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The major regulatory problem in our financial system is the danger of runs on banks. Commercial and savings banks engage in so-called fractional banking. They keep on deposit only a fraction of what they have outstanding in loans. Because banks do not hold enough in cash to pay depositors when many want to withdraw at once, a bank becomes fragile at the time of an economic downturn. And when one bank gets in trouble, depositors get worried about other banks, leading to more runs and a risk to the larger economy. This danger is the prime justification for the intense regulation of banks — more intrusive regulation than that of any other business, itself imposing substantial costs on financial transactions. And still worse, these regulations, as onerous and complicated as they are, often fail in preventing runs.
Thus, financial innovations that perform the same essential function as fractional banks without creating the same danger of economic meltdown are very welcome. One such innovation is peer to peer lending. In this business, an intermediary brings together people who want to lend directly with those who want to borrow. Think of it as the financial equivalent of Uber or Airbnb. Because these creditors are paid from the payments from the loans rather than interest from deposits, they do not create a danger of runs on the intermediary.
In order to get diversification the intermediary often also pools borrowers, and creditors then gets a contract guaranteeing that they will get payments from the pool. Unfortunately, the SEC is moving to regulate such contracts as securities. I will not get into the technical details of whether it is legally right to do so. My point is that as a policy matter it is a mistake to extend the scope of securities law with its large attendant regulatory costs to an industry that may help solve one of the essential problems of financial system. The advantages from protecting investors, if that is what participants in peer to peer lending are, are quite marginal particularly given their likely sophistication, but the cost of retarding innovation is substantial. Bluntly, a score of ill-used investors are a small price to pay for accelerating the rise of a new kind of financial institution that may help forestall the next great recession.
There is a more general point here about regulation. If society confronts huge social problem like financial runs, we need reduce the regulations for other problems that make the more serious problem more expensive or impossible to solve. For instance, if global warming is as substantial a risk as many allege, nuclear energy deserves greater solicitude, because it does not add to the carbon footprint. To be sure, nuclear energy may have some other costs, but these must be weighed against the benefits in preventing the greater catastrophe of global warming. And this perspective is useful in testing sincerity of political advocates. When anyone tells you that the government must issue costly regulations to prevent a catastrophe, ask him what other regulations he would be willing to give up to make the catastrophe less likely.
