Lending, Borrowing, The Future of Credit

The Future of Credit sponsored by Capital One

Credit is the provision of resources (such as granting a loan) by one party to another party where that second party does not reimburse the first party immediately, thereby generating a debt, and instead arranges either to repay or return those resources (or material(s) of equal value) at a later date. It is any form of deferred payment. The first party is called a creditor, also known as a lender, while the second party is called a debtor, also known as a borrower.

History of Money and Credit

Credit means many thinks to different people. However, at its core, it hasn’t changed much since the first lending systems began. These lending systems started on the basis of barter (Metals objects were introduced as money around 5000 B.C.). Before the concept of money being an ‘object itself’, exchanges were done through the medium of barter. Bartering relies on a ‘coincidence of wants’. These wants are a simple method for two parties to get what they want.
Both parties will take a risk:

• - Not being able to pay back the money (and suffering a consequence)
• - Not being able to retrieve the loan

Both parties will be rewarded:

• - Money now (when it’s not available)
• - Money later, in a larger relative quantity

This will not change and the concept of the credit system will remain the same. What will dramatically change is the way in which credit is transacted, the vertical layers above credit and how much easier it will be to get credit

Effects on Credit

The latest financial crisis has caused a drop in lending from many banks. After the various bailouts, one of the key establishments, RBS, saw a drop in lending of 3% last year. Even though pressure from the government (to increase lending) is strong, the company, which is 80% owned by the British public is cautious about how much to lend and to whom. Capital One are trying to make credit clearer.

Banks will always lend to those who are low risk. This allows banks to lend large sums of money to people/companies/institution where there is little risk of default of non-payment. However, whilst they are still acting as a profit-making business, they will continue to operate in a profit making manner. (Some argue this is a meritocracy).

The Psychology of Lending, Markets and Credit

Humans, even though they think they are unique, behave in a fairly predictable way. Dan Ariely’s seminal work “Predictably Irrational: The Hidden Forces That Shape Our Decisions” describes the ways in which humans do not act rationally.

One example from the work is the concept of The Fallacy of Supply and Demand. Consumers will purchase based on value, quantity or availability. What influences their decisions will not necessarily be what is the logical choice but more often whether they are subjected to marketing tactics such as anchoring or comparative product pricing.

John Nash’s Game Theory does not play a role in many of these examples as the lenders and borrowers do not act rationally. They don’t always know the full state of the game and they are not necessarily “playing the right moves” according to logic.

Lenders will continue to lend. Borrowers will continue to borrow. However, there will always be a risk (even though this can be significantly reduced as we will see with Social Lending)

What’s Changing – Microcredits

The world is starting to experiment with a new style of lending. This style of lending is dramatically changing the landscape of those in poverty. Microcredit is the extension of very small loans (microloans) to those in poverty designed to spur entrepreneurship.

Reminiscent of the Irish Loan Funds of the 18th and 19th Centuries, the Grameen Bank of Bangladesh initiated microloans to ‘micro-companies’ who saw a huge success in the viability of their businesses. Many are trying to recreate this success in other poverty stricken areas of the world.

The Cutting Edge – Philanthropy

Lending very large sums of money is normally handled by institutions like the International Monetary Fund. The IMF is the the intergovernmental organization that oversees the global financial system by following the macroeconomic policies of its member countries, in particular those with an impact on exchange rate and the balance of payments.

Lending to large institutions or countries is now starting to happen by the super wealthy. The ‘Giving Pledge’ is an effort to invite the world’s wealthiest individuals and families in America to commit to giving half of their wealth to philanthropy.

The Giving Pledge was started in June, 2010by US Billionaires Warren Buffet and Bill Gates. The list of donors (well in to the fifties within its first month) has seen pledges from the likes of George Lucas, David Rockefeller and Michael Bloomberg.

Social Lending – Is this the future?

Social Lending or Peer to Peer (P2P) Lending is the name given to a certain breed of financial transaction (primarily lending & borrowing, though other more complicated transactions can be facilitated) which occurs directly between individuals (“peers”) without the intermediation/participation of a traditional financial institution.

Ahead of its time was Kiva who have facilitated over $100 million in loans since November 2009. Kiva’s mission is to connect people, through lending, for the sake of alleviating poverty. Kiva empowers individuals to lend to an entrepreneur across the globe. By combining microfinance with the internet, Kiva is creating a global community of people connected through lending.

The future is likely to see and explosion of social lending programs where the risk of lending is spread across many lenders and many borrowers. Companies such as wepay.com are only starting to get in to this new market however, some of the major media corporations are also known to be interested.

Microsoft and more importantly Google are looking at the financial space with the latter beginning to look at comparisons services for financial products. Are we going to see the Goliath of Google starting to get in to this game? They certainly have the capital, the trust of the public and it fits in line with their mantra of ‘do no evil’.

This article was sponsored by Capital One as part of their ‘Credit Made Clearer’ initiative, helping people dispel the myths and understand the jargon concerning credit and finance. Find out more at http://www.capitalone.co.uk/creditmadeclearer.