Musings of a Fintech: Huffle 10 Year Fixed Target Pricing Drops to 4.49%

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The RBA cut the cash rate to 1.75% this week and further rate cuts are expected. This sent the team at Huffle back to the loan lab to tinker with our model. Adjustments are required in our modeling, not only in the yield curve but also the pricing of interest rate derivatives.

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The daily feed of Aussie government bonds show the recent decline in borrowing costs but also a slight increase in steepness in yield curve. This is indicated by the 2-10 Spread, which currently sits around 72bps. On a very simplistic level, this indicates that our expected pricing for a fixed rate, hedging and capital aside, is likely to be 72bs higher than where the variable rate home loan market is.

Updating our models and with a Return on Equity hurdle at 20%, we have reduced our expected pricing down from 4.99% to 4.49%. The main gains are due to the current derivative pricing and volatility.

Why is this the case?

As rates compress towards zero, the embedded call option in fixed rate prepayables has a reduced upside value to the borrower. The result is that this has a reduced sale value that would naturally be added into the price of the mortgage. The overall impact is a bigger reduction in the expected fixed rate loan price compared to the observed rate cut and decline in the yield curve.

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Musings of a Fintech: Single-Product Single-Brand Strategy

One of my guilty pleasures is watching Gordon Ramsay blow off steam. It recently occurred to me that his TV show, Kitchen Nightmares, has a nice insight into bank product offerings, marketing and product development.

In Gordon Ramsay’s Kitchen Nightmares there is one specific action he takes in almost every episode. He looks at their huge menus, usually multiple pages of every option possibly available, and culls it to a 1-page daily menu of the best items. He does this for a few reasons:

  1. Customers can’t decide, it is too hard, and then they pick something they don’t really want or the most popular default item.
  2. The restaurant needs to keep a lot more ingredients and perishables. This has a substantially higher cost in terms of wastage and inability to bulk buy.
  3. The restaurant doesn’t have a clear identity. Does it sell pasta, pizza, fish and chips, burgers or a sub-set of them.

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On the opposite end of the spectrum a great example is one of my favourite eateries in London, Burger & Lobster (no Ramsay link, as far as I know). As evidenced by their name, they only serve 2 things. This offers a great advantage:

  1. They clearly show what they do. Customers understand this. When they want burger or lobster, guess who is the first choice restaurant.
  2. They can buy in bulk. Lots of lobster and beef. This means they can offer more competitive pricing and their staff can become specialized at cooking specific dishes. Margins increase.

Pr. Mark Ritson of Melbourne Business School and advisor to many world leading brands, also believes killing brands or items is more important that creating them. It becomes harder to sell so many products under a house of brands or branded house and also to keep them all relevant. It is also a headache on stocking and matching demand and supply. Large businesses need to reduce first.

So what does this mean for banks and Fintech? We suggest a few key points:

  1. Whilst large banks should be culling SKUs (financial products), FinTechs should fill the void and be product specific. We call this “Single-Product Single-Brand” strategy.
  2. Single brand for a single product: the Fintech becomes specialist in a specific area and customers who want a product go to that fintech first. This creates marketing and sales efficiency as the brand becomes synonymous with that product.
  3. Navigating through most bank websites is like the old restaurant menus. See for yourself – try to find CUA’s credit card products from their home page (hint: you’ll probably have to use the search function as they aren’t there!).
  4. Lack of product differentiation between the banks means customers simply can’t decide. So in the case for home loans, they defer to a mortgage broker for fulfillment – creating an unnecessary expensive cost to acquire new customers.

So where does that leave us? If a bank had to pick what its single product would be, I expect it is going to be deposits. This is the item they are regulated on and have strong risk systems in place, particularly over capital and liquidity. One way this could go is the concept of “utility” banks, which sit as the underlying layer of financial services. On top of this core utility layer there could be a number of “single brand, single product” FinTechs acting as satellites with unique products and customer experience tailored to specific segments.

The major challenge to banks specializing in core deposits? This is the areas that Google, Apple and the large tech giants are likely to go after in coming years, but we’ll save that for another blog.

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