Finding Genius

by Kunal Mehta

  Hirsch believes that empowering consumers to have full control over their data is the future. He believes “every consumer should have a data file that they’re in full control over and they are able to decide what in that file gets shared.” Jiko is one startup attempting to build on this vision. Jiko is aiming to create an individual, decentralized bank with users getting their own technological infrastructure that can serve as their individual “Jiko” banks where their data is stored. By eliminating the model of a centralized database (which is prone to hackers), it provides more security and gives users complete ownership of their data and control over who can access it.

  The Future

  Fintech startups that emerged out of the recession have yet to go through a downturn, so it remains to be seen how they will weather bleaker market conditions. Matt Harris points out that fintech startups will see a slowdown in their growth because “corporations will make decisions more slowly, budgets will be tighter, consumers will buy fewer things, and transaction volume will slow down. The other impact is that people lose their affection for things like trading, investing, and risk when it’s pricey.” Canaan partner Brendan Dickinson believes the lending industry will be affected the most but that in fintech more broadly, “there will be a shakeout when there’s a downturn. Some people will be shown to have no clothes on.” Startups that survive the next downturn will further solidify their trust with consumers as they will show their resilience and ability to endure multiple economic conditions. David Klein believes that a downturn will actually give CommonBond the ability to scale further as the company can prove the strength of their credit and underwriting to the capital markets and as a result, can get increased access to low cost capital over time.

  Startups are preparing for an economic downturn in a variety of ways. In my discussion with Sallie Krawcheck, CEO and co-founder of Ellevest, she said Ellevest has “built a lot of downturns into our projections, which is a hard thing to do.” The company has chosen to be more conservative in projecting clients’ future investment gains. She explains: “That means when we give Ellevest’s clients a projection for 20 years from now, it tends to be lower than the projections some of our competitors give them but we want to give them a higher chance of achieving their goals. So we lose sales upfront but we believe that we gain credibility through a down market.”

  Dickinson’s advice to entrepreneurs in the space is to not discount financial incumbents. There are many reasons they might be slower to innovate, such as legacy technology stacks or endless layers of bureaucracy. However, they do have two major advantages: immense amounts of capital and scale. Startups that have strong relationships with financial incumbents prior to adverse economic conditions will be in a better position as they will also gain access to these advantages. No matter how strong startups have been or how loyal their customers are prior to a recession, having an incumbent’s support will prove greatly beneficial in a downturn and could make the difference between life and death for them.

  Many incumbent financial institutions will still exist 30 years from now. Some fintech startups will become huge financial companies. The incumbents and startups that continue to grow will be those that embed a technology-first and strong data analytics approach in their businesses, stay attuned to and respond to customer needs in a transparent way, and remain secure and compliant within the shifting regulatory framework. There is a massive opportunity for financial institutions to invest in or partner with startups so they can reinforce each other, help each other thrive, and provide more financial tools and access to more customers in innovative ways. The financial institutions and startups that can best navigate these trends and symbiotic relationships will end up succeeding — it all depends on execution.

  SECTION II: MAJOR PLAYERS IN FINTECH

  Student Lending

  A surge in post-recession regulations coupled with rapidly improving technology has led to disruption in the lending market. The recession and regulations that followed caused some legacy financial institutions to withdraw from certain areas of lending such as student lending.12 Concurrently, direct-to-consumer online and mobile distribution channels as well as data analytics strategies have enabled new lending startups to emerge and seize market share from incumbents.

  The burden of student loans is known to most, impacting millions of people. One such person is George, a resident at Mount Sinai Hospital in New York. After his parents spent their life savings to send him and his older sister to private high school, he had to take out $120,000 in student loans across his four years of undergraduate studies. Soon after graduating, he enrolled in an in-state medical school because it offered a solid scholarship package as long as he was willing to work at their hospital for a year. However, he still had to take out student loans. He graduated from medical school in 2018 and estimates that he currently has over $200,000 in student loans.

  He is far from alone. In the United States, there are 43 million federal student loan borrowers with an outstanding total debt of $1.4 trillion as of Spring 2019. Of the 2017 college seniors who graduated with student loans, they had on average $28,650 in debt and research indicates that it takes people over 10 years to pay off their student loans.13 14 This crisis is a multi-generational issue as 37.5% of those with outstanding student debt are under 30 years old and 62.5% are above 30.15 The student loan crisis is only getting worse. A 2018 Brookings Institution report, “The Looming Student Loan Default Crisis is Worse Than We Thought” shows that default rates are rising; they project that nearly 40% of those with student loans may default by 2023. Default rates become more dire when looking at specific cross-sections of the population. For example, 47% of attendees at for-profit colleges end up defaulting compared to 13% of attendees at public two-year programs. The report also found that black BA graduates are five times more likely to default (21%) compared to white BA graduates (4%).

  A confluence of factors has contributed to the ballooning US student loan crisis. The Brookings Institution attributes the increase in student loans to more people attending college and lower earnings from people who dropped out of college or who attended a for-profit institution. In addition, college tuition continues to rise with an average tuition of nearly $35,000 at a four-year, private, non-profit college, making attending college a huge financial feat.

  To fully comprehend the student loan crisis, it is essential to understand the current student loan environment. There are two primary types of student loans: federal loans and private loans provided by financial institutions. The government does not employ a real underwriting model, instead offering Federal Stafford student loans with the same rate to all borrowers. Students often use private loans to fill the gap between what their federal loans cover and the amount they owe to their colleges — an approach George used. When he and his parents were comparing private loan options, he was inundated by daily letters from banks. Ultimately, they decided to choose the bank that gave them the lowest fixed rate because even though the variable rates were often lower, they did not want to be susceptible to rate volatility.

  Many financial institutions used to offer student loan products, but the Federal Family Education Loan (FFEL) program, which enabled financial institutions to originate federal student loans, was disbanded in 2010. In addition, the Dodd-Frank-borne Consumer Financial Protection Bureau (CFPB) turned its attention to student loans to ensure fair student lending practices and handle complaints from student loan borrowers. For example, in 2017, the CFPB fined Citi $6.5 million for misleading student loan borrowers and charging incorrect fees from 2006 to 2015. As a result of mounting compliance costs and FFEL’s dissolution, larger banks such as JP Morgan and Citi terminated student loan originations.

  Given the startling student loan statistics and the vast number of people who are burdened with enormous student debt, an innovative student loan refinancing market has emerged to alleviate some of the burden. Some major startups have emerged in this space such as SoFi, CommonBond, and Earnest and
their core product is refinancing student loans with lower rates. They have all added new products since then: CommonBond now also offers student loan originations, SoFi offers personal loans and mortgages, and Earnest offers personal loans.

  The recession provided the perfect backdrop to launch a student loan refinancing company, so much so that CommonBond’s CEO and Co-Founder, David Klein, refers to the financial crisis as his “fourth co-founder.” That’s because people no longer had as much trust in banks and the resulting monetary policy kept interest rates low to encourage economic activity. Klein said: “post financial crisis, the amount of trust that the public had in banks plummeted. There was an openness among consumers that wasn’t there before and probably would not have been if it had not been for the financial crisis.” Another reason this was an opportune time is that digital natives were beginning to make financial decisions, specifically regarding student loans and the potential need to refinance them. Because of these factors, Klein believes that it was never overly difficult to convince consumers to trust CommonBond. In fact, he believes “there’s more of an inherent trust in online-first companies among millennials” and he is starting to see it in older generations as well.

  Simultaneously, technology has enabled startups to streamline processes through automation and to run robust data analytics and machine learning models. Klein believes that automation is key to having a positive customer experience. For example, CommonBond has automated most aspects of the refinancing application process, relieving customers of the monotonous burden of filling out hours of paperwork. CommonBond’s credit models also bring efficiencies as they can quickly approve or reject candidates and fund loans in a matter of days. A strong data analytics approach has been integral to the startup’s success as they are analyzing more than just borrowers’ credit scores; they are also examining borrowers’ employment histories, industries of employment, and future cash flows, among other variables to create a fuller understanding of potential borrowers. Through the middle of 2019, CommonBond has done over $3 billion in originations.

  As lenders’ models receive more data from customers, it creates a virtuous data cycle, improving their models’ accuracy, optimizing their loan portfolio, lowering their unit economics, and reducing interest rates for borrowers. As a result, lending startups have a lot to gain from strong network effects. Fortunately for them, digital natives are more likely to advocate on their behalf by sharing their financial experiences on social media and referring friends, spreading startups’ reach and feeding their algorithms with more data as they acquire more users.

  Due to their better economics, new lenders are also able to offer lower rates and reach those whom traditional lenders have failed to serve. For the 43 million Americans with student loans, refinancing could help them save up to hundreds of dollars on a monthly basis and thousands of dollars in the long run. These student refinancing startups have a strong mission at their core, making them appealing to consumers who increasingly care about supporting companies whose values they believe in. Further leaning into their social mission, CommonBond contributes to its non-profit partner, Pencils of Promise, to fund the education of students in Ghana. The company also hosts an annual trip to Ghana where CommonBond employees and customers can see the impact their donations have made. CommonBond is sending the message that it cares not only about its own customers but also about the world.

  In an effort to be transparent, Brian Hirsch believes startups should formulate a mission statement in their early days about why the startup exists and its values. Not only does it make the mission clear to consumers, but it also helps attract and recruit the appropriate talent. He believes that “consumers are smart and they’ll read through who’s authentic and who’s not. I think authentic startups that are trying to do good will have a place in this world and will have a chance for success.”

  Market education is essential in the student loan refinancing space as many people are not aware of refinancing as an option, or if they are, do not know where to begin. For example, George knows he could refinance his student loans, but he does not know how to do it or where to start. While he has been lucky to have his parents’ guide him through the process of taking out student loans, refinancing is new to them, so he would have to navigate this journey on his own and know that there is a real value in refinancing his loans.

  From a broader industry perspective, Klein has witnessed a shift in the last few years of incumbent financial institutions wanting to increasingly partner with, invest in, or acquire fintech startups. Lending startups are unique in that they have pre-existing relationships with banks through their warehouse lines and through selling banks securitized loans. In March 2018, CommonBond announced a $50 million Series D round of financing led by Fifth Third. The bank is leveraging CommonBond’s success with millennials and CommonBond is leveraging Fifth Third’s scale, providing a win-win for everyone.

  Out of all the areas of fintech, venture investors believe that the next economic downturn will hit lending the hardest. Matt Harris believes that “you can run however many models you want. Every crisis is different and so you simply can’t predict what’s going to go pear-shaped, in what timeframe, and to what degree. The 2008 financial crisis defied every model we had.” He believes that lending startups can run their businesses more conservatively to cushion themselves for the next financial downturn whenever it hits. However, he also believes that can be tough to do because “all of the other incentives encourage them to do the opposite of that and grow quickly.” He also recommends that they “carry higher reserves and go lend to higher, better quality customers;” however, these efforts also entail slower growth and customer acquisition because they force companies to be more selective about their customers. Harris concedes that running businesses conservatively can be tough especially when venture investors are expecting higher valuations, but believes it is best for companies in the long run.

  Wealth Management

  A prime example of the socialization of finance is the recent movement to bring wealth management services to a broader spectrum of individuals. After the financial crisis, a combination of improved technology, big data, and consumer distrust led to the formation of many robo-advisory startups, which offer automated wealth management services to the next generation of investors.16 Offering services to underserved markets expands this already massive industry. The Robo Report™: First Quarter 2019 reports $229 billion in assets under management (AUM) across 17 prominent robo-advisors.

  Historically, wealth management has only been for extremely wealthy individuals. Wealth management firms typically charge a management fee, which is a percentage of assets held with the advisor. As a result, most firms were not marketing to those outside the upper echelon of wealth holders because the costs of marketing to and serving lower net worth customers exceeded their potential fees. However, everyone needs management of their current assets, not just high net worth individuals. This is especially true as wealth disparities among high-wealth, middle-income, and low-wealth families have widened. Washington DC-based think tank Urban Institute states in its report “Less Than Equal: Racial Disparities in Wealth Accumulation” that between 1983 and 2010, high-wealth families saw their wealth increase by 120% and middle-income families by 13%. However, those in the bottom 20% of wealth holders actually saw their wealth decrease as their debts began to surpass their assets. Wealth disparities are also marked across racial groups. The Institute found that the racial wealth gap is three times larger than the racial income gap; the income gap has not changed significantly over time but there has been a dearth of opportunity for Hispanic and black families to build wealth. The financial crisis only made matters worse with Hispanic families losing on average over 40% of their wealth and black families losing 31%, compared to white families that lost 11% on average. Women also do not have the same opportunities for wealth accumulation as they make on average 78 cents on the dollar, a gap that only widens as women become more senior.
The lack of opportunities for wealth accumulation is especially concerning because wealth accumulation is essential for income bracket mobility. These stark discrepancies affecting large segments of the population have led to vocal support to make financial support and wealth management guidance more accessible. Michael Barr, former US Assistant Treasury Secretary for Financial Institutions under the Obama Administration and a University of Michigan Law School professor, said:

  “After the financial crisis, the problem of income and expense volatility has increased, savings cushions are narrower and many families who were financially secure before are now living paycheck to paycheck…. There is an urgent need for advisors to know about the problems that so many Americans are facing today and many moderate income families would benefit from having a trusted advisor who could help them with very basic financial planning, budgeting and savings techniques. Investment advisors can do a lot to help moderate income families develop the financial wherewithal they need to have greater financial stability.”17

  While traditional financial advisors are unlikely to open their doors to the disenfranchised, some centers have arisen to serve this large, underserved population. In 2008, New York City’s Mayor Michael Bloomberg founded the Financial Empowerment Center (FEC) where people can receive free financial counseling. Providing this service is game-changing as New York found that half of its residents had never received financial counseling. Bloomberg Philanthropies is working with local governments to open more FECs across the US. Across its centers, the FEC has helped 34,000 people by reducing their cumulative debt by almost $40 million and building their cumulative savings by nearly $5 million.

  While the FEC provides a fantastic option to people in select cities, robo-advisory startups have emerged to empower everyone through accessible, digital options. Betterment, Ellevest, and Wealthfront are robo-advisory startups founded in the last decade with this exact mission: to provide automated financial advice and wealth management to everyone. Account minimums range from $0 to $500 on these platforms, encouraging everyone to engage in wealth accumulation.