In Part 1 of this post, I described where we currently are regarding originate-to-distribute risks. Australia has a heavy sales culture across financial services, run by manual processes that the industry admits “mostly does a fulfilment process”. In the long run, FinTechs need to prove they can do more than distribution.
In recent years we have seen wider adoption in the US and Europe for online lending. Peer-to-peer models are particularly powerful, as they don’t require bank balance sheets or regulatory capital and many cost savings can be passed back to lenders or borrowers.
The main risk we see in FinTech lending is that the fledgling industry is trying to replace a mostly reliable format with a model that may overlook risk management processes. Do remember that banks, as much as they try to redress themselves as technology companies, have a core function in risk transformation.
Lending FinTech still needs to consider risk transformation
Risk transformation is an interesting thing. Some FinTechs believe that the sharing economy can probably perform the task itself and this is the purest part of peer-to-peer lending. If consumers can capture the efficiency savings, or at least the reward previously captured by banks, then it serves a purpose. However, I doubt that individuals have the capability to perform all the required risk management functions, particularly the measurement of unexpected losses in recessions.
For FinTechs who have aspirations to stand taller than the past models, they need to develop strong risk assessment at a minimum but also address the potential for fraud or manipulation over time. There are several other mechanisms you can put in place to manage those risks but they will need adoption by incumbents too as existing constraints impact what is achievable.
Will we see a wider distribution model
The question is where do FinTechs go? Without large balance sheets they will either have to be ever more reliant on a retail distribution model (peer-to-peer) or look for alternative wholesale funding models and rely on being a sales entity.
Securitisation immediately springs to mind but I would suggest this will fail if start-ups don’t’ have deep expertise in this area. A type of government guarantee, similar to a deposit guarantee, would also work but needs the FinTechs to demonstrate their ability to manage risk and a standardised framework to be built by a regulator.
What could FinTech risk management look like
Better risk management tools do and can exist but may need system-wide re-design – but start-ups are free of some legacy constraints. Answers point towards new risk management frameworks and how they directly compete against distribute-to-originate risks that sales-only business models face. This might be in construction of the FinTech or by the relationships built with incumbents, and knowledge of regulations would fall upon FinTechs (we doubt incumbents would push this on behalf on fledgling start-ups unless they wanted to pivot to a FinTech centric utility bank).
A key component will be avoiding swathes of sales heavy teams extracting upfront value, even if venture capital investors demand this to de-risk as quickly as possible or to avoid later capital raising and dilution. Luckily tech driven approaches who achieve low customer acquisition cost have the capacity to offer this, as long as the customer can recognise the additional work being done in the background (and government guarantees or third party approvals are effective ways to communicate this).
What Huffle is doing?
We have created an entire risk management framework that covers the above and forms part of why we can bring more attractive home loans to the market. Partially driven by a credit supply chain re-design but also what processes we do:
- Actively managing credit risk and interest rate risk on a daily basis, driven by new data sets and in-house models based upon our prior professional experience
- Being capital additive to the banking system
However, if we truly want to enable these changes, we need to let go of our legacy models that have the originate-to-distribute risks embedded within them. Overall, we’ll have a stronger financial system that will be more resilient through business cycles.