Troy Meddia – By Will Van’t Veld
Few industries have been transformed by advances in information and communications technology (ICT) like banking. For many centuries banking was a relatively low tech and deeply personal industry, then in the span of roughly 30 years, everything from ATMs to internet banking and securitized loans became integral to banking services.
Much of the adoption of ICT makes interacting with financial institutions easier for customers, but greater convenience is only part of the story. As has been abundantly clear since the fall of Lehman Brothers, there’s a special relationship between finance and what happens in the broader economy. New technologies have just enabled a deepening of the integration and the various interdependences.
Matching savers and spenders
At its core, financial services are about matching savers with spenders (either consumers or investors). While major corporations and high income individuals might have the means to do this more directly, for the most part there are serious informational barriers between these groups and financial intermediation is necessary.
Bad loans will seriously hamper profitability, perhaps even solvency, so the extension of credit is always done judiciously. But gathering, storing and analyzing information regarding credit applicants has traditionally been very expensive, putting important limits on the ability of any bank to prudentially extend credit. This cost structure was fundamentally altered thanks to automation, however, helping to change the public’s relationship with respect to credit.
A big change came with the widespread adoption of automated credit scoring models in the mid-90s, which led financial institutions to use risk-based pricing more broadly. Under risk-based pricing those who exhibit a higher risk of default pay higher interest rates, whereas the premium paid by individuals with good credit is reduced. This led to a more efficient allocation of loans which helped to increase the supply of credit.
Credit scoring models also helped make it possible to extend credit even further through the now much-maligned securitization process – i.e. when financial engineering is used to slice and dice risk and transfer it to investors, allowing ever more loans to be created. If the risk is being properly priced in a transparent way, which is why proper regulation is necessary, then this explosion of credit is not destabilizing; it mostly just accommodates for better pricing and assessment of risk by spreading it to a broader investor base.
The impacts of having greater access to large amounts of credit have some pretty broad implications. The convenience value of cash has been greatly reduced, for one, as more purchases are done with credit and ready access to loans has reduced the need for a ‘rainy day’ fund. In other words, some of the secular decline in savings rates is related to the reduced need of having extra cash readily available. Household consumption, as a result, got a significant boost along with economic growth.
There is a risk, however . . .
Future wages and income are dependent on today’s investment, of course, which would need to be financed by foreigners if domestic savings are too low. Some of the trade off is reduced, however, if the financial system is more efficient on a risk-adjusted basis with their capital (i.e. doing more with less, like any industry that becomes more efficient) helping to grow the economy. So long as inflation is tame and defaults remain low everyone is happy. The party is over if all that leverage goes sour, as we all now know.
Ultimately, ICT helped transform the world of banking faster than many institutions could adjust to keep up, but there’s no turning back the clock. The learning curve is steep, and the inherent dangers need to be mitigated, but ultimately innovation brings with it substantial benefits in the long run. Such is the march of progress.
Will Van’t Veld is an economist with ATB Financial.