Risk & Capital Management for a Digital Banking Ecosystem

This is written in conjunction with prior research into operating-company cooperatives and the formation of cell-like business models.

Many larger financial services conglomerates act across multiple areas and jurisdictions but are being forced to have a single-point of entry for capital. The point of this is that capital should be transferrable from sub-entity to sub-entity if it will be used as regulatory capital. If it cannot, then it isn’t really regulatory capital.

Multiple point of entry models exist for banking conglomerates that need to meet multiple jurisdictions. Banks are also split into bank and non-bank parts that make the web very complex (the non-bank must pay more to borrow than the bank). The major point: capital is needed in a centralised place whilst risk and effort often takes place elsewhere. Risk and reward also needs to be aligned as financial services move further towards return on regulatory capital as a key metric.

When building a banking ecosystem that could occur through a similar model to Apple’s App Store, caution should be noted. In the App Store model, external companies develop into Apple’s eco-system, allowing innovation to occur and profits to be shared. Whilst Apple has been hugely successful, more value has been created by companies in that ecosystem: the accumulated value of app-based businesses dwarfs Apple. Also note: Apple doesn’t face risk of failure in each app-based business.

A banking version of the App Store is much more difficult as there is a requirement to have a technology platform plus capital and funding.

Funding is easy to manage and is really a transfer pricing mechanism: how much do you need to borrow to fund your business and for how long. External funding is also possible or straight through referral and broking into external parties. Whilst there may be an interesting cost and flow of funds part here, the mechanism is easy to understand. The key aspect of lending is the capital that protects the funding.

Bank capital or any lender capital (bank or non-bank) is vitally important to protect funding. Capital reflects the level of security any loan has. For banks, this is regulatory capital as it protects depositors against losses and allows banks deposits to be insured.

If we want to build a banking ecosystem, sufficient capital is required. Now each entity could bring their own capital but it causes a problem: they would need to inject it into the holding company to protect the holding company capital and the attached deposits (single point of entry). If this is a non-bank, it will need to attach into the entity borrowing to fund business (security for the debt). Start-ups are also short on capital.

The problem this creates is that each agent in the ecosystem needs to be able to earn and create but the revenue, data and risk needs the correct alignment. In short, we need Fintegration.

Without this commitment, the talk of creating a banking ecosystem is a fallacy. It will lead to a poor alignment between risk and reward, or the banking ecosystem will be anything but: it will be neither a bank nor an ecosystem.

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Risk Retention Is Always Required As Risk is Always Here

At the end of the year in 2006, a group of senior bank executives got together to discuss the year. Included in this was the recent year’s performance, their forecast for the future and general chitchat.

The prior years had been blockbusters for them. Large house price gains, a collapse in the cost of financing (in the form of tighter credit spreads) and fantastic momentum in the economy created a feeling of invincibility. This lead to aggressive future growth estimates, assessment that if there was a contraction, a huge amount was required to even make a small dent into them. They thought the boom and bust cycle was gone forever, they had the best risk systems ever developed and economic profits would continue indefinitely.

Those looking for an alternative the new Star Wars film should consider The Big Short as it has a great explanation that whilst the self congratulation was coming out from one group of executives, others were merrily working away at alternative and very contradictory ideas. Harbinger, a hedge fund ran by Philip Falcone, was one firm to take a dramatically different view that catapulted the firm on the world stage.

So where are we now and what can we learn from this?

From an unknown unknown perspective, risk will always be there. It develops and changes over time and does become mis-priced and buffers for some people become insufficient. Right now, the outstanding $2trillion of debt financing resource companies has a strong parallel and CLO (collateralised debt obligations) that survived the financial crises incredibly well might now face a different and new risk if any form of contagion spills into the market.

Funding has changed dramatically and liquidity requirements reduce the risk of an outright credit crunch (liquidity was mis-priced in 2006). But what else could be mis-priced? Revenue could easily be overinflated and margins can erode so quickly across entire sectors. Within Australia, importers may face greater pressure as currency devaluation is used to support exporter (notably the resources sector). If they can’t pass on increased costs to a constrained consumer, margins will erode. If they try to pass on costs, revenues will fall. We will continue to look at the auto market as our leading indicator.

Can we do more to manage risk?

Returning to risk, my personal view on this matter has always been that the seller of investments or debt needs to have an associated through-the-cycle exposure to downside risk. Even short economic cycles of 5 years are enough time for risk to become poorly allocated by investors. A counter-balance is the skin-in-the-game or risk retention rules proposed in recent years. We are finally starting to see the legislation from the GFC form into live regulation.

This by no means suggests current incumbents don’t understand risk. It is a view that all current incumbents should align to the entire system’s through-the-cycle performance. And this includes sales.

So whilst we don’t know what the future will hold, we should continue to look at current incumbents who are creating large economic profit, are able to directly extract this from the financial system and are not directly impacted from cyclical impacts except for a potential decline in revenue. This means others are bearing the risk that should be allocated to them, a risk that people forget to notice.

Some investment banks proposed that staff should receive portions of the investments they create as a bonus rather than cash. This would cover many areas of insufficient capital. There are many more areas where this can apply and we will continue to discuss them in the 2016.

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Musings of a FinTech: Disruption or Partnerships

The inspiration for this weeks musing come from an article on fintech news: Banks vs. Fintechs.

With Malcolm Turnbull’s government announcing an #ideasboom over the last week, now is a great time to discuss who and where innovation can come from. We say can, rather than should, as innovation is possible from anywhere. However, there is a difference in risk, execution and what the innovation represents.

Firstly, why innovate?

This one is simple: if you don’t innovate, you get left behind as others innovate and find better ways to do things. Innovation also comes in various forms: incremental innovation does continually happen but large leaps forward are also possible. Here we are talking about a leap forward in innovation to create competitive advantages and new systems, something that incremental innovation cannot get you. The mathematician inside me reverts to bifurcation theory: a leap represents a change in behaviour that impacts the way we do things. It’s going from doing things efficiently one way to re-writing supply chains, processes and technology to gain much more efficiency. This can occur through a number of ways, including recessions, but we also want this to occur occur by risk taking, investment and partnerships.

Innovation aims to create better outcomes for people. Better products for consumers, better environmental or social outcomes and better financial returns for those who take a risk.

What is improvement in financial services?

This comes in two formats. We can have cheaper/faster, which is an efficiency drive. We can also have a better  or new product outcome, which might have less risk, greater significance to life goals, more suitable or open up new business or personal possibilities, such as greater certainty, flexibility and security.

Can banks do this?

Yes. However co-ordinating on a new idea and allocating resources on an unknown before any advantage is seen is difficult. Banks are better positioned to use their financial resources and expertise on incremental improvement, and they do. But how do you know where to put your best developers or financial engineers? Do those teams have the ability to pivot ideas and effectively adjust their mandate?

What do FinTechs bring?

True experiments, with higher probabilities of failure but higher rewards, are better done in start-ups. The overall cost is lower as a FinTech can attract top quality engineers (software and financial) who have belief in a vision before it is known if it actually works. They may even need to run multiple experiments (read business failures) before they get the right formula, see the feedback from prior experiments to create the final solution.

Best solution for Australia

Forming partnerships between banks and FinTechs are key. The blended solution brings the best of the 2 groups but also allows freedom for each to operate, including servicing an existing economy and manage uncertainty with the development of the future. This should drive higher returns on capital for banks, improved products for the public and export our expertise, which will create more jobs for the next generation of Australians. FinTech has the potential to create and support 100,000 Australian jobs over the next decade.




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Vacancy First, Price Decline Second

Property investment is a very interesting space. Coming from a fixed income investment background, the obvious link to fixed payments, generated from rent less interest costs, on an asset spring to mind. Capital appreciation is usually included. Capital depreciation can also be considered: maintenance should be offset by rental payments.

Overall, this means that a property’s price has a mostly linear relationship with rental rates. If you are really looking at this, vacancy rate forecasts should also figure. Vacancy is a natural aspect of renting: customer churn and lack of demand all take their place.

Vacancy rates themselves create something interesting and we quickly start to see a complex relationship. Vacancy could occur from a high price: the property owner waits until a high-paying customer comes along and may have higher specification in the property. The vacancy rate could be naturally adjusted by lowering the rental price and we have an really interesting dynamic between price equilibria that can be saved for another day.

More concerning is that a decline in demand due to a shift in people wanting to rent for any price is also possible. Loss of jobs, a desire to buy and not rent or property investors not wanting to rent places out altogether as it may not be economical versus their view on capital depreciation.

A new Prosper Australia report suggests vacancy rates in Melbourne for Investment properties is over 20%. This causes a few concerns:

  1. Investors are short of demand or they are choosing not to rent out
  2. What is happening to rental prices: we would expect the to decline if there is an oversupply of rental property
  3. Has the investment case for property shifted from net rental metrics to pure capital appreciation

Our expectations is a mix of these and other factors. The greatest concern is the pure-play capital appreciation. If all the recents returns are due to capital appreciation, then we expect a higher level of selling if prices decide to flatten or decline: investors will want to lock in returns in uncertain times, such as a recession.

This also suggests a breakdown in investment thesis: leaving places empty, particularly apartments, means the land value is the main driver in price. We agree there is a grab for high quality locations but this may not be the most efficient allocation of capital. Watch this space.

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