TradFi Inefficiencies are Holding Consumers Back
By Karl Jacob, CEO and co-founder of Home Coin
Today’s banks and financial institutions are not built for consumers. They are relics of an ancient past, built atop dated, inefficient and bloated systems of bureaucracy that rather than helping consumers, instead operate at the behest of corporate shareholders. In the following piece we’ll touch on inefficiencies of the modern banking system especially as they relate to mortgages and consumer savings accounts, and make the case for alternative options that leverage learnings from the TradFi space to provide transparency and accountability across products.
By and large* U.S banks are privately-owned, for-profit institutions. Despite policymaker’s pointing to the benefits of banking for economic development, the reality is that these institutions operate for the benefit of the shareholders. These shareholder stakes form the majority of a bank’s equity capital - a buffer against losses in the case of hard times - and every year profits are paid back to the shareholders in the form of dividends, with some profit set aside to add to overall bank capital.
*Credit unions are excluded from this category, however, as they are non-profit, member owned institutions designed to encourage savings and make excess funds within a community available at low cost to their members.
There are generally three ways banks make money. First, banks profit from the “spread.” The spread is the difference between the interest rate banks pay consumers for deposits and the interest rate they receive on the loans they make. Next, banks earn interest off the securities they hold and finally they earn fees for customer services such as loan servicing and checking account overdrafts.
Setting aside the obvious irony of customer fees for automated transactions, let’s focus in on the inefficiency of this second method- accruing value from held securities, in particular interest-earning loans (e.g., mortgages, letters of credit, and inter-bank loans).
Mortgages in particular are a very attractive revenue source as they are secured by homes and therefore low-risk, steady-return. In the worst case default scenario, the lender can sell the house and use the money from the sale to repay the loan amount which is usually only a fraction of the value of the house. This is why there are $2 trillion worth of mortgages purchased by banks, companies, and governments each year. In fact, the U.S. government currently holds $2.38 trillion worth of mortgages.
Additionally, lenders charge loan origination fees to process a new loan application. These are meant to be used to offset the cost of underwriting and verifying a new borrower. These fees can range from 1% to even 8% based on a variety of factors such as credit score, total asset vs. liabilities and yearly income. If lenders don’t use an origination fee it’s because they’re likely making their money back through higher interest rates or prepayment penalties.
This means that in addition to making money off of mortgage payments, banks also make money off the origination fees used to put together the mortgage in the first place. But what happens to this profit? As we learned earlier, it certainly doesn’t go to the consumer. With current mortgage interest rates hovering around above 6% you might expect to see consumer savings rates hiked as well. Not so. The three largest banks in America currently offer 0.02%-0.1% for their high yield savings account while the fourth, Citigroup offers only 2%. For context, Wells Fargo, who holds almost $275 billion in mortgages, will earn over $8 billion each year from consumer money deposited in their accounts.
For too long greed and the rigid, inflexible nature of these systems has worked against consumers. The 2008 subprime crash clearly brought this out into the open, showcasing that armed with ample capital and lowered interest rates, originators were willing to undertake riskier loans in order to increase their return. Investment banks in turn added fuel to the fire by increasing the number of subprime loans lenders could originate by selling these mortgages on the secondary market, collecting origination fees and freeing up more capital for more lending and liquidity. Add to this massive overleveraging through Credit Default Swaps on top of faulty ratings from credit agencies (a centralized “trusted” source) and we all know what transpired.
This is why we need alternative answers to the conflicts of interest, consumer and investor vulnerability, and asymmetric access to information that run rampant in the financial landscape. Blockchain technology has the potential to mitigate if not solve these issues. Where TradFi has obfuscated fee structures and hidden players, blockchain banking allows transparent transactional relationships with open access to code and on-chain data. Where conduct is mishandled by conflicts of interest, blockchain steps in with clear and stringent guidelines. Here, code is law.
For the consumer, there is no clearer step forward than moving towards blockchain technology.
Karl Jacob is a serial entrepreneur who has been building, advising and investing in companies for the last 20 years. He is currently co-founder and CEO at LoanSnap Inc. Karl’s career has been focused on founding companies that solve big problems and those companies have helped tens of millions of consumers.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.