Implications of Facebook’s Libra – separating lending from the payments system

24 Jul 2019

Professor Brian Kantor

Investec Wealth & Investment

Facebook’s new blockchain-backed payments system, Libra, raises some interesting questions about the future of lending and the payments system.

Is Facebook’s new blockchain-backed payments system, Libra, a pure and much lower cost payments system? Or is it a bank, or equivalently a money market fund, upon which transactions can be drawn conveniently for low or no fees?

The operating costs for a bank providing a payments facility are largely covered by the difference between the interest paid on deposits (perhaps zero) and the interest earned by the bank/payments provider making loans.  This makes the bank, unlike, for example, Visa, which collects fees to cover its costs – and does not make loans.
 
The profitability of banks depends in part on managing their cash reserves, keeping them as small as possible to meet demands for cash.
The banks have cross-subsidised the fees that they might otherwise have had to charge with the revenue earned from their lending activities. The profitability of banks depends in part on managing their cash reserves, keeping them as small as possible to meet demands for cash. They try to hold no more than prudent levels of reserves of equity capital to cover non-performing loans, while providing shareholders with enough of a return to keep them in the banking business. 

It is this leverage (banks holding fractional reserves of cash) that exposes the bank shareholders (and the broader economy that depends upon sound banks to facilitate transactions) to the danger of non-performing loans exceeding the equity of the bank. However, it is not only the deposits (liabilities of the banks and assets of depositors) that may be destroyed by the failure of a banking system. Of greater importance is that the payments system can go down with the banks, with truly catastrophic effect for any modern, highly specialised economy that depends on its payments system. 

Perfect safety for a payments system can only come when deposits are fully backed by cash issued by the central bank, thanks to the latter’s power to create as much extra cash as the system might need. 
 
SA banks lose as much as R800m a year to credit and debit card fraud. 
Blockchain may well offer enormous savings in protecting the transactions they give effect to, against fraud. These savings would mean low enough fees to cover the full costs and still provide a profitable return on capital and avoid the dangers of leverage. SA banks lose as much as R800m a year to credit and debit card fraud. They likely spend even more on trying to prevent fraud. 

Leaving banks to make the trade-off between risk and return has worked well enough for most, but not all the time. The Global Financial Crisis of 2008 (GFC) demonstrated why it is important to be able to deal with a banking crisis should banks or (more specifically) the payments system delivered by banks, be threatened with failure. The solution to any run on the banking system is for the central bank to supply more than enough cash to the banking system to stop any run on the banks, as the GFC also proved. 

Perhaps modern information technology will allow 100%, central bank deposit-backed (not private bank-backed) fee-collecting payment providers, to compete effectively with the deposit-taking banks for our transaction balances. If they do so, deposit-taking banks, supplying a bundled service of payments with the aid of leverage, may fade away to be replaced by other forms of financial intermediation – that is, by other financial institutions that can provide essential credit and take on leverage profitably, but without accepting responsibility for effecting payments.
 
The wise thing to do would be to let a profit-seeking, competitive financial system evolve in response to the preferences of lenders and borrowers and for regulators to stay out of the way so that a pure payments system could possibly evolve. 
This new world (of fully backed transaction accounts) may be the next phase in the evolution of the modern financial system, one that would provide for the separation of the payments system from the dangers of leverage. The wise thing to do would be to let a profit-seeking, competitive financial system evolve in response to the preferences of lenders and borrowers and for regulators to stay out of the way so that a pure payments system could possibly evolve. 

However, if Libra is a bank dressed up as a money market fund and carrying risks on its balance sheet, it should also be required to play by the same rules as its banking competitors. However, these rules applied to vulnerable banks could be relaxed if the payments system were secure.

About the author

Brian Kantor headshot

Prof. Brian Kantor

Economist

Brian Kantor is a member of Investec's Global Investment Strategy Group. He was Head of Strategy at Investec Securities SA 2001-2008 and until recently, Head of Investment Strategy at Investec Wealth & Investment South Africa. Brian is Professor Emeritus of Economics at the University of Cape Town. He holds a B.Com and a B.A. (Hons), both from UCT.

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