What will Happen in the DeFi lending area, A Primer: Traditional Credit and its Importance

Coin Tokyo Article

Why Credit Matters

Credit is the most boring topic in finance. It’s also the most exciting. 

Credit is boring when it exists, invisibly, as part of the fabric of a financial system. In places where this is the case – like Japan – only the absence of credit would be exciting, exciting the way natural disasters are exciting. In places like Japan and the US, credit is institutionalized.

In other parts of the world, like many countries in Africa, Latin America, and South-East Asia, institutional credit barely exists. Sometimes it doesn’t exist at all. People there can’t buy homes or cars on credit and they can’t take out loans to start a business. Countries without institutional credit, however, tend to have very well-developed informal (or social) credit systems. In India, it’s not unusual to tell a shopkeeper that you’ll pay him tomorrow for the milk you are bringing home today. Imagine doing that at a 7-11 in Tokyo.

All credit removes friction from people’s lives. Informal credit allows people to buy milk even if they don’t have enough money on hand. Institutional credit allows people to buy a car even if they don’t have enough money on hand.

Credit is a critical lubricant in any financial or social system.

But what is Credit?

Credit is Trust.

The shopkeeper in India knows the person who has taken his milk without paying. The shopkeeper (lender) knows that the borrower lives in the neighborhood, he knows how the borrower has behaved well in the past, and he knows the borrower’s friends and acquaintances. These social connections make it highly likely that the borrower will eventually pay for the milk. This “social credit” guarantees the loan.

When credit is institutionalized, that social element doesn’t exist in that way. Even if your banker knows you, the bank’s shareholders don’t. How then can they trust that you will repay a loan without a social guarantee? Very simply, in exchange for lending you money, they hold on to something you don’t want to lose, either an asset, your reputation, or both. The asset – which we can call collateral in this case – is given to secure the repayment of the loan. In English, that means that if the loan isn’t repaid, the borrower gets to keep the asset. If you borrow money to buy a house, the bank gets to keep the house if you don’t make contracted payments. This is called the liquidation of a loan. The collateral is sold for cash to recover the money lent. 

Collateral therefore acts as an enforcement mechanism for the repayment of the debt. Simple, but, unfortunately, not enough in a lot of cases.

What happens if the property market crashes between the time you take out a loan to buy a house and the time the bank realizes that you aren’t going to repay it? They may then be unable to liquidate the house for anywhere near the amount of money they lent you to buy it. 

So what else can an institutional lender get from a borrower to secure a loan? Something very similar to what the shopkeeper in India has: the borrower’s reputation.

Reputation as Collateral

Reputation is precious, and it is most precious to its owner. Its loss can be devastating.

The shopkeeper can destroy someone’s reputation by telling the community that one of its members doesn’t honor their debts. Once that’s known, the individual in question is unlikely to be offered credit by other merchants.

Institutional lenders, without the social network, essentially have the same power. They have it thanks to the credit reporting and scoring systems that exist in every developed economy. 

The mechanism is simple:

  1. Lenders report their clients’ behavior to credit bureaus.
  2. When an institution is asked to extend credit, they ask the credit bureau for a summary of the potential borrower’s past behavior. 
  3. The credit bureau summarizes that behavior into a credit score. 

Someone with a low credit score is unlikely to:

  • get another loan, 
  • be given a post-pay phone contract, 
  • be able to rent a home, and even
  • be able to get certain jobs. 

Loss of reputation in the form of a low credit score can be devastating.

This is how credit works traditionally, but what happens in the crypto space?
For the answer to that question, read “Crypto Credit – From Zero to One Trillion”.

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