As part of our series that analyses the various aspects of the FinTech revolution, we already looked at #WealthTech and #PayTech. Today we look at another success story of financial services disruption: #LendTech. What are the different models? How does FinTech disrupt the traditional players? What are the challenges for the new entrants? And how can the incumbents respond? We will look at these questions and, as always, consider the role of regulation, too.
What is LendTech
LendTech or Lending Tech focuses on alternative lending models that seeks to use innovation to disrupt the entire borrowing market from consumer loans to mortgages to student loans to business lending. It’s a massive market so naturally the digital competitors go after every angle of the incumbents existing market, employing automation, big data analytics, and artificial intelligence. This comes at the cost of traditional lenders like brick-and-mortar banks as well as the providers of credit data that would deliver the information that determined whether a loan would be approved or not. It also affects intermediaries, brokers that would either refer the borrower to a financial institution on one hand or to investors on the other but we get to this in more detail below.
The market opportunity
The market opportunity is massive. The consumer lending market in the US alone sings to the tune of $3.867 trillion of consumer credit outstanding according to the figures recently released by the Federal Reserve for February 2018. A lot of this is credit card debt and a very specific US phenomenon for a total of just about $1 trillion. On the whole the spike is fuelled by the low interest rate monetary policy following the financial crisis, but reviewing historical numbers the trend only knows one way: up!
So, clever start-ups have been exploring the traditional lending models and found ways to step in where traditional lenders either to retreat, would not lend or had to give up a piece of their share. Zopa, the UK based peer-to-peer (P2P) lender originated its first loan in 2005, followed by the US start-ups Prosper and Lending Club, together the latter have originated loans of more than $43 billion in loans (according to their websites), but let’s have a look at the different models.
Lending in three forms
One way to categorise and describe the different models of the new entrants is by the base of its borrowers. Either they serve individuals, for example for credit card debt or student loans, or they focus on companies, mostly on small and medium sized enterprises (SMEs). Or they serve both. Zopa and Prosper, for example, started with individual borrowers on their marketplace platforms; Funding Circle instead allows investors to lend money to SMEs and Lending Club does both, but what they have all in common is the way they cut out the middleman and connect borrowers and investors directly.
Lending in two forms
You could also categorise these alternative lenders by their funding model: marketplace lending versus balance sheet lending. While the group described above simply creates a marketplace for borrowers to request a loan and lenders to invest, the second category keep the loans (if approved) on their own balance sheets until they find the investors. Kabbage (for SMEs) and SoFi (for personal finance such as student loans, mortgages and loans of individuals) are two big players that use this model.
In any case the aim is to match supply and demand. In the marketplace model both the party and the investor need to register while the FinTech sits in the middle, conducts checks on the loan request and manages the payments between the two parties. In the balance sheet model, only the loanee registers while the FinTech does the legwork on finding the investor. Theoretically, in the first model there is less liquidity as for a loan to be made a respective lender needs to be found. The down side of the second model is that it potentially carries more risk. In reality, the lines blur between the two models, especially when a marketplace lender has already generated sufficient traction. This is also true to an extent for balance sheet lenders that have attracted sufficient interest from investors and can allocate these funds quickly.
The FinTech Edge
The success of these FinTech firms is primarily based on innovation and flexibility. This means for starters focussing on the core functions and the outsourcing of everything else. Be lean, be agile, be innovative. That seems to be the basic mantra for success. For example, marketing is often performed through online and social media channels, mouth-to-mouth propaganda, but without the need of cost intensive brick-and-mortar branches. The loan application and approval process are automated as much as possible. This reduces cost while it also presents the customer with an often paperless, but more importantly quick digital experience. An invaluable advantage if you’re used to wait for weeks to hear back from your local bank to have a loan arranged after you’ve spent days doing large amounts of paperwork.
The automation of the approval process is based on the use of the analysis of traditional and new forms of customer information. While traditional lenders especially base their decisions on traditional risk and credit scores as well as other information such as employment situation, home owner status or the post code of the applicant, FinTechs use additional information such as the cash flow based on a client’s current account and social media (in the case of individuals) or for business in the form of non-financial data such as business volume, the nature of a company’s activities, reputation and vendor information including sources like PayPal, Amazon, eBay, and Square. By doing so, the alternative lenders create a comprehensive panorama based on dozens, sometimes hundreds of data points that aim to give a better understanding of the applicants credit worthiness.
Another powerful tool that FinTechs use are Partnerships, above all with traditional financial institutions, to tap the client base of these organisations that provides access to entirely new range of customers together with a stamp of approval that increases a FinTechs credentials. At the same time it makes sense for the introducing incumbent if the Fintech addresses market segments it potentially couldn’t speak to, for example, millennials.
The role of traditional players
Is it all gloom and doom then for the traditional players? Of course not. First of all there are a number of challenges for FinTechs. Despite the general openness and support of regulators around the world towards innovation, regulation is as challenging for alternative lenders as for traditional institutions if not more since the latter often simply have significantly better resources and more experiences dealing with it.
Another is scale: the success of Fintechs is also based on concentrating on one segment of the value chain, which naturally has its limits, in particular in light of increasing competition. Adding additional services can be a whole new game and isn’t guaranteed to work out. The financial institutions of old again have larger resources to withstand failure or changing times/economic climates.
Talking about competition: it’s not only the traditional banks that are catching up, learning from the success of the challengers and copying their models. There is also the potential threat from the tech giants that have slowly, slowly entered the arena of financial services. In the case of lending, key players like PayPal, Amazon and Square have started introducing their own products and services for SMEs. Given their firepower, both in terms of finances and technology, could present a major challenge for FinTechs and banks alike.
As always, a challenge also provides an opportunity for the traditional players. For the traditional data providers, the use of alternative data points like social media is a challenge, but the value of such data is often disputed. Old fashioned credit scores and related data in combination with new data points and data from alternative lenders could create an even better picture with regard to a client’s credit risk. New regulations like PSD2 will further contribute to open banking and the access of the client data. This presents an opportunity for traditional data providers, too.
And for banks? For instance by providing liquidity: in the example of balance sheet lending, banks and institutional investors provide some of the liquidity needed and with a growing market. The value of global P2P-lending is estimated to increase from $75bn to approximately $1trillion in 2025. That funding will need to come from somewhere and presents a substantial opportunity for the old guard.
The customer experience: FinTechs cannot afford to maintain expensive branches and instead employ call centres for customer support. While this is a cost-effective approach, especially in combination with additional services traditional financial institutions can use this to their advantage to provide better service and use the additional analytics introduced by the newcomers to reduce the credit risk as well as the costs of loan origination. In many cases, one of the strengths of the challengers is the superiority of their service: for instance, OnDeck staff explain in detail to their clients if a loan application has been rejected and advise them how the chances of future requests can be improved. It’s this kind of hands-on approach that limits negative customer feedback and helps to spread the word even if rejection rates of alternative lenders are usually high. Customer satisfaction has to be at the centre of FinTech Innovation but the same is true for traditional banks.