Before we delve into variables and risks within FinTech and lending, we need to start with a simple view of what banks are.
Banks are a financial intermediary between sources of money, such as companies creating value and individual depositing their salaries and savings, and companies or people needing money, such as a loan.
The core basis of our financial system is that banks originate-to-hold to both sides of their equation (borrowers and lenders). A company borrowing from a bank owes the bank money, which is a clearly separate risk from a pensioner with their cash sitting in a savings account, for example. That pensioner receives interest payments that are unrelated to the risks the banks makes elsewhere.
Deposit holders (The Pensioner) then get government protection if the bank fails. If the bank fails, this will be due to incredibly severe losses in their lending books (insolvency) or a deep mismatch in the timing of loans (this is to do with liquidity). Banks are well regulated to cover these risks.
This model works well on a few fronts, most notably if the lenders (The Pensioner) and borrowers want 2 different things. This creates the requirement for banks to manage risks and perform maturity transformation. A bank’s core function is risk transformation.
The above model is a well-tested model and has functioned for many years. Bank regulators set capital to cover risks that has mostly worked but is also expected to fail at some points in time and this is where regulators, central banks or governments need to intervene.
Originate-to-distribute systems are slightly different and were originally about removing risk from the banking system: allowing banks to sell on some of their risk to investors who want that specific risk or require a higher return. This then frees up banks to make sequentially more loans rather than being full of legacy loans.
Problems pop up straight away
We have a few clear problems here. Firstly, this enables more lending. This is good if it allows more companies to exist or allows more people to borrow to achieve life goals. However, the expansion of lending pushes up asset prices. Further, the selling of loans by the bank puts a slight question as to what they care about: volume quickly surpasses quality.
This model works well if the risks are well-managed and consistent, however we have seen how this breaks down when fraud or manipulation is introduced. The originate-to-distribute increases the potential for fraud and manipulation as selling becomes a primary function for more of the credit supply chain.
Under the microscope
Now we must realise a few things: if we start to look at bank processes in a more granular way, originate-to-distribute appears in several formats in most financial intermediation systems. Sales functions themselves are originate-to-distribute, particularly if those functions are rewarded in a predominantly upfront manner or have little risk on the table.
The construction of the Australian mortgage industry brings up more examples of originate-to-distribute.
Firstly, most Australian banks under the standard variable home loan place several of the loan risks back with the borrower – notably bank credit spread risk and interest rate risk. Secondly, mortgage brokers are a large component of the mortgage industry.
Borrowers keeping the risk
The obscure part here is that if you take a loan from a bank as a borrower, the bank keeps the default risk but the borrower faces a number of other risks. The borrower keeps the interest rate risk and credit spread risk. What this means is Australian banks have manufactured a way to maintain margins and allow them to originate loans in a limited risk environment: they can simply increase interest rates to cover their margins.
Mortgage brokers are a direct originate-to-distribute model as a sales function. If they don’t’ originate loans, they don’t get paid.
Why we don’t like this
Returning back to the originate-to-distribute, as the sales function or bank is less inclined to hold risk themselves, they really only care about volume knowing that they can re-price loans at a later date. This isn’t a claim that it is occurring, rather than an observation that this has a potential weakness for fraud or manipulation. Variable rate loans and the attached credit supply chain have become lazy: risk transformation has reduced as borrowers keep more of the risk.
Now we have set out the problems in the current system, we can start to look at how they relate to risk management for FinTech and why a superior system is expected to emerge. Tune in for Part 2.