Consumer Credit in the Entrepreneurial Age
European Straits #58
Dear all,
I often talk about fintech in front of various audiences—corporate executives, entrepreneurs, policymakers. My key message is always that the revolution in finance is not about big data, machine learning, chatbots, and crypto protocols. Rather it is about the current paradigm shift and how the financial needs of businesses and households are changing as a result. The financial powerhouses of the Entrepreneurial Age won’t be the firms using the most cutting-edge technology. Rather the winners will be those who design financial products more in line with the new paradigm.
Take the case of consumer credit. An entire system involving central banks, government subsidies, retail banks, and one-of-a-kind financial institutions such as Fannie Mae and Freddie Mac in the US and the Caisse des dépôts et consignations in France has been designed to finance the typical middle class household of the age of the automobile and mass production: a married couple of salaried workers with 2.2 children whose financing needs are related to owning a suburban home, one or two cars, and occasionally borrowing money through a credit card to cover peaks in their consumption.
Today’s Entrepreneurial Age is very different. It is marked by greater instability at every level, which leads to permanent fluctuations in households’ sources of income. Workers alternate periods of training, wage-earning, starting a business, looking for a job, working as a freelancer. With this intermittent working life, the income structure of households evolves at a much faster rate, not without transition periods which present many challenges from a financing point of view. How can an employed person ensure the continuity of their income when they quit and found their own business? How can a self-employed person smooth out their income if their business is seasonal? The value propositions of traditional retail banks do not meet these needs that are only becoming more typical.
The bubble of student loans in the US is one sign of the financial system's radical inability to meet today's challenges. Investing heavily in initial training is poor preparation for a career during which an individual will frequently switch jobs. In addition, entering one’s working life already riddled with debt means ruling out entrepreneurial ambitions from Day One. The gap between the level of student indebtedness in the United States and uncertainty in their future career is what inspires the hypothesis of a student loan bubble. It also explains the diminishing rate of young people starting up new businesses and the exhaustion of the US prosperity engine.
What’s more, there are new needs that banks should learn to cover. Housing is a case in point. To date, banks have not developed products beyond granting credit for buying a home to households with savings and a high probability of a stable, single-sourced income in the future. Despite their purportedly high knowledge of the risk profile of their customers, banks are unable to guarantee rent payments to a landlord or attribute a high credit score based on an individual’s future earning power in an age marked by permanent instability and frequent career shifts.
In the US, Fannie Mae and Freddie Mac are two government-sponsored enterprises that were founded following the Great Depression with the purpose of securing the financing of home mortgages and raising levels of home ownership as well as affordable housing. Yet in the new age, the stake is not merely to buy a flat or a house close to the factory or office where an individual will hold a job for years. Rather it is to be able to move in and out without hassle and without the upfront costs and occasional asset depreciations that go with frequently switching jobs and changing your domicile.
Thus the financial system needs to deploy more capital in a new breed of consumer finance. But there are many prerequisites. First, we need to innovate in the manner in which we assess individual creditworthiness—and on that front the abundance of data in an economy rewired by ubiquitous computing and networks is certainly helpful. Second, we should bring the government along, like once happened in the US with Fannie Mae, to be the guarantor of a new kind of financial product. These new value propositions should be to the Entrepreneurial Age what mortgages were to the age of the automobile and mass production—not a loan to buy your own house, but rather a loan to make it easier to switch careers in an economy where economic security depends on one’s capacity to rebound.
The usual objection is that if we give individuals credit to take a sabbatical and make a career shift, most of them will squander it on useless things and end up more miserable as a result. But we need to realize that this imperfection already existed in the times when mortgages were the pillar of consumer finance: some people used them to make wise investments on dynamic real estate markets; others squandered them buying a house in poorly chosen locations where the value of their asset could only go down. The 2008 crisis itself is the result of the mortgage economy running amok and leading people to invest in overvalued assets that neither they nor their bank could recover at face value.
What would be the equivalent of mortgage origination in the case of a career shift credit? I think that the abundance of data creates value that makes it easier for banks to reach better allocation decisions: much like Amazon in retail, banks need to learn to exploit data so as to turn everything, including failure, into a value-creating process. Beyond that, the more comprehensive tracking and predicting of individual income will make it easier for banks to claim loan reimbursement over longer periods of time.
This could appear as a nightmarish vision of crushing lifelong indebtedness, much like exists with student loans today. But it’s precisely where the government can make a truly beneficial difference once it realizes that this new approach to consumer credit should be an integral part of the Greater Safety Net for the Entrepreneurial Age. As proved by mortgages in the past, there has never been a problem with many households borrowing money over the long term. The real problem today is that most people are borrowing that money for obsolete/overpriced assets (such as a college education) or to compensate for the failures of social insurance mechanisms.
You can read this paper I wrote in 2015 with my wife Laetitia Vitaud: Do Banks Still Have a Future? And I’ll obviously be exploring this topic in more detail in my coming book HEDGE!
Warm regards (from London, UK),
Nicolas