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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