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.