Tom On The Banking System Architecture Issue

The banking system we have today is financial infrastructure similar to the old phone networks in preInternet days – it’s way too centralized and too many tolls are paid as the flow goes through the money centers.

Interestingly the $100,000 limit on FDIC insurance is encouraging people to move their assets out of the money centers and directly into regional and local banks.

The pain of transition to a less centralized and less intermediated financial system will be great but hopefully less than the cost – not only in funds now but efficiency later – of keeping the old infrastructure in place.

Originally posted as a comment by Tom Evslin on A VC using Disqus.


Comments (Archived):

  1. Phanio

    My sediments exactly!

  2. andyswan

    Great comment Tom.I think it would also be wise to take a REALLY strong look at the role the federal government had in this crisis via their insane affirmative-actionish “home ownership opportunity” programs, which essentially forced FRE and FNM to fix prices of toxic debt at unsustainably high levels.Should government EVER be allowed to fix, cap, or floor prices on anything??? Is such action ever sustainable?

  3. Hutch Carpenter

    Maybe I’m still too groggy pre-coffee out here on the West Coast. Tom (and Fred) – what problem are you addressing? “Too many tolls are paid”. Is it lack of innovation? Is it that profit margins for regional and local banks have been hurt by a centralized clearing and settlement infrastructure?If this post relates to the current financial crisis, how exactly would decentralization address that?

  4. bernard lunn

    The Economist gave me perspective on this – as it often does. In the early 1980’s, the financial services industry accounted for about 10% of GDP. Last year it hit 40%. That is simply too much. The job of circulating money is important, but not that important. Methinks some smart start-ups will figure out how to take costs out of this process!

  5. Tom Evslin

    Fred:Thanks for reblogging.The costs of centralization in a network arebottlenecks, over-vulnerablity to failure of key nodes (sound familiar?), high tolls at the choke points, and lack of innovation. The Internet showed dramatically how a decentralized network created opportunity by reducing or eliminating these costs.From a nework engineers POV, our financial network is exhibiting all of these problems in spades. It’s pretty clear that thje toll-booth keepers were able to collect a huge amount of the money which passed through the system – much in the form of their profits on the transactions and in the markup on the strange securities they created. I’d argue that so much money left the market in “toll collection” that a collapse was inevitable – similar to the Internet bubble once people started taking their profits out of the game.If mortgage funds or loan funds for small business don’t have to be collected by either government or Wall Street before they can be disbursed locally but instead flow freely either at the local level or globally from areas of surplus to areas of need (sounds contradictory but think of the Internet), then we’re not vulnerable to this kind of systemic failure.But the question for now is how do we get through the disruption? Do we have to prop up the old system while we transition? Does propping up the old system just prolong the pain? I’d argue the latter but there are certainly responsible and respectable arguments on both sides.

    1. Druce

      YES – this is 100% correct – throwing money at the system without fixing the underlying instability is nuts.Here are some things that need to get cleaned up before we start talking bailout:- Large markets without disclosure and central clearing, a/k/a financial weapons of mass destruction. When there is distress, nobody knows who will go belly-up and the market stops functioning. (you need decentralization but also central traffic cops like DNS)- Rating agencies – If you accept high fees to rate garbage bonds AAA so banks will buy them, you should lose your nationally recognized reporting agency status.- Toxic loans, like option ARMs. If a mortgage broker puts someone in an inappropriate, predatory loan, he should go to jail, just like a stockbroker selling penny stocks to a grandmother.- Fraud sentences for people who originated mortgages that had no chance of getting repaid, and those who sold bonds backed by them that had no chance of getting repaid.- Revisiting the ‘lender of last resort’ compact – the deal is, if you’re too big to fail and therefore deserving of a backstop, whether GS or AIG, you have to pay for that backstop, disclose your risks, and take prudent risks.

    2. Hutch Carpenter

      Tom – If I’m reading you right, the assumption here is that the money center banks grow uncomfortable with the risk in smaller banks, and stop the flow of funds to them. This in turn means less availability for mortgages and small business loans.The problem I see in that is that there are macroeconomic factors and signaling effects that pervade the financial system. If you “re-route” the flow of money to be much more many-to-many, you have not eliminated those aspects.For instance, the borrowing costs for these smaller banks will still be affected by the overall economic picture. These smaller players will still have to go the capital markets. And the capital markets will still take signals from how the money center banks behave, not how the Bank of West Texas behaves.So these smaller banks will still have problems getting the capital they need to lend during times of economic distress.If anything, putting the availability of funds in the Fed’s hands should help overcome times of possible “irrationality” in the markets. The Fed isn’t in the game to make a profit. Its goal is to keep the country’s economy moving forward.Decentralization doesn’t change the macro factors that connect financial systems globally.

    3. iamverytall

      I agree with you in some respects, but I think that you’re overlooking some of what happened on Wall Street. The major Wall Street banks weren’t just nodes in a financial pipeline, they also functioned as end-points. Looking at their returns, the amount of money that they’ve made strictly as transactional facilitators has decreased significantly over time. The sharpest contrast can be seen in equity trading, where full service transaction fees of over 10 cents a share have slid to 3-6 cents over a number of years. Outside of full service transaction costs, there’s a significant shift to even lower cost transaction types, such as Direct Market Access, which allows institutions to transact for 0.10-0.20 cents per share. From this perspective, the plumbing has been getting better and better.From my perspective, a lot of the problem stems from the fact that the banks shifted their attention from facilitating transactions to actual trading and investment. A lot of the money that they’ve made over the past few years has been from proprietary trading activity, which they’ve been able to juice up through 30:1 leverage ratios. As the markets crumble, this is clearly coming back to bite them.In regards to mortgages, they have been able to make good money here, but that’s because they were providing services beyond ‘basic plumbing’ that essentially couldn’t have come from anywhere else. In order to package mortgages into securities palatable to the buy-side, you would have *had* to have had a fairly large balance sheet, otherwise you never would be able to warehouse a sufficient number of securities to alter* the investment’s risk profile. Unfortunately, in the process of warehousing these mortgages for repackaging, the mortgages started blowing up, leaving the banks holding onto securities that weren’t worth anything close to what they had paid for them. Hence the financial insolvency.I disagree that the problem at the core of the current crisis is the amount of money that Wall St. skimmed off of their transactions. If you think about hedge funds, PE funds and VC funds, they all skim off a very large amount of capital from their investors. However, this isn’t a problem because the returns that they generate for the investors more than compensates for the amount that they take for themselves.Moreover, there is a staggering amount of capital still at large in the system, much of it locked up with institutional investors, sovereign wealth funds, etc. The problem is that no one wants to hand it over to banks in exchange for the assets on their balance sheets. This would all be fine, except for the fact that the banks perform other activities that are central to the ongoing lubrication of our overall economy.It’s essentially as if you found out that your neighborhood grocers suddenly revealed themselves to be chronic gamblers on the verge of going broke. You’ve also noticed that a lot of the meat that they’ve been trying to sell you has been infected with E. Coli, and there may have been some issues with the milk and the produce that you have no idea about. You still have plenty of money, but probably don’t have any inclination to buy anything else from them. Suddenly, the grocers start closing down and now no one can buy any more food. The problem wasn’t that the grocers were making profits, or that there were only a few of them supplying the neighborhood.This response has gone a bit long and is probably missing a few points. There are also obvious flaws in the analogy, but hopefully it sheds some light. Responses are of course welcome.* I would like to qualify the word “alter” by noting that the diversification that banks provided did in fact alter the risk profiles of the MBS, just probably not to the same extent that bank analysts thought it did.

  6. Druce

    FAIL – there are three problems, #1 is markets that are locking up, #2 is the banking system needs to be deleveraged, #3 confidence must be restored so people start lending. A shotgun-style intervention does zip for #1 because it’s not realistic price discovery, is an inefficient way to do #2, and does zip for #3 .Buffett and Soros are on the right track (Google: ft soros paulson blank cheque). Just offer the Buffett/GS deal to any bank that wants it – all the money they need at 10%, in a preferred stock that gets paid off before stockholders, and convertible into equity at Friday’s price if the bank recovers and the stock goes up. (Call it the ‘equity discount window’ – since lending banks money through the Fed discount window and levering them up more is not what they need right now.)This kind of backstop would require maybe not even $100b (wild-assed guess, 10 GS bailouts), would make money for the government in any scenario short of the end of the world, and would prevent widespread bank collapses. It won’t make everyone start lending again or prevent the natural course of the business cycle and the housing bust – what goes up must come down.But the $700b ’splurge’ won’t do that either. Attempts to repeal the business cycle are futile, and we’ll just pay for it through higher taxes, higher inflation, less growth for far longer.Much as I would like to give Paulson and Bernanke the benefit of the doubt, unless you have meaningful market reforms and very judicious market intervention, the $700b blank check is simply the world’s biggest earmark, the bridge loan to nowhere. Wall Street is trying to railroad through one last feeding frenzy at the trough, and après moi le déluge.

    1. Jonathan

      On October 24, 1929 when JP Morgan’s broker Richard Witney, walked onto the floor of the NYSE and bid 205 for US Steel — after it just traded at 190 and was falling fast — the market suddenly realized that the price the stock had been trading at just might be wrong. The market lock started to dissolve and confidence began to build. The process of deleveraging slowed down, giving people a chance to buy or sell. I’d say #1, #2, and #3 were all addressed.Paulsen is saying the Gov’t will buy mortgage bonds at “hold to maturity” prices. This differs wildly from the current market prices and seems to upset those who think markets reflect all available information so a price which is higher than market is a bailout. But markets don’t always clear on price. The implied default rates embedded in the current market prices that vulture funds are bidding for mortgage product are incredibly high and reflect a situation of something like Great Depression x 2 or x 3. By standing up and saying he’ll pay a rational price, Paulsen, like Morgan before him, allows the market to clear and confidence to be re-established.

      1. Druce

        How’d that US Steel trade work out after October 24, 1929? Say around 1933?Richard Whitney ended up in jail for embezzling from clients.I hope it works, but I fear it won’t.

        1. Jonathan

          I hope it works too. But watching the medium of exchange seize up and doing nothing about it is a sure-fire way to make sure it gets worse. Sure, US Steel had a nasty 1933, but it lived to see another day. I wonder if they would have been so lucky today.

  7. kidmercury

    yes the system is too centralized and that is the entire problem, the whole problem is the federal reserve system which gave us the first great depression and is now giving us the second one. paulson of course is now calling for the fed to have even greater power, and thus we are moving to greater centralization.abolishing the federal reserve system will enable a fair monetary policy, rather than one that is excessively expanded to create bubbles and the ensuing depression. failure to acknowledge the federal reserve’s role in the creation of this depression, and the previous one, ensures that history repeats itself, and that this depression is far more painful than it needs to be.

  8. SSM

    Would love to know what kind of response you received to your New York Times article. Do you plan to respond to anyone who wrote to you as a result of the article?

    1. fredwilson

      Yes, I’ve been responding to most of the emails. There have been some that were so far removed from what we do that it suggests the writer didn’t read the article. Some of those did not get a response but some did

  9. MassMan

    Transitioning to a decentralized system would be an unmitigated disaster. My reasoning is simple: One of the main causes of today’s crisis is a lack of transparency and the scrutiny that accompanies a transparent system. We need not look to far afield to see what happens when you have many entities interconnected without regulation or transparency. It’s called the CDS marketplace and the hedge fund industry. These conjoined twins will produce a financial shock that will make the current crisis seem like a walk in the park.Centralizing around well-capitalized broker-dealers and open exchanges would make the regulatory environment far easier to manage and to protect. Lax parsimoniae (“law of parsimony” or “law of succinctness”) which states “entia non sunt multiplicanda praeter necessitatem,” roughly translated as “entities must not be multiplied beyond necessity”.MassMan

  10. JLM

    Perhaps the greatest comfort that I take in this financial crisis is that the mistakes were so fundamentally obvious (well, perhaps in hindsight). I am very, very confident we can correct them for all time.The first mistake is that lenders wrote mortgages that had obvious flaws which created unacceptably high probabilities of failure. Sure, there was lots of political pressure to make these loans and I give the Barney Franks and the Chris Dodds of the world the blame for that. But, really, no-doc, 100% plus closing costs loans??? This violates every rule of banking 101. Banking is not a social engineering lab experiment.The second mistake was to allow Wall Street to create derivative financial products which embedded these bad loans in securities (not hugely complicated securities) which purported to concentrate the risk in a lower tier security while magically purging the risk from a higher tier security. Somehow we started with a lump of coal and fooled ourselves into thinking that the top tier was a diamond. Even Wall Street cannot make chicken salad out of chicken excrement.The third mistake was to strip these securites and distribute them to disparate groups of investors which precluded the possibility of combining them again when it came time to simply collect on the mortgages. It is probably important to note that nobody on Wall Street in a blue shirt with white collar and french cuffs really knows how to collect a past due payment on a single family home in Montgomery, Alabama.The fourth mistake was to allow firms (Freddie, Fannie) to warehouse these suspect loans (not securities but the loans directly) with no more capital than the current balance on their postage meter. If you want to trade in junk then you should have capital equal to at least twice the annual rate of default. If the annual default rate is 4% then you need 8% capital. Go try to form a de novo bank and see how much capital you are required to raise in order to obtain a new bank charter.The fifth mistake was we allowed GSEs to lobby and make political contributions which is simply a way of saying they were allowed to bribe their regulators. Does anybody else think it is obscene to allow the head of Fannie or Freddie to make a political contribution to Barney Frank?It was simply stupid to allow naked short selling and to repeal the uptick rule. And, yes, I think it is time for Chris Cox to go to a well deserved rest in California.The last thing is that when things were obviously going wrong, no auditor offered a “going concern” opinion on a single one of these firms. How could the entire freakin’ industry collapse and not a single auditor expressed any reservations as it relates to capital adequacy on balance sheets which were leveraged 15-40x and contained obvious and significant toxic assets? You would think someone would have by just blind luck.While this is a huge mess and will take some time to get over it, I am also very confident that even $700B is an insignificant percentage of our GDP and that if we can keep our heads and avoid comparisons with time periods in which our GDP was comparatively smaller then everything will be just fine.If your annual income is $100K and you have $20K of credit card debt, then you have a problem. If your annual income is $1MM and you have $20K of credit card debt, then you don’t have a problem. You simply have a bill to pay.I think we simply have a bill to pay. A big bill and the kids are not going to be able to borrow the credit cards again any time soon but just a bill.It would also be very helpful if during the height of a capital crisis, the tax rate on capital gains was reduced to zero if for no other reason than to state the obvious — there will be huge offsetting capital losses but also to attract huge pools of capital by offering the highest possible tax adjusted rate of return to investors who might contemplate taking a chunk of the action.Let me close by saying I have huge misgivings in allowing a product of Wall Street to run the triage part of the recovery.