Exploring new Journeys for Bank Capital

I recently met an old acquaintance of mine who has built a successful career in advisory, research and consultancy work, mostly working for banking institutions and brokerage firms.?He pitched a new idea to me over coffee and whilst I won’t go into the specifics of what he is working on, ?two interesting aspects of it have provided a catalyst for this piece. First, the opportunity that he is exploring, in its own particular way, fits into the theme of contextual banking that Paolo Sortini of IBM has been developing, but in an entirely different operational area. Second, the idea highlighted the fact that in certain areas of capital markets, there remains structured solution opportunities that join up reinsurance risk, with capital provision in ways that often turn out to be most useful in times when the availability of liquidity and confidence in risk management in capital markets is weak.

I will extend my thoughts on around this further a bit later, but first wanted to highlight the increasing presence of contextual banking in the world of venture capital and the sub-domain of alternative finance and lending.??It used to be the case that many different types of banking, especially those operating in niche markets would create and maintain a vertically integrated stack to originate, underwrite and manage credit risk, but now more and more firms are thinking about placing larger pools of capital, via a single debt financing solution design, with dedicated fintech lending firms as well joining up with BAAS providers as dedicated client acquisition and product distribution channels in their own right.

The interesting thing about both approaches, although they can be different in terms of their implementation and commercial constructs is that in both cases, the lender is prepared to operate at arms-length from the end client, and seek to make their return via the income obtainable through a theoretically an intermediary that is easier to on-board and administer, while also being theoretically more credit worthy (from a capital resource perspective).?Furthermore in this type of solution, the lender is more than likely to be mis-matching their own lending structures in terms of rates and covenants compared to the client’s actual lending counterparty.?In other words, all of the innovation and risks that relate to managing the product design, its distribution, and its risk management are moved from the core banking operations into either the alternative lender’s domain or the banking as a service provider.

In times of very low interest rates, and very high availability of liquidity the return profile of this type of strategy probably didn’t look very attractive at all, but the situation today is wildly different on so many levels. This should explain a lot about why in an increasing amount of venture deals, the debt financing amounts available are much larger, as is the pool of financial institutions, both traditional and alternative credit providers who are keen to participate in segmentation strategy in both customer and product terms in this way.

This type of model seems to be particularly relevant when the end client is a retail client or a small business enterprise, and seems, from the tracking I have been doing to seeing accelerated participation in the last year, with total lending amounts well above 10bl and still growing even whilst the general cost of capital has been rising.

This development has given rise to a belief that contextual banking is not only going to include product compliance and transactional solutions, where it has its traditional routes, but also will get into other areas, such as supporting capital market operations.?The rising cost of provisioning required against trading loss, which is especially sensitive on fast and significant rising interest rate scenarios would appear to support a growing need for solutions that involve balance sheet borrowing, but when one considers the potential risk of very rapid impairment that can come from either malfeasance, or poor risk management, it is clear that any sort of solution is probably going to require some type of insurance risk backstop.?

There are different ways that excess capital pools could be accessed starting to emerge in relation to very short term liquidity provision, so there are some new types of cash marketplaces for institutions starting to engage financial institutions on this, but in any case, the bottom line is that contextual banking enablers that are focused on the redistribution of capital for a wider variety of purposes seem to have a place to occupy in this theme. ?My perspective on this is that elements of blockchain technology via smart contracts that guarantee compliance to capital terms of use, covenants that need to be adhered to, and the risk rating of underlying capital market position (acquired through systems like Calypso, Murex etc) have a fundamental role to play and that even predictive algorithms that can assess forward risk more flexibly than existing techniques will also become part of the delivery equation that makes this possible.

In other words, contextual banking has more opportunities to spread as banks realize that in a hyper-personalized banking world, with huge segmentation driven solution designs from traditional and non-traditional participants, becoming a jack of all trades (esp. in the universal sense) is going to work less and less well.