February 08, 2017.

The vicious and unforgiving nature of the credit cycle will weed out fintech companies that don’t embrace strategic inefficiency and appreciate the necessity of saying "no."

The future of fintech is bright, almost blindingly so, but many of the entrepreneurs in the industry fail to grasp what will eventually lead to the downfall of countless fintech firms, particularly those that lend money.

Written by John Maxfield - Originally published at this link.

An unhealthy obsession with "yes"

There's a belief among technology-based lenders that the goal should always be to say "yes." If someone needs money, it's less about whether that person or business is a good credit risk than it is about the customer experience and the length of time it will take the borrower to access their funds.

The homepage of LendingClub (NYSE:LC) advertises personal loans of up to $40,000. You can "apply online in minutes" and "get funded in as little as a few days," the company says. Another prominent fintech lender Funding Circle claims that small businesses can get loans from between $25,000 and $500,000 in as little as 10 days.

These are innovative services that seek to fill important niches in the credit markets. They enable people who have historically been shunned by banks to get loans in order to expand their businesses or to pay off credit card debt at less usurious rates. But even good ideas can be taken too far.

It's on this note that fintech lenders can learn a lot from the history of banking. And the most important lesson of all revolves around the frequent need to say "no."

Those who forget history...

The credit cycle is the most powerful force in finance. Credit expands at a voracious rate when times are good. But it then contracts with such suddenness and viciousness that anyone who isn't prepared for the turn will be crucified on the cross of credit, similar to the 17,000 banks that have failed since the Civil War.

Lenders get overconfident when the economy is ascending. They convince themselves and those around them that this time is different; that they've finally cracked the nut on protecting their institutions against widespread default.

Warren Buffett refers to this as the institutional imperative, which he defines as "the tendency of executives to mindlessly imitate the behavior of their peers, no matter how foolish it may be to do so." Buffett wrote this in the early 1990s, just as the credit cycle came crashing down on an entire generation of lenders who had convinced themselves that credit risk was a thing of the past. "In their lending, many bankers played follow-the-leader with lemming-like zeal, now they are experiencing a lemming-like fate," Buffett continued.

We've seen tendencies like these emerge time and again throughout history. In the 1980s, investment managers believed that so-called portfolio insurance had eradicated the risk of owning stocks -- a close cousin of bonds and thus merely an alternative type of credit. It only became clear how naive this was once people realized that portfolio insurance had actually accelerated the market crash on October 19, 1987 -- so-called Black Monday.

The same was true in the lead-up to the financial crisis of 2008. Lenders had convinced themselves that mortgage-backed securities and credit default swaps offered ironclad protection against a downturn in the housing market. This liberated them to lend money to all comers irrespective of income, assets, and credit history. We all know how that story ended.

This is why the best bankers, those like JPMorgan Chase's (NYSE:JPM) Jamie Dimon, are obsessed with risk and humble in the face of the credit cycle. "No one has the right to not assume that the business cycle will turn," implored Dimon on the eve of the last crisis. "Every five years or so, you have got to assume that something bad will happen."

This is also why investors and entrepreneurs should recoil whenever they hear leaders of fintech companies insinuate that they've neutralized credit risk once and for all. Take this claim from ZestFinance, an online lender that applies "Google-like math" to make credit decisions:

This new technology is able to consume vast amounts of data to more accurately identify good borrowers -- enabling higher repayment rates for lenders and lower-cost credit for consumers.

At ZestFinance, there is no human interaction of any kind involved in underwriting. Instead, we rely on several mathematical models running in parallel to make underwriting decisions. While many creditors take hours, or even days, to make credit decisions, we make them -- accurately -- in less than 10 seconds.

This lack of humility is a mistake. While there's always the possibility that ZestFinance has truly tamed credit risk for the first time in thousands of years of lending, there are entire graveyards filled with companies that have said the same thing throughout history.

Tempering dogma with reality

The idea that credit should flow swiftly and freely is laudable, but it must be tempered with reality. Banks are retail operations that sell money, a commodity that anyone would want at the right time and at the right price. When it comes to credit, in turn, it's often more noble and responsible to say "no" than it is to say "yes."

"It's a well-known maxim that one of the hardest things about running a business is to maintain the ability to say no and thereby save limited resources for the best opportunities," writes Duff McDonald in his biography of JPMorgan Chase's Dimon. "Over time, most companies simply lose their discipline."

The same point was made by Fred Schwed, Jr. in his classic satire of Wall Street Where Are the Customers' Yachts?:

The conservative banker is an impressive specimen, diffusing the healthy glow which comes of moderation in eating, living, and thinking. He sits in state and spends his days saying, with varying inflections and varying contexts, 'no.' ... He says 'yes' only a few times a year. His rule is that he reserves his yesses for organizations so wealthy that if he said 'no,' some other banker would quickly say 'yes.' His business might be defined as the lending of money exclusively to people who have no pressing need of it.

This seems insensitive and exclusionary, but there's more than a grain of truth to it. Just ask the hundreds of banks that failed in the wake of the financial crisis after convincing themselves that credit risk had been eradicated from the face of the earth.

Embracing strategic inefficiency

The key to avoiding this fate is to embrace inefficiency, albeit to a careful and conscious extent. It's on this score that claims from fintech companies (such as LendingClub, ZestFinance, and to a lesser extent Lending Tree (NASDAQ:TREE)) about rapidly approving loans to people that they've never met in person is so concerning to anyone with any knowledge of the ceaselessly undulating waves of the credit cycle.

More than a century ago, one of the two namesakes of JPMorgan Chase, John Pierpont Morgan, was asked during a Congressional hearing if commercial credit was based on money or property. "No sir. The first thing is character," Morgan responded. The inquisitor persisted: "Before money or property?" To which Morgan responded: "Before money or property or anything else. Money cannot buy it ... because a man I do not trust could not get money from me on all the bonds in Christendom."

It's tempting for fintech entrepreneurs to reject this as outdated advice. After all, we no longer lumber around in horses and buggies like Morgan did. The Pony Express has since been replaced by the telegraph, which was later replaced by the telephone. Penicillin wasn't discovered until 15 years after Morgan uttered these words. And, of course, we now have the internet and big data.

"Since the modern credit system was created in the 1950's, the world has changed," claims ZestFinance. "Technology has changed. So should credit."

Defeating naivety

I'm picking on ZestFinance only because it's the most open with its belief that the power to assess creditworthiness has been fundamentally transformed by technology. Indeed, based on conversations I've had with fintech entrepreneurs in the past, this opinion is common among fintech entrepreneurs who are well meaning and have years of experience writing code, but little knowledge of the undomesticated nature of credit.

One explanation for this naivety is that many fintech entrepreneurs don't appreciate how common financial crises are. In the nearly 215 years since the turn of the eighteenth century, as I've noted previously, the United States has experienced 14 major bank panics. That equates to one every decade and a half.

Another explanation is that fintech entrepreneurs involved in lending have the luxury of being dogmatic, as their personal capital tends to be insulated from their firms' credit decisions. Just like the fat cat bankers of yore, marketplace lenders such as LendingClub and Lending Tree traffic in other peoples' money, merely matching creditors with debtors. The inherent fragility of this model has proven itself repeatedly in the past. It was a loan broker that caused the nation's first "too big to fail" bank, Continental Illinois, to go under in 1984. And it was mortgage brokers like Countrywide Financial that led to so much destruction in the crisis eight years ago, which explains why JPMorgan Chase has forevermore sworn them off.

Nassim Taleb makes this point especially elegantly in his book Antifragile. "For the Romans, engineers needed to spend some time under the bridge they built -- something that should be required of financial engineers today," he writes. "The English went further and had the families of the engineers spend time with them under the bridge after it was built."

In short, while it's tempting to dismiss the hundreds of years' worth of experience reflected in the history of banking as outdated, fintech lenders do so at their peril. This won't be obvious until the credit cycle takes a turn for the worse, which could be many years from now, but when it happens it's those companies that embrace the lessons of the past that will not only survive the chaos and disorder, but emerge from it in a stronger competitive position.