I recently had the opportunity to talk with multiple executives of Fintech firms -- i.e., tech companies that provide financial services online or by way of simple and highly customer-centric mobile apps.
These are incredibly innovative businesses, and it was a pleasure to speak with the people that are powering them forward.
In the course of these conversations, however, I kept finding myself thinking that many of them aren't giving enough credit to the economic and regulatory dynamics that loom over the financial services industry.
This partial blindness convinces them that disrupting the industry will be easy, as if this is the first time in history that a collection of new firms have sought to revolutionize the way that money is allocated between savers and spenders.
I believe this is a mistake. I also believe that the Fintech companies that combat this belief with humility will be among the few that prevail in the end.
The holy grail of finance
I'm talking specifically about depository institutions, as cheap money by way of deposits is the holy grail of finance. Just as importantly, when you couple that with a prudent lending operation, you're able to realize the full profit potential of a large deposit base.
It's here where humility comes into play.
If a Fintech company wants FDIC insurance, which is necessary to acquire the quantity of cheap deposits it'll take to attain sustainable long-term profitability, then it'll have to submit to the same regulatory and compliance framework that traditional banks do.
On top of this, for a Fintech company to truly disrupt the financial services industry at its core, it will need to crack the nut on credit risk -- i.e., the risk that loans will default when the economy takes a turn for the worse.
I got the impression that most Fintech executives I've spoken with believe that taming credit risk, and the credit cycle more generally, is easy. The key to doing so, they argue, is in the effective use of "big data" -- the combination of vast tracks of traditional and nontraditional observation points in order to inform the decision-making process.
But this argument ignores a fundamental fact. No institutions have better data on individual consumer's financial worthiness -- not to mention historical trends of loan performance more generally -- than banks do.
The nation's biggest financial firms in particular have the ability to know basically everything about almost everyone. It's just a matter of creating systems that will allow them to tap and exploit their vast repositories of transactional data.
When talking about big data, then, it's critical to appreciate that banks have a considerable lead over Fintech firms. It's also critical to appreciate that bankers are doing everything in their power to leverage it to the greatest extent possible.
Giving credit to the credit cycle
It's true that banks haven't always done the most amazing job at managing credit risk in their own right.
But it's a mistake to interpret banks' struggles in this regard as an intellectual shortcoming unique to bankers. We all suffer from the same emotional and behavioral biases that lead banks to lend too much money when the economy is roaring only to then regret the decision later on.
It's a lot like Jerry Seinfeld's routine about morning vs. night guy. Night guy wants to stay up late and drink too many shots of Jagermeister. But it's morning guy who pays the price.
Given this, banks' struggles to thread their way through the credit cycle should be interpreted instead as a sign of just how difficult it is to do so both profitably and over a long period of time.
The credit cycle is a powerful and unpredictable force. Any belief that it can be tamed is, among informed observers, laughable.
Not to mention the fact that it may not be in society's best interest to tame it in the first place. If you look at history, you see that much of America's rapid economic ascent was funded with bonds or bank loans that subsequently defaulted.
In the Gilded Age, for instance, the reason the United States was able to expand its railroad network so far so fast is because credit poured in from Europe. This positioned the country to populate the entire Western portion of the continent in a surprisingly short amount of time.
Along the way, the credit-fueled boom faltered on multiple occasions -- most critically in the 1870s and 1890s, after which full-scale economic depressions took hold.
With the benefit of hindsight, however, it's clear that those were small prices to pay given that they yielded the most powerful and industrialized country in the world. And it did so just in the nick of time, as the speed at which all of this was achieved went on to position the United States to weigh in on the balance of power in Europe when it was so important to do so -- in the two world wars, that is.
The point being, even if we wanted to tame the credit cycle, it's still the banks that are best positioned to do so given their access to more and better data. And given the importance of prudently managing credit risk to realizing the full value of a deposit base, it stands to reason that banks probably aren't the pushovers that many Fintech executives and participants seem to think.
I'm not saying that some Fintech companies won't be able to overcome these hurdles, as some probably will. But I am saying that it will be a hard-fought battle and that approaching it with the humility it deserves is, I believe, a necessary component of success.
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