The Risk Industry

Three months ago, I pointed out that telecom is a bad poster child for reform because it has an unfair advantage- the network effect. I wrote about how retail is a better poster child, and also sidetracked into services retailing, but left one question unanswered: is there another industry which could benefit as much from the network effect as telecom has? Well, it’s time to answer that question.

The answer is: Yes. The financial services industry (which is actually several industries together: banking, insurance, wealth management, brokerage, capital markets, consumer lending, project finance, and probably half a dozen more).

Financial services benefit from the network effect because the fundamental product that all these sectors deal with is not equity shares, or bonds, or currency. It’s not even money. It’s risk. And every person plugged into the organised finance system is a producer and a consumer of risk.

This is similar to how the telecom industry’s fundamental product isn’t phone calls or SMSs or IP packets, but information. And everybody plugged into a telecom network produces and consumes information. The important thing is that they trade it with each other, not with the phone company- which is why the network effect kicks in.

Similarly, in the financial system, the important thing is not that a particular company takes on risk. The important thing is that all customers produce some sort of risk, which they sell to some financial intermediary- whether a bank, an insurance company, or to investors directly- which then repackages or restructures it, and sells it back to other customers. The more consumers of financial products there are, the more valuable the financial system is.

Of course, there are complications which the telecom sector doesn’t face. A voice call or an SMS goes through pretty much as it is, intermediated only by machines, but risk has to be broken down into its components and repackaged by human beings before you can sell it on further. This means that there’s more intermediation, and less transparency between intermediaries. Transaction costs are higher. But the model is the same.

What all this means is that the Indian financial services industry could take off as fast as the Indian telecom industry. It would have to overcome a bunch of hurdles first: regulatory, technological, environmental, and organisational- but the potential is there.

(Disclosure: I work in the financial services industry myself, so I may not be entirely objective.)

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