Oct 28, 2019

Diego Zuluaga on Libra, Real-time Payments, and the Legacy of the Community Reinvestment Act

The CRA has inadvertently pushed out the low-income borrowers it was intended to help
David Beckworth Senior Research Fellow , Diego Zuluaga

Our guest today on the Macro Musings podcast is Diego Zuluaga. Diego is a policy analyst at the Cato Institute Center for Monetary and Financial Alternatives, where he covers financial technology and consumer credit. Before joining Cato, Diego was Head of Financial Services and Tech Policy at the Institute of Economic Affairs in London.

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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth: Hey Macro Musings listeners, this is your host David Beckworth. Before we get to today's show, I wanted to let you know that we now have a Macro Musings hotline number where you can call us with your questions. We plan to do some shows in the future where we play and answer your questions, so if you want to be a part of the program, please call us on the hotline. The phone number is 802-466-2276, and you can also email us with your questions at macromusings@mercatus.gmu.edu. Now, onto the show.

Our guest today is Diego Zuluaga. Diego is a policy analyst at the Cato Institute Center for Monetary and Financial Alternatives, where he covers financial technology and consumer credit. Before joining Cato, Diego was Head of Financial Services and Tech Policy at the Institute of Economic Affairs in London. Diego joins us today to discuss his work in this area. Diego, welcome to the show.

Diego Zuluaga: Thank you David, I'm thrilled to be with you.

Beckworth: Glad to have you on. Now, you're in the financial reg world, in that policy space, how did you get into it?

Zuluaga: Well David, really it was wanting to reconcile a number of different goals when I finished college. I had studied economics, and I had developed an interest in finance primarily because I also studied history and I thought that the interaction between economics and financial history was particularly enticing. And this was in the context of the immediate aftermath of the financial crisis, and ongoing questions about the discipline of economics and what it should do and what it could do. And coming out of college, I didn't really know what I wanted exactly to do, but I wanted to have enough time to think about subjects that I cared about. I wanted hopefully to have a career that would allow me to move around and meet interesting people, and hopefully feel like I was making an impact.

And I happened to come across the object of think-tanks, which is something that's quite unknown to a lot of people, but obviously in our world is very relevant in terms of developing ideas that then policy makers, legislators, regulators and hopefully the public at large will come to assume as desirable in things that should be done. And looking into that, I finished college in Canada, at McGill University, and I decided that I wanted to move to the UK and work in a think-tank there. So, I spent five years at the Institute of Economic Affairs, some of that time I also spent in Oxford doing some graduate work in finance. And in the course of that, I just decided that policy work was the sort of stuff that I wanted to focus on, and eventually I got the opportunity to do the same thing here in the US, so that's been very exciting ever since.

Beckworth: Let me ask this question. Coming from London, from Europe to the United States, a very different set of regulatory issues, although there are some international rules that are similar, but was it a big learning curve having to come here and learn the financial landscape in America?

Zuluaga: Well, one of the nice things about the US is that so much of the empirical research in finance uses datasets from America, and uses the regulatory environment in America as the baseline.

Beckworth: Okay.

Zuluaga: And the reference. That in fact, even as a foreigner, if you want to familiarize yourself with the literature, you're going to end up knowing about Glass-Steagall, about the fact that the US had unit banking for a long time.

Beckworth: Okay.

Zuluaga: About the US mortgage system and the role of Fannie and Freddie, the moment you want to study financial regulation globally and how regulation develops and the sort of real effects that it has, I think you end up just becoming more familiar. So, it wasn't as much of a learning curve as if I had moved, I don't know, from the UK to China. Or to Germany or something like that.

Beckworth: Well, that's kind of an indictment on our financial system, right? That all these weird, bizarre, unique, idiosyncratic features of the US economy… unit banking laws, the large number of banks we have in this country. So, maybe we're kind of a basket-case compared to many other parts of the world, or am I being too harsh?

Zuluaga: I don't necessarily think that you're being too harsh. It is actually interesting that you will see Glass-Steagall still raised as a recommendation that people make for banking regulation elsewhere than in the United States, so separation of retail, commercial from investment banks, when there's no historical precedent for that in say Europe, and there's no experience that investment banking in any way made retail banking or universal banks more systemically risky or more unstable than they were being universal banks. So, that's sort of a way in which there's some externality, I guess it depends on the analyst, whether it's positive or negative in terms of what the US has on the rest of the world.

Of course, my colleague George Selgin, has written a lot about the fact that banking systems around the world, primarily in Canada and in Scotland, perhaps offer an example for a more stable, more dynamic banking system. Stable and dynamic, that's the paradox, but it seems to have been both than what we have in the US.

Beckworth: Yeah, Canada seems to get it right on many fronts. Banking, monetary policy, on many levels. So, they're a great example for us to look to, but we don't always follow them. But speaking of the US banking system, how would you assess it overall? Just kind of a broad 30,000 foot view, where is banking in the US?

Zuluaga: To me, the key word about the US banking system is fragmented. As many of your listeners will know, we have had historically in the United States, many more independent banks than you would expect for the number of US population when you compare it to other countries around the world. And the nature of that fragmentation was, for the most part, regulatory. It was preventing banks from establishing branches, having jurisdictions at the state level that foreclosed competition between states in terms of financial institutions. And that had all manner of policy, and in fact, economic implications over time. And I think we're still experiencing those. Even more than 20 years after financial legislation was put in place to completely liberalize branching all across the United States, that was in 1996, we still have more than 5000 commercial banks and thrifts in the United States.

To compare that, say, with the United Kingdom, which is also a financial services hub like the US, the five or six largest banks in the UK have 80% of deposits. That's the sort of kind of concentration you might expect to have in a more liberalized banking system. In so many of the debates we have in financial regulation today, from housing finance and the role of Fannie and Freddie, to the role of the Federal Reserve in the provision of payments, to the regulation of financial technology companies, and how competitive or uncompetitive banks and depository institutions are have to do with the fragmentation and the small size, the small median size of the typical financial institution in America.

So, I think that's the key word if we want to begin a discussion of anything, because you'll find that it has ramifications, usually negative ones I would say, all over the place.

Beckworth: And that is a legacy of these unit banking laws? Is that kind of a culture that emerged where towns would keep out competition? What's the backstory for why there is so much fragmentation?

Zuluaga: Well, I'm not as much of a banking historian as George Selgin, of course. But I would say that yes, it's a legacy mostly from the 19th century, by which there was a coalition of interests that promoted a system of great fragmentation of banks. On one hand, you had the populist angle, if you will. These were people who interpreted that banks would only serve the local communities, they weren't really trustworthy, and they were only part of the community if they took most of their deposits and made most of their loans in the local community. And that shaped regulations that banned more than one office for a bank, so that you wouldn't spread out, you wouldn't necessarily have what they called capital export, which was taking deposits from customers in a certain area, and then deploying them as loans elsewhere.

Of course, portfolio theory tells you that it's a good idea, actually, to diversify. And there are economies of scale in lending, and in financial services provision in general. And therefore, that probably the optimal size of a bank is not one single office, but that was the interpretation that a lot of these populists had. And then, and this is something that George has studied in great detail, you had the relationship that small banks had with large banks in Chicago, and especially in New York, that created a vested interest for banks in New York to preserve that kind of fragmented nature. In fact, George has argued that the existence of the Federal Reserve is the product of that unholy alliance of small banks and the very sort of vested interests of the very large banks in New York because they saw their privileged position as intermediaries of funds, and sort of the main nexus between small banks and the capital markets compromised if there were a liberalization of branching laws.

Beckworth: So, the Federal Reserve is partially a creation of the influence of the New York banks. And what is his paper called where he goes over the-

Zuluaga: It's called *New York's Bank*.

Beckworth: *New York's Bank*. Yes. Yeah. So, it's a really interesting read. We'll provide a link to that on the web page for this show. One of the things that's happened recently in the banking system has been this discussion of real-time payments, so a large number of banks have together started their own real-time payment system. But the Fed also recently introduced its plans to do its own banking system. How does this play into the fragmented nature of banking, and is it an important development?

Zuluaga: Well, it's an interesting development because real-time payments, that is the instantaneous access to funds that are deposited in one's account, that's something that has become the rule in other jurisdictions. And I think policy makers and analysts in the US look at payments in America, and they think that it's falling behind what you have in the UK, or now in the Eurozone as well. And those are primarily the reference that they use. And in fact, it's true that instant access to funds is important to a lot of people. We have a significant share of the US population, anywhere between a quarter and half of the US population who live, in some way or form, paycheck to paycheck. And not having access to one's bi-weekly salary in order to pay rent and other major expenses as soon as that that salary is earned can be problematic in terms of incurring additional fees. It can cause people's credit scores to go down as a result. All manner of adverse consequences.

So, I guess there's an inclusion, a financial inclusion dimension in having real-time payments provision. The key question is whether the public sector is better placed to provide real-time payments than the private sector. And I think the argument there is obviously contested, but I think there's a lot of evidence behind the case that the private sector could provide this more efficiently, and critically at a much more early date than the Fed proposes to do. I think when they came up with their own proposal for real-time payments, the Fed said that they would have it probably by 2024, 2025. Now, anyone whose dealt with public sector projects knows that the original deadline-

Beckworth: It's a best case scenario.

Zuluaga: ... is not usually ... exactly. Is not usually the realistic one. But at any rate, let's take it at face value and say that within six years you can have it. We already have a consortium of banks covering about I think 50 percent of deposits in the ... called The Clearing House, who have been providing real-time payments for some time now. And the Fed’s response to their existence was that they were not, what they call, ubiquitous. Ubiquitous meaning that every single depository institution is part of that network. And to them, that is an important feature of any real-time payment system because you want all Americans to have access to it.

Beckworth: Right.

Zuluaga: And the more people are involved in the network, of course, the more attractive the network becomes, there might even be economies of scale, economies of scope in having more membership. That's a valid argument as far as it goes. It still doesn't prove the case that the Fed is well-placed to provide real-time payments, because the cost of provision might be higher, the incentives to engage in behavior that is anti-competitive or monopolistic are higher because the Fed is, by definition, a monopoly and it has sovereign immunity from the antitrust laws, and that's an important consideration to keep in mind. But also, organic developments between 2019 and 2025 likely mean that we're going to have many fewer banks at the small end of the spectrum than we do today.

And small banks are typically the ones that are not part of The Clearing House. What I mean by this is consolidation will likely drive greater interconnection between institutions within the payment system. And in fact, you might have private developments resolve that ubiquity problem anyway. Going back to your question as to how the fragmentation and the legacy of unit banking shapes this debate, it is the small banks that have been mainly pushing for the Federal Reserve to provide real-time payments. They don't trust the large banks, and who knows? Maybe they have good reason not to. Maybe the large banks don't have their best interests at heart. After all, they're in competition.

Beckworth: But they should be also skeptical towards the Fed because we've seen in the past what happens when the Fed does get into payment systems, and this is likely to be the case, what I've read is the Fed has to cover its costs. And so, once it gets into this business, it's going to have to find ways to generate revenue to cover the costs, by law, and what it’s done in the past is it gives volume discounts.

Zuluaga: That's right.

Beckworth: And who gets volume discounts? The big banks.

Zuluaga: Right.

Beckworth: So, effectively this could be a situation where small banks end up paying more by using the Fed's system.

Zuluaga: That's right. Yeah.

Beckworth: Which is ironic.

Zuluaga: And the volume discount issue is interesting, because it makes sense from an economic viewpoint that if you're a bulk purchaser of services, that you would get better value, you would get a better deal from the provider, right?

Beckworth: Seems reasonable.

Zuluaga: And that happens all across the economy, in retail, and in every other area. And that's true as far as it goes. Now, small banks are concerned that volume discounts will make their own payments provision uncompetitive. That they in general will become less attractive as service providers than the large banks and that will drive increased customer reliance on the larger banks. But one thing The Clearing House has done to assuage the small banks' fears is promise, vow not to give volume discounts to the larger players. But that can only happen if the TCH is the main provider. Because the moment you have a competitor in the Fed, and the Fed provides volume discounts, then you, as The Clearing House would have to match it, because otherwise-

Beckworth: To compete on price. Right.

Zuluaga: ... all the large bank's business is going to go to the Fed. So, it's an interesting kind of, I suppose Cournot kind of dynamic, duopoly dynamic that emerges when you have the two providers, which can be perverse.

Beckworth: It just seems to me that the small banks should've thought through this process a little bit more before they got so worked up and supported this. But who knows? Like you said, a lot of organic changes may occur and maybe something good will come out of this no matter what happens. But one of the things related to the question of banking in the United States lately has been this question of fintech. And maybe you can define fintech for us, and then a second question, is fintech becoming a more important part of our life relative to traditional banking?

Zuluaga: Sure. I would define fintech, which stands for financial technology, as the use of new technologies, particularly data aggregation, and remote access to services and information in the provision of financial services and credit. In some ways, that definition applies to financial services provision ever since the beginning of time, right? We've always had financial technologies of one form or another, and the credit scoring, which emerged in the 1950s and '60s, was an early way to standardize customer data so that the market would become more competitive and also lenders would have a better idea of how good a credit a particular customer was. And that information and record could be exported to other places. But fintech now is talked about in the context of the internet, in particular. And the application of internet technology to the provision of financial services. So, the fact that you can now, you can purchase a house and get a mortgage online, without ever interacting with a human being, and without ever walking into a branch, whether it's a bank branch or an office of some other provider, or a mortgage company or something like that.

And you can also get very many other financial services just online, even your bank will have a suite of facilities that are not branches, for you to check your balance, check out products that you can apply for, apply for them, submit the required information, and so on. And the implications of that technological deployment across banking and financial services in general, and credit, is that first of all you have a reduction in costs, you have easier access, you probably have better, more transparent transmission of information on both sides, and hopefully as a result of that you make transactions likely to happen more easily. You also have an increase in competition. It used to be the case, particularly in the US given the unit banking context, that if you wanted a mortgage loan you would probably have to go to the local thrift, the local savings and loan.

 Like in George Bailey in the old movie.

Beckworth: Right.

Zuluaga: And apply there. And if you couldn't get a mortgage from them, then you were basically screwed. Now, not only do you have more competition on the branch side to the extent that any bank can branch anywhere it wishes to so long as it has requisite regulatory approval, but also you have a lot of competition for people who aren't even located there. Quicken Loans, which is a company based out of Detroit, is the biggest originator of mortgages now in the United States.

Beckworth: Wow.

Zuluaga: By number of mortgages, because they focus on the smaller side of the business, lower value mortgages, which is itself a telling factor, right? Because you're increasing the margin at which you can extend the loan cost effectively now. Wells Fargo is still the biggest provider by volume. And there's a lot of competition there, of course. But Quicken is one of the main players, and they've become one very, very quickly. And you see this across the board. You have so many firms that do personal loans, student loan consolidation, credit card provision online. And so, what you have is depository institutions who traditionally provided the whole spectrum of banking services seeing that a mixture of technological innovation, driving lower costs, and regulatory increases particularly after the financial crisis, raising costs, are making their involvement in some businesses more difficult.

There was a paper in 2017, from Buchak and a couple of other authors, published by the National Bureau of Economic Research, which finds that about 60 percent of the decline in bank lending and the rise in non-bank, primarily fintech lending, since 2007 is due to technology. And about 30 percent is due to regulation.

Beckworth: So, what will the future look like? Will I still have a traditional bank account for getting my paycheck, for paying bills and will everything else be done through fintech apps and online programs?

Zuluaga: Well, I think it's very much open to speculation.

Beckworth: Okay.

Zuluaga: It's early to tell. But I would say the following. The one thing that we see increasing and a lot of attention is being paid to, is the ability for people to take the data that they've accumulated over the years of business that they've provided to a particular bank, and port it to new providers. Meaning right now a lot of the value that a bank derives from you is the fact that they've known you for five years, or 10 years, or 15 years, and nobody else has known you for that length, period of time, and they have neither the obligation nor necessarily the custom of making that data available to you. They don't even necessarily have adequate means to make the data available to you.

But where we're moving to, and this is a phenomenon called open banking, and something that's starting to happen in Europe, and I know the US Treasury is trying to make happen in the US more driven by the private sector here, because of data privacy concerns and other things. But it's to encourage financial institutions to make the data available to customers. That increases competition, it means you can use mobile apps to manage your finances because they get access to your bank account, you can use mobile apps to recommend products to you and say, "Right now you have a money market fund that's giving you 50 basis points. Go to this other one that will give you 190." And you can actually drive a lot of efficiency by simply giving access to your own data to third-party providers.

That raises all manner of concerns, as I said, not only in terms of privacy but in terms of hacking, and potential abuse and fraud, and so on. But it's also very exciting. In terms of what I see the landscape becoming, I do see a decline in the depository institution model, just because the current regulatory environment means that it's very disadvantageous to be a depository institution. And in fact, and you know this is more of a Selgin subject than it is my own, one might say that the current regulatory model of depository institutions creates more instability in the system. And so, it's very difficult to, unless we have sea change in regulation, to move away from that kind of dynamic.

Whereas, an institution, and most fintechs are like this, an institution that doesn't take deposits, borrows short-term from its own funders, which sometimes are the capital markets, sometimes they're banks. And then lends short-term to retail borrowers might be more stable and will face less regulatory pressure.

Beckworth: What about cryptocurrencies? Would you classify that as a part of Fintech or is that-

Zuluaga: Oh absolutely, yeah.

Beckworth: Okay.

Zuluaga: It's just, I didn't focus on that just because it's a relatively niche side of the market.

Beckworth: Okay. Let me ask you about cryptocurrency. So, for many people that's the great thing right now and many people still believe in it. And there's a debate as to whether it will ever emerge as a medium of exchange, truly be used as a transaction asset as opposed to purely speculative. And where do you come down on that? What's the future of cryptocurrencies as money?

Zuluaga: Right. That's a very open question, and you will get probably as many answers as there are cryptocurrencies. And I think to give you an idea, there are about 1800 cryptocurrency projects in existence right now.

Beckworth: Is there a Diego cryptocurrency yet?

Zuluaga: Well, not one that I am aware of.

Beckworth: Okay. None that you've made.

Zuluaga: Yes, I take no responsibility for what will happen to that particular token and its value over the next few months, if there exists one. Just for the record. But the thing about cryptocurrencies is that it's a label now that's applied to a range of different units of value, or tokens, digital tokens that are created for the exchange of goods and services. Bitcoin was, of course, the founding cryptocurrency, and it began its existence into 2009, and it still accounts for probably about half of the global market share of cryptocurrencies. It's still by far the largest. But Bitcoin is genuinely decentralized in the sense that it's a software that runs the supply of the token over time, that has mechanisms for individual users to verify and validate transactions, and therefore is not inter mediated in any way, no one centrally manages it.

It's the software that has created conditions for individual people to benefit from the fact that they verify this Bitcoin blockchain, the ledger that contains all transactions, and make sure that no fraudulent transactions happen, and that people's desire to exchange Bitcoin for something else actually takes place. But we also have things like Libra, which are definitely intermediated. In fact, they're basically a Facebook-led initiative, although Facebook has a number of different partners. And Facebook and its partners will be the ones running that particular cryptocurrency, deciding they will be ... we can talk about this in detail if you want.

Beckworth: Yeah, let's do. Let's do. So, this would be a stablecoin? Or what would you call Libra?

Zuluaga: Yes. Well, it depends on ... some people define stablecoin as something can be exchanged for a unit of Fiat currency. I would describe Libra as a stablecoin even though it's not strictly that. Because Libra's value, the value of any unit of Libra, is going to be accounted for by assets, denominated in Fiat currencies, but in a basket of them. So, there will be some bank deposits, and there will be some probably some government bonds in dollars and Euro, and Yen, and Swiss Francs, I imagine. And those will fluctuate in value with respect to each other, and therefore, depending on where you live and what your primary medium of exchange is, you are not guaranteed that the value will be stable-

Beckworth: It's not a pure stablecoin.

Zuluaga: Exactly.

Beckworth: Now, you've written several pieces on that, I think a three-piece series, with the title *Of Libras and Zebras: What Are the True Financial Risks of the Facebook-Led Digital Currency?*And you have in each of your essays, and I'm going to link to this on the show, but you have systemic risk, monopoly risk, natural security risk. So, walk us through your take on the Libra.

Zuluaga: Sure. When Libra was announced, and it was quite an abrupt announcement considering the possible magnitude of this product in June of this year, it was only a few months ago, three months ago, there was a lot of uproar. Among policymakers, among commentators, among people who watch financial markets, because of Facebook's role in the product, but also because the Libra Association, this consortium of companies used the term cryptocurrency to describe Libra. And you put Facebook and cryptocurrency together in 2019 and you're bound to get a lot of controversy out of it, right?

Beckworth: Right.

Zuluaga: And there were hearings in Congress, and my concern in writing this series was to try and demonstrate to people that a lot of the risks that were raised as potentially associated with allowing Libra to happen, would not in fact materialize into the extent that there were such risks, they were probably less harmful in magnitude than a lot of people assumed. So, to begin with systemic risk, I mentioned that Libra will be one for one exchangeable for a basket of assets and currencies from a number of jurisdictions. The systemic risk that we associate with banking typically comes from the fractional reserve nature of the system. And that, and interaction with perverse incentives or bad regulation, or other things is what sometimes is ushered in bank runs and other kind of phenomenon that lead to liquidity crunches and potentially to solvency crises even.

I don't see how that would materialize in an environment with a payments network where each unit that you use to pay is fully backed by real assets, or fiat currency. Or bank deposits that are themselves insured. With regard to national security I mentioned as well, that the network is going to be run by a bunch of companies, most of these are financial companies so Visa's involved, MasterCard's involved, PayPal's involved. They will all have to be registered as financial intermediaries, and watch out for money laundering and knowing the identity of their customers, and so on.

So, unlike what we've seen in the fringe space of cryptocurrency, where sometimes they've been used for terrorist purposes or drug exchanges, or other illicit activities, I don't see at all an easy way that anyone could use Libra to do so, because they would be stopped at the point where these validators will check out their identity. And then finally, in terms of competition, look. This is another payments' provider, in the US we have about eight million households that lack a bank account and therefore lack access to a large part of the payment system. A lot of these people are also immigrants and people who send remittances home, and they're paying quite hefty fees, seven percent to 10 percent of the amount they send each time they send a remittance. And around the world we have about two billion people who don't have a bank account.

And I think that payments provision by tech companies is definitely a very attractive alternative, and a compliment to the existing payments provision by financial institutions. For two reasons. The first one is that a lot of people use tech services and don't use banking services. In the US, we have about 96 percent of the population with cell phones now, but only about 90 percent to, 92 percent of households with bank accounts. But then secondly, these organizations can provide these products more cheaply than a lot of banks can, because they would strictly be focusing on payments, and issue a lot of the more heavily regulated financial services that are the source of a lot of compliance costs. And those two together mean that I think something like the Facebook-led Libra promises a lot, not least because Facebook already has two billion users. And you add the hundreds of millions of users of the other companies I've mentioned, and you suddenly find yourself with a very, very large, probably the largest potential network, single network in the world.

Beckworth: So, the Libra would be more of a payment system than an alternative currency, is that right?

Zuluaga: I would say that's right, yeah.

Beckworth: Okay. And the appealing feature is that it would reach to all these unbanked people around the world, it would be like a retail version of the IMF's reserve, its SDR – the SDR is really for central banks – but it would be like kind of a version of that but for the world. And you have the built-in network effects of Facebook already.

Zuluaga: Exactly.

Beckworth: And so, you could overcome some of the questions about how do you get network effects for something global? You have them already.

Zuluaga: That's right. You would, and you would have ways in which people can earn Libra, without leaving the platforms on which they already operate. So, for example, something that my friends how work more on tech policy tell me, is that Facebook wants to move away from using customer data to bring ads to them and bring things that they think they would like and make relevant because a lot of the privacy concerns that have arisen in recent years. And Libra offers a way to create a new business model by making it rewarding for you as a Facebook user, to review things on the platform. To like things that you actually like. You might get Libra rewards as a result.

Beckworth: I see.

Zuluaga: What that means is that, you suddenly have a stock of Libra as a Facebook user, and you probably want to make use of it. And it happens that you can now buy things on Facebook, you can make payments on Facebook already. You might be able to use the Libra for that. So, Facebook I'm sure, and other companies, will give you an excuse to use your Libra. And in that way, that's how you start to create a network. How else could you do it? Well, we mentioned the Libra Reserve, the government bonds that Facebook and its associates are going to be holding in the Libra Reserve will give them an interest income. And that interest income won't be passed on to Libra holders, but it can subsidize the maintenance of the network. That means that you will probably be able to make payments on the Libra network quite cheaply.

And if you're a merchant running a physical store, right now you have to pay anywhere between 100 and 200 basis points, for every transaction that's done with a debit or a credit card.

Beckworth: Expensive, yes.

Zuluaga: That's right. And if you can encourage your customers to use Libra, and there's no fee associated with it as a merchant, it becomes attractive. And if MasterCard and Visa are involved, well they hold about 80% of the payment card business. So, that's another big incentive to do so, and relatively low information costs in promoting this kind of strategy. So, I see a lot of ramifications in terms of making Libra workable. Not to mention in developing companies, it can actually become a sort of quasi, and I know you've written on this, a quasi-safe asset where you can move away from your unstable domestic currency under capital controls, and you can use something that is moveable internationally. And probably in great measure attached to the US dollar.

Beckworth: Yeah, so that's a nice segue into the next question I had related to Libra, and that is a proposal made by the Governor of the Bank of England, Mark Carney a few weeks ago at an important conference where he was motivated in part by the idea of the Libra, but he said, "Let's take a little different direction. Let's have a synthetic, hegemonic currency", and that's a mouthful. But his idea is central banks, major central banks could issue some digital currency and then there'd be this international synthetic currency that would be backed by them, and his motivation is also to kind of have a rival to the dollar. The dollar's reach is growing, there's many good reasons to have the dollar, but it also means that there's this global financial cycle, things are more interconnected, and it's something they have to wrestle with.

So, he says let's make a rival, let's make another reserve currency of the world and let's do this. And the challenge I see with his proposal is the huge network effect of the dollar. Whereas I think what you were telling me with the Libra, they don't have that same issue because they're not trying to make a whole new currency, a whole new network of money. They're providing a new payment system versus trying to compete directly against the dollar where I think Carney's proposal would be a direct ... can they compete against the dollar directly? And I think that'd be a harder battle to fight. I don't know.

Zuluaga: I agree with you, and I think the use cases are harder to, on the retail side anyway, are harder to imagine for this kind of synthetic instrument. I know that the IMF has been trying to promote the use of a special drawing rights, which are a basket of the leading currencies.

Beckworth: Yeah.

Zuluaga: And interestingly enough, the renminbi became a part of that basket a few years ago, to make it more widely used as a way for them to disperse their loans to particular countries, and so on. But I think even sovereign borrowers are somewhat wary of a synthetic instrument because it's more difficult to understand. I think if you're Argentina, and no one would want to be Argentina now, but imagine you are Argentina, you would probably rather borrow in dollars where you know one variable you have to pay attention to. And you know who you have to appeal to if push comes to shove and you need to appeal to somebody than to borrow on a synthetic instrument that is run by a distant organization, which in the case of the IMF would be Argentina's own creditor.

So, like you, I struggle to imagine how you get the first few transactions, the first kind of wave of adoption that drives the rest. Not least because on the retail side, it is true, that most of our transactions are in our domestic currency. So, the US dollar globally has a huge network, but every other country has a tremendous network within their own jurisdiction, because most people when they operate cross-border, they just do so in their own currency and exchange it ad hoc, rather than holding an ongoing balance in some sort of foreign-

Beckworth: Oh right.

Zuluaga: ... or synthetic instrument.

Beckworth: So, in this brave new world with Libra there, and we're using Libra, we would still be using our own domestic currency, or in the case of the dollar, the dollar, but we would have this second facility, this second option for facilitating payments, Libra. So, Libra would coexist alongside the widely used currencies already there. Is that how it would work?

Zuluaga: That's how I would see it working, yeah. I think in fact, I think developing countries will drive a lot of the initial adoption. That, and then people operating on internet platforms and using Libra in the way that some people use a Starbucks card. Or an Apple card.

Beckworth: Okay. That’s a great point.

Zuluaga: Where you don't actually mind having $50 on your Amazon card. So many of us shop on Amazon, at Amazon or Starbucks, or Apple, that you don't see it as a nuisance. You see it as almost equivalent to $50 in currency.

Beckworth: Right, right.

Zuluaga: Because you will eventually end up using it. And I think Libra has a network large enough that people will think of it in the same way.

Beckworth: So, Libra's one big, giant Starbucks card.

Zuluaga: Yes, exactly.

Beckworth: Okay. Now it's all clear, thank you for that clarification. All right Diego, let's switch gears and talk about a recent paper that you have produced and it's titled “The Community Reinvestment Act In An Age of Fintech and Bank Competition.” So, we've touched on Fintech, we've touched on this issue of bank competition, and you have some pretty startling findings in this paper. And before we get to them, why don't we walk through what is the Community Reinvestment Act? Let's just say CRA for short, so everyone knows we're talking about the Community Reinvestment Act, but what is the CRA? What's its history? And how did we get to this point today with it?

Zuluaga: So, the CRA is a piece of financial legislation that was passed in 1977, and it instructs banking regulators, that is the Federal Deposit Insurance Corporation, the Federal Reserve, and the Office of the Comptroller of the Currency. These are the three agencies that regulate banks in the United States, to encourage them to “serve the convenience and needs of the communities” in which they do business. Now, the CRA was passed in the late '70s as part of the package of anti-discrimination legislation that was introduced at the time. This is a follow-up to the Civil Rights Act, and the Fair Housing Act.

Beckworth: Okay.

Zuluaga: Then you have the Equal Credit Opportunity Act, the Home Mortgage Disclosure Act, and finally the CRA. And even though the statute doesn't mention race, it talks about serving the communities, a lot of the concern that drove the passage of CRA was the idea that banks were not lending in minority communities and that this legacy of discrimination, what was called redlining, remained prevalent even long after the decision had been made to prevent any kind of discrimination on grounds of race, or other personal characteristics. And redlining indeed was a very prevalent phenomenon from the 1930s onward. It's interesting that the government had a very major role in the promotion of Redlining because after The Great Depression, the Franklin Roosevelt administration created the Home Owners’ Loan Corporation to infuse liquidity into the mortgage market, and to refinance mortgages for people that were struggling to repay.

And as part of that policy, the Homeowner's Loan Corporation issued maps for the main metropolitan areas in the United States. And those maps would contain different colors depending on how “hazardous” the regulators judged those areas to be. Not surprisingly, the ones colored red were the ones that had a lot of immigrants, and minorities in them. And as a result of that, the banks who were the originators for this agency, were discouraged from lending in those kinds of communities. So, it was the kind of bottleneck created by government in this secondary market side that drove a lot of the Redlining and it's prevalence over time. But at any rate, in the 1970s, policy makers really wanted to make Redlining a thing of the past, and they passed the CRA, and the way that regulators have implemented that regulation is to assess banks, evaluate banks on how much they lend to communities at different incomes.

Wherever they operate an office or a branch, they're expected to lend to communities at all income levels, and to all census tracks that are near that particular office or branch. And the regulation is 42 years old, of course the banking landscape has changed a lot since. And we've had a very strong increase in competition, and what my paper tries to do is to evaluate the ongoing validity of the CRA, its effectiveness, and to assess some of the arguments that have been made around it. Some people argue that the CRA has actually promoted more lending to low income communities, and more home ownership and more small business lending. Other people have said, and particularly they use data from the run up to the financial crisis, that CRA lending is riskier and it compromises the prudential stability of financial institutions, depository institutions.

And I find that there's some grounds to vindicate that latter view but I also have found that because of the incentives created by the CRA, a lot of the lending isn't going to the people that are targeted by the legislation.

Beckworth: That's the most startling part of your paper. So really, flush that out for us. Who really is benefiting the most from the CRA according to your findings?

Zuluaga: Sure. So, I need to just quickly explain the way the regulations work in order to get to that.

Beckworth: Okay.

Zuluaga: The way that regulators evaluate banks is they look not only at loans to low income borrowers, that is households that obtain mortgages or small business loans, but they look at census tracks as well. That is the measure that the US Census Bureau uses for neighborhoods. They tend to contain about 4,000 people, each of them. And so, what regulators want to make sure is that banks that are near several census tracks that have ATMs and branches, and offices nearby, lend in all of them. And the way ... whether those are low income, or middle income, or high income census tracks. Now, what that means is that you as a bank, are able to fulfill the letter of the law in the view of regulators. If you lend in areas that are low income, regardless of which borrowers you lend to. And what I found looking at data from the DC area is that – the DC area, listeners who are from outside the area should know, has been gentrifying very quickly and rapidly in recent years – is that more than two thirds of CRA lending is going to high income borrowers in low income areas.

So, the people I call the gentrifiers. And I don't think this is deliberate on the part of banks. I don't think there's a sort of secret policy document inside the vault of each bank, saying, "You shall make your CRA loans to high income borrowers in low income areas." I think it's trying to juggle together a lot of different objectives. It's being prudentially sound, fulfilling the objectives of the CRA, getting a good return for your shareholders. And allocating scarce credit to the highest and best bidder you can find. And all of those together mean that you would lend to higher income people because they typically are better risks. They are more credit worthy. And it's not only that more CRA loans are going to higher income borrowers. But looking at individual track data, what I and a colleague found is that for every additional percentage point in CRA mortgage lending in the DC area, the share of minority residents in that track decline by 3%.

Beckworth: Wow.

Zuluaga: And the way we interpret that result is that, of course there are several different drivers, but we try to account for everything. The way we interpret that is that in the context of some supply restrictions on how much housing you can have in any area, what CRA lending is doing is it's making easier for gentrifiers to move into lower-income neighborhoods, and it's pushing low-income renters out, without necessarily increasing the ability of minority home buyers to get a mortgage loan. So, it's really not fulfilling the spirit of the CRA effectively at all, is what we find.

Beckworth: So, it's intensifying the urban problem where people can't afford to find housing unless you're in the high income brackets, you're successful. So, in a lot of the poor neighborhoods, people are being pushed out, and this CRA is inadvertently contributing to that.

Zuluaga: That's right. Yeah.

Beckworth: What's been the reception of this finding? It's a pretty amazing finding. Have you gotten feedback, like, "That can't be", or, "Wait a minute", or, "Wow"? What's the general sense you got?

Zuluaga: Well, interestingly enough, the reaction among the people who follow the CRA has either been the realization that yes, absolutely that is the case because those are the dynamics that the regulation drives. And some other people, not being so much surprised as seeing an argument for updating the CRA given…

Beckworth: Okay. Let's refine it. Yeah.

Zuluaga: …the changing environment. I don't think anybody has reacted adversely to it. In fact, the Comptroller of the Currency, Joseph Otting, a few weeks ago said ... used himself as an example of someone who would qualify for CRA credit, who would qualify a bank for CRA credit.

Beckworth: Okay.

Zuluaga: Because of his mortgage in DC, without being the kind of borrower who was at all targeted by the CRA. And I think in the reform proposal that hopefully we will get in the next few months to try and change the way that CRA is implemented, that will be taken into account. And I hope that they will not consider gentrifier loans as part of the evaluation process anymore, because it really isn't at all what the CRA is supposed to do. But one thing that I think is important to point out is that this resolves a bit of a puzzle because for a long time, the argument around the CRA has been between the people who say, "We don't need the CRA, it only encourages banks to make risky loans. Look at the financial crisis." And the people who say, "Look. Let's check actually the credit worthiness measures of CRA borrowers. They're much higher, they're almost as good as prime borrowers."

And I think my research, to the extent that these DC results can be applied elsewhere, resolves that puzzle by saying, "Yes, of course. The reason CRA loans are less likely to default than your typical subprime loan, is that your borrower is not a subprime borrower." Even though the CRA sort of is trying to get credit to the people who don't have access to traditional forms of credit. So, that's sort of the puzzle that emerged, which I've tried answer here.

Beckworth: That's interesting. Yeah, so a lot of the increase in housing price has been attributed to zoning restrictions, restrictions on supply, and what the CRA is doing is just kind of amping that up, just it's increasing the pressure on housing prices by bringing in people with high incomes and pushing out people with low incomes. And it'd be tough if you're low income to stay ... let's say you paid off your home, what's going to happen is your housing price is going to go up, your property taxes are going to go up, it just gets harder and harder to live in an area that's been gentrified.

Zuluaga: Yeah. Gentrification gets a very bad rap in social commentary and in policy and so on. All of the research that I've seen around gentrification as the process itself that is the renovation of neighborhoods, the arrival of new people, economic revitalization and so on. It's very positive, it's really as you say, supply-side restrictions on zoning that decide whether it's great or just good in terms of the displacement of existing residents. There was an interesting Fed paper that came out about a month ago, which looks at gentrification across a bunch of metropolitan areas in the US. And they find, not surprisingly, that gentrification is great for educational outcomes because obviously funding for local schools improves, crime rates go down, economic activity goes up, unemployment declines, poverty declines.

But they find that it's particularly positive in smaller metropolitan areas, and they attribute this to two factors. One, that the people who otherwise would be displaced are more likely to be homeowners in small metropolitan areas than they are in LA, New York, San Francisco and so on, and therefore if you have equity in the home you won't be displaced in a way that makes you necessarily entirely worse off, because you are selling out and getting some equity out of your house before you leave. But the second thing they say is these areas are less likely to have restrictive zoning than a lot of the major metropolitan areas. And they've also had less of a dramatic growth-

Beckworth: Like a Houston-

Zuluaga: ... in the house price index in the last few years.

Beckworth: Or, you said smaller metropolitan-

Zuluaga: Yeah, well, these would be sort of Nashville, Memphis, Raleigh, North Carolina.

Beckworth: Okay.

Zuluaga: It depends on the individual zoning laws of the locality. I'm not arguing that every small locality has great zoning laws. I'm sure there are plenty of cases, but that's not the case.

Beckworth: But small metro areas that do have fairly lenient zoning laws, this would be the-

Zuluaga: Those are the sort of the primary example of areas where gentrification is universally beneficial.

Beckworth: Okay. Now, let me just go back a bit on the CRA and let's be specific here and very clear, who does this law actually apply to? What type of financial firm?

Zuluaga: It's only for depository institutions that are not credit unions.

Beckworth: Okay.

Zuluaga: So it's banks that are subject to the CRA. And the reason for that is that at the time of the CRAs passage, banks were the main providers of credit, and branches and offices were judged as a good measure of a bank's activity, where it took deposits and where it should lend in the minds of policymakers, but also the sponsor of the CRA, William Proxmire, who was a senator from Wisconsin, he said, "Well, the federal government is giving banks so many privileges by chartering them, giving them a discount window lending via the Fed, giving them a master account, giving them access to the master account at the Fed, and giving them deposit insurance, and various other privileges", which it should be noted the government had imposed on banks rather than banks always requesting them from it.

But he said, "Because they get all these privileges, it's only fair that they should provide something back." And he said as well, "We have a unit banking system with restricted competition in the United States now." And so, they're getting, each individual bank, is extracting rents from its local community because it has no competition via this chartering system that prevailed in the 1960s and '70s. And so he said, "We need to make some sort of imposition to make sure that banks are actually lending to everyone who lives there. It's their duty to the public." The reason credit unions were excluded is that credit unions are supposed to have a common bond with their members, but that common bond doesn't have to be geographic in the way that the CRA operates. It can be the economist credit union-

Beckworth: Right, work-related…

Zuluaga: Yes, exactly. And so, it means that the CRA wouldn't apply very well to credit unions.

Beckworth: Yeah, so I guess a couple takeaways from that. One, it only applies to deposit institutions, traditional banks. It excludes credit unions, and a lot of people use credit unions. It excludes Fintech funding for mortgages. So, one point in your paper I think is really worth stressing is, in some ways the CRA is obsolete. And the point you stressed earlier, right? A lot of people are getting funding through these alternative mechanisms outside of banks, so in some level it is kind of obsolete in terms of what it's supposed to do.

Zuluaga: Right. More and more lending, particularly the lending that the CRA targets, which is mortgages and small business lending, is happening through non-bank channels. As I say about three quarters of mortgages, low-income mortgages that are guaranteed by the federal housing administration are now originated by Fintechs. Their share of the mortgage market is increasing is probably in the 30% to 40% range. Now, a lot of the largest players are non-banks in mortgage lending now. The same is beginning to happen for small business lending. Part of it is the sort of the hangover from the financial crisis, but it means that the CRA applies to a smaller and smaller share of overall lending in the United States. I don't think that's a reason to apply the CRA to Fintech firms, because Fintechs are already, if you look at the data, lending more to the communities that the CRA targets than banks themselves-

Beckworth: Interesting.

Zuluaga: ... which suggests that competitive conditions and the right regulatory environment can actually encourage, or doesn't preclude institutions from serving low-income borrowers, and particularly the cost advantages that Fintechs have mean that they can get good returns from a relatively smaller loan, and they can read better into the finances of a customer thanks to data aggregation and other things, and therefore can serve them better than a traditional institution might. So, I don't think that's a reason to bring Fintechs under the CRA. But I think the accumulation of evidence, it's common for regulators themselves to talk in glowing terms about the CRA and what it’s done, and much as I support the objectives of the CRA, I don't see the empirical evidence to vindicate that optimism. What I see is quite a few papers that show that in certain instances, CRA lending is riskier.

There was a paper by University of Chicago economists in 2012 that showed that right before a CRA evaluation, banks would increase their lending in those marginal loans were about 15% more likely to default. Another paper found that there was an inverse correlation between how good your evaluation according to the CRA was, and what your prudential standards were. So, there was a conflict between the two. So, there's some evidence on that front. But also, my own evidence suggests that it's a very miscalibrated kind of standard. So, what I say in my paper is I think repeals should be much more seriously considered than we currently are considering it. That doesn't prevent me from suggesting halfway steps, of course.

Beckworth: Well, let me ask this other question. Because the CRA is increasingly obsolete and it was tailored just to banks, the depository institutions, it kind of sheds some lights on this debate that was had after the financial crisis, what role did the CRA play in the housing boom bust 2008, around that time? And in my takeaway, and I think it's kind of confirmed with what you're saying is, it really wasn't that consequential. In terms of a lot of the mortgages were these private label, Wall Street funded mortgage firms that were outside the scope of the CRA. So, is that a fair take? And therefore it's kind of misguided to put the blame of the financial crisis at the feet of the CRA?

Zuluaga: I think that's fair. Most of the lending that was most problematic, particularly in the latter years, before the financial crisis, say 2003, 2004, 2005, 2006, happened from mortgage companies that are not subject to the CRA. CRA lending as a whole is too small a share of overall lending to have been the main driver of unsound lending. And yes, the private label securitizations mostly contains subprime loans that wouldn't make it into CRA evaluations anyway because regulators don't like to count subprime loans for the CRA, even when they are from banks. But that doesn't mean that the CRA is particularly effective. I think the reason some people argue, or some people have taken the view that the CRA contributed to it is they conflate the CRA with Fannie and Freddie's affordable housing goals.

Which also have low-income lending elements. But it's a very different story with Fannie and Freddie because they buy virtually all of the originated mortgages in the United States. And if you give them an ever increasing ... given their duopoly, they were the only ones who were performing this task, if you increase the share of low-income mortgages that they have to buy and securitize, you're encouraging them to scrape the bottom of the barrel more and more. So, you wouldn't be surprised if that played a very significant role in the crisis. But the CRA was marginal if it played a role at all.

Beckworth: All right. Now in the time we have left, what would you recommend as these halfway steps? Or put differently, how would you improve the CRA if your ideal of it being taken away, how would you make it more workable?

Zuluaga: Well, I think first of all, we have to look at what the CRA gives the regulators power to do. CRA performance must be taken into account by the Fed and other regulators when they approve bank mergers. That means that in certain instances, regulators have an incentive not to approve a merger, even when it would improve competitive conditions in a particular market. Because of CRA performance. It also gives community activist groups an incentive to protest mergers in a bid to try and get funding from the banks so that the merger will actually happen. So, the political economy of the CRA is problematic when you actually look at what the overall policy goals of banking are. To promote competition, access to financial services, financial inclusion and so on, as well as the goals of the CRA.

But what I suggest as well in my paper, is that if we are saying that banks have some sort of duty above and beyond their private sector activity to the communities that they serve, well let's give them an obligation to lend to certain low-income communities, but let's give them the right to pay other organizations to fulfill those obligations on their behalf. And what I'm thinking of in particular, are Fintechs, but also what are called Community Development Financial Institutions, which are a special kind of financial institution that gets some subsidy. And those specialize in lending to marginalized under-served communities. And I think the efficiency gains from having these specialist players actually undertakes CRA lending would be great, but I think what would be even greater is the fact that they would carry those loans on their own balance sheets so that they have an incentive for that lending not to be unsound in the way that Fannie and Freddie didn't.

And certainly mortgage companies didn't because they had the assurance that they could always sell on in the case of Fannie and Freddie, to the secondary markets. And in the case of banks to Fannie and Freddie. Or mortgage companies to Fannie and Freddie. So, I think that sort of trading system just as we have cap and trade schemes in other areas, would encourage greater efficiency, would encourage people to specialize, and it would ensure that the obligations that regulators thought were adequate to impose on banks were actually fulfilled.

Beckworth: All right. Well, with that our time is up. Our guest today has been Diego Zuluaga. Thank you for coming on the show.

Zuluaga: Thank you David, it’s been a pleasure.

Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast app, and while you're there, please consider rating us and leaving a review. This helps other thoughtful people like you find the podcast. Thanks for listening.

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