NEW LENDING FOR A NEW ECONOMY

April 15th, 2015

by Lawrence H. Summers

Lend It Conference, New York City

April 15, 2015

As delivered

It is a great privilege to be here, and I have to say, the size of this crowd, the entrepreneurial energy in this room, the extent of the dialogues and the deals being cut in these corridors gives me hope for the future of the lending industry, gives me hope for the renewal of the American financial industry, and gives me hope for the future of our economy, and the global economy.  And that is even without mentioning, Peter, my gratitude for having been introduced without the usual economist joke.  It was not so long ago that I was introduced by the guy who said, Larry, do you know what it takes to succeed as an economist?  And I said, no.  And he said, an economist is someone who’s pretty good with figures, but does not quite have the personality to be an accountant.  That was in Moscow and no one got the joke.

Here’s what I’d like to do today:  I’d like to talk to you about why I think this is a challenging time for the American economy, talk to you about why I think the conventional financial sector has, in important respects, let all its main constituents down over the last generation, talk to you about how I believe technology-based businesses have the opportunity to transform finance over the next generation, and reflect with you on the principles that should guide public policy with respect to the sector going forward.

This is a challenging time for the economy:

The American economy, at one level, we can take great satisfaction.  I can tell you I was there, that if you looked at any important economic statistic between the Fall of 2008 and the Spring of 2009, GDP, industrial production, unemployment, anything, it was worse than it had been after the fall of 1929.  The trend was faster and further down than it had been after the fall of 1929.  Depression was a real possibility.  Thanks to a combination of the vitality of the American economy and the policies that were put in place, we have not seen anything like a depression.

On the other hand, on the other hand, one has to look with very considerable concern at what has happened to the economy.  Today, the GDP of the United States is about 10 percent, or $1.6 trillion less than people expected it to be in 2015, as of 2007.  That $1.6 trillion lost represents about $20,000 for the average family of four, and that loss is taking place each year, and that loss is taking place against a backdrop of a United States that is doing relatively well compared to the global economy and particularly to the economy of the rest of the industrialized world.

If you look at markets, something quite remarkable is the case.  In Europe, the 10-year interest rate in Germany is 18 basis points.  In Japan, it is comfortably below 50 basis points.  In the United States, it is below two percent, and if you look at real interest rates, that is, interest rates adjusted for inflation, they are negative in Europe and Japan and about 20 basis points in the United States for a 10-year period.

What does that tell us?  All of that sloshing, all of that money, sloshing into government bonds, to the point where their yield is negative, is telling us that, despite all the opportunities that exist in the modern world, markets are seeing some kind of chronic excess of saving that is not being effectively channeled into investment. That failure means less investment, which means less growth, and that lower growth, in turn, means more pessimistic expectations.

THE FINANCIAL SYSTEM IN A MODERN ECONOMY:

What is the function of the financial system in a modern economy?  The function of a financial system is to connect those who want to put off consumption, whether it is for a rainy day, to send a child to college, to accumulate wealth, to build a house, to prepare for retirement, or to look out for one’s children.  It is to take those who wish to defer consumption and save and, in order those, in order to put those resources to good use among the large number of people who should have good use for resources such as living in a house before they’ve accumulated the wealth equal to the value of the house, putting in place necessary public infrastructure, or doing productive investment that raises the productivity of large number of workers.

It is the task of the financial system to make that connection, and if what we see is that that connection is not being made – then we are seeing lower levels of investment, lower levels of interest rates – that has to raise a question as to how well the mainstream financial system is functioning.

But one can raise a question about how well the mainstream financial system is functioning in a more direct set of ways:  Is it meeting the needs of borrowers?

Well, small business lending is a much smaller fraction of total bank lending than it was 15 years ago, and small businesses, not just in the United States, but in most parts of the industrialized world, report themselves to still be experiencing a credit crunch.

Home ownership rates in the United States have fallen behind by a generation.  It is appropriate and right that credit is not nearly as available for mortgages as it was in 2005 or 2006 or 2004.  It might be appropriate and right that it’s not as available as it was in the early 2000s.  It is, surely, not appropriate that credit is not nearly as available for middle class potential homeowners, as it was in the late 1990s.  It is not appropriate that private equity firms are reaping huge profits by renting homes to homeowners who cannot get mortgage credit and charging them rent that equals eight or 10 percent of the value of those properties.  It could be that those people could be paying three, or four, or five percent of the value of those properties and enjoying the appreciation, as well, if our financial system was doing a better job of providing credit.

Credit is increasingly unavailable for those wishing to pursue higher education because of the great difficulties that the mainstream system has had in distinguishing better from worse risks.  Renaud Laplanche famously got the inspiration to start Lending Club by asking himself, why it was, in the modern technology age, that if he put money in the bank, he got two percent, and if he tried to take money, he tried to borrow money from the bank on his credit card, he paid 17 percent, and this was in the era of computers.   Since Renaud Laplanche had that insight, spreads, administers of costs in mainstream banks have risen not fallen.

So, the first disappointing aspect of the mainstream financial system is that it has not succeeded and is succeeding less well than it once did in its basic function of providing credit to people.

The second respect in which the mainstream financial system has let us down is that if you look over a long period of time, the returns earned by investors in large, mainstream financial institutions, have fallen way short of market returns.  For a number of investors, for those who invested 10 years ago or 20 years ago on a long-term buy-and-hold basis, in a number of institutions that we can all name, the return has been negative 100 percent because they lost all their money.  Those who invested in a number of other institutions that still function on a large scale today, have lost more than 80 percent of their money, given the losses and the dilution associated with the financial crisis.  On average, returns have fallen far, far short of the S&P 500.

So, the financial system hasn’t worked so well for the benefit of its customers.  Borrowing is hard.  It isn’t working so well for the benefit of its creditors.  You don’t earn any money anymore when you deposit money in a bank, and it hasn’t worked so well for the benefit of its, and it hasn’t, and it hasn’t worked so well for the benefit of its share owners, either.

It also hasn’t worked so well for the rest of us.  Think about the last long generation.  We saw the Latin American debt crisis that brought the major financial institutions to the brink.  We saw the 1987 stock market crash.  We saw the S&L debacle.  We saw the New York City real estate crash.  We saw the 1994-1995 Mexican financial collapse.  We saw the 1997 Asian financial crisis.  We saw the 1998 LTCM Russia episode.  We saw the 2000 Internet bubble.  We saw the 2001-2002 Enron long-term high yield bond debacle, and all of that was a prelude.

It is high time for reflection on the renewal of the financial system and the creation of a financial system that will work more viably for savers and borrowers, and will work more viably for the benefit of the economy.  Some substantial part of that effort involves public policy.  It involves government regulation.  It involves the kinds of issues that people dealt with in Dodd-Frank.  It involves thinking about too big to fail.  It involves capital requirements.  It involves thinking about resolution regimes, and the like.  That is not my topic today.

TECHNOLOGY-BASED BUSINESSES HAVE THE OPPORTUNITY TO TRANSFROM FINANCE:

Some other very substantial part of the solution to that problem, to the renewal of finance around benefiting people rather than benefiting money lies in technological innovation and its application.  Because if you think about it, finance is an information-intensive business.  It’s all about information, and we are living through an extraordinary period of information technology innovation.

My Smartphone right here – this device costs about $500.  It has more computing power than the Apollo project did that sent a man to the moon.   It has more accessibility of information. If you have this device, than you have access to all of the Harvard libraries.  I work at Harvard.  If you gave me my choice – no Smartphone and free access to the Harvard libraries 24 hours a day or full access to my Smartphone, but no longer any access to the Harvard libraries, that would not be a hard choice.

And if you think about the ability to be in touch and connect with people around the world, you would rather have this device than have the White House communication system as it stood when John F. Kennedy was President of the United States.

And here’s the remarkable thing:  there will be a date; it might be three years from now, it might be seven years from now, but it won’t be 10 years from now, when there will be more Smartphones on Earth than there are adults.  Now, admittedly, that’s, in part, because there’s going to be some people in Hong Kong who have four, but we are not far from the day when almost everyone on Earth will have a Smartphone.

That is a moment of extraordinary potential for information technology innovation.  We do not know and we cannot forecast all the forms that it will take.  There was a very good book, or at least at the time it was thought to be a very good book, that was written by a Harvard colleague of mine and a MIT professor, in 2004, and it was an attempt to look very carefully and very thoughtfully at what technology could do, but what would still be the domain of the human brain, and what it would be a long time before technology could replace, and they chose a canonical example of something that was easy for humans but hard for technology.  That canonical example was making a left turn in the face of oncoming traffic.  Google solved that problem within five years after those sentences were written.

We do not yet know all that technology will be able to do.  We do know this, and it’s a good law for thinking about the world, whether you’re thinking about the arrival of financial crises or you’re thinking about the dissemination of technologies, we know that things take longer to happen than you think they will and then they happen faster than you thought they could.  That’s the way it was with the housing bubble collapsing.  That’s the way it was with the pervasiveness of the personal computer.  That’s the way it was with the Internet becoming part of the fabric of all of our daily lives, and that will be the way it is with respect to the next set of innovations.

So, as a general proposition, I would suggest to you that technology has immense potential.  And I would suggest to you that it is an oddity, that until quite recently technology has not been disruptive of mainstream finance.  Yes, there have been huge amounts of financial innovation, derivatives, different kinds of derivatives, whatever, but they have been more for the benefit of money than they have been for the benefit of people.  Paul Volcker was not exaggerating very much, if he was exaggerating at all, when he said four or five years ago that there hasn’t been an important financial innovation since the ATM.

I joined the Lending Club board because I believe that the thrust and the strain that is represented by all of you in this room, the application of information technology, to take frictions out and make finance work better, and, in particular, though this is not the only sphere where this is important, to do so with respect to lending, I believe, has the potential to, over time, be transformative of the financial system and to address its infirmities that I described a few moments ago.

What were those infirmities?  Frictions that were too large, that represented too large a gap between what savers receive and what borrowers pay.  Banking without banks can take three percent, five percent, six percent out of the cost of intermediation. Taking the friction cost out is profoundly making finance better, but that is only one of the benefits.  A second benefit is that the systematic use of data on a large scale will permit better credit judgments, and that will permit the more accurate allocation of capital.  The more accurate allocation of capital means higher returns, which is good for the providers of capital.  It means that capital will be available to the previously unrecognized creditworthy.  It means that those who are creditworthy, but have not yet been able to prove themselves to be creditworthy, will now be given opportunities to prove themselves to be creditworthy and enter the mainstream and see their borrowing costs decline over time.  It means that capital will be allocated more wisely, which means that there will be more efficiency in its use, which, ultimately means more jobs and better products throughout the economy.

Some of that’s going to come from better use of existing data.  Some of that will come from harnessing data streams that were previously available.  I’m privileged to serve also on the board of Square.  Square has an important new product, Square Capital, that lends to small business but with the informational and enforcement advantages that come from handling all of their credit card processing, which permits them to make much lower cost loans available, and to make decisions more rapidly.

The use of technology has a third major benefit.  It provides a much more satisfactory kind of consumer experience.  We live in a society because of all the ways in which we are conditioned, when all of us are less patient than we would have been a generation ago.  One manifestation of that is that if you watch the evening news, the average film clip of somebody being interviewed is now eight seconds.  In 1968, it was a minute and eight seconds.  Well, that growing impatience means that if we apply for a loan, we want to know the answer, yes or no, now, not yes or no in the mail three weeks from now.  We want to interact with institutions who don’t ask for our trust, but earn our trust through the efficiency with which they deal with us.  And if you look at the performance scores of firms like Lending Club, in contrast to the favorability ratings from consumers of large banks, it is an ocean of difference.

And so these models offer a better consumer experience, more informed allocation of credit, substantially reduced frictions, and I believe they have the opportunity also to contribute to greater financial stability in our economy.  They have the ability to contribute to greater financial stability in several ways.

First, the basic lesson of this field of ecology; a lot of things you learn in the field of ecology, but if there’s one take-home less from ecology it is this:  Diverse ecosystems are much more resilient than beautiful ecosystems.  A financial system in which credit is provided by banks, credit is provided through traditional capital markets, credit is provided through platform lenders, and credit is provided through specialty finance vehicles supported by information technology – a financial system that is more diverse – will be a financial system that is more stable.  It is a financial system that will be more free of the positive feedback loops that happen when credit contracts and, therefore, asset values decline, and, therefore, credit contracts, and, therefore, asset values decline, and it happens again and again.

If we can have more resilience in the basic provision of credit through more diversity, we can have a more stable financial system.  Platform lending doesn’t have the central connection to leverage that traditional banking does.  There is no entity that carries a balance sheet with leverage.  There’s nothing there that is too big to fail.  There is nothing there that requires deposit insurance.  There is nothing there that is implicitly subsidized, and there is, therefore, a greater contribution to stability, to the kind of stability that we seek to achieve.  And better information technology and better credit decisions mean less risk of failure and that, too, is a contributor to stability.

So, I believe that the financial system, traditional financial system, given its performance, is ripe for disruption.  I believe that it is more than most sectors the moment for disruption, given success and informational technology, and I believe that the nature of the incipient disruption, the use of information technology to lend in new ways, is directly responsive to the problems that have caused such dissatisfaction with the financial system over the last generation, and that have contributed to our economic problems, and those slow growth forecasts, and those remarkably low interest rates.

FIRST PRINCIPLES THAT CAN GUIDE PUBLIC POLICY FOR NEW LENDING:

How should public policy view all of this? I would suggest four precepts.  It will not resolve every specific regulatory question, but I think if we are able to follow these four precepts, the future can be very bright, both for entrepreneurs and for almost everybody because almost everybody is a stakeholder, one way or another, in the success of our financial system.

What are those precepts?

First, permission not prohibition.  Let new business models emerge.  Regulators should allow new firms to operate, generate data on the outcomes created by novel business models before writing new rules.  Yes, regulation is necessary, but only when it is necessary.

I was privileged to serve as Secretary of the Treasury, and in the Treasury Department, under President Bill Clinton.  One of the much less remarked, but I think more important, developments during his Administration was the decision in the mid-1990s to establish a presumption of permission with respect to the Internet.  It was not, at that moment, entirely obvious what the right approach was to this new technology, and the decision that President Clinton made, advised, ironically, by Ira Magaziner, who had earlier been an advocate of a very substantially regulated healthcare system.  The decision was, yes, we will be vigilant with respect to privacy.  Yes, we will be vigilant with respect to monopoly.  Yes, we will be vigilant with respect to national security, but that the presumption would be of permission, rather than a presumption of prohibition, and I believe that is hugely important with respect to new information technology, businesses generally, and it is important, in particular, with respect to lending business.

Second principle:  Insist on transparency and disclosure, then let consumers decide.  As new lenders serve parts of the market that have historically not had access to credit, high rates may draw regulatory scrutiny.  Regulators should require full transparency and disclosure, and see how consumers react to new products and prices before writing rules.  Make no mistake, I am not arguing for laissez-faire.  Make no mistake, there have been multiple instances in the past of financial innovation, in which consumers were substantially exploited.  We saw that with respect to a number of the innovations in mortgage finance just a dozen years ago, but, but we need, also, to recognize that people are not going to improve their credit without getting credit.  That when they get credit, they have the opportunity to improve their credit, and we need to allow those with new business models, seeking to reach new populations, an opportunity to show what they can do, as long as they do it with full transparency and full honesty.

Third principle:  Maintain a level playing field.  Don’t give incumbents an unfair advantage, but discourage business models based on unfair regulatory arbitrage.  Regulators should strive to put entrants on equal footing with incumbents, but to do so without sacrificing consumer protection.  No lending business, on-line or off-line, should get a pass on usury laws, on fair lending requirements, on disclosure, or on other critical safeguards.  At the same time, the choice to operate in non-traditional form should not mean an exemption from principles that have been regarded as appropriate to apply to all lending.

It is essential that requirements that are not longer appropriate, like the requirements for the monitoring of the balance sheet of banks, are not enforced on institutions that do not have balance sheets, but serve only as platforms.

Fourth principle:  provide workable regulatory frameworks.  To date, regulatory authorities have generally maintained appropriate attitudes towards innovative lenders.  It will be important as the industry evolves and grows that regulators not create overhangs of uncertainty or burden excessively those attempting to innovate.

If we can adopt these precepts and other related precepts, I believe that the next decade can be a period of unprecedented financial innovation in lending businesses.  That innovation can be a source of entrepreneurial innovation for those in this room and many, many beyond.  That, more importantly, it can mean that the basic function of a financial system to provide higher returns to savers, lower costs to borrowers, while permitting investments that drive the economy forward can be performed better in the future than it has been in the past.

Innovation in lending, payments, funding, and allocation of risk, I believe, offers tremendous potential for making the American economy and the global economy not just more efficient, but more secure and more stable. And when I think about the magnitude of the problems, and they are many, and I think about what I had a chance to see somewhat closely – the tendency towards dysfunction, the occasional ossification of tradition in Washington – I know that while the right public policies are hugely important, that the task of renewal of our financial system is not primarily one for public policy.  It is primarily one for entrepreneurial innovation, and that is why the size and growth of the LendIt conference seems, to me, to be so positive a sign for our future, and I am so very glad to have had the opportunity to address you.

Thank you very much.