya (View Profile | View All Posts) at 7:26 AM

Jimmy G's Restaurant Raising Money Through Crowdfunding [Source: http://www.youtube.com/watch?v=3joIGR_1o30 ]

Too big to fail. We've heard this description uttered many times in the past few years by bankers and policy-makers alike. Some financial services institutions have become so enormous that if they were to go under, they'd pull many of us down with them.

Depending on your point of view, if a big bank is ailing then it pays to prop it up, at least until the bank can weather a financial storm or two. Another side of the argument is that the bank might operate more efficiently and need less outside assistance if it weren't so large.

Indeed, some political leaders and economists have touted the importance of smaller banks as well as the "little guy" in the global economy. One such business leader, Muhammad Yunus, won a Nobel Prize a few years ago for advocating micro-lending; that is, loaning money in small amounts to local entrepreneurs who might never see the inside of a big, global bank.

Crowd-funding is another variation on the micro-lending theme. In the United States, for example, recent legislation has allowed non-accredited investors (people with a liquid net worth of less than $1 million) to begin lending to or investing in small businesses and start-ups. This activity used to be the exclusive realm of venture capitalists and private equity shops, both of which represent investors with a lot more than $1 million to throw around. Innovations abound in this space. New financial services firms are springing up to connect small businesses with local lenders who want to invest in their communities.

Being a private equity shop, however, has obvious advantages. Besides having access to a wide array of financial resources, the firm and its accredited investors can tap into vast amounts of professional market and industry research. So the investments they make tend to be more careful and calculated than someone lending a couple thousand dollars to a local business. Crowd-funding might be where fun meets finance, but it could also open up a can of worms when it comes to the financial IQs of the investors. Remember Warren Buffett's mantra that it's best to invest in what you know.

Muhammad Yunus makes the point that as economically important as it is for money to trickle down into mainstream society because of the activities of affluent dealmakers, so, too, should money trickle upward because of the activities of local businessmen. They are building capital in their ventures one dollar at a time. In fact, my prediction is that when people look back on the dawn of the 21st century, two developments in the world of finance - micro-lending and too-big-to-fail banks - will stand out as defining the era in which we live. They seem to be opposing forces at first glance. But I think they've actually helped each other in that they create a balance in the global economy with which everyone can live.

One of the themes of a recent Infosys survey, Engaging Digital Consumers, is that customers are more empowered than ever because of the rise of social media. They are willing to share personal information with companies that can be quite valuable. But first they have to trust the company and believe that they're going to get something in return. In some ways, the popularity of crowd-funding mirrors the rise of the digital consumer. Just as social media make the sum of the parts more powerful than the individual consumer, so, too, does crowd-funding. At the end of the day, 10 small loans to a recipient are essentially the same as a single large one. The people who contribute the 10 small loans, however, are more likely to have stakes in the same communities as do the recipients.

One such crowd-funding innovator, the founder of Funding Community, recently told the business press that his portal aggregates contributions into a single loan, charges a 2.5-percent fee for doing so, and 7- to 9-percent interest, depending on the creditworthiness of the client. Another crowd-funder called Pave offers stakes in someone's potential future earnings. They're smart marketers, calling their loans "social financial contracts" that the firm says go to people who want to pay off student debt, start a non-profit, or finance a start-up. Pave charges a 3 percent origination fee and an additional 1.5 percent a year on the contract.

Crowd-funding also challenges the notion that only Western financiers with MBAs know how to spot innovation and incubate business ideas that are potentially lucrative. The emerging markets are filled with entrepreneurs who are brimming with ideas. They are inventing new products and services on relatively little money compared to their Western counterparts. Crowd-funding in the emerging markets can give these innovators the funds they need to break out and attract international investment.

You have to wonder if the big banks are even noticing these developments. As long as large corporations need financially savvy firms to investigate their capital structure, place valuations on their business lines, and arrange loans in the hundreds of millions of dollars, the world will need big banks. But I imagine they'll coexist with financial institutions that begin to look more like Yunus' Grameen Bank and the new Funding Community in America.

What crowd-funding has done is to renew the banking industry's focus on local communities. Ironically, if you trace the history of any too-big-to-fail bank far back enough, you'll discover that it began as a small, community lender itself. And, at the end of the day, what matters to national governments is if it's 'too big to bail' - whether a too-big-to-fail bank or a crowd funded one - policy decisions will depend on the impact such failures will have - resulting in bail-outs or buy-outs - using tax-payer money.

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