Let’s take a trip down memory lane. Unlike other industries, banking as we know it has always been underpinned by a unique regulatory framework; unique in the sense that it’s a cross-coupling of ‘carrot’ and ‘stick’ dynamics. Post-2008, the ‘carrot’ has come in the form of increased liquidity and solvency guarantees to banks. The stress tests that followed the financial crisis imposed a ‘stick’ in the form of capital requirements to accompany the guarantees. In the 80s, such a stick would have been manageable because all activity was posted on a single balance sheet. All regulators had to do was closely monitor every entry on the balance sheet to ensure that banks didn’t ramp up excessive risk to exploit the liquidity and solvency guarantees.
Cue in technology. Banks could now manipulate and redistribute money activity and credit across balance sheets and jurisdictions at high speed and low costs. Credit was mobilized across all fronts, which resulted in banking activity being recorded outside the balance sheet. Technology made it exceptionally difficult to impose effective capital requirements. With Basel I, banks were forced to come up with clever ways to reallocate assets away from their balance sheets, yet still maintain the same risk exposure. Enter securitization! Now we know securitization was primarily used to disguise risk from regulators. Instead of dealing with the issue then, all regulators managed to do was review and update the regulations at the time.
Enter Basel II and internal risk management systems, which meant capital requirements were contingent upon on ‘true’ market, credit, and operational risk. ‘Innovation’ threw a wrench in the works in the form of ABS, CDO and second-order derivative structures (well, and Fabulous Fab). What these ‘innovations’ did was remove almost all risks from the banks’ balance sheets. Well, we all now know what transpired. These ‘innovations’ didn’t foster efficiency and transparency. Instead, they just circumvented regulations.
Basel III will not really prevent banks from trying to eat the carrot and avoid the stick. All it‘s going to do is add to the complexity and further fuel increased fintech activity. Good news for fintech.
How will (unregulated) Shadow Banking 2.0 affect fintech?
Inadvertently, the financial crisis of 2007-2008 precipitated the rapid growth of fintech. Within fintech, the P2P lending space has and continues to see some fantastic growth. However, beneath the numbers, hedge funds, banks, credit insurers and asset managers have taken over the investor side of P2P lending. Some of these institutional investors have access to public guarantees, or receive financing from institutions with such guarantees. A case in point is Lending Club. The credit line extended to Varadero Capital by Citi benefits from public guarantees and eventually ends up on the P2P marketplace as loans. The US P2P lending space is starting to see securitization of bundled P2P loans with AAA labels. Collateral for borrowing on the money markets? Could the potential risks that such arrangements carry easily spread to fintech or stunt the trajectory that fintech is on?
A sign of things to come? It was very apparent (for example, when BBVA acquired Simple, an online-only bank, and Barclays acquired RainFin) that banks are looking for ways to take advantage of the lack of meaningful regulation.
What’s different this time around? Will new regulations improve transparency? Will they dampen stability risks? Will the regulations help in the assessment and mitigation of systemic risks posed by other entities and actors? It’s very hard to predict the nature and form of the burgeoning involvement of banks in fintech without bringing up regulation. I think what should be happening is a rethink of financial regulation for the digital 21st century instead of updated, pre-digital financial regulation frameworks. You and I know that fintech doesn’t need another Fabulous Fab in the woodwork somewhere plotting to game the collaboration.
– This article is reproduced with kind permission. Some minor changes have been made to reflect BankNXT style considerations. You can read the original article on Kevin’s website here, and source material can be seen on The End of Banking website at this link. Our many thanks go out to The End of Banking for allowing us to publish this article. Image: Atilla Kefeli, CC