Central Banks aren’t accountable—by design

One of the risks that banks and non-bank financial institutions alike must manage is the untrammeled power that financial regulators have to make or break their businesses. Of course, plenty of other sectors are heavily regulated; but central banks are unusually muscular, independent regulators.

It turns out there’s a good reason for this. The original function of central banks, and their most important role even today, is managing the stability of the national currency. By creating money or taking it out of circulation (achieved these days by manipulating interest rates), central banks defend against inflation. It turns out that this is highly susceptible to meddling from politicians, whose calculus is short term and who often seek to interfere with decision-making at central banks in an effort to goose the economy and, at the same time, their own popularity. In the long run this kind of interference is disastrous, because it can lead to dangerous levels of inflation. For this reason, it has become customary to charter central banks with a very high degree of autonomy, and central bankers jealously protect this independence to preserve their credibility in the eyes of the markets.

Over time, the mandate of many central banks around the world has been expanded to include regulatory responsibilities created by legislation (for example, supervising banks) and in many cases to financial policymaking. This evolution was natural: central banks were and are well positioned to understand the inner workings of the financial system given their interest in the role that financial intermediaries play in money creation.

But a problem has emerged. In democratic societies, we expect that policymakers will be accountable to the will and interests of voters. Normally, when governments delegate policymaking (rather than embedding it directly into law) they do so by bestowing such authority on government agencies. While this insulates the policymaking process from seedy business of legislative horse-trading, it still leaves technocratic policymakers exposed to the pressures of democratic politics, since they are situated within bodies that are ultimately headed by politicians or political appointees.

When financial regulation emanates from an independent central bank, no such pressure is brought to bear. And this is something to worry about. There are too many countries where important innovations are being kept from consumers by financial regulators. To take just one obvious example, the governor of the central bank in Nigeria has decided that he doesn't think that mobile operators should be allowed to offer payment services. Given the power vested in his office, he has been able to bar them from doing so without giving much thought to whether ordinary Nigerians want or approve of this policy.

In cases like this, I can’t help but wonder if outcomes would be better if consumers’ voices were heard a bit more loudly in the policymaking process.

Joint ventures and misadventures, regulatory edition

Today in my Twitter feed I saw a number of links to a story indicating that the “Uganda Communications Commission (UCC) is partnering with Bank of Uganda to set new rules that will govern the Mobile Money trade.” The article doesn’t give specifics about how this is going to work, but it is emblematic of an emerging trend in which telco and financial regulators set out to regulate mobile money together.

Unfortunately, this is bad news, for a few reasons.

1. In general, the only thing harder than getting a regulator to move quickly is getting two regulators to move quickly, together. This will be especially true given that, in every country I’ve worked in, these two regulators have radically different styles and approaches.
2. Mobile money services are payment services, which financial regulators are competent to regulate. There is virtually no useful role for the telco regulator in such tie-ups, expect perhaps to help their colleagues understand a bit better how mobile networks operate (which of course they could do informally).
3. The likely outcome of a collaboration between these two regulators is regulation that pertains specifically to mobile money. This is a mistake, because it means the financial regulator will have missed out on an opportunity to put in place more comprehensive payment system regulation that would support not just mobile money, but also other payment services, such as those that are card-based or offered by non-banks other than mobile operators.

Imagine for a moment (you will have to use your imagination, because I don’t think this has ever happened) that a bank decides it wants to get into mobile telecommunications, either by becoming an MNO or an MVNO. Would a special collaboration between regulators needed in order to oversee this novel arrangement? Of course not. The bank would need to apply for a license from, abide by the rules set out by, and submit itself to oversight from the telco regulator, in addition to its pre-existing obligations to the banking supervisor.

A less hypothetical example is Starbucks in the UK. When Starbucks wanted to get into payments, did the FSA need to draft special regulations in collaboration with the coffee-shop regulator? Of course not. Starbucks simply applied for an e-money license from the FSA.

I could go on, because this is kind of fun (what if a pharmaceutical company wanted to offer insurance? What if a cigarette company wanted to start drilling for oil?), but I think the point is clear. Mobile money is just another payment service. That it is offered by a company that is in another regulated business is not a good enough reason for create a cumbersome regulatory superstructure to oversee it. 

The myth of safe banking

There is a pervasive assumption, implicit in many of the debates around the emergence of new financial services, that banks are paragons of stability and that deposit accounts are the gold standard for safe storage of value. After all, banks are heavily regulated, they have giant compliance and risk-management functions, and they are conservative by nature. What better place to store your money?

But this intuition gets the causation exactly backward. Banks have injected caution into their DNA and are subject to extensive prudential regulation because their business model is so risky. Banks accept short-term deposits and make long-term loans, rendering them constitutionally incapable of honoring a large number of withdrawals simultaneously. This is the worm in the bud of the fractional-reserve banking, and it haunts banks (and occasionally entire banking systems) during times of crisis.

You might think bank runs are largely a historical phenomenon. Actually, in America alone, a bank fails every week or so. You don’t hear about it the regulator has gotten very good at winding up banks (they can do it over a weekend), and because depositors are protected by insurance.

Now there have been howls of objection from those in the traditional banking industry that customers of Bluebird—a prepaid debit account offered by American Express in the United States—do not benefit from federal deposit insurance. Deposit insurance, they imply, is what distinguishes safe checking accounts from unsafe stores of value.

But again, this gets the logic backward. Deposit insurance emerged as a way to protect consumers from bank failures and to make such failures less common by reducing the incentive of individuals to participate in a bank run. As with any other form of insurance, deposit insurance protects against risk—in this case, the riskiness inherent in storing your money with an institution that is going to lend the vast majority of it to someone else. Were deposits risk-free ways of storing money, deposit insurance would be unnecessary.

For centuries, we have tolerated the fundamental instability of the fractional-reserve system and done our best to contain the risks associated with it. This is because our economies would grind to a halt without financial intermediation, of which banks are traditionally the engines. But just because you rely on something doesn’t make it safe.

The appification of consumer finance

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In the bad old days, when you bought a smartphone (aka a Blackberry) or a PDA (aka a Palm), you were basically stuck with the software provided by the manufacturer of the device. Of course, there were ways of installing new programs, but it was a hassle and there weren’t many developers. All this started to change in July 2008, when Apple launched the App Store, which made it easy for users to download and in many cases buy—and, equally important, for developers to list and in many cases sell—applications. Today, apps are the dominant paradigm not just on smartphones, but also on tablets and increasingly on the desktop, too.

It occurs to me that the explosion of importance of apps is a useful metaphor for where I think we are headed in retail financial services, which I wrote about in my last post. In the bad old days, customers were reliant on their bank to provide a basket of most of the financial services that they wanted to consume. Of course, some banks offered services provided by other parties to their own customers (mutual funds and insurance products spring to mind as examples), akin to Palm licensing bits of software from other companies for its Pilot. But customers could either take the options their bank had curated or leave them. 

But I believe we are starting to see the contours of the next phase in consumer finance in which customers mix and match products offered by different providers, allowing them to arrange a suite of services that together meet their financial wants and needs. This in turn will allow, or force, providers of financial services to specialize in products that meet sometimes very specific requirements. And switching from the metaphorical to the literal, the user interface for many of these services will in fact be apps: see for example SocietyOne, a slick mobile-first P2P lending platform. What’s interesting is that this evolution is happening at the same time in both developed countries and in developing ones—or at least, those like Kenya where payment services are taking off. The operating system on which all these apps will run is the payment system, allowing customers to move their money between products as they wish.

If you think this metaphor is sound, then you may not be quite as dogmatic as many are about the need for payment services to be fully interoperable. We currently have two major incompatible app platforms in the world, with a few other also-rans, and it is the very fact that these ecosystems are in competition with each other that spurs customer-benefitting innovation. As such, this metaphor implies something different with respect to interoperability than does thinking of payment services as “rails” on which financial products can be delivered. Fragmentation (incompatibility or duplication) in rail networks is so costly that they are typically regarded as natural monopolies. Whether payment systems are, in whole or in part, natural monopolies is a question the answer to which I’m not too clear on.

In any case, appification will transform the way that financial products are delivered and consumed. It will upend the financial services industry and make tough new demands on financial regulators. But it will be an unmitigated boon for consumers.

Prising apart lending and deposit taking

An important theme on this blog is the disaggregation of the value chain in financial services. Usually what I mean by this is the separation of payments from the core banking services of deposit taking and lending. But perhaps even more interesting is the separation of deposit taking and lending themselves. 

Taking deposits and then on-lending them appear inseparable, but we don’t have to look very far for examples to show that they aren’t. In the developed world, a galaxy of specialized lenders such as credit card issuers and mortgage lenders focus squarely on the asset side of their balance sheets; in developing countries, many microfinance institutions work the same way. Without deposits, these entities fund their operations from equity or by borrowing wholesale in the capital markets. Conversely, there are banks like ING Direct that accept deposits but don’t make retail loans, and of course an increasing number of non-banks like Safaricom accept what walk and talk like deposits from customers. (If it weren’t for poorly thought through rules, some of these would even pay interest.) These entities aren’t allowed to on-lend those funds (for that would make them banks) or invest them in risk assets, so they park them in a regulated bank account instead.

In all these cases, financial intermediation—that is, the transformation of savings into capital that can be used by others for investment or consumption—doesn’t stop; rather, it occurs through new channels, facilitated by multiple institutions rather than one.

The separation of deposit taking and lending is good for consumers in part because it permits specialization. Surely one of the reasons that credit-card issuers like American Express and Capital One are good at what they do (and I mean good both in the sense that they offer products and services that customers like and in the sense that they do so quite profitably) is that they are focused on just on side of their balance sheet, whereas to excel as a bank, you have to win in two very different product lines.

If this is true for giant companies, it is especially so for startups, which can typically only hope to do one thing properly at a time. As such, the growing separation between lending and deposit taking is helping to make financial services more attractive to entrepreneurs. This in turn creates further value for consumers by exposing the retail banking sector to the kind of competition that more nimble upstarts bring to bear.

Technology (including but not limited to mobile technology) is an important catalyst for this divorce of lending and deposit taking. First, technology is making product innovation in both areas easier. In the UK, payday lender Wonga offers an ingenious design-your-own loan facility online; Zidisha is working on something conceptually related, but optimized for poor countries. On the deposit-taking side, M-PESA and its progeny are made possible by widespread mobile connectivity.

Second, technology makes it easier for customers to pick and choose financial services from different providers. A major enabler of the big retail banks’ “financial supermarket” strategy was the degree to which it was annoying for customers to open and maintain accounts at multiple institutions. Electronic channels (e.g., online and mobile banking) means that such “multi-homing” is much easier than it used to be. This in turn allows customers to use a wider range of financial instruments, offered by a larger number of institutions, to manage their financial lives.