Rethink the customer to build the bank of the future
This year’s annual leadership dialogue was held in conjunction with the inaugural The Future of Finance Summit to discuss how new business models and technology are disrupting and transforming the industry.
- The panel of this year’s leadership dialogue talked about the evolution of marketplace platforms in the two large markets of US and China
- The agenda focused on a number of major disruptions that are transforming the industry
- The panel also stated that technology will transform the foundation of risk management and the lending business
The panel of this year’s leadership dialogue was comprised of Barney Frank, former US Congressman, chairman of House Financial Services Committee and co-author of the Financial Reform Act; Ron Suber, emeritus president of Prosper Marketplace, one of the US leading online marketplace lenders, Tang Ning, CEO of CreditEase, China’s leading online peer-to-peer lending and wealth management/investment platform, and David Shrier, managing director of MIT (Massachusetts Institute of Technology) Connection Science and Engineering.
Unsurprisingly the agenda focused on a number of major disruptions that are transforming the industry. None more so than how the emerging network economy is transforming the traditionally intermediary based business of lending and investment, through the activities of marketplace or peer-to-peer platforms.
The discussion was wide ranging, and touched on the evolution of marketplace platforms in the two large markets of US and China and implications for other markets; regulatory attitude towards these players and shadow banking in general as well as how emerging technology in data analytics, artificial intelligence and automation will transform the foundation of the lending business.
The advent of the network economy
The network economy, an evolution and extension of the information economy, distinguishes itself by one key attribute. By Wikipedia’s definition, products and services in the network economy are “created and value is added through social networks operating on large or global scales. This is in sharp contrast to industrial-era economies, in which ownership of physical or intellectual property stems from its development by a single enterprise.”
Hence, the business models of network economy companies are not necessarily based on them owning the assets that ultimately generate revenue and profits, in the case of the lending business – a loan, but that that asset and ownership rights for value embedded in it is created by a social network/platform. Hence, a marketplace lender is a misnomer because it is not really a lender in that it does not lend from its own balance sheet but by facilitating lending between individual borrowers and lenders through its platform, and each lender actually owns a piece of the loan.
The same for other network based companies, such as Uber, Airbnb, that do not actually own the products and services that they offer to users of their respective platform. And because these network companies facilitate the connection and transaction between individual users and product/service, i.e. value, providers, they “democratise” the whole process of production, procurement and delivery.
They allow exchange to happen at the lowest unit of value, and between the largest number of users and producers. Scale becomes a non-issue and is in fact a strength of the operating model, and they become a more inclusive way of producing and providing products and services.
And through the use of big data analytics, artificial intelligence and automation they are able to better understand the behaviour and characteristics of individual users and producers, to facilitate more efficient value exchange between them, optimising marketing and conversion potentials as well as to managing and mitigate risks.
The evolution of marketplace platforms
Suber described the evolution of the marketplace lending business in the US. In the first phase, around 2006, it was structured like an online exchange such as eBay, where it was purely peer-to-peer and there were no institutions, where people bid against each other as investors to determine the price, i.e. rate, the term, and the amount, versus the borrowers.
The second phase occurred between 2008 and 2013 – where the platforms developed credit models to better assess and price risks, and verification models to assess the borrowers and they started to register with the Securities and Exchange Commission (SEC) and state governments where they operated in. Then, in phase three from 2013, at least in the US, they started to move away from the pure peer-to-peer model and invited the institutions in, where they created loan origination channels “which banks could buy and leverage, and rating agencies could rate, and we started to securitise our loans in 2014.”
Some banks partnered with these platforms to do LAAS – lending as a service – where the banks maintain the website and the front-end, and the platform does credit processing and customer verification. The banks buy the loans they want, and the ones they don’t go to the marketplace. Some banks are looking to buy platforms and some are building their own, like Goldman Sachs. The Office of the Comptroller of the Currency (OCC) is also looking at allowing fintechs to operate chartered banks. Tang shared that the peer-to-peer marketplace lending business in China has stayed close to the original peer-to-peer business model and has in effect evolved and expanded the network effect into the related peer-to-peer wealth management area.
Unlike the US, China lacked a proper and robust credit infrastructure: “We have no credit bureau, no FICO score. The underserved need was very obvious at that time, and so, institutions were enabled to help. So, we invented the marketplace lending model. In later years, the model grew to a trillion-dollar industry, and it’s now a pillar of China’s financial innovation.”
In addition, such platforms have made financial inclusion and serving the unbanked possible. But can it be replicated in other emerging markets with huge unbanked populations? Participants shared that many challenges remain, one is the lack a centralised credit system to help assess, price and underwrite risk, next is the platform’s ability to compete with banks on the cost of funds, especially given the current low rate environment and lastly, the prevalence of online and identity fraud that increases the risk of losses.
Regulatory attitude towards alternative lending models and shadow banking
Securitisation has created alternative fixed income asset classes in consumer and retail loans such as student loans, business loans and mortgages. These assets end up being bought by asset managers and creating very liquid exchange traded funds (ETFs) and mutual funds.
In the US, such asset managers are part of a huge shadow banking system that include securitisation vehicles, asset-backed commercial paper conduits, money market funds, markets for repurchase agreements, investment banks, and mortgage companies, etc., that is bigger than the traditional banking industry, estimated to account for up to 75% of total financial sector assets, or about $5 trillion, of which $3 trillion alone in ETFs.
The global financial crisis was in part caused by improperly, some may say fraudulently, packaged and sold asset backed and securitised products. So, what are the regulators doing about this?
Congressman Frank shared that regulators are working on several things: “The law gives the regulators the power to regulate activities, not institutions. If people are engaged in derivative trading, they’re covered. I don’t care what they’re called. They could be a baseball team, but they are subject to the requirements, and that’s the major thing. Secondly, the Financial Stability Oversight Council, which is all the regulators, have the power among themselves to reach out if they find a particular activity is not being regulated to regulate it. As far as the funds are concerned, many of them have, in fact, been regulated by the SEC. We did, for the first time, in the bill, begin to require some information from the hedge funds.”
He added that the Office of Financial Research, which is charged with “looking at what’s going on and recommending regulations if they think there’s a problem”, has said that asset management needed to be more closely regulated over concerns that they are engaged in activities that “might be leading to an overconcentration in a particular area that might cause some vulnerability.”
He highlighted a potential resource problem that the regulators may have to do their jobs properly. “The two securities regulators that have particular responsibility for derivatives – the SEC and the Commodity Futures Trading Commission – depend on annual appropriations, and here, you are right. They have been starved of their appropriation. ……. They are regulating hundreds of trillions at nominal stakes, so yes, that is a problem. So, it’s not a lack of legal authority, but the Commodity Futures Trading Commission in particular has been starved of an appropriation.”
Technology will transform the foundation of risk management and the lending business
One of the problems that banks are not reaching larger segments of customers is because of the limitation of legacy system to properly price risk said Shrier.
“We’re seeing is a lot of mispriced risk, and people are using 60-year-old linear regression models to price credit. It’s better than nothing, but it turns out that new machine learning systems and advanced analytics can give you a much better way to price risk, and so, you can start to segment out – instead of just burying everything in yield, you can actually segment out the different gradations of risk,” he explained. The good news is that machine learning systems are becoming commoditised. Banks don’t have to build their own; they can now rent it off the shelf and get very good capacity in the cloud.
He shared the example of MTN Group, Africa’s largest wireless operator and its head of digital services, and quoted former Barclays Africa banker, Stephen Van Coller, who is looking at financial services and inclusion from a new perspective. “You couldn’t build the bank of the future within an existing banking infrastructure.
And the way that you construct a financial institution to serve a billion people with an average balance of $50 looks a lot different than serving 100 million people with an average balance of $500.” He concluded that the way that banks can serve more people and make them bankable is when they start to rethink the customers and look at who they are.
Keywords: The FoF Summit, P2P, AI, LAAS, ETF, Network Economy, Big Data Analytics, Marketplace Lending, Disruption
People: Alicia Garcia Herrero, Eugene Tarzimanov