As we’ve noted in the past, global regulators are trying to poke into the “shadows” of the financial system so that all the stringent reforms pending for banks don’t simply drive business out of the regulators’ reach. So far, the focus has been on “credit intermediation” – that is, shadow activities that mimic the maturity transformation long the hallmark of commercial banks. However, there’s another major shadow financial activity – non-bank payment system operations – that warrants immediate attention.
Several years ago, a large banking organization asked us to look at PayPal for them as a potential acquisition. PayPal then was largely a venture-capital concept with more cool charts showing “beamed” money than customers. When we assessed the product, we thought it looked a lot like banking – after all, it’s principally about taking one person’s money to give it to another to execute a transaction. As a result, we thought PayPal would be regulated as a bank. We were right at the time, but PayPal then craftily redesigned a few finesse points and squiggled out of bank regulation. The rest, of course, is payment-system history.
Since PayPal’s launch, lots of other nonbank retail-payment products have swallowed traditional banking functions. Whether through acquiescence or distraction, large retail banks generally let the PayPal phenomenon go unchallenged. Now, though, three large banks are circling the wagons, recognizing that an array of new technologies poses a still more profound challenge.
Benign neglect is no longer possible because Congress has stepped in. Under new law, both debit and credit cards are under stringent new rules that sharply curtail profitability. Most of the substitute payment products are not, however, similarly honored with Congressional attention. As a result, if it’s no longer possible to make money with traditional retail payment instruments – at the least, a challenge should the FRB’s interchange rule advance – the only way to stay a player in this critical business line is with non-traditional payment instruments. If banks continue to give this game away to non-banks, their fundamental role first will fade and, then, end in favor of these unregulated innovators.
Should regulators stand by and let this happen? If one reads all the rhetoric about shadow banking’s risk in the credit intermediation business, one would think regulators would be hot on the trail of shadow banks in the retail payment market. Risks here are different – operational, not credit – but risks there are nonetheless. And, these risks can well be systemic, as any sudden disruption of retail payments is of course a potential systemic event.
But, to date, there hasn’t been a peep out of the U.S. bank regulators, the Financial Stability Oversight Council, or the Financial Stability Board about retail-payment products. We suspect it’s because they are all wholly preoccupied fighting the last systemic crisis, when credit intermediation was of course a serious, systemic sore spot. But, as always, new risks lurk and the shadow payment system – rapidly growing and outside the heavy hand of regulators or the vengeful scrutiny of Congress – is the place to look.