The Business Lending Blog

A Macro Economic look at ‘crowd funding’ Worldwide

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John Stuart Mills, an English economist, once explained “a crash doesn’t destroy wealth, it merely reflects the extent to which wealth has already been destroyed by stupid investments made during the preceding boom.” This explanation suits the origins of the 2008 banking crisis.

When Ireland joined the EU in 1999, it gained seemingly unlimited access to credit. This allowed banks to lend much more than they could borrow. In the three years prior to the 2008 crash, AIB and Bank of Ireland doubled their loan books. Not only were they borrowing more than they could afford, increasingly Irish banks were lending to unqualified borrowers. Competing banks became reluctant to refuse loans out of fear of losing customers to competing lenders. Because there was more money available to lend than there were quality loan demands, banks relaxed their lending standards in order to get business. With the booming global economy, the risk of default seemed nonexistent. Leading into the crash of 2008, Irish banks were approving loans that were unsupported by cash flows and were secured by nonrecourse personal guarantees. When the global economy softened, foreign banks began “call in their loans” – ie to ask their Irish counterparts for their money back. Because Irish banks had been borrowing on the short term and lending on the long term, when the foreign banks called for payment of their money, Ireland had nothing to give them.

What Ireland’s Central Bank governor Patrick Honohan called one of “the most expensive banking crises in world history” ended up costing Ireland €64 billion. Bankers threatened the government with economic collapse brought on by a run on the banks unless they were bailed out by the government. The government capitulated, and the bailout started in September 2009 with a government guarantee followed by a recapitalization of the three largest banks – Bank of Ireland, AIB, and Anglo Irish Bank.

Ireland’s banks are still smarting from the aftermath of the 2008 financial crisis. Limitations on available credit to lend is coupled with strict new regulations on lending standards and practices to create a very different lending environment than existed before 2008. As a result, small and medium businesses (SME’s) trying to expand in today’s Irish economy find it hard to secure a bank loan. This is why there is a strong demand for alternative sources of lending in Ireland.

Of course, Ireland’s isn’t the only economy in which access to credit is limited in the post-2008 environment. Throughout Europe and the U.K. SME’s are struggling to acquire the funding they need to succeed. Additionally, the unemployment rate in Ireland has risen from 5% in January 2008 to 13.5% in March of 2013. Preventing capital from reaching small businesses is only exacerbating the increase in the unemployment rate. According to the Ewing Marion Kauffman Institute, on average, start-up companies create 3 million jobs per year while existing firms lose 1 million jobs per year. Clearly help is needed to finance new SME’s in Ireland. One of the most successful and prominent means for SME’s to access alternative finance is through crowdfunding.

The economic benefits of crowdfunding are plentiful. Fred Wilson, a prominent American venture capitalist, calculates that “if Americans used just 1% of their investable assets to crowdfund business they would release a $300 billion surge in capital.” Aside from the most obvious advantages, the survival of SME’s and pumping money into the economy, there are more subtle gains as well. For example, entrepreneurs are put off from creating new entities in slow economies. In order for an economy to get back on their feet, it is vital that there is innovation to create jobs and increase the flow of money in the economy. Crowdfunding gives entrepreneurs hope that they can get their projects funded and encourages them to create regardless of the current economy.

The creator of Indiegogo, an international crowdfunding website, outlines two important economic benefits that will arise from the success of crowdfunding. The first is that it will shift the responsibility of the traditional financier from “gatekeeper” to “amplifier.”

Ireland’s Enterprise Minister, Richard Bruton, explains that crowdfunding is “a means of ‘democratising’ access to funds and supply of capital and moving the model away from venture capitalists and angel investors.”

Simply put, investment bankers and venture capitalists will no longer mandate which start-ups get funded. Rather, financiers will review and highlight those startups and existing SMEs with potential to succeed while providing the general investor the opportunity to invest in a broad range of other business, both startups and those seeking to expand. On average, a traditional investment banker may review 2,000 business plans per year and chose to invest in perhaps five. Thus the odds of any single startup business of acquiring traditional funding is just over .2%, which is dismal. With crowdfunding, the decision to invest rests not with an individual financier but rather with the community of investors. This will clearly pave the way for the success of many more SME’s and start-up companies.

Another economic benefit of crowdfunding is that, with more people investing relatively small amounts, the risk/return ratio will improve. Under traditional financing structures, when one venture capitalist or investment banker loans large sums to a business, the risk/return calculus rests entirely with one lender – making the risk of the loan astronomically high. With crowdfunding, as the sum loaned by each individual decreases, the risk/return ratio for any particular investor decreases because the amount of capital invested is less. As explained in a study conducted by BBVA Research USA, “investors willingly decide which projects to finance based on their tolerance to risk and other considerations…crowdfunding break down the risk into small pieces and sell them to a potential large group of investors.” Essentially, the risk dilutes as the number of investors increases.

While it is uncertain what the future holds for crowdfunding, the potential exists for this alternative form of finance to encroach substantially if not replace entirely traditional banking for personal and small business loans. For the foreseeable future it is unlikely that crowdfunding can create the capacity to fund huge multi-million dollar projects. Nonetheless some believe that in the very long run, crowdfunding will replace banks entirely by providing such services as credit cards, mortgages, and ATM’s, all of which now are within the province of traditional banking.

Research by:
Rachel Kagan, Elon University, North Carolina, USA.