Photo: Priyanka Parashar/Mint
Photo: Priyanka Parashar/Mint

What start-ups can learn from the Fintech meltdown

Smart entrepreneurs will do well to understand the depth of the recent issues in the Fintech space

Last couple of weeks have been tumultuous in the world of Fintech, or more specifically, “Lendtech". Two of the bellwethers of the industry, US-based LendingClub Corp. and On Deck Capital Inc., have seen sharp drops in their stock, albeit for very different reasons. The significance of these signals goes beyond market capitalization—there is a sudden pullback of lender confidence in these platforms, sparking off a potential liquidity crunch. Money is the lifeline of lending businesses; a sharp drop in money supply can bring these engines to a halt.

So what went wrong, and what are the lessons for start-ups still looking to disrupt the lending markets?

The most important criterion for investors to part with their money is trust. At first, this may sound obvious. However, one must understand that this trust is not just a matter of good intent; it is a function of controls, alignment of incentives, and in no less degree, enabling regulation. From a young start-up standpoint, innovation always precedes controls. Recent events must make the start-ups stand up and recognize the importance of putting in controls and audit mechanisms in place.

Innovation in complex businesses like lending requires participation in the full process and not just in originating the loan. On the other hand, being a lender by oneself has had limitations to scale in terms of capital. Hence many start-ups have gone into a zone of aspiring to control the full life-cycle including underwriting, but stay away from capital exposure. That creates misaligned incentives in the system.

Going forward, expect to see lenders asking for more “skin in the game"—this is likely to increase the capital requirements of lending platforms. Alternatively, lending platforms will have to be more transparent in their credit and underwriting processes—even provide lenders with a higher degree of control in choosing the kind of risks those lenders want to assume. Risk pooling will attract a much higher degree of scrutiny than it has over past 3-4 years.

The source of differentiation has been called into question through this meltdown. In lending businesses, capital moves in and out quickly to where the opportunity is. The only stable source of differentiation is on the demand side—whether it is in proprietary understanding of specific segments, preferential customer relationships, or an ability to deliver a consistently superior and defensible customer experience. Minor innovations in data analysis, or early- mover advantages in online marketing, are not defensible gains. The fall in margins of some of the alternative lending companies reinforce the importance of substantial differentiation that entrepreneurs must bring to the table.

Most lending platforms have scaled on the back of institutional capital. The clear advantage of institutional capital is how quickly it can flow in. The clear disadvantage, which is now visible, is how quickly it can flow out—not just due to trust-based issues, but even to normal market cycles. Construction of a stable and scalable capital base will remain a key challenge for the industry. In some way, this may prove to be the single biggest long-term advantage that banks continue to command, even if they lag somewhat on technology and data innovations.

It is too early to tell whether the questions raised in the last couple of weeks are blips or deep crevices. Or to what extent they represent company-specific issues versus industry-level issues. However, the impact of these questions will certainly drive the future evolution of lending platforms globally. Smart entrepreneurs will do well to understand the depth of these issues, and will steer their businesses to adjust appropriately. The next cycle of innovation will build itself on learnings from the previous ones.

Alok Mittal is co-founder and chief executive officer of Indifi Technologies, a platform for enabling SME loans in India.