Contents

Preface xvii

Acknowledgments xix

About the Authors xxi

About the Website xxiii

Introduction 1

1.1 WhoisThisBookFor? 2

1.2 What is FinTech? 2

1.2.1 Distinction between Financial Technology Innovation and

Financial Innovation 3

1.3 Why Does This Book Focus on Online Lending? 4

1.4 The Hybrid Financial Sector: The Opportunity to Build a Healthier

Financial System 5

PART ONE

FinTech and the Online Lending Landscape—Where Are We Now? 11

CHAPTER 1

Introduction to the Business Models in Financial Technology 15

1.1 InnovationThemesinFinTech 15

1.1.1 Online lending 15

1.1.2 Crowdfundingandcrowdinvesting 17

1.1.3 Transactionsandpayments 17

1.1.4 Personal Financial Management 17

1.1.5 Digital currency and cryptocurrency 18

1.1.6 Mobile point of sale (mPOS) 18

1.1.7 Onlinefinancialadvisory 18

1.1.8 Mobile-first banks 19

1.1.9 A dynamic and fragmented space 19

1.2 The Promises and Pitfalls of FinTech Business Models 20

1.2.1 Streamlining the user experience (UX) and digital integration 21

1.2.2 Setting an industry standard that the financial industry failed to get

off the ground 21

1.2.3 Using someone else's network while only paying marginal cost 21

1.2.4 Providingaworseservicetocustomersatalowerprice 21

1.3 The Pitfalls 22

1.3.1 Overestimating the ability of data science to deal with concentration

and adverse selection 22

1.3.2 Overestimating the value of Big Data in transactions 23

1.3.3 Overestimating people's willingness to trust a FinTech company

instead of another middleman 23

1.3.4 Overestimating the regulators' willingness to pardon a FinTech

company flouting the rules 23

1.4 Why is Financial Technology Innovation Important? 23

1.5 Challenges and Roadblocks for FinTech Companies 24

1.5.1 Lack of a human interface 24

1.5.2 Theneedforbankinglicenses 25

1.5.3 Concernsoverprivacy 26

1.6 FinTech is a Long-Term Play 26

1.7 Concluding Remarks 27

CHAPTER 2

How Does Online Lending Work? An Overview with a Focus on Marketplace Lending 29

2.1 Reliance on Technology and Data 29

2.2 How Do Online Lenders Differ From Banks? 30

2.3 TypesofOnlineLenders 31

2.3.1 Marketplace lending platforms 31

2.3.2 Online balance sheet lenders 34

2.3.3 Lender-agnostic marketplaces 35

2.4 Some Background on Peer-to-Peer Networks 36

2.4.1 Disintermediation or re-intermediation? 38

2.4.2 Infomediaries, intermediary-oriented marketplaces, and the

information value chain 39

2.5 The Business Model of Marketplace Lending Platforms 40

2.6 Onboarding Process 41

2.6.1 Borrower onboarding 41

2.6.2 Lender onboarding 43

2.7 Comparing Marketplace Loans with Bank Credit or Credit Card Debt 44

2.7.1 How do marketplace loans differ from bank credit? 45

2.7.2 How do marketplace loans differ from credit cards? 46

2.8 Who Are the Alternative Borrowers? 47

2.9 Who Are Investors in Marketplace Loans? 48

2.10 Underwriting and Credit Scoring 48

2.11 Regulation 49

2.11.1 Transparency and disclosure 50

2.11.2 Standardization of oversight and monitoring 50

2.12 The Response of Banks to Online Lending 51

2.13 ConcludingRemarks 52

CHAPTER 3

What Made the Rise of Online Lending Possible? 57

3.1 TechnologicalFactors 57

3.1.1 Cheap and ubiquitous computing power, coupled with a revolution

in Big Data and analytics 57

3.1.2 Fastertechnologyadoption 58

3.1.3 Internetproliferationandnetworkeffects 58

3.1.4 The boom in mobile screens 60

3.2 Social Factors 62

3.2.1 Digital connectedness and friendships 62

3.2.2 Impatience with the know-your-customer process 63

3.2.3 Sentiment against the established financial sector 63

3.3 Structural Factors 63

3.3.1 Stricterbankingregulation 64

3.3.2 Disappearance of smaller banks has decreased access to credit for

consumers and SMEs 64

3.3.3 Low interest rate environment 65

3.4 The Perfect Storm 65

3.4.1 From unbundling to fragmentation and back 66

3.5 A Divergence of Trends 66

3.6 Concluding Remarks 67

CHAPTER 4

Why FinTech Lives Outside of Banks 69

4.1 The Technology Mudslide Hypothesis: Sustaining Innovation vs.

Disruptive Innovation 70

4.1.1 Small unproven markets with low-margin products 72

4.1.2 The need for discovery-driven planning 73

4.2 Will Banks Notice the Next FinTech Breakthrough? 73

4.2.1 Incentive misalignment between the short term and the long term 74

4.2.2 Forcing banks to collaborate with online lenders 75

4.2.3 Innovating in-house vs.

4.3 Why Do Banks Have Difficulty in Innovating? 76

4.3.1 Underinvestment in core competencies 77

4.3.2 Imprisoned resources 77

4.3.3 Bounded innovation 77

4.3.4 Performers vs. producers 78

4.3.5 Divergence between core competencies of banks with customer

needs 78

4.4 Developing Core Competence in Financial Technology Innovation 79

4.4.1 The trap of marginal thinking 80

4.4.2 The way forward 80

4.5 Concluding Remarks 81

PART TWO

The Status Quo of Analytics in the Financial Industry—The Perspective of Banks 83

P2.1 BankingisInnovation 84

P2.2 Banking Goes Mobile 84

P2.3 Banks Are Far From Dead 85

P2.4 How to Read This Part of the Book 85

P2.5 What We Discuss in This Part 86

CHAPTER 5

Financial Contracts 89

5.1 Contract Elements 89

5.2 Time in Financial Contracts 90

5.3 Contract Mechanisms Producing Financial Events 92

5.3.1 Principal patterns 94

5.3.2 Interest patterns 99

5.3.3 Accrual interest patterns 101

5.3.4 Credit enhancements patterns 102

5.3.5 Behavior patterns 103

5.3.6 Other patterns 104

5.3.7 Example of financial events 104

5.4 Concluding Remarks 106

CHAPTER 6

Markets 107

6.1 Real-world and Risk-neutral Expectations of Markets 108

6.2 Economic Scenarios Based on Real-world Probabilities 109

6.3 The Risk-neutral Expectations 110

6.3.1 Yield curves 110

6.3.2 Forwardratesandprices 111

6.4 Beyond Market Risk-Free Rates 113

6.4.1 Credit discount spreads based on risk-neutral default probabilities 114

6.4.2 Liquidity spreads 115

6.5 Discounting Cash Flows 116

6.6 Considering Market Elements in P2P Finance 117

6.7 Concluding Remarks 118

CHAPTER 7

Counterparties 121

7.1 Types and Roles of Counterparties 121

7.2 Descriptive Characteristics 123

7.3 Default Probability 124

7.3.1 Structural models 125

7.3.2 Intensity models 127

7.3.3 Real-world and risk-neutral default probabilities 128

7.4 Credit Ratings 129

7.5 Credit Spreads Based on Real-world Probabilities 130

7.6 LinkofCounterpartiesviaMarkets 131

7.6.1 Allocatingobligortoitsownspecificrisk 133

7.6.2 Allocatingobligortospecificmarket 134

7.6.3 Apportioningobligorsacrossseveralmarkets 134

7.6.4 Allocating several obligors to a single market 135

7.6.5 Allocating obligors to several correlated markets 135

7.7 Concluding Remarks 137

CHAPTER 8

BehaviorRisk 139

8.1 Prepayments 140

8.2 Draw-downs/Remaining Principal/Facilities and Credit Lines 141

8.3 Withdrawals 143

8.4 Selling 143

8.5 Default and Downgrading 144

8.6 Use at Default 145

8.7 Recoveries 146

8.8 Concluding Remarks 147

CHAPTER 9

CreditExposures 151

9.1 GrossExposure 151

9.2 NetExposure 152

9.3 Evolution of the Gross and Net Exposures 152

9.4 Exposure Distribution 155

9.5 Credit Losses 156

9.6 Link of Counterparties via Credit Exposures 157

9.7 Concluding Remarks 158

CHAPTER 10

CreditEnhancements 161

10.1 What Are Credit Enhancements? Types and Structure 162

10.2 Asset-based Credit Enhancements 162

10.2.1 Allocating collateral to credit exposures 163

10.2.2 Valuing and adjusting asset-based credit enhancements 164

10.3 Counterparty-based Credit Enhancements 165

10.3.1 Guarantees 165

10.3.2 Allocating guarantees to credit exposures 165

10.3.3 Credit derivatives 166

10.3.4 Lack of credit enhancements in marketplace lending exposures 167

10.4 AdditionalElementsConsideredinCreditEnhancements 168

10.4.1 Double default 168

10.4.2 Wrong way risk 169

10.4.3 Maturity mismatch and payment times 170

10.4.4 Contracts and counterparties dependencies via credit

enhancements 170

10.5 ExtendingCreditEnhancementsinMarketplaceLending 170

10.5.1 Realestatetitles 172

10.5.2 Phone contracts as stores of value 172

10.5.3 Loyaltypoints 173

10.5.4 Life insurance 174

10.5.5 Guarantor systems 174

10.6 Concluding Remarks 175

CHAPTER 11

Systemic and Concentration Risks 177

11.1 Credit Exposure Systemic Risk 177

11.1.1 Chain reactions after default credit event 178

11.1.2 Chain reactions after credit downgrading 180

11.2 CounterpartySystemicRisk 180

11.3 SystemicRiskExposuresandLosses 183

11.4 Credit Exposure Concentration Risk 184

11.5 Counterparty Concentration Risk 185

11.6 Systemic Risk and Portfolio Diversification 187

11.7 ConcludingRemarks 187

CHAPTER 12

Liquidity, Value, Income, Risk and New Production 189

12.1 Liquidity 190

12.1.1 Financial contracts and liquidity 191

12.1.2 Thetimefactorandtypesofanalysisinliquidity 191

12.1.3 Market and funding liquidity risks 192

12.1.4 Measuring and reporting liquidity and risk 195

12.2 ValueandIncome 197

12.2.1 Estimating value 197

12.2.2 Estimatingincome 198

12.2.3 Profit and loss 199

12.2.4 Valuation principles 199

12.2.5 Risk on value and income 199

12.2.6 Stress testing 200

12.2.7 Designing dynamic and integrated stress testing 200

12.2.8 Stochastic process 201

12.2.9 Economic capital allocation and risk adjustments 202

12.2.10 Somekeypointsinapplyingriskmanagement 203

12.3 New Production 203

12.4 Treasury and Funds Transfer Pricing (FTP) 205

12.4.1 Funds transfer pricing (FTP) and transfer rates 207

12.4.2 Treasury in P2P finance 209

12.5 Concluding Remarks 210

PART THREE

Toward the Future of the Hybrid Financial Sector 215

P3.1 Dangers of a Big Bang Approach to Catch Up with Technology Innovation 216

P3.2 TheNeedtoCollaborateinaHybridFinancialSystem 217

CHAPTER 13

Profitability and Risk of Marketplace Loans 219

13.1 UnderlyingAssumptionsoftheAnalysis 220

13.1.1 Getting the input data 220

13.1.2 Time 220

13.1.3 Risk factors 220

13.1.4 Mappingthefinancialcontract 220

13.1.5 Calculatingcontractualfinancialevents 220

13.1.6 Constructing portfolios 221

13.1.7 Analysis outputs 221

13.2 Risk Factors 222

13.2.1 Market risk 222

13.2.2 Counterparty credit risk 223

13.2.3 Behavior 224

13.3 Portfolio Construction 224

13.3.1 Portfolio exposure 225

13.4 Modeling Portfolio Performance 226

13.4.1 Income performance 226

13.4.2 Liquidity performance 227

13.4.3 Stress testing 228

13.4.4 Stress test scenarios 231

13.5 Risk Management 236

13.5.1 Operationalrisk 239

13.5.2 Likely overestimation of borrower quality in marketplace lending 240

13.5.3 A note on portfolio restructuring and optimization 245

13.5.4 Anoteoncollateralandhedgingexposure 246

13.6 The Road Forward 246

13.7 Concluding Remarks 247

CHAPTER 14

Digital Competencies and Digital Dilemmas 251

14.1 Digital Competencies 252

14.1.1 Banks lag in some areas and lead in others: Analytics 252

14.2 Digital Dilemmas 255

14.2.1 Dilemma 1: Disrupt or defend? 255

14.2.2 Dilemma 2: Cooperate or compete? 256

14.2.3 Dilemma 3: Diversify or concentrate? 258

14.2.4 Dilemma 4: Keep digital businesses separate or integrate them? 259

14.2.5 Dilemma 5: Buy or sell businesses in the portfolio? 259

14.3 Concluding Remarks 260

CHAPTER 15

Digital Strategy 263

15.1 WhoNeedsDigitalStrategy? 263

15.2 Frameworks to Analyze the Impact of Innovation 264

15.2.1 Thediffusionofinnovations 264

15.2.2 The hype cycle 265

15.2.3 Big Bang Disruption 266

15.3 Spotting Signs of Trouble on the Horizon 267

15.4 How Banks Can Overcome the Innovator’s Dilemma 269

15.4.1 Developdisruptiveinnovationinaseparatecompany 269

15.4.2 Plantofailcheaply 270

15.4.3 Let those in charge of innovation formulate their own rules and

processes 270

15.4.4 Find new markets 271

15.5 FromProducertoSupplierandMovingtoaNewSingularity 271

15.6 From Closed Innovation to Open Services Innovation 272

15.7 The Role of Leadership in Driving Emergent Strategy 273

15.8 ConcludingRemarks 274

CHAPTER 16

The Hybrid Financial Sector 277

16.1 ForcesofCompetitionintheDigitalAge 277

16.1.1 New pressure on prices and margins 277

16.1.2 Competitors emerging from unexpected places 278

16.1.3 Winner-takes-all dynamics 278

16.1.4 Plug-and-play business models 278

16.1.5 Growingtalentmismatches 278

16.1.6 Convergingglobalsupplyanddemands 279

16.1.7 Relentlessly evolving business models—at higher velocity 279

16.2 TheDangersofKnifeFights 279

16.3 Good Ideas in Marketplace Lending That Might Be Here to Stay 280

16.3.1 Credit scoring with fringe alternative data 280

16.3.2 Responsive, always-on banking and near-real-time credit 281

16.3.3 LendingasaService(LaaS) 282

16.3.4 The ability to invest in fragments of loans 283

16.3.5 Unbundled, streamlined financial services 284

16.3.6 High standards for data and transparency 284

16.4 The Alternative to the Hybrid Financial Sector: A Doomsday Scenario for

Established Banks? 286

16.5 Concluding Remarks 286

CHAPTER 17

Unified Analytics 289

17.1 Why Do Marketplace Lending Platforms Need Unified Financial Analytics? 290

17.1.1 Advantagesforlenders 292

17.1.2 Advantagesforborrowers 293

17.1.3 Advantages for marketplace lending platforms 294

17.1.4 Advantages for guarantors and protection sellers 295

17.1.5 Advantagesforbanks 295

17.2 AnOverviewofaUnifiedAnalyticsPlatform 296

17.2.1 Standardizingfinancialdataandanalytics 299

17.3 Concluding Remarks 301

Bibliography 303

Index 307