‘Fin’ versus ‘tech’ in fintech

Published by the R Street Institute.

Financial technology – or “fintech,” in the modern parlance – may be seen as trendy, but computing technology has strongly influenced banking and finance for decades. Its effects include the creation of general-use credit and debit cards, going back to the 1950s, which we now take for granted worldwide; ATMs available any time and almost anywhere, going back to the 1970s; and the data capabilities that make structured mortgage-backed securities possible, going back to the 1980s.

Visa and MasterCard are considered leading fintech companies, which they are. Former Federal Reserve Chairman Paul Volcker once cynically remarked that ATMs were the only real financial innovation of recent times. Meanwhile, MBS vividly display the double potential of innovation, first for growth and then for disaster.

Investment banker J. Christopher Flowers has expressed the view that the current fintech boom will “leave a trail of failed companies in its wake.” Of course it will, just like the hundreds of automobile companies that sprang up a century ago or the myriad dot-com companies that mushroomed in the 1990s. The automobile and the internet were both society-changing innovations and the hundreds of failures are how we discover which are the truly valuable ideas and which aren’t. To paraphrase Friedrich Hayek’s memorable essay, competition is a discovery procedure.

Over time we will find out which innovations are real and which are mere fads. A key distinction in fintech, as in the financial world in general, is between those changes that make transactions faster, cheaper, more mobile and less bothersome (the “tech”), on the one hand; and those that make it easier to make loans and take credit risk (the “fin”), on the other. The former are likely to yield some truly useful innovations; the latter, which require lending people money that you hope they will pay back on time and with interest, is an old and tricky art. It is much easier to fool yourself about whether you are actually improving lending, as compared to technology.

Consider the idea of “lending money over the internet.” The “internet” part may invent something faster, cheaper and easier—just like the ATMs Volcker touts. The “lending money” part may be simply a new name for making bad loans, just as the dark side of MBS turned out to be.

So on one hand, we may have real innovation and progress, and on the other, merely endless cyclical repetition of costly credit mistakes. For example, the fintech firms LendingClub and OnDeck Capital presently find their stock prices about 80 percent down from their highs of less than two years ago, as they learn painful lessons about the “fin” part of fintech.

Nor is this distinction new. As James Grant, the acerbic and colorful chronicler of the foibles of financial markets, wrote in 1992:

In technology, therefore, banking has almost never looked back. On the other hand, this progress has paid scant dividends in judgment. Surrounded by computer terminals, bankers in the 1980s committed some of the greatest howlers in American financial history.

So they did, and more than 2,800 U.S. financial institutions, their growing computer power notwithstanding, failed between 1982 and 1992.

Bankers in the 21st century – avidly using vastly greater technological prowess, supplied with reams of data, running complex computer models to measure and manage (or so they thought) their credit risks – made even more egregious mistakes. As we all know, they created an amazing credit bubble and came close to tanking the entire financial system. Did the technology help them or seduce them?

Mathematicians and physicists – the “rocket scientists,” as they were called – had brought their impressive computer skills to Wall Street to help apply technology to mortgage finance. In the memorable summary of George Mason University’s Tony Sanders, “The rocket scientists built a missile which landed on themselves.” The mistakes were in the “fin” part of this effort, not the “tech” part.

In every financially trendy boom, we hear a lot about “creative” new financial products. A painful example was the homeownership strategy announced with fanfare by the Clinton administration in the 1990s. It called for “creative” mortgages, which turned out to mean mortgages likely to default.

Such products, no matter how much innovative computer technology surrounds and helps deliver them, are not real financial innovations. They are merely new ways to lower credit standards, run up leverage and increase old risks by new names. They are thus illusory financial innovations. As also pointed out by James Grant, science is progressive, but credit is cyclical.

Real innovations turn ideas into institutions which endure over time, various mistakes notwithstanding, as credit cards, ATMs and MBS have. Illusory innovations cyclically blossom and disappear. Both produce uncertainty, and uncertainty means we cannot know the future, period. We will continue to be surprised, positively and negatively, by the effects of financial innovation.

In short, financial markets are always in transition to some new state, but only some of this is progress. The rest is merely cyclical repetition. What is fintech?  Doubtless, it is some of both.