--- begin forwarded text Date: Sun, 25 Oct 1998 16:07:04 -0400 (AST) From: Ian Grigg <iang@systemics.com> To: dbs@philodox.com Subject: e-cash, banks, systemic risk, and financial safety in the Metro Cc: daveb@hyperion.com, djackson@jackson-trading.com Reply-To: iang@systemics.com Sender: <dbs@philodox.com> Precedence: Bulk List-Subscribe: <mailto:requests@philodox.com?subject=subscribe%20dbs> X-Web-Archive: http://www.philodox.com/dbs-archive/ I've been a faithful believer in the past that banks are not the right organisations to get involved with electronic cash. To some extent, this has been merely a learning exercise in order to determine the shape and composition of the ideal organisation that should be involved; starting off by rejecting the status quo is always educational. When building electronic cash systems, it is an obvious question to ask, and if not, your customers soon do so for you. Over time, another face has arisen, that of defending society from threat of the new world being monopolised by the dinosaurs of yesteryear. In short, the need to keep banks out of electronic cash. At the end of this rant, I have attached a post from Dave Birch of Hyperion, in which he presents some evidence of how banks are failing in the smart card area. This I find personally amusing, as I argued in my paper on the EMI's 1994 Opinion that smart cards were something that the banks could get into and sensibly monopolise. I guess that argument now looks somewhat weak. Whether banks should be involved in electronic cash is part of a wider question as to whether they should be involved in payment systems. Such a question is not really discussed; It is fairly to clear to me after several years of central bank watching that much of the regulators' thinking in these areas is muddied due to their lack of appreciation of the key distinction between banking and payment systems. In private and sometimes in public, the more enlightened of the insiders tend to agree that such a distinction doesn't really make sense to most central bankers. In such a void of discussion, it is insufficient to simply state that the business of payment systems is not the business of banking, as I have been doing for the last few years. Making such a statement does gives rise to the conclusion that as different businesses, payment systems and banking should at least be separately regulated. From any sensible business principles, unless there is a compelling reason to combine them, one separates them (and it should said that the marketing benefits of securing additional customer ownership for banks are not really compelling enough to argue for public intervention). Such an argument is consistent and valuable, but has not really made the grade as far as convincing the world to change. We need more. We need to collect more information on why payment systems need to be decoupled from banking. One argument that has arisen, which I have been recently made aware of through discussions with Douglas Jackson, is that the combination of payment systems and banking raises the risk of systemic failure in the economy. The logic runs like this. Banks, being the places where the money is kept, are subject to attachments by goverments; one of the bugbears of Free Banking is that it is not stable in the long run, being unable to survive a long-term attack by a regulator that seeks to attach the funds managed. Now, leaving aside from our natural distaste of theft with coercion, we need to identify how this makes the system weaker. When a regulator coerces a loan out of a bank, such as occurs regularly in periods of systemic turmoil (LTCM, the Asian crisis, S&L, need we go on?), then the bank that extends these funds will be made weaker. That is, it has somehow been lumbered with a non-performing asset, which weakens its balance sheet. To see how this must be the case, consider what would happen if the loan made was in fact a performing one. Trivially, any bank would take on a performing loan without the advice of any regulator, as this can only be good business. Therefore, any business that the regulator gets involved in must be non-performing, and therefore must involve coercion (or perhaps some other subsidy, but that is not considered here). Now, this pushes the bank in the direction of failure. If the bank fails, we now have two problems, being the original failure that caused the coerced loan and the second failure of the coercee. It takes no learned education to see that this process is starting to look like an epidemic. If the bank does not fail, then all is apparently well and good. Regulators might argue that their coercion and the consequent dead loss to the bank's balance sheet did in fact pay off, in societal terms, and they simply need to be careful to only load up a bank as far as it can support the load. The problem with this is that the regulators can make no such argument. Was it Mises who said that governments have no special monopoly on good decisions, and therefore no better ability to regulate than the market itself? Sooner or later, the regulators will make a mistake, forcing their new found compliant bank into bankrupcy in order to bail out the previous disaster. Can we accept that? We might be able to, if it was some statistical thing - every now and then, our leaders make a mistake, and something breaks. Every now and then a bank fails that did not need to, but most people shed only crocodile tears over bank failures. Well, no. Unfortunately, the mere action of succeeding in repairing the situation by coercing one good bank to bail out another bad bank causes a reward scheme that self-perpetuates the activity. More simply, bad behaviour gets rewarded, and good gets punished. Where does this incentive lead to? Evidently, repeated bail-outs and bad loans across the entire banking industry, which net out to a general weakening of the industry balance sheet. This industry-wide weakening to the system of banks is not a good sign, but when it is coupled, as it causally must be in this case, with a regulator's propensity to shift bad onto good, and risk an occasional mistake in the act, then the whole system is at risk from the very people sworn to protect it. People need banking, not banks. Who said that? He might have been thinking of the above, and perhaps predicting that we would not be able to escape from a situation of regulated weakness in the banking sector. Assuming we cannot avoid the above problem, and it is historically evident that many best efforts have failed, then we must look at containment. Banks may be unsound; the economy must go on. And herein lies the nub of Jackson's argument. What better way to spread failures than through payment systems? Payment systems by their nature link banks into a system of banking. Better than that, or worse as the case may be, payment systems are generally offered to and used by many other sectors of the economy. Such a powerful invention as the payment system, or money as the economists like to call it, will be made universally available. Their power is a double-edged sword. Failure of a payment system is capable of crippling economies, toppling governments and causing widespread destruction of wealth. Russia today, Albania yesterday, and the Weimar Republic in yesteryear are powerful reminders of what happens when the payment system fails. Clearly, to then reserve payment systems to banks, which are fundamentally regulated as to be unsound, is to raise systemic risk. The hitherto unchallenged argument of the central banks, that their role is to protect the system against systemic risk, should now be presented back to them as a reason for them not reserving payment systems for banks. Independant payment systems, separated from the regulated, risky and weakened world in which banks operate, must therefore decrease systemic risk in the financial system, ceteris paribus. This argument is one that supports separation. Is there another? And to be rigourous, is there an argument that supports the combination of banking and payment systems? iang PS: follows is Dave Birch's post that catalysed this rant, although the thoughts have been permeating for many a year. Also note that this inclusion does not in any way evidence Dave's endorsement of my arguments. =======8<==========8<==========8<==========8<==========8<=== From: Dave Birch <daveb-lists@mail.hyperion.co.uk> Frank Sudia said

Several large organizations have undertaken consumer purse trials in the US, which have been miserable failures.

The only consumer purse trial I can think of is the Mondex/Visa trial in New York. I saw a report on the web a couple of weeks ago (Business Week? Internesia sets in). The top three places where consumers in New York wanted to use their electronic purses were for subway tickets, taxis and payphones: not one of these was included in the trial. I bet that you can buy a fur coat in Bloomingdales with your Mondex card but not pay a parking meter. Worldwide, the situation is much therefore more interesting than your comment suggests. I might characterise it as follows... Several large organisations (banks) have undertaken consumer digital money trials which haven't been runaway successes. At retail point of sale, which is where electronic purses are being trialled, smartcards have no competitive advantage over cash whatsoever. Why do they persist? It's because banks treat electronic purses as cards (instead of computers, which is what they actually are). As a consequence, they are handled by the "card services" (or whatever) department of the bank. What is "card services" main business? Merchant acquiring. Who do "card services" talk to about electronic purses? The merchants that they already acquire credit card transactions for, rather than they guys who run parking meters, vending machines, payphones, taxi meters etc etc etc. Other large organisations (not banks) have undertaken consumer trials which have been great successes. Examples are * mass transit operators (e.g. Hong Kong mass transit does more smartcard transactions every day than Mondex and VisaCash have done in their history) where people find smartcards far more convenient than tickets or coins. London Transport are soon going to issue more than 7 million contactless smartcards for people to pay for subway and bus fares: how long before the newspaper vendors at the stations accept these cards as well? * campuses (in Europe and the US), where people need change for a million reasons everyday (photocopiers, payphones etc etc) and it saves the campus operators a lot of money to not have collect cash from machines. I'm just as frustrated as everyone else that electronic purses aren't catching on as quickly as I'd like. All I'd say is that purses will come (even in America), so it's best to just take it easy and wait. Regards, Dave Birch. === mailto:daveb@hyperion.co.uk ===== http://www.hyperion.co.uk/ === --- end forwarded text ----------------- Robert A. Hettinga <mailto: rah@philodox.com> Philodox Financial Technology Evangelism <http://www.philodox.com/> 44 Farquhar Street, Boston, MA 02131 USA "... however it may deserve respect for its usefulness and antiquity, [predicting the end of the world] has not been found agreeable to experience." -- Edward Gibbon, 'Decline and Fall of the Roman Empire'