Banks and Crowdfunding: Embrace it or perish


Firms increasingly involve customers in the production process and service they provide in order to realize successful projects. They outsource tasks to an (un)identified crowd, called crowdsourcing, in forms of idea generation, product development, problem solving and fundraising. This is a low-cost method of increasing product/service performance since the only optionally additional costs are rewards for the crowd.

In this blog the focus will be on the fundraising form, crowdfunding, where the crowd can online donate money to projects and firms. This money will be used to finance the projects or investments of the firm. Furthermore, crowdfunding creates public attention for and feedback on the project and tests the market potential of the product.

Firms can choose to raise capital in the form of equity or debt. Factors like a lack of pre-existing resources, risk, moral hazard, information asymmetry and the amount of capital needed should be taking into consideration in deciding how to raise capital (Schwienbacher and Larralde, 2010).

Next to the question how to raise capital it is also important to address whether raising capital for a project by crowdfunding will be successful. First of all this depends on legal issues. The regulations on crowdfunding by the JOBS-act permit companies to raise limited amounts of capital from a large pool of smaller investors (Mollick, 2012). Moreover, there are national regulations on the number of shareholders a private company can have. Secondly, geography is important since this might enable firms to have a large social network and high quality products. These factors can predict the success of the project (Mollick, 2012).

Other factors that determine the success of crowdfunding projects are the type or organization (profit/ non-profit), control preferences, amount of money required, fundraising duration and project size.

The overall success of crowdfunding depends on the success of these projects as well as the success/failure rates of start-ups. Crowdfunding will success in the future when investors will have high returns on their investment.

These high returns might persuade investors to invest their money in crowdfunding projects instead of saving their money in bank accounts receiving lower returns. Since investing in a few crowdfunding project would be more risky for investors than saving their money in bank accounts they can invest in more crowdfunding project (hedging) or can invest by the use of pooling investments and thereby bear market risk over multiple investors.

Moreover using crowdfunding investors will be able to choose in which project they want to invest their money. When putting your money on a bank account, banks will invest your money to projects that are unknown to the investors. In the former, investors feel empowered and have the idea that they contribute something to a project.

In order to tackle this threat banks should embrace crowdfunding. They can realize this by letting investors choose where their saving money is in invested. In order to implement this banks have to deal with IT and risk management implications. Although crowdfunding is focused on projects that raise relatively small amounts of capital in comparison to the money stored in banks, this crowdfunding solution will increase investments in banks as well as the popularity of the banks.

References:

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One response to “Banks and Crowdfunding: Embrace it or perish”

  1. timleerdam says :

    Very interesting article. As we can see from the many blog posts on the different ways of crowd funding, it definitely an area with a lot of growth. But I do have some questions regarding banks investing in these crowd funded projects. I would assume that people give money to the bank to keep it safe, and invest it for them. This example would propose that they can choose themselves. Research (E.G. Ordanini, 2009) shows that the crowd has often altruistic motivations to invest in projects, such as a desire to see a specific product or a feeling of joy to help somebody. This would not necessarily form the basis for good financial planning, and can have a strong negative impact on the savings of customers. Furthermore, when clients pick the crowdfunded projects themselves, it could be questioned why they need the banks at all. And there will be clients that may not have the time or skill necessary to evaluate the different projects. A solution could then be to let the financial institution pick the projects. But this of course would devaluate the human interaction that is such a recognizable part of crowdfunding. Moreover, these financial institutions have billions to invest, and these crowdfunded projects often have a far smaller scope. It might require too much human capital to invest and oversee all these projects, and as a result the returns on stocks and bonds might be preferable. Now obviously, crowdfunding is an important tool in the new world, but I would see it more as a niche market for investors. Or perhaps I have misinterpreted the system. What do you think?

    Ordanini, A. (2009),Crowd funding: customers as investors, The Wall Street Journal, 23 March 2009.

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