Have you ever considered the similarities between children and banks? Not that both seem to like you more when you have money. I’m talking about risk, and how to deal with it. It may seem like an odd comparison, but stick with it.
Visit any Accident and Emergency department and you’ll see that kids are not great at assessing risks. Bumps, bruises, broken bones and beads stuck up noses attest to this. Risk is an inevitable part of a child’s everyday life. They play and are natural risk takers. They need these experiences to learn and develop.
Banks are also driven to take risks. They must if they want to deliver the levels of profitability and growth their shareholders demand. And it’s fair to say they haven’t been that great at assessing risk either. You may remember the subprime mortgage crisis, Barings Bank, or the UBS rogue trader scandal?
And the similarities continue. In the world of child safety things are changing. There is a move away from so-called helicopter parenting, where risks are avoided if at all possible. New thinking focuses on managing risk as far as necessary, not as far as possible to keep children safe while also allowing them room to grow.
And things are changing in the world of bank risk management too. Many now feel that existing risk frameworks are too rigid and offer only analogue solutions in a digital world. A recent McKinsey report on the future of bank risk management, for instance, highlighted the ways in which risk management systems need to evolve to cope with changes in customers’ expectations and new tech-based business models.
But we are not there yet. And while having robust risk frameworks in place is important, they can pose a significant roadblock for fintechs and others. Let’s take a look in more detail at why.
Banking is a risk business
“Predicting rain doesn’t count. Building arks does.” This Warren Buffet quote sums up the ultimate goal of a bank’s risk management system; to identify and evaluate potential losses in the future (the storm may be coming), and to take precautions to deal with them if they occur (let’s get the ark ready, just in case). This is not the problem.
The issues come when you drill down into the risk categories banks use in their risk frameworks. They were established in the twentieth century and are increasingly considered to be highly unsuitable and outdated yardsticks with which to measure the risks posed by young fintech businesses.
To illustrate this, let’s look at two of the main risk categories banks use–regulatory risk and credit risk– and how they can impact the growth or even the survival of a young business.
First, regulatory risk. Currently, there are no global regulatory standards for the cryptocurrency and blockchain industries. While there are various country specific regulations this situation has created significant uncertainty, in particular among banks that operate globally, about which governance structure to follow. And lets not forget the requirements for banks to know their customers, and to ensure anti-money laundering processes are in place. Banks don’t like this uncertainty, which leads them to view these businesses as ticking regulatory and reputational time bombs. It’s a huge compliance headache that they don’t want to put the resources in to solve. Building such compliance and monitoring systems is expensive, and some banks conclude the costs just aren’t worth it.
Credit risk arises from the possibility of non-payment of loans. To protect themselves, banks conduct checks, often through a credit rating agency, to satisfy themselves that individuals or businesses won’t run out of income over the loan period. Banks are very sensitive to credit risks, and even a small rise in risk can impact profitability significantly. This can pose problems for startups with no credit history to speak of. And the situation is even worse startups in the blockchain, AI, crypto and fintech spaces, which are also viewed as highly risky, in many instances simply because they are tech companies. Anecdotally at least, there is a lot of evidence out there of instances where banks have been unable or unwilling to explain to such companies why they have been turned down for a loan, as a customer, or even why a relationship has been terminated. In addition, in the new digital economy, for example in the software development space, young companies have few if any tangible assets to put up as collateral against a loan. The result; they don’t get a potentially vital loan.
Life for a tech startup can be nasty, brutish and short
Outdated risk frameworks, the fear of regulatory fines or reputational damage, and the tsunami of new banking rules and regulations have undoubtedly hampered the ability of banks to do business like they used to, and to support new business models as they should. Unfortunately, all this has occurred during the rise of the new digital economy.
It’s clear that the pace of change we are experiencing requires a new and more flexible approach. Something needs to change, and change quickly.
At INITIUM we understand the sector and know the issues these companies face. Our multi-jurisdictional banking group is being built from the ground up, meaning we are not hamstrung by outdated models and ways of thinking. We employ our banking and industry expertise alongside state-of-the-art technology to gain a comprehensive understanding of the sector, its risks and how to assess and manage them effectively, which allows us to support the strongest businesses with the core products and services they need if they are to thrive.