I’m revisiting an old post in part due to reading an excellent article in HBR on disruptive innovation.
One particular point stood out and it was the chart showing how incumbents move from low profitability products (low-end) to focusing on high profitability products and customers (high-end). This makes complete sense: as you establish yourself and grow, your portfolio of customers should be streamlined to what makes the most money. Your business may have achieved the required scale to deliver the more profitable products. In lending, the obvious example is the mortgage product due the required scale for deposit financing. The profitability should be driven by Return on Regulatory Capital (RoRC), however other items always need to be considered.
I have said several times that SME or personal lending is not profitable through business cycles if the cycle times are short. During downturns, these portfolios experience heavy losses that take many years to recoup. I have always believed the magic number is 7 years (roughly derived from a 7%-12% loss in 1 year offset by 3%-5% pre-expected loss margin in other years). In the sense of thinking about lending on the efficient frontier, SME or personal lending is not on it whilst mortgages are close to the optimal point (see below, numbers in brackets are approximate net returns for a relative perspective only).
Due to this, the appetite to increase lending to this segment is limited: any additional lending is generally at the riskier end of this segment, meaning the time between recessions needs to be longer for it to be profitable.
On the other hand, mortgage lending is somewhat different. Highly collateralised loans, with loan-to-value ratios less than 70% need a hefty recession to really hurt. Think 40% decline in house prices as well as the recession’s severe default impacts. In other words, mortgages still make money in a modest recession.
This leaves a big opening for FinTech: SME or personal lending has a ready market. In a similar way to the HBR article, this is certainly the low-end of the market. Unlikely to be profitable through shorter business cycles or they have a terrible RoRC, hence why the opportunity is there. Peer-to-peer platforms have found an additional way to mitigate the recession cycle risk: decentralised risk taking.
Disruption occurs if FinTechs can climb up and offer products to the higher end of the market. But how can a FinTech entrant establish the infrastructure to offer more sophisticated lending products?
Why are mortgages more sophisticated?
This is less easy to explain but comes to liquidity. SME or personal loans are short term, such as a few month to a few years. This means the invested money is returned to the investor within a reasonable time and they are happy to leave it on the platform for a few years. Mortgages are very different: the time may be 25 or 30 years before it is a fully returns and with an average return time between 4 and 7 years (due to refinancing). This is a little too long for the crowd and requires more sophistication in the form of maturity transformation, an aspect of banking that is very important and a major failing through the financial crisis (credit crunch).
What can FinTechs Do?
- They will need to bulk up on skilled staff for one. If you don’t have a specialist risk and capital team, you will struggle to perform a maturity transformation.
- You can decide to not be a disruptor. Instead a FinTech can be a complimentary service to a particular bank and you attempt to disrupt together.
- Enter the higher end of the market (mortgages) with a low-profitability product (I have deliberately left out the description of this). Here you hope the infrastructure will develop around you or you have the ability to turn what looks unprofitable into something profitable through innovation (e.g. your data analytics capability).
Bigger questions come out of this:
- How does a FinTech diversify quickly enough. If it doesn’t, we may start to see a higher failure rate across FinTechs
- There is a shared incentive across lending FinTechs to build a shared deposit infrastructure to help them diversify