Industry Expert Q&A: Balancing Growth with Risk in the Post-ZIRP Era

As we find ourselves in a post Zero-Interest-Rate-Policy (ZIRP) era, an important question has arisen: how do we balance growth and risk in a way that’s attractive to capital allocators and to the business relationships that fintechs are going to have with banks?

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Recently, I sat down with three fintech industry insiders to get their practical advice and perspectives in the post-ZIRP era. Jason Henrichs, CEO of Alloy Labs Alliance, Frank Rotman, founding partner of QED Investors, and Jason Mikula, publisher of Fintech Business Weekly and author offered their insights into sustainable growth over the next 12-24 months. 

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We explored the transformation in fintech strategies post-ZIRP, discussing the evolving fintech customer acquisition model, heightened regulatory scrutiny, shifts in VC investment focus, and the rising costs of risk management:

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Q: What are a few key takeaways you are seeing in this post-ZIRP world?

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Insight from Jason Henrichs: ZIRP changed how banks approach deposit strategies & partnerships

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ZIRP really changed some of the core focus areas for banks for the last decade. If you ask them what is your deposit strategy, they’d say, “We don’t need more deposits, we have more than enough deposits, don’t talk to us about that.” Well suddenly, non-zero-interest rates - they care quite a bit about that.

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A second piece is that when it comes to partnerships, the question becomes how can they help solve not just for deposits, but also for differentiation? That becomes a greater source of concern and impetus to do more. At the same time, banks also are slightly more hesitant because now the concern is whether these startups are going to be stable, and how we begin to think about that long-term, true partnership.

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Insight from Jason Mikula: Regulations and markets change depending on their country 

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For the last four or so years, I worked as an advisor, consultant, analyst, publisher, and author, spending a lot of time in the Banking-as-a-Service (BaaS) space, which has been very much top-of-mind. 

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One key takeaway: it’s worth pointing out that regulations and how markets work in different countries can be radically different. Things like the existence of an EMI license or how easy or difficult it is to get a de novo charter, make for a very different environment in countries like the United Kingdom and in Europe versus in the United States.

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Insight from Frank Rotman: ZIRP changed how businesses were created - and not necessarily in a good way  

I am the founding partner of QED investors, a global fintech firm with 20-odd investment professionals that started in 2008. It was an odd time to start a fintech-focused fund, but it was a good time, too, because we were able to see everything that was happening and we evolved as fintech evolved in the ecosystem. 

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As for what’s changed and what we’re focused on - the ZIRP era was a bit dizzying; the entire way businesses were built and funded changed fundamentally, and not necessarily in a good way. I like to say, Darwin went on vacation for a couple years and now Darwin is back. So, we can get back to building fundamentally good businesses and we can do it in a disciplined way and I’m looking forward to this next generation of companies that I think will be built in a more sound way than companies being built during ZIRP.

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Q: As a VC, how did the ZIRP environment influence investing strategies in fintech? What were key metrics that were previously prioritized that may not be prioritized anymore?

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Frank: ZIRP changed the classic VC cadence of building businesses in stages

If you think about what VC is at its core, it’s about taking an idea and then de-risking it in stages. So, you can’t tackle everything all at once, it’s just too complicated to take a business that is going to be built over a seven-to-10-to-15-year period and just say, “We’re going to tackle everything at the same time.” If you do that, you’re going to fail. There’s just too much to do and you don’t have enough talent. So the concept is, you take a business, you break it down in pieces, you figure out what you’re going to concentrate on. You raise capital to concentrate on it, you put a learning agenda in place, and you put money to work. And as a capital allocator, you’re putting people and money to work to basically either get proof or anti-proof that you’re either right or wrong. 

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If you get proof, you’ve earned the right to raise more capital, and if you get anti-proof, you have to fix it before you can raise capital again. And I think that’s the classic VC cadence - you embrace capital after you’ve proved something. I think ZIRP kind of blew that up. It was much more about momentum. It was much more about top-line only. It was much more about raising lots of capital, so instead of sequencing your vision, and your ambition, you would do it all at once because you thought you could raise the money and just hire the people. 

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I think we are going to learn - when we look back at the companies that were funded during ZIRP - that by not staging ambition, it actually caused a lot of companies to fail. The discipline of having to turn over your cards and having to prove yourself with actual proof - not just top-line proof that you’re growing customers, but proof that you’re actually building a good business - I’m hoping in this new era, we’re going to be back to that. In the old era, if you grew by 2x, it didn’t matter how much capital you used to get there: you’re worth two times, or three times, or five times as much as you were before. And the numbers have just gotten so disconnected from the business and performance itself that a lot of companies are now suffering from funding in a very awkward way.

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Q: What should fintechs that are just starting know about this post-ZIRP era??

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Frank: Access to capital has fundamentally changed

We’re about two-and-a-half years into the correction. We could literally pinpoint the date when the global memo went out to every founder and every starter and every VC on the face of the planet that said “capital just got more expensive.” So two-and-a-half years is not a long memory. But there are going to be some painful situations that unfold that create the stories the VCs start telling the founders about and the founders start learning about it. I think the problem is that the seed stage and the pre-seed stage is just persistently sticky, and it’s just a huge base of the pyramid with lots of different capital sources that are in a little bit of denial about this new environment and how it works. So, if the founders are able to tap capital in the way they've tapped it in the past, all it’s going to do is give them one round of capital to behave poorly - or maybe they behave well - but it’s their option. And then after that, they could end up running into a wall if they don’t get far enough, fast enough.

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Jason H: Selling is not always an available go-to option

On the flip side, there’s also this belief there’s a soft landing that isn’t always going to be there on the other side. Just as there was always someone who was willing to give you money in a ZIRP world, there was always this belief, “I can always go sell.” And unfortunately for a lot of these companies - and I think this is actually more pronounced in the Series A, Series B - where they haven’t gotten far enough to be worth the valuation they raised at, or even the amount of capital they’ve raised, that there’s really this disconnect. There’s not always a willing buyer for these things, I don’t care how good your technology is.

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Frank: Many founders are liabilities, not assets

A lot of founders don’t want to hear this because they think of themselves as an asset, and a lot of them are actually liabilities - if you’re not making money, you might actually be a liability. It doesn’t matter if you put $10 million into building technology, if that technology doesn’t integrate as easily as snapping your fingers into someone else’s technology - which it rarely does - then there’s money you’re going to have to put in to be able to use that technology. If you don’t have real customers and real revenue streams that are coveted by the end buyer, then you might be a liability, not an asset. If you’re burning money to fuel the burn, that’s a liability, not an asset. So, it’s not as easy to sell a company, even if you think you’ve built something that’s valuable. A lot of times, it’s actually worth, let’s just call it rounding to zero, which means you might acquire the people and the technology and then shut down. It’s actually harder to sell a company than people think.

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Q: How have non-normal business environments - like the ZIRP era - impact how business models were shaped? 

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Jason M.: Building business models during unconventional operating times are oftentimes built on false assumptions

To echo some of Frank’s sentiments, it should be about building a company that is durable and sustainable across different operating environments, whether that is 0 percent interest rates with quantitative easing, higher interest rates, very low default rates, or a recessionary environment where unemployment, credit risk, and defaults rise. And what we saw, particularly in that 2020-2022 period was not just ZIRP, but also just unprecedented levels of stimulus, whether it was in the form of checks mailed to every household in the form of expanded unemployment, or on the business side, in the form of PPP loans. 

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That is the opposite of a normal operating environment. And so if you built a business model - whether in fintech or real estate - during that environment and assumed those conditions were going to continue, you had a very, very flawed business model built on very flawed assumptions. Take the cost of funds, for example. If you built a non-bank lending business assuming you’re going to have access to debt capital at a certain price point and lo and behold, that number starts going up, the economics of your business have changed dramatically - particularly if you’re in near-prime/subprime where you may have more sensitivity around who you can approve around certain APR thresholds. 

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So, I think the top-line takeaway is that in retrospect, the assumptions that went into funding certain businesses or business models in that time period - and I think a lot of people recognized it at the time, though not everybody - were not valid. And now we’re seeing the fallout from that. 

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Q: How has the increased regulatory scrutiny in the past year affected fintech partnerships with traditional banks?

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Jason H: Regulators need to understand that risk is different for different fintech offerings and partnerships

One of the biggest impacts in the regulatory environment was actually the Silicon Valley Bank (SVB) failure. Not because SVB’s representative of fintech partnerships or startups, but really because this is one of the few times that you see a regulator really be taken to task that they were caught asleep at the wheel. And as a result, you’re seeing that not only because there was not enough scrutiny, consultation, and pushback from regulators earlier on some things that were clearly not being handled correctly, but now you see a regulator and people using jobs at regulatory bodies very publicly - which also doesn’t happen very often. Now you’re seeing an overreaction on the regulatory side. 

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The part I want to call out is: We say “fintech partnership” as if it’s a well-defined term. Take “BaaS.” When we dig in, do we mean the program, the neobank, the lender as a service, the middleware provider, or the bank behind it? And then you have to understand that’s a very different risk profile than, say, partnering with a company like Unit21. What someone is doing where there can be manual checks that’s not at all customer-facing, and can be operated in parallel, is different from using something internal like a tech partner whose plugin can sit in Excel and actually never leaves your four walls. 

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So to say, “All of fintech is scary,” which is a lot of what regulators’ overreaction is, is really not helpful. In fact, I think it’s increasing risk in the system because as we’re frantically chasing to eliminate all risk and catalog it, is it all equal risk? As opposed to a true risk-based system, what is the risk inherent here? Let’s put the appropriate amount of energy against it. And lastly, these aren’t all partnerships. A lot of them view themselves as vendors, so it is not risky in that regard. 

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Frank: Financial technology regulation is not new; it’s their explosive growth that regulators are struggling with 

Banks have always used technology. How many of them own their own core systems that they built themselves? That’s technology they procure. How many of them have used third-party collection agencies, how many of them have used third-party fraud detection programs? There have been third-party vendors that offer technology solutions to banks for forever; it’s just there’s been a Cambrian explosion of them with the startup ecosystem taking off and fintech becoming real. 

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Basically anything that was managed within a bank using spreadsheets needs to be replaced by a technology solution that has a lot more controls in place. And there are a lot of things that are still being managed internally through spreadsheets in banks. So, I just think it’s the Cambrian explosion that the regulators are having problems with. There are smaller companies that haven’t yet figured everything out versus the big companies of the world - it’s just a different order of magnitude, but it’s the same problem that’s been around for a long time.

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Q: What do fintech companies - or other technologies offering financial services to end-customers - face when they need to partner with a financial institution?

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Jason M: The model is not new, but the complexity of the relationships is, which creates new challenges - and opportunities.

Not to beat a dead horse, but those partnerships are not a new thing either. Remember Bankcorp and MetaBank (now known as Pathward Financial, Inc.) powering prepaid card programs or the brick-and-mortar payday lenders of the early 2000s that the FDIC finally kind of strong-armed out of existence? That model’s not new. I think some of the pieces that are new are the amount of layers and thus the amount of complexity. We’ve seen a recent enforcement action that is, as far as I am aware, the first time it’s ever enumerated not just third-party risk, but fourth-party risk and fifth-party risk. And so the Cambrian explosion that Frank’s talking about comes with a lot of opportunity, but it also comes with new kinds of risk that I think not just regulators, but also some of the banks - not all of them - are struggling to wrap their arms around.

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Frank: State regulations are highly complex; a simplified regulatory environment at a national level could ease some of that complexity

It’s also an industry that’s highly regulated, but mostly regulated at the state level rather than the federal level. There are competing regulatory bodies that try to vie for who they get to regulate -  it’s an interesting fight if you actually watch it from the outside. But when you start to think about things at a state level, it gets very, very complex, which is why a lot of these fintechs prefer to join with someone who has the entire state environment figured out or is regulated at the federal level. If they can partner with someone who’s regulated at the federal level, there’s one set of rules to follow instead of 50s. So if you’re a lender, you can apply and get a state lending license and you have the ability to lend within that state. But if you have to do that 50 times and you have to have different credit policies or different regulatory bodies coming through and all the overhead associated with that, it actually creates massive complexity. 

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A solution would be to simplify the regulatory environment and find a way to create special-purpose charters to do one thing and be able to do it nationally instead of having to do it state-by-state. But instead, if you need money transmission licenses, it’s state-by-state and if you need lender licenses, it’s state by state - and it’s that kind of complexity that has led fintechs to find someone with a national charter to actually partner with because it simplifies their world.

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Q: There is the cost of doing risk and compliance effectively. What is the right balance between growth and effective risk management?

Jason M: The metrics that define “growth” have shifted 

Part of what we’ve seen that Frank pointed out is the shift in what metrics people are paying attention to. If what you care about is what I would consider a vanity metric, like number of users or a number of accounts, or even, to some extent, top-line revenue, you can make those numbers go up. Look at a mature company, like PayPal, and the fact it needed to restate numbers because it detected a large amount of fraud that was driven by referral bonuses. There’s an example where a public-market company was catering to what investors apparently cared about at the time and they made numbers go up. In the short term, maybe that was a “success,” but in the medium-to-longer term, it was not. Growth, obviously, is good and necessary, but is it sustainable growth? Is it profitable growth? 

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Frank: The past is as important as the present; cutting corners can be a liability in the eyes of reg

I think it’s an unfortunate truth, but every time you cut a corner, you’re creating a potential liability for the company, and that liability lasts a very long time. So when regulators are regulating, they’re looking backwards, they’re not looking forward. When they look backwards, it’s not three or six months - they could be looking back years. And you could be a totally different company from then. You could have already closed all the gaps and buttoned yourself up by the time regulators come in, but they’re going to look at who you were in the past and how you were behaving in the past. They could end up fining you, issuing you cease-and-desist orders - they could issue whatever they want, depending on the regulation they’re enacting. You’ve got to be very careful because cutting corners might make the short-term numbers go up, but it could be creating a hanging liability for the company that is actually very dangerous. 

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In diligence as an investor, one of the things we look for is the “file cabinet,” which is an old-school term, but it is where the lawsuits or the complaints from customers are. We need to understand how much of a hanging liability there is potentially in the company because it could come back to haunt you if customers are complaining or if regulators are digging into certain practices. 

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Jason H: Understanding the risk at each stage of growth is key to successfully aligning fintechs with banks

t I think the idea is if you go “great guns,” you expose yourself to great risk at the outset. But if the startup gets itself aligned with the bank, if the startup has FOGO (FOMO on growth), but the bank has FOMU (fear of messing up), you need to get those two things in alignment. And the only way you do that is by staging. For this stage, how much risk can we take on, what have we proven out from a risk basis rather than a fundraise basis? Let’s graduate to the next level and as we expand the circle, we need to add more risk and compliance to it. 

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The Takeaway

Balancing risk and growth - especially in a post-ZIRP era - is always a challenge for financial services companies. It’s been especially tricky operating in an environment that is far from “normal,” especially as the landscape continues to change. As financial technology continues its explosive growth with more and more players entering the field, this subject will continue to be top-of-mind for those in it. While this scratches the surface of an immense and complex topic, traditional financial institutions and fintechs will need to continue to work together to effectively tackle this question.

To learn more watch the full discussion: Balancing Growth with Risk in the Post-ZIRP Era.