Bypassing Banks Using Tech

Financial intermediaries, like banks, mutual funds and brokers, who connect investors to firms (who need finance), have existed for thousands of years. Because they control a scarce resource, information, these intermediaries are expensive. Platforms, like crowdfunding platforms (organised meeting places for investors to meet firms) offer an alternative. Today's technological revolution is all about the competition between centralized intermediaries and decentralized platforms.

This lecture discusses the technological innovations that are responsible for this competition: crypto, big data, and AI.

A lecture by Professor Raghavendra Rau


The transcript and downloadable versions of the lecture are available from the Gresham College website:
https://www.gresham.ac.uk/watch-now/bypass-banks

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Transcript

0:00

- Let me start with a personal anecdote, right? How is technology affecting finance? But how does technology affect any of us? How does it affect our personal day to day lives? Well, as Wendy pointed out, my name is Raghavendra, and this is a complicated name. Most people find it difficult to pronounce, but I had no idea just how difficult it was until I realized that even computers had a difficult job pronouncing this. Let me explain. I use a service called Google Voice. So when someone calls my phone and leaves a voicemail, Google transcribes it into an email and sends it to me on email. So, this is what Google did to me. It says, "Hello, this is Robert Green. I'm calling you for National market Research firm. We would like to speak with, the Avenger."(students laughing) Raghavendra, the Avenger, kind of similar, right? I mean, I'm okay being called the Avenger, but it's kind of seems rather silly, right? So I said, okay, I'm going to change my name to something else. I'm going to shorten it. I'm going to call it Raghu. Unfortunately, technology screws up here as well. You type the word Raghu into Google and search for it, this is what you end up with, right?'Cause ragu sauce, you have ragu bolognese, you have ragu, but there's no human being. I said, all right, let me try something else. I took a photo myself, uploaded to Google, and did a reverse image search on that photo. Said, who is this person? And Google very confidently says, this is who you are. Some of you may recognize the gentleman. It;s Ben Bernanke, the former head of the Federal Reserve in America. Very important guy. He was charged of setting interest rates in America, and therefore the world, but he's also 20 years older than me. I said, okay, let me find someone else, someone maybe a little younger. And so Google says, this is who you look like.(students laughing) And some of you may human recognize this gentleman, right? Especially those who watching English Premier League football. It's of course Pep Guardiola. So what are we going to talk about today? Well, we are going to talk about the problems that financial intermediaries have, and specifically the major problem financial intermediaries have is how to deal with information, specifically, three types of information. Number one, imperfect information. We do not have enough information to make decisions properly. Second one, asymmetric information. The person on the other side of the deal has more information than we do. And the third one, behavioral problems. That means, in other words, even if you do have the right amount of information, we don't know what to do with it. We make mistakes in dealing with that information. So these are the problems that financial intermediaries face, and the thrust of my six lectures is about how technology is changing the way we deal with these problems. And in particular, I'm going to talk about three types of technology. Cryptography, big data, that is basically sensors/smartphones, and artificial intelligence. Let me start with an example of how technology transforms the world of finance, and the example goes back all the way to 1838 with the patent by Samuel Morse of the telegraph. Now, before the telegraph came along, what was the prior technology available? Well, there were homing pigeons, there was the Pony Express, people riding on horses from one town to another, there were visual telegraphs, people standing on top of big hills waving flags to each other, and railroads. The common thing with all these technologies were, number one, they were slow, number two, they were expensive, and number three, they were limited. So what did the telegraph do? The first thing the telegraph did was replace all these technologies, and it replaced them because it dramatically reduced costs. Initially, there were a bunch of firms competing with each other to introduce telegraph services across America, later replaced by a single firm, Western Union. And ultimately, the telegraph itself was displaced by a newer technology, the telephone. But how did the telegraph changed the world of finance? Well, the major thing that telegraph did was basically centralized prices. They had one price everywhere. Let me give you an example. In 1846 in New York, two cities, Buffalo, Upstate New York, and New York City, the prices of corn and wheat in Buffalo lagged four days behind those in New York City. What that essentially meant was, suppose you are buying corn in Buffalo, you have no idea whether the person who's selling the corn is actually maybe really want to sell the corn or maybe he has news that the price in New York is about to fall. You don't know which one is true, so you're always worry about trading in a place where the corn and wheat prices or prices of any commodities lags behind that of another place. Well, in 1848, those two markets were linked telegraphically, and the prices were set simultaneously, and this happened all over America, and people tried to capitalize with this one as well. Over the 19th century, literally hundreds of exchanges appeared and then disappeared all over the country. Only five exchanges remain important. New York, Philadelphia, Boston, Chicago, San Francisco, and each of them specialized. New York, for example, specialized in stocks and bond trading. 90% of stocks and bond trading today in Americas carried on Wall Street in New York. Chicago, options and so on. So each market specialized in a particular type of financial transaction. But why was centralization so important? Well, the big thing centralization does is increases liquidity. As I said, one of the things we are worried about in finance is that when we buy or sell something, the price moves against us because the market infers information from our trading. If he buy, for example, lots of corn, market thinks, oh, this guy has information about where corn is going to go, the price moves against us before we have a chance to take advantage of that. Same thing when you're selling, price drops when you're trying to sell because people assume that you know what's happening to the market. But when liquidity goes up, we become price takers, not price makers. So in other words, regardless of how much you buy and sell, the price doesn't move against you. Beyond this, because of the presence of increased liquidity, people were more willing to invest in these new (indistinct) securities, right? There was an increased amount of investment in the market, and brand new types of institutions arose to cater to this demand. You investors wanting to invest in these new types of opportunities. Well, a brokerage house would come in and say,"You know what, can help you buy shares, which will allow you to invest in these opportunities." Analysts came along to say,"Well, we'll help you analyze these companies to figure out which one of these are good investments." And of course, you have investment banks who came along to say to the firms,"We have an idea what the market is thinking, we'll enable you to price these shares appropriately." So all these new institutions arose because of technology. Eventually, of course, the telegraph disappeared. So from 1850, when the telegraph was first introduced, it costs about a $1.55 for a 15-word message. Price slowly dropped over time until 1902 when the telephone was introduced. And now notice that the price of a telephone call keeps dropping, the price of the telegraph keeps going up. Today, the cost of a phone message is effectively zero. Most of us have unlimited minutes or big buckets or minutes, so the marginal cost of a phone call is close to zero. In contrast, you can still send a telegram, by the way. Not everywhere. I don't know if any of us have sent a telegram. At least, I haven't sent one since possibly the 1980s. But in Japan, you can send a telegram. People send it for birthdays, for weddings, things like that. But the way they send the telegram is curious. You go to the telegraph office, you say, "I want to send a message congratulating this person on his graduation," the telegraph operator takes your message, types an email, sends the email across the country, person on the other side, prints out the email onto a telegram form, and then hand delivers it to the recipient. So, it's a telegraph sort of, but it doesn't actually exist anymore. But, so what this basically says is the telegram and the telegraph services improve the speed of communication, the telephone increased it even further, but is improving the speed of communication enough? Let's go back to 1754 BC, the Hammurabi code. If you just think of the Babylonian economy at that time, the Babylonian economy was partly barter, partly currency. So they had about a hundred laws, which talked about property and commerce, right? Things about debt, about interest, about collateral, and they had very strict standards to prevent usury. For example, if you are a lender, you can't charge more than 20% for a server-based loan, you can't charge more than 33% for a grain-based loan. You also had certification. As a lender, you could only sign, finalize the contract before a witness. And finally, those collateralization. So these are secured loans. Now, think of these four things. They are what we have today. Nothing really has changed from 1754 BC to 2022. So, there are some things which have changed. For example, collateral would be houses or property like today, but you could even use your wife or your child as collateral in those days. That, by the way, you cannot do today, right? If you really didn't have either a wife or a kid who blames you, I mean, you know, you're willing to sell them off as collateral, you would have to enter into slavery yourself to pay off your debt. Apart from that though, the rest of the features are pretty similar to what we have today. So what does the finance world look like today? Well, we have enormous sums of money wired daily across the world, right? We have card payments for the standard method of payment for most of the developed word. For example, I mean, I don't carry cash, right? Almost never have cash. Everything is on my phone, or payments by card. If you want to borrow money, credit is granted with credit score models, but none of this is really new, right? If you think about wiring money across the world, doing the crusades, when the knights would go to the Holy Land to fight the infidels, they would carry letters of credit with them from their banks. The letters of credit is just an ancient form of what we do. Now we wire transfer the money, then you would just go from, carry a piece of paper with us to tell the bank there to advance us money on our account back home. Card payments is just an advanced form of store credit. In fact, the earliest credit card was in New York where a group of merchants, basically restaurants, got together to have a Diners Club. And the idea is, if you have a Diners Club card, you can go to a restaurant and have a meal. Basically, you're taking a loan to have a meal. You pay off the loan over time, right? But that store credit, and store credit has been around since stores have been invented. Nothing new in this. Or even the credit score models we used today. 300 years ago, we'd have the same credit score models being used. So what's the takeaway here? The takeaway is simple. In the past, technology has dramatically reduced the cost of collecting and processing information, but it has not changed the business of making payments and loans, and it has not eliminated the essential frictions involved from adverse selection to moral hazard, right? For example, if you took a loan the time of Hammurabi, you'll face roughly the same moral hazard and adverse selection of a loan at the time of Bill Clinton. And just as important, the incumbent institutions were the only ones who had the money to apply new technology. So whenever you had new technology coming along, the incumbent institutions would apply it first, and they would earn more money. So, what has changed? Well, there have been lots of developments in the last 10 years. Some of these developments include, central bank issued digital currencies, what we call GovCoins, we have private digital currencies, Stablecoins, we have decentralized finance, what we call DeFi, we have tech platform firms arising, Apple, Google, Alibaba, we have big data, we have AI algorithms who understand who you are and predict your preferences. What are the technological innovations that cause this change? As I said, there are three major innovations I'm going to talk about in this series. The first one, cryptography, the second one, big data, basically sensor technology, right? So beginning with introduction of the first smartphone, the iPhone in 2007. And of course artificial intelligence. There are a host of other ancillary technologies. For example, you need hard disk space, that's the cloud, you need cheap computing power, processing powers become cheaper and cheaper every year, but that's ancillary. It doesn't really change the business of finance. The first three have really changed the way finance works, and that's what I want to focus on. To understand that, let me give you a very simple picture of the cycle of finance. What we have here on the left-hand side is the firm. The farm needs money to invest. It doesn't have any money. The people with the money on the right-hand side, the financial marketers, the investors. So the firm goes to the investors and issues securities. What are the securities? Well, short-term debt, long-term debt and equity. What are these things? Well, they're basically pieces of paper. For example, debt would be a bond that looks like this. It says, give me money, and in return, I'll give you interest payments every six months, and then after two years, I'll give you your money back. Or for five years, I give you your money back, whatever. Or they can say, give me your money and I'll give you a share of my profits. If I make a lot of money, you make a lot of money. I lose money, you may lose some money as well. So the different type of financial instrument. The market values these financial instruments and decides how much they're worth, and so they transfer the money to the firm. The firm takes that money and invests in assets, short-term assets are called current assets, long-term assets are fixed assets. In a restaurant, for example, your current assets would be your food, your accounts receivable, things like that. Your fixed assets would be the building, would be the kitchen equipment, like, the refrigerator and so on. Your long-term assets. But the key is, those assets generate cash flows. Part of those cash flows go to the government in the form of taxes, unless, of course, I guess, if you're part of the trust government, which doesn't believe in collecting taxes. Part of that is retained by the firm in the form of retained cash flows, and part of it flows to the financial markets in the back for dividends and debt payments. Well, this is the cycle of finance. Money flowing from investors, the firm, flowing back to the investors in the form of dividends and debt payments. So, where do the banks fit in? Well, the key thing is, the firm and the market don't know each other. The firm doesn't know who is willing to offer money. I don't get any emails in the morning, for example, from Google saying, "Hey, we have a new investment project, would you be willing to give us money?" I mean, I'll pay nothing. I do get some messages from Nigerian princes, but those have been falling off lately as well, right? But apart from that, we really don't see, we don't see anybody, the firm doesn't know who we are, we don't know which firms need money. So, the first job of a bank is to match the borrowers and the lenders. I deposit my money at Barclays, Barclays lends the money out, but I don't know who Barclays is lending to. The money goes beyond my sight. I don't know and I don't care. The second thing is that, when I deposit my money in a bank, I expect to withdraw my money at the drop of a hat, right? So, for example, I might go to to a restaurant, and I want to pay my bill, I want to be able to withdraw my money from my bank account right away. So that's a short-term deposit. But firms don't borrow for the short-term. They borrow for five years, they borrow for 10 years, 20 years, so the bank has to transform maturity from short-term to long-term. And of course the borrowers have to be good because if the borrowers don't pay back the money, the bank is out on a limit. So the borrowers have to be assessed for credit worthiness. And finally, the banks provide liquidity. So, this is the major rules of most of these banks. Do they make money? Is this lucrative? The answer is yes. How lucrative is this? Well, this graph here is taken from a paper by Thomas Philippon who's a professor at NYU. What he shows is, in 1880, this graph year represents finance income as a proportion of GDP, US GDP. So in 1880, if you look at that number, it says, 2% of American GDP was in the finance industry. By the year 2014, it was 8%, that basically means that the finance industry has grown in importance by four times. It has quadrupled in importance over 130 years. So why do banks make so much money? Well, typically three ways. One is, of course, we talked about matching borrowers and lenders, but that's one of the ways they make money. I deposit my money in a bank, I get maybe 1%, maybe 1.5, it's really generous these days, but the borrowers pay eight or 9%. That difference, the net interest margin is what makes the banks the money. Second thing, they facilitate easy payment. So when I make a payment, Visa, MasterCard, a group of banks get that money, they charge a fee to the merchant when I make a payment. And, of course, bank charge fees. They charge fees for everything, right? They charge fees for finding good investments. They charge fees for advising firms, like in corporate finance, for example. In fact, I was actually recently reading a novel by an author called Alan Campbell. Very good author, highly recommend him. But it's called "Damnation for Beginners." It's about this old woman who comes to a bank to complain. And she says, "Look, I borrowed money from you guys a long time ago to buy my son a graduation present, and I've been paying back that money, and I've been paying it back for eight years. Money wasn't that much. I didn't borrow that much. Why am I paying back so much money?" And the teller looks it up and says,"Well, I see that you actually did pay back the money. You were supposed to make 26 payments." She says, "Well, I made 86 payments." And says, "Well, no, you were supposed to make 26 payments, but on the 26th payment, you paid too much.""Instead of paying 10 pounds, which is what you were supposed to pay, you paid 20 pounds." So we said, "What are we going to do with the extra 10 pounds?" And we said,"Well, obviously she wants to open an account with us, so we opened an account for you.""Unfortunately, our account opening charges are 20 pounds, so we gave you a loan to open your account for with us, and, of course, you have to pay interest from that loan, which you didn't, and then you have to pay interest from the interest, which you didn't, so now you owe another thousand pounds." Now, this is a story, right? But there's an uncomfortable element of truth in some of these stories. Okay, so our bank's doing a good job. This is the second graph from the same paper by Thomas Philippon, and this shows you the profits that banks are making on the amount of money they manage. What you see here is the ratio of finance income to the level of assets they manage, and notice a difference between this graph and the previous graph. Previous graph are very steep, This is relatively flat. What does that mean? Well, what this means is, profits from financial intermediation have been relatively constant for the last 130 years at about 2%. What that means is there have been zero efficiency gains in banking since 1880. Whatever work your grandfather would do at a bank, that's pretty much the kind of work you do at a bank today. Kind of depressing when you think about it. Anyway, this would all be okay if banks were doing enough of their jobs, aren't they? Well, let's talk about before to after the financial crisis. On the top left hand corner, that's the amount of European securitization across Europe before and after the financial crisis. At the beginning of the financial crisis, banks are about 710 billion pound of use securities available. By 2012, that had dropped to over 240 billion. Simultaneously, the Bank of England and other central bankers around the world dropped interest rates. So the average interest rate of the Bank of England from '75 to 2008 was 8.6%. On 2009 to 2013, they averaged 0.5%. And after that, from 2013 onwards, for a few more years, it became 0.25%. Very little opportunity for the banks to make money on that. Simultaneously, people became very comfortable doing stuff online. And most interesting, right in the bottom-left hand corner, there was an survey done by the British Social Attitudes group, and they would ask firms every year,"Do you think your banks are well-run?" They ask people every year,"Do you think your banks are well-run?" In 1987, 91% of the people they asked thought that banks were well-run. By 2012, that number had dropped to 19, a drop of 80%. Effectively today, banks are usually at the bottom of the trust tables every year. Year after year, banks are at the bottom. This is the latest Edelman Trust results. So Edelman Trust has this surveys every year where they ask,"What do you believe?" Do you believe that any of the people in these industries will do what is right?" It's kind of impressive. The banks stay usually right at the bottom of the trust tables, right? This 2021, the only industry that did worse than banks was social media, but that's relatively new. Banks have been consistently at the bottom of their class every year since the Trust Barometer was introduced. So I want to ask yourself, do you really need a regulated financial intermediary today? Well, if you eat alone, you can go to LendingClub or Ochoa to directly borrow loans without a bank being involved. If you want to buy cryptocurrencies, there's things like Coinbase, which will allow you to buy cryptocurrencies. If you want to send cash overseas, Wise will do that for you. You want to buy a house? Social finance, SoFi, will lend you money to buy a house without needing a bank. If you need a wealth manager, Wealthfront and Betterment will manage your money for you. If you want insurance, car insurance will be provided by Root, Lemonade provides gadget insurance. If you have no idea what banking alternative you need, you can go to angel List. It has a list of literally hundreds of banking alternatives, all of them providing services that the banks do not do. So, what are the pain points for traditional banks? The first one is, of course, this emerging competition I was just talking about, but that's just FinTech companies. There's a whole bunch of other competition also coming into play here. For example, we have tech companies, we have telecom companies, and, of course, the FinTech startups. Customer expectations have been evolving over time. The burden of regulations on banks has dramatically increased since 2008. And finally, banks operate with a host of legacy systems. Systems written in the 1970s and the 1980s. Let me ask you guys a question here, What would learn a computer language today for finance, what do you think is the most lucrative computer language to learn?- [Student] COBOL.- Okay. Excellent. The answer actually is COBOL. Excellent, right? COBOL is a language which was written in the 1970s. It was actually my second computer language. It shows how old I am. But the point where COBOL was, all bank programs are written in there, but all COBOL programmers are retiring or dead. Well, I'm not yet either, but the point about this is, if you want to learn how to run these systems, you have to go to think about how to maintain the bank current system, you bolt on new stuff onto this. This is like flying a plane and repairing the engine while the plane is flying. It's super tough bank to do this. So they create, they have a lot of problems, and the biggest problem deal with information. And as I said, three types of information, imperfect information, asymmetric information, and behavioral problems. We'll talk about these issues as we go forward. But for first, I want to focus on asymmetric information for the remainder of this talk. So what is asymmetric information? Asymmetric information arises from something we call principal-agent problems. A principal is someone who hires an agent to do something for them. For example, if I hire a mechanic to repair my car, I'm the principal, the mechanic is my agent. If I hire a broker to sell my house, I'm the principal, the broker is my agent. If I'm working for a company, the company is the principal, I am the agent. So principal-agent problems are everywhere, but there are two big problems for finance. One is called adverse selection, and the other is called moral hazard. What are these two things? Well, adverse selection arises before you write the contract. For example, think about a car insurance company. If you are a car insurance company, what type of drivers do you want? You want safe drivers, right? You do not want reckless drivers. They'll have accidents, and it costs too much to keep them. So, what do you do? You can ask them, right? Are you a good driver? But honestly, who's going to tell me that they're reckless or a horrible driver, right? It's almost impossible to get that information from you. That's the adverse selection problem. It's called a hidden information problem. The information that the agents have, that you want to get out of them, but they won't tell you what that information is. Adverse selection. The second problem is moral hazard. Moral hazard is after the contract is written, the person changes their behavior. For example, this is called hidden actions because you can't see the actions after the person signs the contract. Again, going back to the car insurance example, now that I'm insured, I drive a little less carefully than I would had the car not been insured, because now the insurance will pick up the tab if something goes wrong. So let's see how these problems, the way banks and other insurance companies and other financial institutions, let's see some new and novel ways of solving these two problems. Let's start with a simple question. If you borrow money from a bank, assume you're credit worthy, assume that you have the ability to borrow from a bank, I'd like to see... I can sort of see hands over here. But let me ask you guys, would it be easier to borrow a hundred pounds from your bank or a hundred thousand pounds from your bank? Let's take a show of hands. How many people would say a hundred pounds? Okay, excellent, hands going up. Beautiful. A hundred thousand pounds? Okay, some hands going up there are two. The answer is, I'm going to side with a hundred thousand pounds rather than a hundred pounds. The reason is very simple. The bank has the same adverse selection problem as it always had. It has to judge whether your credit worthy or not, whether you're going to pay back the money or not, so it has to put somebody on the job. Somebody goes through your credit files, somebody checks whether you have an employment record, somebody checks all these things. For a hundred pounds, there's no profit. The profit margin is so small, I can't hire somebody to look at you. For a hundred thousand, I have a ton of margin to look at you to figure out whether you're a good customer or not. So in other words, basically, it's not worth it. For a hundred pounds, the bank says,"I'm not even getting out of bed in the morning." I mean, if the bank said something like that, right? So, now I'm going to show you an example where it works in a completely different way, microfinance. The first microfinance institution, Grameen Bank, was set up by Muhammad Yunus in 1976. He actually got on Nobel Prize, a Nobel Peace Prize, for that a few years later. But the average loan Grameen Bank makes is about $270. Not $270, $270. How do you make a profit with 270? If you go to Sri Lanka, the average loan is $180. That's tiny. How enough do you make a profit with $180? Muhammad Yunus' big realization was, he has to solve this adverse selection problem. He has to figure out who are these people who'd be willing to pay back their money? In addition, he has to figure out, how many of these guys are not going to change their behavior after borrowing from you. Now, the bank manager can't do this, right? I mean, they go around the villages in Bangladesh and so on, but they can go around maybe once a month, maybe once a quarter, not enough. So, the big innovation here was that, the people who most capable of monitoring you are your neighbors. So Yunus, basically, in Grameen Bank, does not make loans to individuals, they make loans to groups of people. Maybe 20 people. Usually, women. Women are more trustworthy than men, right? Men tend to get drunk and gamble and stuff like that, so Grameen lends mostly to groups of women. And to get into a group to borrow from Grameen, you have to be introduced by somebody in the group already. So that means basically somebody's already solving the adverse selection problem. This person will pay back the loan. But why do you solve the problem? Well, Grameen also tells the women, if any one person in this group doesn't pay back their money, the entire group gets your loans cut off. So now you have an incentive to watch what your neighbors are doing. If your neighbor's not, take the money and goes gambling with it, they're like, "Sorry, that's my money you're gambling with." So they keep their fellow members under control. That's an example without technology. Let me give you an example with technology. This is another company. This is one of several companies, this is not the only company, which it's called Tala. Tala operates in four countries, Mexico, Philippines, Kenya, and India, and here you make loans on smartphones. So you apply for a loan using a smartphone. So, what kind of information does Tala ask you? And Tala doesn't lend to groups, it lends you individuals. Okay? So what kind of information do you think a company like Tala wants before it makes you a loan? Let's ask some questions. So, credit history, what do you guys think? Yeah, yeah? I see hands going up. Okay. What about jobs? That be okay? Yeah? Salaries. Any others? What else do you think Tala would ask for?(student speaking faintly)- Residence?- Excellent. Answer is, none of the above. What Tala ask is very simple. You upload your photo, you answer maybe a three-question questionnaire, and that's it, and they make you alone. Wait, how are they solving the adverse selection problem? The answer is, when you install an app on your phone, the app usually asks for permission, Can I access your location? Can I access your camera? Can I access, blah, blah, blah, right? How many of us actually pay attention to that? Do we? Many of us just say,"You know what, okay, whatever, I just want the app." But during that time, when you're making the loan application, the first thing that Tala does is to check all your contact list, right? Do you have any of your people on your contact list borrow from Tala before? If they have, have they paid back the money? If they had paid back the money, that's good news, because assumes that people hang out with other people who are like them. If your friends haven't paid back the money, you're not going to get a loan because they assume that deadbeats hang out with other deadbeats. But that's not all. Maybe all your friends, none of your friends have borrowed in Tala before, and Tala checks your entire list of contacts. How many people do you talk to on a regular basis? You talk to at least 56 people a month, that's a sign that you have a deep, broad social network. You can call on people to get money, maybe, if you owe money to Tala. How many people do you talk to, on the length of time, to at least one person? You talk to at least one person for more than four minutes a day, that, you have a deep social relationship to at least one other person. It goes deeper. How do you spell the names on your contact list? For example, if you say Raghu, gardner, right? Many of us do that for our contact list. I can think of examples. Or so and so. Mechanic, something like that, right? We put names down names like that, just the first name and the occupation to call people for their phones. It's not good. If you, on the other hand, if you had typed in capital R, A-G-H-U, space, capital R, A-U, open parenthesis, mechanic, closed parenthesis, that's someone who's really anal. That person is 16 times more likely to pay back the loan than somebody who writes, Raghu, mechanic. So be very careful when you're writing stuff in your contact list. But that's not all. Next, we move to location. Every few minutes your phone is calling out the closest cell phone tower saying, here I am. I want messages or I want data. I want something. So, your phone is tracking you minute by minute. So what happens? Well, if it turns out that fella just checks your location records, if your phone is in the same place every night

from 9:00 PM to 5: 38:24

00 AM, Tala knows you have a home. Because if you are homeless, your phone are in a different place every night.

What about from 9:00 AM to 5: 38:32

00 PM? If you're on the phone is in in the same place there, it knows you have a job and I know approximately where the job is, right? You can tell right from the location services on your phone. So, I don't need anything else. Your phone has already given me all the information you need. Let me take another example. Car insurance. This is a company I mentioned earlier called Root. Now, remember, the car insurance companies want safe drivers. How does insurance pricing model work? Well, the way it works is, you have maybe a pool of, let's say, a hundred drivers. Of those, 10 reckless, they will have accidents, 90 of them were safe. So what you do is you collect premiums from all the a hundred and hope that the premiums will pay off the reckless driving accident of the 10 people and leave a profit left over. Root doesn't do this. What Root does, it looks for traditional things, but it also asks you to download an app onto your phone. So, what does the app do? Well, it turns out, they look at a bunch of factors. The traditional pricing model says, what's your credit score, what's your driving record, what's your age, what's your marital status, and so on. Root add to that by looking at your driving behavior. That means, while you have the app on your phone, what you do is you download the app, you keep it on your phone, you don't have to have it open, you just have it on your phone. And while you have the app open, while you have the app on your phone, Root is monitoring everything about your driving. How fast you drive? Do you go around corners too fast? Do you break too suddenly? What is the congestion on the road you drive? I mean, that's from taking from Google Maps or things like that. So many of us are thinking,"Wait a minute, when I have the app open, I'll drive carefully." I mean, I'll get a good rate, and then I'll drive normally. Root has already thought of that. Turns out, that when you download the app, you drive around like you normally would for a few weeks, not a couple of days, for a few weeks. I can guarantee first day you might drive super carefully, second day, maybe a little less carefully, day three, you have totally forgotten there's an app in your pocket monitoring everything about your driving. So, what happens if you're a bad driver? Root says, "Well, we don't want you.""You're not a good fit." Root isn't the right fit for everybody. A model don't work... It's a polite way of saying, you're a terrible driver, I don't want you as a customer. And the Root app doesn't need to be open, you basically just give it permission to run in the background. Same thing, which I just talked about. Now, what happens to these other people? Well, who do they go to? The other insurance companies which are not using technology. So now the pricing model of the other insurance companies changes. They started out with a pool of 90 good drivers and 10 bad drivers. But the good drivers have all gone to Root, and the bad drivers have come to you, so suddenly you have a model where you have 80 bad drivers and 20 good drivers. The only way you can make a profit, increase your insurance premium. But if you increase your insurance premium, the good drivers leave. Eventually, you get driven out of business. So one of the conclusions from this is, if one company is introducing technology, everybody has to. It becomes a Red Queen's race. Okay, let's take another example. Gadget insurance, Lemonade. Now, many of us, when we pay our premiums every month, and something happens, like, we break our laptop or we break our phone, and it is our fault, do we say, "Oh, this is my fault. I'm not going to ask the insurance company to pay for this." Some of us do. We have very honest people. But some of us will say,"You know what, I've been paying my premiums. I'm not going to tell the insurance company it was my fault. I'll say, it's an act of God.""The dog grabbed my laptop and dropped it into the commode or something like that." So, that moral hazard, and Lemonade want you eliminate that moral hazard. The likelihood of you claiming for stuff, which is really your fault and you know it. So what does it do? Well, this pricing model works like this. When you sign up for Lemonade, it asks you for what do you care about? For example, you might say,"I care about saving the dolphins or saving a whale," something like that. So what Lemonade does is basically says,"Look, we pay your claims, and if you do not claim, we will give the remaining money after we take our cut to causes you care about. So the hope is, if you're making a claim for something, which is your fault, you're actually taking money away not from Lemonade, but from something you care about, so you might be more reluctant to make that claim. Lemonade tries its best to really emphasize that by putting all the stuff on his website like,"We provide life saving care to so many rescued animals. We planted so many..." Good stuff, right? So you're more reluctant to claim if you are working with Lemonade. Now, let's invert the moral hazard problem. This is Coventry First. Usually, more hazard means, these guys are doing something which is bad for society. For example, you're driving fast, you're driving recklessly, could have an accident, hurts people, that's bad. Coventry First is a different model. In America, one of the things with American life is that your medical insurance is tied to your job. If you don't have a job, your medical insurance, not so good, or non-existent in some places. But if you're working for a company, you have medical insurance and in some cases, if you're important enough, the company will take out a life insurance policy on you, It's called key man insurance, and what happens is, if something happens to you, you have a heart attack or something, the company has been paying the premiums on your behalf, they collect the money on the life insurance policy and use that either to treat you or replace you or whatever. So here you are, medical insurance through your job, life insurance, through your job. Now, suddenly you're fired. Or in American parliament, they let you go. I mean, it's not like, we've been holding you back all those time, and now you can fly free to new places, new adventures, right? That's terminology. Anyway, so they've let you go and they're like, and you're like, "Man, I need medical insurance." And they're like,"Oh, well we have this life insurance policy. We are not going to keep up the premiums. It's useless to us, so here's the present. Farewell present. You can keep it up and you keep paying the premium, you're totally fine." But you don't want that, right? You want medical insurance, not life insurance, so you can go to Coventry First. In this particular case, this guy had a life insurance policy of 1.5 million, and he went to Coventry First, and Coventry First said,"You know what, we'll pay you $196,000 for it, we will keep making premiums on your behalf, and when you die, we collect the money." These are called debt bonds for obvious reason. So what you do is submit a questionnaire, authorization to Coventry First, along with carry illustrations, medical records over the last five years, Coventry First determines the value of there policy, and then there's a change of ownership or beneficiary forms for insurance company, and then it continues making payments on your behalf, and when you die, they collect insurance. Now what's the problem? The problem is, what kind of customers this Coventry First want? Health insurance companies want healthy customers. These guys want unhealthy customers. The ideal customer is someone who sells an insurance policy to you, walks through the door, and drops dead of a heart attack right there. Perfect customer. And talk about doing things for social, right? So these guys, in normal life, if there's car accident and stuff, bad for society, but these guys are going to use their $196,000 to buy medical insurance to keep them alive, which you don't want either, but you can't stop them. I mean, that's why it's such a weird and interesting, innovative model. Anyway, point of course is, that's one problem. These guys are doing tough, which you don't want them to do, keeping themselves alive. The second problem is, how do you find out when the guy is dead? Because nobody, and I guarantee, nobody on that deathbed, on that dying breath say,"Call my insurance company, I am dying." Nobody does that, unless they're collecting the premium. These guys aren't, right? So Coventry First has a line in their contracts, which says something like,"We have the right to call you on the first of every month, and you better pick up the phone. If you don't pick up the phone, we're going to assume you're dead, right? So, you have picked up the phone and you call you, and they say, "How are you feeling? You're still alive. Oh, dear." They don't say that out loud, but you know what I mean. Well, that's an inverting moral hazard problem. Let's talk about another model. Reducing adverse selection. This is a company based in Germany, which is about 600 million Euro turnover, 3000 employees, operations in 20 countries. Now, what was interesting about this company was that its banks were exposed to the Asian financial crisis in 1997. So what happened was the bank said,"Look, we have the big crisis, we have lost a lot of money, so we are cutting off any funds going to the firms in Germany who are not exposed to the crisis." So the CEO of this company got mad. He said, "You know what, I spent all my time trying to get firms and stuff filled up for the stupid banks, they won't gimme any money when I really need it, I'm never going to deal with the bank again." So what he did? Put an ad in the local papers. He said, "Guys, the bank is paying 4%, I'll pay 5%. Give me money." And the German regulator said,"You can't do this, you're not a bank." And he said, "Well, what can I do?""Well, you can issue bonds." He said, "Well, bond, that's like a fixed deposit. Fine." Put an ad in the paper saying,"I'm offering bonds for 5%." Now, who are the most likely people to buy the bond? This is a small town in Germany. So, local people, right? They walk by your plant every day, they talk to your employees, they have beers with your employees, they know how healthy the firm is, so they're more willing to give the firm money. Unfortunately, that seems like a particularly small market. I mean, small town in Germany, how much money can you raise? These guys have been doing this from 2002 to 2013. That's last year. We have data, but they've been going on for a very long time. What really enabled them to survive was the development of what we call evangelical investors. That's a form over there. Now, what turns out, that when people give money to things which are... This is an unlisted company. It's an unrated company. It could be risky. We don't know. So what do you do? You give money to this company and you're nervous about it, so you tell your friends. You're like, "Hey, look, why don't you invest in this company too? My friend invests, they've done their own investigation, it reassures me a little bit." So these guys started talking about it to other people. They were what we call evangelical investors, and these guys expanded and expanded and expanded year after year after year. So until 2013, they're all over Germany. One company over there raising money all over Germany, almost entirely word of mouth. They never went back to a bank after 2013. But these are just the beginning of all the things we're going to be talking about. We have been talking about alternative ways of raising finance. We've talked about direct issue bonds, where there's also crowd funding and peer-to-peer lending. We can talk about alternative wealth management systems, advisory services, global advisors. We've just talked about debt bonds. Alternative payment systems, so mPesa, alternative remittances, alternative Visa, SWIFT, inter-bank transfers, Bitcoin, distributed ledger systems. Why are all these technologies taking off now? Well, back in 2000, when my students would come to me and say,"I want to start a new business," how much money do I need to raise?" I'd say, you need about $5 million from a venture cap fund or an angel investor, but in 2005, the rise of open source software like GitHub where you can just download the modules you need, drop the price to $500,000. Beyond that, the introduction of the cloud, the Amazon Web Services here meant that you could start a business with just a laptop. You just need to be connected with the cloud. You could rent hard disk space. Today, the cost to start a new business is $5,000. This is incredibly cheap. Let me give you a couple of examples. Both my students, one of them came to me a few years ago and he had said he had started a new blockchain company, blockchain for initial public offerings. I said, "How many people are in your company?" He said, "Three." I said, "Who are these three people?" He said, "Hey, I'm the CEO, my wife is the co-CEO because she doesn't want to be working under me, and, of course, I have this third guy who's the chief operating officer." I said, "Who's this third guy?" And he said, "Well, we met him and he has this team, so it's like 'The Magnificent Seven'." There's one guy who deals with web services, there's one guy who deals with the banks, one guy who deals with technology, they go to new businesses like this, they take the company, make it successful, and then collect the money, and then move on to the next village to save them and so on and so forth, exactly like the "Seven Samurai", if you guys have seen that. The other example is, actually, another of my students who was from Zambia and he got two job offers. One job offer was from a mining company, which is old company, which is involved going to a mine, digging for mine or ore, or refining it and selling it abroad. The other one was an educational technology company. Financial literacy in Africa is a big problem, and so the educational technology company was to try to get people more involved, more financially literate in Africa. He said, "Which company do you think I should join?" I said, "Educational technology sounds more interesting to me." He said, "Yes, but I have a son. I mean, he's just one year old. I need a steady paycheck.""The ed tech company is not giving me a paycheck. What should I do?" I said, "I can't give you any advice, I'm not in your shoes, I don't have any kids." So he said, "Okay, fine, thank you for nothing," and then, you know. I met him a few months ago and I said,"Which job did you end up taking?" Let's take a show of hands. How many people say he went to the mining company? Couple of hands out there. Okay. Few hands at the back. How many people say he went to the educational technology company? Several hands up here, excellent. Hands up there, beautiful, beautiful. The answer is, he took both. I said, "What do you mean you took both?" He said, "Well, I work in the mine during the week, in the evenings, on the weekends, I work on the educational technology company." I said, "Where is this education technology company based?" And he looked at me like I was crazy. I mean, I said, "Where's the headquarters?" He said, "What headquarters?" I said, "Where do you people meet?" He say, "I haven't ever met them." One guy's in Singapore, one guy's in Manchester, one guy's in Australia, I'm in Zambia. We just connect on Slack and we work on the thing together. We don't physically have to be there. That's one of the reasons why these technologies are taking off. It's so cheap to start new technologies. And I'm, as Wendy pointed on the beginning, I run the Cambridge Centre for Alternative Finance. This was established in January, 2015. We are looking at all these research themes. Our website is available here and all the information was published, is free on our website and we talk about FinTech and how it's changing the world. Next time, next month, I'm going to talk about blockchains, and I'm going to talk about why blockchains succeed, and I'm going to talk about them without any technical knowledge whatsoever. So, we talk about how blockchains work using the example of Romeo and Juliet, but that's for next time.(students applauding)- [Student] When I'm going to do business with a company, one of the first, I have a series of questions I ask myself are then, one is, what is your business model? Particularly, if it's a free company, a free service. Secondly, what is your liability model? In other words, if it goes wrong, who do I shoot and where do I find them?- Those are good questions. The point in think about this is most of these are the initial stages, at least, they're just that, the business ideas. It costs you almost nothing today to experiment. And it works, then you take it to a more traditional route. But at the beginning, it's much easier to experiment. Play with it, see if it works. If it doesn't, abandon it and move on. I think that is the difference. And a lot of these things do not actually have to be regulated yet until, for example, DeFi models, which I'll talk about in January. Most of them are unregulated, and the people working in these areas don't exactly know how regulation is going to be applied to them, so they have never dealt, in many cases, with the formal financial intermediaries. That's an interesting issue, and we'll talk more about that two lectures from now.- (indistinct) asks, "The app use that you've described contradicts Data Protection law. How on earth do they get away with it?"- Which app? Sorry, the Tala app?- I think he means the, or she means the Tala app.- Yes.- The app, yes.- Well, they ask you for your permissions. I mean, you've given them permission. If you do not give them the permission, they do not give you a loan.- [Student] It's also a function of where it operates.- I'm sorry?- [Student] It's also a function of where it operates. It wouldn't be able to do it in the US or the...- I don't know. Root, for example, gets a lot of permission to track exactly where you're driving.- [Student] In the US, we just pretty much prevent asking their permissions, do they?- [Wendy] That's interesting, isn't it?- It could be. But do note that a lot of apps, even in the UK, do ask for a lot of permissions and you have no idea where it's going. You don't know what they're doing with the data. So, in this particular case...- [Student] If you are in United States, you have to actually stipulate the purpose of your data collection.- Fair enough. I'm agreeing with you there. All I'm trying to say is, in a lot of cases, these guys collect information and you still don't know why they're using that information.- Do you think some of the big banks and financial institutions will go under due competition from linear tech startups?- That is an excellent question. As I answered in that previous answer over there, one of the issues which happening is, many of these people with these startups, they don't know how the modern financial world works. So, there is this friction right now where the traditional financial intermediaries are saying,"Well, we are regulated, the government is allowing us to do this stuff, these guys are doing stuff which is not allowed." How is that friction going to be resolved? It's an open question. I don't know what's going to happen, but there are lots of fascinating developments in this world, in this space.- Raghu, thank you so much and we're very much looking forward to the subsequent lectures in your series. Thank you, everyone, for joining us.- Thank you, Wendy.(students applauding)