What is Finance?
The idea of finance, as explained by this post from The Baseline Scenario (which I’m now subscribed to) is pretty simple:
The financial sector connects savers and borrowers – providing “intermediation services”. You want to save for retirement and would obviously like your savings to earn a respectable rate of return. I have a business idea but not enough money to make it happen by myself. So you put your money in the bank and the bank makes me a loan. Or I issue securities – stocks and bonds – which you or your pension fund can buy.
What happens when you put a lot of money in one place, however, is quite a bit more complex and that’s what the author tries to explain. The more I read this stuff, the more I think we’re bound to swing back to the simplicity of something like peer-to-peer lending.
Hi, I'm 
Dunno about peer to peer lending, I can’t see much more to it than a buzzword. On one level it exists on the same level it has for years, lending friends and family $20 here, or $50,000 there. That’s not going away of course, but the big question is can it scale? And that’s anything but simple.
You can look at finance as a massive infrastructure of trust and risk management. And it’s at that distinction between trust and risk where a lot of the current problems emerge. An old bank exists as a trust relationship, they are structured to make you think they are trustworthy, that your money is in better hands with them than under your mattress. And when it comes to making loans they have an extensive infrastructure for vetting whether the borrower is trustworthy.
Gradually though risk became a replacement for trust. Rather than “I trust you will repay” it became “You are an acceptable risk”. It’s a subtle difference and barely noticeable at first. But eventually when the institutions were able to transform their concept of risk into a single easily computable number the difference became huge. And suddenly everyone woke up and realized that their risk numbers were wrong, and boom you have a financial crisis.
The challenge with scaling a peer-to-peer lending system is how do you establish a relationship of trust outside of traditional family, friend and business networks? The old banks did it by operating on a community level. They kept a network bigger than their customers, but compact enough that they could vet their borrowers from within their network. IE you could gain the trust of the bank by having a bit of deposit history, plus a few recommendations from other customers. Not impossible for a peer-to-peer lending system to solve this issue, but certainly not simple or trivial in anyway.
That’s what the bankers say they do, and most people think that’s what they do. The biggest part of the business though is that they are allowed to leverage their deposits and so that they lend more capital than they have in their reserves.
Think about it, if you were allowed to collect interest lending money you don’t have, who wouldn’t be rich?
I’ve noticed a lot of talk about returning to ‘simpler’ financial instruments in the past 12 months or so.
While I completely agree that MBS’s & CDO’s were little more than illogical and irresponsible tarted up high-risk instruments, I don’t think extreme simplification (such as P2P lending) is necessarily the answer.
Robert Schiller talks about economics and finance as a constantly evolving technology, and I tend to agree. The path we went down over the past 4 or 5 years may have been the wrong one, but that doesn’t mean we should revert the technology back 200 years.
Even relatively simplistic things like bonds become extremely complex extremely quickly, so I’m not holding my breath while I wait for the investment bankers to suddenly start issuing 2 page prospectuses. P2P lending will definitely have a role in the future of economics, but for either serious investment or serious philanthropy, I don’t see them as being anywhere near as significant as many seem to think.
I took a number of finance courses in college (journalism school) and I can’t remember the name of the professor, but he had a simple definition: finance is the idea that a dollar now is worth more than a dollar tomorrow. That’s finance.
I was looking for info about this on Google and came upon your post. I found it to be nice and clear. Thanks
Thanks a bunch for sharing this with all of us you really know what you’re talking about! Bookmarked. Kindly also visit my website =). We could have a link exchange arrangement between us!