The rising interest rate cycle of the last two years has been accompanied by the deterioration of capital market conditions, adversely affecting most fintech start-ups.

Investors discounted valuations, making raising new equity capital significantly more challenging compared to the era of zero-cost money. Simultaneously, for operational start-ups that continue to grow their customer base and balances, higher interest rates may provide a much-needed extra capital cushion through increased interest income.

Moreover, if managed prudently, this cushion can be extended, protecting income from potential decreases in interest rates in the future. Additionally, for some fintech start-ups the current high interest rate environment could provide a much needed competitive edge in their core product set-up.

The balance sheet of a typical fintech

A significant portion of fintech firms in the market provide transactional services, such as prepaid cards, transfers, payments, remittances, and FX conversion. At the core of most products is the current account with the fintech company, facilitating transactional services—essentially, a prepaid cash balance with the firm held at a 0% interest rate.

In essence, this is a free liability on the fintech balance sheet. Current accounts paying 0% rate are a golden goose for the commercial banks and arguably the most marginal products in the non-negative rates environment. Monetising client balances at higher interest rates can generate additional interest income, delivering that extra capital cushion. Still, important aspects need to be considered to maximise those client balances and avoid material risks.

What assets?

The easiest way to earn revenue on client balances is to place cash on deposits with commercial banks. It can be either an interest-bearing current account for easier liquidity management or term deposits. In both cases, the resulting return will likely be at a discount to the prevailing risk-free rate in that currency, with the term deposit potentially bringing a higher return due to committing the funds for a longer period. The type of permissible assets will be driven to a large extent by the firm's licence type.

In the case of an EMI licence, the firm will be mainly restricted to commercial banks’ deposits, government (HQLA) bonds, and some money market instruments. Having multiple bank and transactional counterparties becomes crucial to access competitive pricing in this case.

Additionally, significant consideration must be given to the average duration of the asset portfolio, as major maturity transformation in the EMI portfolio is neither advisable nor prudent. Obtaining a portfolio yield over the risk-free rate in such a case is challenging but may be achievable.

Getting the most yield out of client balances may require considering the whole spectrum of permissible instruments, including less obvious ones. For example, in the EU, interest rate swaps are yielding 20-30 bps above government bonds for medium-term maturities. This amounts to an additional €1 million per annum of P&L for a €300-500 million client portfolio, enough to cover the additional cost of having that expertise and infrastructure in place.

In the case of a more flexible regulatory regime than EMI, many more opportunities to monetise balances become available, both in the areas of credit and liquidity spread yield enhancement through a wide range of financial fixed-income instruments.

Interestingly enough, that extra P&L pick-up through monetising the client balances can be used to improve the core transactional product pricing and the competitive position of the given fintech by partially sharing it with the clients. Namely, reducing transaction fees, bid-offers spreads and improving cashbacks.

Risk considerations

When building an asset portfolio funded by client balances, a meaningful risk framework should be put in place, along with behavioural considerations about the stability and longevity of customer balances. This should provide clarity on the proportion of balances that are stable and can be deployed to longer-dated assets, and what proportion is volatile and should be kept as a liquidity buffer.

This can be achieved by behavioural modelling of the deposits keeping in mind not to overly rely on the historical data, as the data series of the past economic cycle with low interest rate may imply a lot more stable customer balances. Besides, a clear distinction between “going concern” and “stress” scenarios needs to be introduced to manage interest rate and liquidity risks respectively. 

Additionally, metrics for liquidity and interest rate risks should be monitored and internal limits put in place to ensure that the company can fulfil its obligations at any time and avoid market losses.

Although many such metrics are well known and widely used in the financial industry its relevance and impact could be somewhat different for a fintech firm. Take, for example, the NII sensitivity, i.e. the measure of the sensitivity of net interest income to the prescribed changes in interest rates over a certain period of time, let’s say one year. This metric is a bread and butter for IRRBB management in any commercial bank and a focus of the regulators who are planning to introduce system-wide limits for banks on this metric.

While clearly measuring the volatility of NII, often one of the major source of P&L and capital creation for commercial banks, this metric may not fit for internal constraints for a fintech firm, as NII is often a side benefit to the mainstream transactional fee-based revenue streams and can be viewed more like a positive bonus rather than the core of the business.

To illustrate the above point, imagine a fintech firm providing transactional services and rolling all client 0%-cost balances on overnight deposits with a highly rated commercial bank earning close to the risk free rate in a given currency. From the business perspective - this fintech is an example of the most conservative way to manage client deposits as all liquidity risks are covered even for 100% client balances outflow. From the NII sensitivity - that fintech, keeping all assets in the overnight bucket absorbs entire volatility of the interest rates in its NII and breaches regulatory contemplated limits (Standardised Outlier Test II).

Separate attention should be paid to the liquidity risk as one of the key risk factors for any fintech, in particular, if any asset maturity transformation is implemented via investment instruments. Liquidity buffers need to be established and constantly recalibrated, stress tests to be run, and liquidity gap limits established.

In general, all the above activities amount to building a Treasury/ALM function within the fintech finance team. Although there are many overlaps with more standard commercial bank risk considerations, some features regarding both modelling and risk metrics for a fintech firm's risk framework need separate and detailed consideration.

How fintechs should handle interest rates going forward

Many fintech firms are well-positioned in the current high-interest-rate environment and can profit from earning higher yields on client balances. To maximise this revenue while staying prudent risk-wise, a fintech firm should develop its Treasury/ALM function—open multiple bank accounts and actively negotiate commercial terms, develop market capabilities and expertise, establish market counterparties, and internally launch financial products, including interest rate derivatives.

Investing in or developing its own infrastructure and statistical models and building a robust risk framework will also allow it to lock in a higher interest yield over a more extended period and be immune to a sharp drop in interest rates going forward.