Crowdfunding and Financial Intermediation

City Weekly called a couple days ago with a few questions about the recently passed JOBS Act, and specifically about the new provisions for "crowdfunding" of small startups.  The article is here.

"Financial intermediaries" are institutions --- banks, venture capitalists, private equity, angel investors --- that make money by connecting investors with good investments.  If you have a deposit account at a bank, the bank is essentially borrowing money from you (paying you a low interest rate) and then lending it to someone else (and charging them a higher rate).  The bank makes a buck on the spread.

One question to ask with any sort of intermediary is why the parties on either side of the transaction can't simply go around the intermediary.  That is, if the bank is paying you one percent but charging a borrower three percent, then why can't you just call up the borrower and offer to lend at 2%?  You earn a higher interest rate on your money, and the borrower pays a lower rate.  This would cut out the middleman, and the banks would quickly go out of business.

This observation suggests that intermediaries can survive only if they're doing something better than you could do it yourself.  In the case of financial intermediation, one of the big possibilities is that banks/VCs/angels are better at distinguishing good investments from bad.  If borrowers know better than potential lenders whether their investment opportunities are likely to pay off, then you can easily get a market for lemons, which is a subject I blogged about in long-winded, four-part fashion back in 2009.

So I think the whole crowdfunding thing is a bit more complicated than just saying "Hey, let's use the internet to allow investors to connect directly with promising startups."  Banks and VCs do things that us regular people just aren't good at --- like reading financial statements and assessing future market growth --- and the internet isn't by itself going to make us a lot better at these tricky tasks.

Financial intermediaries are really interesting to economists, probably because the very fact that intermediaries exist tells us something about when markets work well and when they don't.  I'm attending the Financial Intermediation Research Society annual meeting next week, and you probably don't need me to tell you what a good time that is....