There are fights going on in the banking industry right now that I want to rant^H^H^H^H call attention to. They are issues that most people probably don't know or care about, and yet they will affect our collective quality of life directly.
What do credit cards, mortgages, and over-the-counter (OTC) derivatives have in common? They are all products that are non-uniform - that is, each bank gets to make each product individually.
Defenders of deregulation would argue that the freedom to innovate in any way the banks can imagine is good for all of us, because the innovation leads to efficiency.
Despite having been raised by liberal socialists, I am sympathetic to this argument. I work in a highly deregulated industry (IT/computer tech) and would be at best grumpy if anyone told me how I could go about writing X-Plane.
But is that really the right analogy? I submit that banks don't fear the end of innovation - they fear the beginning of commodification, and we have a perfect analogy in the PC industry.
The computer hardware industry is, to put it bluntly, brutally competitive. It's not an easy part of the industry to make money in. Every year a PC sells for less money, but does more. Poor companies like Dell and HP are caught in the middle of that.
Okay - who are we kidding? No one is crying a river for HP or Dell, but being able to buy a laptop for under $500 is pretty awesome. There is no question that, from a price performance standpoint, whatever economic force is holding HP and Dell (and all of the other manufacturers) feet to the fire is yielding real dividends to consumers.
I believe that the force driving the price of PC hardware down is: commodification. Simply put, all PC hardware is like all other PC hardware. For any given product category, the ways a manufacturer can "innovate" is limited by the implicit rules of the PC ecosystem.
- RAM & Hard Drive: you can increase capacity, decrease latency. But you can't go changing around how the part fits onto the motherboard.
- CPU: you can increase the number of cores, you can increase speed. But you can't change what types of computer programs it runs.
- Graphics card: you can increase how many triangles you can draw. You can increase how much detail you can draw per pixel. But you have to do this via a standard interface.
When the specifications of a product become limited, it can be commodified - produced the same way by multiple manufacturers. Purchasers can easily change between suppliers, which puts intense competitive pressure on manufacturers to compete on the "commodified" axes (that is, the official ways commodities are measured).*
So let's take this back to banking. Look at things the banking lobby hates:
"Plain vanilla" pre-approved consumer products. This would be direct commodification of anything in the consumer market. When the only thing banks can compete on is interest rate, interest rates are going to get driven down about as low as they can go. (The loss will come out of the banks margin on the product.) It's understandable why they don't like that.
OTC vs. Exchange Traded Derivatives. This is complicated enough to warrant another blog post, but basically a derivative sold on an exchange is a standardized, commodified derivative, and the companies "manufacturing" the derivatives for trade make only the thinnest margin on large volume.
By comparison an OTC derivative (a custom derivative made by a big bank for a company - think of it as getting a car designed from scratch instead of just going out and buying a Honda) is sold by one bank . There aren't any comparable derivatives to even check the price against! Which product do you think is more profitable?
Commodification is appropriate when we can quantify exactly how we want to select our products. Commodified memory works because we can standardize all but two variables: size and price. For a given class of memory, we can then buy the cheapest chips.
Could we do that for financial products? Yes! I reject the claim that exotic mortgages are useful for some class of buyers with special needs. If this were true, they would not have become the standard financing vehicle for several years. I think we know what most people want from a mortgage:
- Low up front costs
- Low monthly payment
- Low interest rate
In other words, when it comes to a mortgage, there is really only one variable: price. If that isn't a product waiting to be commoditized, I don't know what is.
If there is a single idea I want to leave you with, it's this: different kinds of innovation are good for different parties, and commodification channels that innovation into avenues that are good for the purchasers of a product. There is nothing anti-competitive about commodification. In fact, I would argue that it is anti-competitive
not to have commodification.
Banks like the current system because they can offer products just different enough, just confusing enough, just opaque enough that consumers can't direct purchasing power toward the competitor who provides the best deal. Commodification would make these products transparent, and would make the market
more efficient.
In a commodified world, banks would have to innovate, but they'd have to innovate on how to get us the best price on a mortgage, not on how to hide the fees in the hardest-to-find places.
* I would be remiss if I were to pretend that this always works out well. Five years ago, the commodity for CPUs was clock speed, rather than throughput, and the result was the market producing CPUs that ran very fast, but got very little done as they ran.
