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Get Nothin' on Your Money and Your Cheques With Fees

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This was the heading of a recent Citi research report in the US, on the investment prospects of various regional banks. The title being an obvious play on the words from the infamous Dire Straits song 'Money for Nothing'. The broader subtext being that the banking system is broken.

The traditional role of a bank as intermediary between customer's deposits and lending to borrowers is being challenged. There is a growing argument gaining momentum to the effect that banks are not absolutely necessary in this process.

There are many market players and commentators claiming that there is a revolution in the banking system under way. Senior industry professionals, regulators and investment superstars are taking note.

The revolution is taking its form in varying ways, but all essentially involve circumventing the banks. There are now burgeoning online platforms allowing investors to lend direct to borrowers in what is called peer-to-peer lending or crowd funding. There are also various alternative finance funds being set up to lend directly to Small to Medium Enterprises, property developers, and for mortgages. It seems that the market to lend money is not a monopoly for the banks.

One of the UK's online crowd funding internet sites, Funding Circle, has attracted investment from some of the City's biggest names including Jon Moulton (from Better Capital) and Charles Dunstone (the co-founder of Carphone Warehouse). They have also recently raised money from US venture capital outfit Union Square Ventures which has been an early investor in some of the internet's greatest hits to date - including Zynga, Twitter, Tumblr, and Foursquare.

So instead of an investor putting their money with a bank, and not really having any real idea of what the bank is doing with their cash, investors can now invest directly into a loan or fund making such loans. This way an investor can make a much more direct and informed assessment of the risk profile of their investment - and can usually achieve a significantly higher return on their cash than a deposit with a bank.

Andy Haldane, the executive director of financial stability at the Bank of England, recently likened the current disruption in the financial services world to that experienced in the music and publishing sectors over the last decade. As Mr Haldane from the Bank of England explained:
"With open access to borrower information, held centrally and virtually, there is no reason why end-savers and end-investors cannot connect directly. The banking middlemen may in time become the surplus links in the chain. Where music and publishing have led, finance could follow."

This 'revolution' is being driven in part by a number of different factors: People have learnt that the traditional role of a bank has since long been surpassed. Over the course of the last couple of decades banks have gone from deposit takers and lenders, to proprietors of convoluted financial instruments and products, though to straight out proprietary risk takers. We have also learnt that in a market driven by short-termism and self interest, the best interests of customers can be significantly blurred.

The credit crisis has proven in its most simple terms that banks can make bad decisions. Banks can blow up. Investors can lose their money.

In the current environment banks are having significant difficulty coming to terms with the new world order of things. There is a shifting regulatory and political landscape that banks are now dealing with. The Volker rule in the US means that banks are no longer able to bet their balance sheets on speculative investments (which was previously a very profitable business for them). They are also dealing with the windup loan books that were pushing the envelope right into the credit crisis; and are now being forced to raise more capital to comply with new regulations (Basel III et al).

In addition to all of this, we are currently in the lowest interest rate environment in the history of time. Therefore, many investors are struggling to get a return on cash. The stock markets remain relatively volatile, and many investors are still shaken by the phenomenal roller coaster experience of investing in equities during 2008 and 2009. Alternative finance, peer-to-peer lending and similar investments offer a unique alternative that can capitalise on the current market situation.

With uncertainty in the global economy prevailing, and a less than enthusiastic view towards 'banks', the burgeoning trend in alternative finance is likely to continue.