Will FinTech Companies Disintermediate the Banks?

By Roy C. Smith

Regulation following the Financial Crisis of 2008 has tied the global banking industry in knots, especially the European portion of it.  Increased capital requirements (relative to risk-adjusted assets), decreased leverage, requirements for liquidity, stress tests and fears of litigation for products or trades that go wrong -- along with serious damage to reputations -- have forced most large banks into subdued “regulated public utility” business models, from different from the opportunistic, trading oriented, integrated capital markets/commercial banking model that all adopted after the repeal of Glass-Steagall in 1999.

So, the financial services industry is now vulnerable to attacks from outside the industry, especially from those aiming to use modern technology in various ways to secure competitive advantage.

A new financial industry – Financial Technology (“FinTech”) – has already risen to challenge the old by offering new ways to use modern software and Internet technology on a (much cheaper) non-banking regulatory base to disintermediate traditional financial products (mortgages, personal loans and deposits, trading, asset management, and transaction processing). And they have been quite successful so far by reducing the cost of and access to financial products to tech-savvy retail users. Quicken Loans is now the country’s second largest mortgage provider; in 2017 five of the top ten mortgage providers were non-banks that accounted for $114 billion of mortgages. Lending Tree is the leader in the non-bank digital lending market place, providing $41 billion of personal and commercial loan originations in 2017, and a variety of “robo-advisers” accumulated $181 billion of advisory assets under management. In addition to these sectors, FinTech activity also is spreading to insurance, payment processing, and blockchain management. All of these sectors have been growing much faster than their banking industry peers, but because of the vast size of the global financial services industry, their cumulative market shares remain small. Risks associated with FinTech activities, so far, have been minimal - exposures are diversified over large numbers of relatively small separate accounts.

In February 2019, Forbes published its fourth top-fifty FinTech list. The top five firms on this list had combined (estimated) market value of $50 billion. Some have already gone public, others are “unicorns” (financed by private equity funds) waiting their turns.

FinTech firms compete on the basis of accessibility, price, convenience and the ability to gather customer attention in fresh and innovative ways. Accounts can be opened and deposits made in no time. Loans can be obtained without guarantees or collateral after filing out an on-line form for an algorithm to process. Costs of trading and execution are competitive with on-line brokers. But, so far, these low-overhead entities are not subject to banking and securities regulation, nor are they entitled to Federal Deposit Insurance.

FinTechs do not have large balance sheets, and so must sell off the loan/deposit packages they generate, either to FNMA (for qualifying mortgages), or to banks, the institutional or securitization markets. This, however, exposes FinTech firms to wholesale rates set by the interbank markets (to which FinTechs do not have access unless they have a partnership with a bank). In other words, after a certain amount of grabbing of low-hanging fruit, the FinTechs don’t add much economic value to the markets they hope to serve, especially to larger customers. They do hope to operate on a small business friendly basis, and at a lower cost because of lower overhead and regulatory costs.

FinTech risks can involve faulty algorithms that don’t keep up with quickly shifting changes in the consumer credit market, liquidity squeezes when mark-to-market accounting requires write offs just when assets need to be sold and new investors are scarce. Further, large retail banks will fight back – Goldman Sachs and Citigroup have announced major digital banking initiatives.

FinTech investors will do well to remember the tech revolution of the 1970s when approximately 100 PC hardware manufactures competed to dominate this new industry. Investment banks clamored to underwrite new issues of securities issued by companies with no profits.  Only a handful of these companies have survived. The early days of the Internet provided a similar scene of B-to-B and B-to-C innovation that also left only a few firms on the field after the “tech wreck” of 2000-2002. Those that disappeared either went bankrupt went bankrupt when roll-over and working capital finance dried up suddenly (many did), or were successful in quickly selling their firms to larger competitors like Microsoft that used high-priced stock to acquire technology they didn’t have.  There have always been profits to be made in technology revolutions, but big losses too.

Tech revolutions often start with attacks on stogy industries that need restructuring and renewal, and can raise capital because their undertakings are the newest new thing. The various financial service industries are now in the cross-hairs. The established financial services firms, particularly the banks, are also trying to adjust their business models to utilize technology to lower costs and make things work better. Some banks will make successful business model transitions, but many won’t and will be broken up and restarted by new investors supporting FinTech applications. Some of these may be large non-financial, tech heavy corporations like Walmart, Amazon or Apple  

But in the end, all finance involves other people’s money and requires regulation. Non-banking entrepreneurial ventures are not the same once they are captured by the regulators. Competition too is different in markets willing to take risks for small gains. The list of large non-banking firms that failed in taking over investment banks and brokers in order to turn them around is very large and includes such companies as General Electric, Prudential Insurance, Sears Roebuck, and American Express.

Still, Fin Tech firms have been able to attract start-up capital readily, some from private equity firms that intend to provide funds for promising companies to grow as fast as they can without worrying about profits, then selling to another financial service company or going public, much like Tesla, Lyft and Uber have done. But when bubbles burst, profits are hard to find. Uber’s stock is down 18% since its IPO, Lyft’s is down 33%, and early FinTech darling, Lending Club, is down 86%.

FinTech is here to stay, but not all the FinTech companies are.  The financial services industry needs the know-how, the energy and the new product innovation that FinTech represents, but a lot of it will come from tech engineers hired by the banks, such as Goldman Sachs at which computer engineers now represent a quarter of the firm’s total headcount.

Bridging The Public Pension Fund - Infrastructure Gap

By Clive Lipshitz and Ingo Walter

During the State of the Union address, President Trump issued a renewed call for an infrastructure bill. Two days later, the House Committee on Transportation and Infrastructure held its first hearing of the new Congress to address the state of U.S. infrastructure. Confronting the nation’s infrastructure gap is one of the rare bipartisan issues in Washington today. It is a priority for the American public and for elected officials at the federal, state, and local level, all of which make it a likely legislative focus for both the 116th Congress and the Administration.

That U.S. infrastructure needs improvement is not news. Any discussion about closing the $2 trillion 10-year investment gap quickly zeros-in on funding – revenue streams in the form of dedicated taxes or user fees – and financing solutions. While there are perfectly suitable public finance tools, a large pool of untapped available capital resides in the retirement funds of public sector workers. In a new, detailed study of the $4.3 trillion U.S. public pension system, we’ve investigated the infrastructure investments undertaken by the largest public pension systems in the country. Our findings suggest now might be the perfect time to match pension capital with infrastructure investment needs, creating winners on both ends of the financial chain.

Infrastructure assets have features that are appealing to pension investors. They are long-duration and offer some degree of inflation protection. They are not correlated with the other asset classes so they offer much-needed diversification. Best of all, they generate steady cash flows to meet the needs of current retirees. These are among the reasons pension funds have cited when establishing programs to invest in infrastructure, and our analysis bears out most of these benefits. Still, infrastructure investment programs in big American public pension funds are relatively recent and they remain small – averaging less than 1% of fund assets.

Implicit in public pensions’ investment objectives is to accumulate cash flow-generating assets and hold them for a long time. Yet when pension funds invest in infrastructure, they typically invest in private equity-type funds that often have first-rate expertise but seek capital gains, not current income. And the funds usually buy infrastructure assets from other private owners. These investments have generated strong returns in the form of capital gains, benefitting substantially from rising valuations. Infrastructure assets now trade at multiples well in excess of those in other investment classes such as real estate and private equity. But these investments don’t generate much in the way of the cash-flows pension funds need to support current retirees. Bottom line: Insufficient investment in infrastructure as an asset class, using the wrong investment vehicles, and for the wrong purpose. There are better solutions.

To explore ways in which pension capital might evolve into a financing solution for U.S. public infrastructure, we might look to models that have been successful in other countries.

In Australia, asset recycling is a financing tool that has been used successfully to “repurpose” infrastructure capital. Public sector agencies sell long-term concession rights on existing infrastructure to investors (including pension funds) and use the proceeds to finance development of new infrastructure. The public sector retains ownership of the legacy assets, receives cash proceeds to develop new infrastructure, and avoids burdening its public finances with more debt. Private investors get a stream of proven cash flows from existing infrastructure over a fixed period of time. The federal government often provides an incentive in the form of a top-up of the proceeds from the concession sale.

True, institutional investors like pension funds are wary of investing in ground-up development -- they are properly concerned about cost overruns, delays, and unpredictability of revenue streams. But pension systems are uniquely positioned as informed and influential players in regional and local economies. Just one example: The Quebec pension fund, CDPQ, developed and operates Montreal’s light-rail system and was able to assemble the financial and technical resources and muster the political support to pull it off.

Among the other ways to deal with infrastructure project risk is partnering pension capital with the knowhow of EPC (engineering, procurement, construction) firms, which have extensive experience in designing and delivering new projects. Dutch pension funds, for example, have invested alongside engineering firms in new road construction projects.

Of course, using pension capital on public works requires strong governance to avoid white elephants, waste, and bloated costs. The presence of private capital can provide necessary transparency and discipline. And there is an argument for investing pension capital locally. If done right, it can generate economic development, which in turn leads to more jobs and more tax revenues – ultimately favorable to sustainable pension finance. Additionally, when pension funds invest directly in infrastructure, they don’t introduce the political risk of transferring “crown jewels” to private investors.

Most important is to put in place mechanisms that will allow for an improved flow of investable U.S. infrastructure assets. When that becomes evident to pension fund administrators, they will become more comfortable expanding their allocations to this attractive asset class – perhaps to the 5-10% levels that are common in Canada. This will provide hundreds of billions of dollars in incremental financing which will go a long way to reducing our infrastructure gap.

Clive Lipshitz is managing partner of Tradewind Interstate Advisors. Ingo Walter is Professor Emeritus of Finance at NYU’s Stern School of Business. Their study “Bridging Public Pension Funds and Infrastructure Development" has been released in the spring and is available on SSRN.