In conversation with Raghavendra Rau
In an interaction between Malvika Chandan and Raghavendra Rau, Sir Evelyn de Rothschild Professor of Finance at the Cambridge Judge Business School and a past president of the European Finance Association, the latter speaks about the development of non banking finance in the developed world and about his research interest in individuals’ risk taking ability.
“A typical bank has to be extremely forward thinking to lend an entrepreneur money as he has no collateral and nothing to put on the table.”
“Alternative finance does not involve a formal intermediary and can change capitalism and the classic idea of an entrepreneur going to a bank to get a loan.”
How does alternative finance work? What does this channel offer that banks do not? How entrenched is it in the UK?
Alternate finance studies anything which has to do with non banking finance. The commercial banks, investment banks are formal financial intermediaries so they are extremely well regulated and the government has given instructions on how much capital they need to keep on hand, how much they can lend, what proportion of their total capital they can keep and stuff like that. Now the problem with that is it puts strictures on the bank themselves. For example, a bank would not lend necessarily to an entrepreneur with a brand new product idea who needs funds to develop it. A typical bank has to be extremely forward thinking to lend an entrepreneur the money as he has no collateral and nothing to put on the table.
Having a formal financial intermediary setup increases cash flow into already established companies and capital is diverted away from new growth opportunities, new growth sectors of the economy with not much collateral but just ideas. Now for the economy to grow we need the 2nd sector – the first sector is already established. There has to be a bridge between one and the other. In the old days, if I were an entrepreneur and came to you to get money to launch a new business, and you have never met me before today, why would you lend me money? I could say I promise to give you back your money and I would say that even if I don’t have the intention to return it. So, the bank in those circumstances act as an intermediary – the bank sits there and says that I certify that I am investigating his records and look at his credit records and bank balance and find out he is good credit risk. But you can’t do that, you don’t have time and technology and the monitoring ability to do that. So, that’s why banks were very successful in the past. But the cost of that monitoring technology has come down dramatically these days. Now-a-days everything is on an app. The new crowd sourcing and peer lending platforms did not exist more than 10-15 years ago because the technology was not there. Now If I am an entrepreneur and I have an idea, I list my project on a platform and compete with a whole bunch of other people. If I want money to flow towards me I have to provide guarantees and certificates that I am not going to steal your money, as an investor. So, the whole area is developing outside the entire financial market.
So they fall under the ambit of NBFC?
Some of these things are just fascinating. For instance, even an established firm in Germany was looking to the Cambridge Centre. What happened was in 1997 there was the South East Asian crisis, markets crashed. Unfortunately lot of banks in Germany were exposed to that crisis. So, they basically cut back on their lending even in Germany. These German firms had nothing to do with the South East Asian firms. They were upset that their funding is being cut off. One of them in particularly said that they were tired of dealing with banks. They’ve given me money when times are good and they don’t give me money when times are bad. He saw an ad in the newspaper which said banks are lending money at 5% and he could get it there at 7%. The regulators came down and said you can’t do that as you are not a bank, but you can issue bonds. So, for the last 15 years this company has been directly issuing bonds to local townspeople without them having to go through a bank. At the annual beer festival in that town you can buy a beer and a bond at the same time. You could go up to a stall and buy both and they would pay back Euros 1000 over years. Why would you lend money to a company like this? You know the company, you can see the guy there, he goes to the same restaurants as you do, and his children go to the same school as your children. That’s localised lending and it is now spreading. There are now about 50 companies who have started doing like that. It’s completely outside the formal financial market.
Alternative finance does not involve a formal intermediary and can change capitalism and the classic idea of an entrepreneur going to a bank to get a loan.
What about the risk, lending to entrepreneurs with great ideas, but no collaterals or product, which is why banks shy away from giving them loans?
Nobody knows the answer to that. It is the first time something like this is happening. That’s why we have the Centre. We have collected data from 64 crowd sourcing platforms and have individual loan level data—who applied for and got loans, who are their investors, what their profiles look like, so, then we can find out what makes one group of entrepreneurs more successful than another group of entrepreneurs and maybe draw lessons from that. We are watching this as the market evolves.
How do you link academics to actual commercial activity, specifically in this area of innovation and financing? What are some of the challenges and the opportunities?
We have one advantage at Cambridge. It is one of the largest entrepreneurial clusters in the world after Silicon Valley in the US. It’s called Silicon Fen. Fen means a marsh and Cambridge used to be settled in a marsh. It has about 700 entrepreneurial firms which have opened there in the last 30 years. The reason it works is because the University gives a strong support to the faculty who decide to set up their own ventures.
How is it for entrepreneurs to be in the University town and have the ecosystem and support?
The key has to be that entrepreneurs should be willing to take risks. Also, the entrepreneurs, professors in this case, need to be sure that the idea won’t get stolen. The University has an incentive to say – that’s not your idea – you developed it in University time, it is our idea. But if that’s the case then why should I develop an idea. The University benefits as it take the major chunk of the equity if the company goes public. But it gives full copyright to the entrepreneur behind the idea.
You’ve made an interesting comment on your website regarding “markets not being efficient in the long or the short run”. What’s your view in terms of its functioning and the time it takes to actually process and reflect developments?
The basic idea of market efficiency simply says, new information is the only thing that reflects in prices. In other words, when new information arrives the market prices instantly incorporates that. For example, a company announces a stock issue today but carries it one month later. If the market is really efficient all the stock reactions would happen at the time of announcement, nothing should happen at the time of execution. What we find typically in cases of initial public offerings, the price jumps on the first day but goes down in the long term, so you are worse off by investing in a company that issued a new batch of shares than 5 years after the initial public offering. This states that the price was too high at the IPO and the investors have not realized that up to 5 years later. That’s the example of market inefficiency that I am talking about.
What the way around it?
That’s the paradox. It again goes back to economics of information. It’s the same idea with entrepreneurs. The entrepreneur believes that his idea is a good idea. He has to figure out a way to convince investors that it’s a good idea. Those are called corporate governance mechanisms, when the entrepreneur says that I am convinced it’s a good idea and here’s how I prove it. One way is to put your own skin in the game. If I really believe my idea is good then I would put a bigger cheque in it. If I am convinced of it and pay my own life savings into it, it might be easy to convince others it is a good idea. You do not need a bank to certify it if I show you that I have invested all my savings in it.
You have also done some interesting work in the area of risk taking and how to assess an individual’s risk-taking ability.
What we are trying to do is look at why some individuals specifically CEOs take more risk than others. The idea we had was that the stuff that is happening when you are growing up affects the way your brain develops. What we found was when you are exposed to large levels of low level trauma when you are growing up, say natural disasters but none of the disasters killed anybody so, when you eventually become a CEO, risk taking is not a big deal for you. You can handle risk. You don’t even think about it because your brain developed differently. On the other hand if you had a major disaster happening, and say your best friend was killed in school because of a tornado, you find it stressful and consider risk to be bad and you don’t want to go through this again. In this case, when you become a CEO, your firm ends up holding less leverage more cash, you make fewer acquisitions. On the other hand if you have lots of low level trauma and nothing major happened, you end up doing exactly the opposite. You end up taking much more leverage, less cash and more acquisitions and stock is higher. So, risk is no big deal.