Can Fintech Fix Financial Services?

A review of the new Michael Lewis movie The Big Short describes a scene during the 2008 financial crisis in which renters were “kicked out of their homes because their landlord didn’t pay the mortgage, even though they were making their rent payments in full.”

It serves as one of many examples of how our malfunctioning financial system produces fundamentally unfair outcomes.

Why do we need that system? Americans feel about bankers the way they do about lawyers: they’re all bastards — until you need one.

In his book Other People’s Money, financial writer John Kay states that finance contributes to society in four principal ways: it matches lenders with borrowers, helping to direct savings to their most effective use; it enables individuals to manage personal finances over a lifetime; it helps manage the inevitable risks in life; and the payments system facilitates buying and selling, as well as the paying of wages and salaries.

These are the sorts of things provided by the financial industry that are used by ordinary people and businesses, and their benefits make obvious sense.

But those fundamental services make up a small fraction of the activity carried out by most institutions in the wider financial system. Overwhelmingly, their activity consists of trading. As Kay writes, “to an extent that staggers the imagination, they deal with each other.”

That trading is where Wall Street gets most of its “casino” image. The excesses around the behavior are legendary. Another Lewis work, Flash Boys, details the spending of hundreds of millions of dollars so that certain traders could gain an advantage of microseconds in trade execution.

And much has been written about the byzantine creation of the collateralized debt obligation (CDO), which played such a crucial role in the financial crisis. It is somewhat terrifying to reflect upon the fact that the people who produce such toxic products and behaviors are the same people upon whom we rely for such fundamental services as preparing our personal accounts for retirement.

What ought to strike an astute observer, though, is that the two behaviors are entirely separable. Money, for the most part, is simply information about value and who controls it. Despite all of its bells and whistles, and even its legitimate complications, finance is suited for takeover by information technology for that very reason.

But treating finance’s inefficiencies and bad outcomes as primarily a technical problem would be a mistake. The thing most in need of disrupting in finance is not the algorithms. The finance industry has never been bad at math — indeed, they pay top dollar for it. Nor is it the technical infrastructure — though that truly is desperately in need of replacing.

The thing most in need of innovation in the financial sector is the nagging feeling on the part of the everyday customer that somewhere, somehow, he is getting screwed. That feeling is foremost a result of the complex and often bizarre ways in which financial institutions trade and offload their risk (when it is not a result of outright malice), and it is in no way fundamental to the nature of providing financial services. It is the sort of thing that gets people who pay their rent on time kicked out of their houses, and it is something we do not need.

The still-nascent fintech industry is at something of a reflection point. The volume of funding moving into the sector is enormous. Companies need to decide what sort of business they want to be and what fundamental value they want to provide. Both types are already emerging.

Consider Sindeo, which uttered an amazing sentiment only a lightly regulated financial business could have the luxury of uttering with regard to its lending business: “We come from the mind-set that anything can be done. Then we figure out how to make it compliant.”

Many other fintech businesses are rapidly issuing loans and bundling them into securities in a manner that many are rightly concerned is reminiscent of the subprime mortgage boom.

This sort of approach does nothing to actually “disrupt” finance: It is fundamentally the same sort of mortgage chop shop that was so widely criticized following the financial crisis, albeit with a better web app.

Kay has a good piece of advice for the people trying to get into this business: “There was no alchemy through which a collection of loans on weak security to unreliable borrowers could be anything other than just that.” It has never worked in finance before, and it will not work now, regardless of the quality of technology behind it.

Alternatively, there are businesses like Earnest. Earnest also has discussed securitizing loans, but it considers doing so as the logical progression of a much more fundamental business plan that aims to improve the experience of getting and repaying a loan.

All of this, to be sure, is just press. It is no guarantee of a companies’ long-term behavior. But if the press is at all indicative of the actual culture of the companies, I suspect it will be the Earnests of the world, and not the Sindeos, that ultimately disrupt finance.

Regulators have already trained their eyes on fintech, and they are scrutinizing everything from their algorithms to their lending practices. Fundamentally unsound businesses simply will not survive this scrutiny, nor that of their customers, in the long term.

But there is risk from outside the sector, too. The recent surge in bank-to-fintech partnerships and purchases runs the risk of making a lot of fintech founders very rich. While they will certainly view that as a good thing (and I can hardly blame them), it will also make their companies more susceptible to the same behaviors that make banks so frequently unpleasant to deal with.

This is the greatest risk the industry faces as a whole, that they will simply become another arm of the thing they set out to replace. As a society, we ought to hope, however vainly, that when they look at the big check, they at least pause for a moment on our behalf and think about why they got into the business in the first place.