FinTechs in the Lending Industry
Lending has been one of the most primary functions of money markets and banks. Investment firms and private lenders are the lenders in the financial services indus- try. A prospect typically approaches these lenders when he/she needs a considerable amount of money to be borrowed for a longer term and is often referred to as a formal lending. There is another form of lending that is common between friends and family for small amounts of money and usually over a short duration. This lending happens in the case of an emergency, crisis and in situations where the bor- rower knows he/she cannot reach out to established lenders for multiple reasons.
The reason can be the lack of documentation, lack of borrowing capacity or any other reasons. This kind of P2P lending between family and friends is the most frequently done and is referred to as informal way of lending. On the basis of this, the entire lending industry can be categorized into formal and informal lending. Formal and informal lending can be further categorized as found below. Formal Lending This is the type of lending where the lender and borrower enters into a formal agree- ment to lend a certain amount for a specified duration. The borrower guarantees that the initial amount will be returned to lender along with a specified interest at the end of the agreed duration. The lending could be done either against a lien of moveable or immovable property or just based on a commitment from the borrower to return the loan without any lien on any property. In some of the Third World countries, lending is prevalent against livestock, and in extreme cases it could be even against a lien on a person. The formal lending in a more-organized market can be further categorized as below: a. Lending to an individual customer b. Lending to business corporations c. Lending to government d. Lending to FIs There are other complex lending mechanisms including the lending by a consor- tium of lenders to a business group; but to keep the case simple, we will restrict the lending discussion to the above-mentioned four types. The processes and software systems for formal lending have evolved over time. Every improvement in the software systems for lending has ensured there are less chances of committing fraud on an individual level. Additionally, there has been a radical transformation in software systems to carry out the due-diligence process regarding creditworthiness. This has helped to better predict nonperforming assets (NPA), i.e., the aggregate amount to which the borrowers will default on. In turn, lesser provisioning for NPAs has helped bring down the interest rates. The interest rates are typically calculated by estimating the cost that a lender incurs including the cost of funds. Lesser NPA amounts mean less provisioning for defaults which in turn means less cost of funds, thus ultimately bringing down the interest rate. To explain this further, let us take a hypothetical case in which 10 borrowers col- lectively borrow $100. Let us assume that the lender incurs a cost of about $7 and makes a profit of $3 for every $100 borrowed. Therefore, the net interest rate charged by the lender would be $10 for every $100 borrowed collectively from all the borrowers or $1 from each of the borrower. The basic assumption behind this calculation is that all the lenders will return the capital borrowed on time and in the agreed-upon installments. Now let us assume if two of the borrowers default on the loan taken out from the financial institution, then the next time the bank will end up charging $20 not paid plus $10 in expenses in total to all 10 customers. This would increase the interest paid by each individual borrower from $1–$3. Thus, the more borrowers default on their payments, the interest rates charged next time by the lender would be higher. One of the advantages the formal lending process brings in is reduced default at the individual level. The financial crisis of 2008 has shown that it is the large corporations rather than the retail borrowers who have defaulted for huge amounts of money, consequently raising the cost of managing funds for lenders in the for- mal economy. The defaults have also brought in regulator and paperwork require- ments for both the borrowers and lenders, further increasing the time to market and increasing the overall cost of funds. In some countries, the state subsidies and writing-off of loan defaults have increased fund costs for lenders in the formal economy. The situation is ironical from an honest customer perspective, as after going through a tiring process of lending, they are not getting the benefit of a lower interest rate. Instead, they are getting penalized for somebody else’s wrong-doing despite they themselves are being honest. Lenders rely on the credit scores by credit bureaus and credit rat- ing agencies to determine the creditworthiness of retail and corporate customers respectively. Interestingly enough, the credit ratings improve if an individual bor- rows more and repays the same in time. Unfortunately, this system has a number of drawbacks:
1. It indicates how the customer has repaid in the past and is not predictive enough to determine the future paying capacity of an individual.
2. The system ignores people who might be paying by using their savings or cash and thereby having better creditworthiness.
3. This reliance from lenders on credit scores eliminates first-time borrowers with good creditworthiness.
Owing to regulatory processes and huge costs and time involved in transform- ing their monolithic systems, established and large lenders have stayed away from changing any process involved in determining creditworthiness. FinTechs, being agile and building their systems from scratch, have been able to define the disrup- tion of determining the true creditworthiness of the individuals. Informal Lending This type of lending exists from a time before formal lending started. Informal lending typically involves low value transactions, but the frequency or number of times this type of transaction is conducted, is far higher than any other form of lending. This type of lending is also known as P2P lending. Lending between friends, family, acquaintances, etc. can be considered as this type of lending.
Lending through quasi-governmental bodies, nongovernmental organizations (NGOs) and religious institutions can sometimes also be categorized as informal lending. Community lending amongst business communities to provide working capital assistance to one of their members can also be called informal lending. Additionally, lending to a fellow businessman to overcome difficult business con- ditions can also be termed as informal lending. Shopkeepers enabling customers to purchase items on the credit, to be paid back at end of a specified duration like month, is also a type of informal lending. This is one of the most common forms of lending in emerging nations. FinTechs through platforms like P2P lending, community lending and multiple other types of lending, have been very active in transforming the informal lending.
Through their platforms, FinTechs are now able to provide a more organized mechanism to borrow, thus building transpar- ency in the informal lending space. Additionally, FinTechs have also ventured into the areas of POS lending. This type of lending again is more prominent in the informal lending markets. FinTechs Disrupting the Lending Business The lending business is also closely associated, and sometimes have been inter- changeably used, with the credit markets. The credit markets have the same formal and informal categorization. There are typically two types of credit systems—open- end and closed-end credit options. In the open-end type of credit, the credit is of a revolving nature, i.e., the amount of credit that can be borrowed each month and has to be paid back after a specified time period. Closed-end credit is a type of credit wherein a fixed amount of borrowed capital is returned in installments. When the installments are of equal size and paid back monthly, then the installments are called as equated monthly installments (EMIs). The customer continues to pay interest until the original capital borrowed (also called principal) is paid back. The amount outstanding on credit cards is a typical example of open-end credit, and housing, car loans, etc., are typical examples of closed-end credit.
There are multiple variations of credit. A special mention needs to be done for subsidized credit, wherein the government or an institution provides credit at a lower interest rate or with a relaxed return period. There is also a form of credit that people take from one paycheck to the next in a revolving manner to bridge the gap between the expense and paycheck. This is called a payday loan. In another variation, people borrow against insurance policies and sometimes against their retirement accounts. There is another form of mortgage that usually senior citizens avail of and is known as a reverse mortgage. In this kind of mortgage, a person borrows against his/her property, an annuity amount that will be settled with the property ownership being transferred to the lender at the end of the term. The overall lending business is also dependent on the type of mortgage that is kept under lien for borrowing the amount. If the person borrowing against noth- ing except a guarantee to return the amount, then it is called as unsecured debt. Whereas if the debt/loan is taken against a movable/immovable property then it is considered a secured debt. There are more complex definitions and variations of the above-mentioned debt and lending terminologies, but we will restrict ourselves to the form of lending mentioned above. Please note for the remaining part of this book, we will be using the following words interchangeably—mortgage, lending and credit—since we are talking about the credit/lending industry as a whole and not about a specific process within. After the financial crisis of 2008, compliance-related requirements to approve loans increased for established credit and lending companies. This resulted in their processes becoming more cumbersome and time-consuming. FinTechs emerged in this space. They were not only changing the prevalent business models, but were also ensuring regulatory compliance. Since they were agile, they could easily transform existing products or bring in new services/products that would address the huge opportunities that lay untapped in the informal lending space. FinTechs are offering multiple different types of lending which were not addressed by estab- lished companies owing to their being either informal lending processes or them being perceived to have insignificant transaction volumes. The different types of lending offered by FinTechs can be broadly categorized into the following types of lending: a. P2P lending b. POS lending c. Online lending [B2C and business-to-business (B2B)] d. Payday lending e. Microfinance f. Crowdfunding Additionally, there are FinTechs that are offering platforms that are disrupting the businesses supporting/enabling the lending businesses. These platforms thus offered are either available as stand-alone offerings or bundled into the overall lending platforms.
The customer journeys offered by these platforms have been quite disruptive and have not only driven their adoption, but also have been instru- mental in making the entire process less time-consuming and simplified. “Cutting the queue,” “loan approval under a minute” and “get the best loan offer” are some of the catchy phrases that have been implemented in reality by these platforms. The business functions that FinTechs are disrupting the most are listed below:
1. Origination 2. KYC 3. Aggregators for loan providers 4. Credit score providers 5. Loan/credit/mortgage counseling 6. Loan repayment schedulers 7. Loan enablers FinTech disruption in the lending business is primarily centered around the follow- ing types of lending. P2P Lending In this form of lending, the transaction is done between individuals directly. The amount involved and the terms of payment are mutually agreed upon by the lender and borrower. This is one of the most prevalent forms of lending in the society. The reason for such lending is usually manifold.
1. It could be to earn goodwill from an influential person. 2. It could be to help somebody in distress. 3. It could be for somebody to make a most-desired purchase. 4. It could be done for somebody to earn profits. 5. It could also be done for multiple other reasons. The profits that lenders make in P2P lending is usually much more than the formal lending system and therefore this type of lending is more popular. P2P lending has traditionally been done through informal mechanisms and is usually not encour- aged by any established lender in the formal lending space. The interest earned on the lending is usually decided upon multiple considerations and the circumstances prevalent for the lender and borrower at the time of the lending or borrowing respectively. Some of the considerations that lenders use to determine what interest rates are to be charged are:
1. The reason for borrowing and its criticality.
2. The duration required by the borrower to return the amount.
3. The potential risk of default by the borrower.
The interest rates thus, are quite variable and in some cases the interest could be multiple times what is being charged in the formal lending system. In some coun- tries, P2P lending as part of an informal system is considered illegal. Though this is one of the most detested types of lending, it is yet very popu- lar because it ends up providing just-in-time financial support. The reputation of the buyer and lender is the key for any P2P lending to take place. The reputa- tion of either is known through references close to both the lender and borrower. Additionally, information gathered through word-of-mouth also determines the creditworthiness of the borrower, as well as the trustworthiness of the lender to return the mortgaged assets once the loan is repaid. In some cases, the lender physi- cally verifies the mortgaged assets including gold, real estate, etc. before giving the desired financial assistance to the borrower. The recovery by the moneylender for the amount financed in the informal system is usually done in person and in cash. The lenders, in case of difficult or unwilling borrowers, typically employ the services of musclemen to recover the loan. This practice in particular has been criticized for being unethical and a kind of extortion or torture. In most of the humanitarian arguments against this type of lending, the borrower is considered of less means and it is difficult for him to return the loan taken. All the above makes P2P lending a multistep, person-dependent and expensive alternative for borrowers.
Consequently, P2P lending is usually resorted by borrow- ers when either the avenues for formal lending has been exhausted or denied to the borrower. In some cases, P2P lending is done if the amount involved is small and a large financial institution would not want to get involved in such a low-value trans- action. While there are disadvantages of P2P lending, it is so popular because (1) it provides just-in-time lending, (2) the approval process takes less time, and in some cases, it is instant, (3) since the lender usually knows the borrower, typical borrow- ing prerequisites like KYC, on-boarding, etc. is eliminated, (4) the payment terms are quite flexible, (5) interest rates are quite flexible and (6) decisions like interest rates to be charged, loan tenure, EMI, etc. are taken on a case–by-case basis and usually done within a day itself. In the last decade, multiple start-ups/FinTechs have brought in P2P lending platforms. These platforms blend the flexibility of informal P2P lending with the transparency and trust of formal lending. These platforms offer multiple features like:
a. The verification of lenders and buyers b. Maintaining ratings for borrowers and lenders c. Multiple calculators and auction engines for getting the best deal from a lender/borrower d. Flexibility in defining the terms of the interest payment on a case-to-case basis e. Enabling direct online payments and in some cases, direct debits f. The lending marketplace for borrowers and lenders g. Credit checks for borrowers h. In some cases, guaranteed returns in case the borrower defaults i. Easy to use interfaces for asset and collateral mortgaging j. Differential interest rates and multiple different types of lending The following is a summary of some of the ways P2P lending platforms have dis- rupted the lending space by blending the right flexibility with trust and trans- parency through use of technology. Some of these platforms have also introduced innovative ways of P2P lending and therefore, are quite successful and popular. Most of the P2P lending FinTechs have created an Online marketplace wherein the borrowers and lenders can post details about their borrowing and lending requirements respectively. Then the members of the website can decide to participate in lending or borrowing in response to posts that are available on the site. This translates into potential lenders choosing from a list of borrowers depending on the interest rate offered, grade of the loan and the amount and purpose for borrowing the money. The process starts with borrowers applying for loans. The borrowers can apply for loans only if they meet a certain credit score requirement. Their loan then gets listed on the platform, and investors can browse through all the listed loans. These platforms verify their borrowers through a systematic verification process. Once a borrower is approved/certified, the loan is issued to the borrower if it is fully funded. The loan listed by the bor- rower stays for a certain specified time, and once it’s approved, gets it within a very short time frame. The borrower then starts repayment of the loan after a cer- tain specific number of days. The payment is principal plus interest on a standard amortization schedule. In case of some of the P2P lending platforms, all the funds are queued on a first come, first serve (FCFS) basis. The money invested by an individual is then distributed to multiple borrowers at market rate. Therefore, a single investor could be lending to multiple borrowers and a borrower would be borrowing from multiple lenders. Each investor’s investment is typically broken down into chunks of small amounts of the total amount invested. The borrowers are then categorized into a risk market based on various criterion like identity, affordability, employment and credit history. Every time a borrower repays the loan, the platform deducts the invested amount by the EMI paid and adds the interest to the lender account. The money in the lender account thus keeps adding up, which is then reinvested in lending to multiple other borrowers. From a lender’s perspective, they are invest- ing money for a specific duration and at an acceptable interest rate. Therefore, the platform keeps on reinvesting the amount at that acceptable rate. In the past, P2P lenders have also experimented with the auctioning of loans to investors. The lenders on the basis of the loan amount, interest offered and bor- rower ratings and past history would be participating in the auction process. The auction would additionally drive borrowers and lenders to decide the best common terms of agreement for lending to begin. This mechanism has been quite effective
of a one size fits all approach of the established lenders. They use the credit score only to qualify or disqualify a borrower, but the interest rate they charge is the same for all the borrowers. Therefore, a good borrower pays the price for the payment not being made by defaulters. Additionally, unlike their established peers, most of the FinTechs do not let a borrower’s credit score get impacted if they apply for a loan or enquire for a loan from them.
A large number of P2P firms also publishes the gains made by investors and often provide a comparison of the profits investors would have made while investing in traditional financial instruments from banks and capital markets versus investing in their own platforms. In P2P lending the chances are high that borrowers would default and there- fore it is one of the key performance indicators for any P2P lending platform. Consequently to safeguard their investor’s interest from a borrower’s default, some of the FinTechs introduced a fund or notes. These funds or notes cover the inves- tor’s losses in case the borrowers default. Therefore, lenders are protected from a default risk. Most of the P2P platforms have also started rating the borrowers on a number of criteria before deciding on the rate of interest based on the risk category the borrower falls in. The loan pricing algorithm has therefore become a key factor for the entire system, and lenders have to agree to the terms laid out by the system before they start extending the loans. These platforms make money by charging fees from borrowers or lenders, and some other platforms charge the fees from both, but the fees are quite nominal as compared to the established banks. Additionally, these platforms allow lenders to start lending from as little as few dollars to millions of dollars by individual lenders and large investment/lending firms. Every time a borrower repays the loan, these exchanges deduct the loan servicing fee for itself, deducts the invested amount by the EMI paid and adds the interest to the lender account. The money in lender accounts thus keeps adding up, which is then reinvested in lending to multiple other borrow- ers. As mentioned earlier, a large number of P2P lending firms are converting their loans into collaterals and derivatives that can be traded in the primary and secondary markets thus creating an additional source of income for themselves and investors. P2P lending is now being adopted globally, including in China, where around half a trillion dollars worth of loans have been provided through P2P lending platforms. There are multiple platforms in China that have prospered in the last 5–7 years. Some of the P2P lending platforms in China are Tuandai.com, PPDAI. com, Eloancn.com, Touna.cn, Renrendai and Lu.com Some of these platforms typically work like online exchanges that facilitate information and ratings for borrowers and lenders. These platforms have different interest rate plans based on the grading of the loans. Lenders can invest in them based on their risk capacity. The platforms also have links to social networks as it encourages lending to family and friends. It also relies more on these connections to impose social pressure and to reduce defaults. The most interesting thing about these platforms is they keep flashing the income earned by investors daily/monthly etc. and that drives more new investors to get into the platform.
A large number of P2P firms maintain a complete database of all the loans issued through them on their website. The database is available for analysis by request through the website. This is an entirely different level of transparency exhibited by FinTechs as opposed to large banks, which do not make their loan books available for scrutiny on this level. Consequently, these p2p lending firms have challenged banks by being transparent between lenders and borrowers and the commission it makes as a market place, which is much different from what large banking or lend- ing institutions have to offer. Besides these P2P lenders, there is an ecosystem of data analysis platforms that can help analyze data about customers. The platforms typically include NSRPlatforms, lendingRobot and PeerCube. Some of these plat- forms even offer advice on how an investor should be investing. This is a great example of how FinTechs are making inroads into the business functions primarily managed by large banks. Large banks typically do not want to give loans to small businesses as they believe recovery could be high risk. Instead they prefer to invest money in giving loans to moderate and low-risk businesses. Ironically, banks have lost huge sums of money to established businesses, yet they are reluctant to lend to small business. Additionally, owing to their large size, it is very expensive for large banks to evaluate the worth of small businesses and the subsequent servicing of the loans. From an investor’s perspective, banks (deposit and investment) have catego- rized investors into debt, equity or commodity investors and their hybrid products. There is no place for a low-risk debt investor to make more money by still being a moderate risk taker. This is where these lending platforms have made it simple for these investors and borrowers to come together and make investments on genuine borrowers. Additionally, since the invested amount is further split into fractional amounts across multiple borrowers, the investors make moderately higher returns by taking a fractional risk. This is different from what an investor would have made in a traditional banking or investment set-up. The different variants of P2P platform include:
◾ An aggregator for borrows and lenders and the primary focus is informative. ◾ A marketplace for trading to take place between lenders and borrowers directly. ◾ Invest on behalf of lenders to a specified group or kind of borrowers. ◾ Issue marketable securities on behalf of borrowers to be invested and traded like debt securities. POS Lending This type of lending is prevalent as a formal channel of lending in most of the established markets. In almost all other markets, this type of lending is existent as informal, ad hoc and circumstantial. The informal lending in most of the cases would happen at POS for the retailer, wherein one would want a loan to settle
his/her purchases. The retailer would take into consideration the following factors before offering these kinds of loans: 1. How frequently did the customer visit the store and how loyal was the cus- tomer to the store? 2. What is the general economic status of the customer? This would typically be known as the borrower would be in the vicinity of the retailer. 3. Did the customer pay off the loan taken previously in a timely manner with- out coaxing? 4. The amount that was being typically borrowed by the customer. This was usually determined based on the capability of the customer to pay back his/her loans. 5. Finally, to maintain the transparency, the store owner would typically note all of this in a book as scribbled notes, which were time and again exchanged between the customer and retail store owner. In a more formal setup point #1 would be replaced by KYC for the customer, points # 2, 3 and 4 would be equivalent to determining the creditworthiness of the customer and point #5 would be replaced by maintaining and reporting the account-related activities. This type of credit was traditionally offered to maintain customer stickiness (loyalty) and there was usually no interest involved. Though in some cases since the customer had less negotiating capability, because he was bor- rowing and there were not many alternatives, sometimes the retailer would charge for the purchased items at their will for a customer borrowing at POS. All these arrangements would be informal and would depend upon individual rapport that the customer has had with retailer. Once the supermarkets started coming up, only the customers with enough cash to last throughout the month would visit them. Customers whose purchases or requirements for the month exceeded the amount they had, would still buy from their neighborhood stores on a short-term credit. Large retail store owners realized they were losing business and customers by offering no credits, and therefore they soon brought in a credit facility that would now be availed at the point of purchase by swiping their credit cards. The credit taken by the customer on credit cards could be paid back in 21days, while the store owner would get the payment within 3–4days. This continued to be a great solution that was adopted until people started realizing that the experience of using and managing credit cards was getting out of hand. Also, the credit card companies were not offering loans on individual items purchased. Instead, they would provide loans on the entire credit card balance or an individual would have to avail a separate personal loan. Owing to exploitation and ballooning disputes, multiple governments brought in compliance and regulatory checks on these loans, and in some countries even declaring this practice illegal. All of this led to less businesses authorized for issu- ing POS loans, and the cost overheads including the regulatory compliance led to increasing the overall interest rates charged for these loans.
The customer experience was more person-dependent and very few firms employed professional practices in offering loans and managing account statements. During this time, multiple e-commerce businesses emerged and within no time, a large part of in-person pur- chasing shifted to online purchasing.
Though online purchasing simplified the pur- chasing process, but the POS lending was still missing. Credit cards offered loans, but that was offered at a very high interest rate and the eligibility was dependent on credit scores. Additionally, this kind of loan would be treated more as a personal loan and would not have any relevance to the purchases made or the stores from which purchases were made. Therefore, looking at potential opportunities, FinTechs started making POS lending a formal process. Initially it was PayPal and then a host of other companies like Affirm, Klarna and Zest started becoming popular in this space. The potential of this market is assumed to be half a trillion dollars. While FinTechs were transforming POS lending, the technology disruption in POS systems was transforming the customer experience at checkout counters. The earlier-generation POS systems would typically be placed at the store exits, and there would be a large line of customers waiting to get their purchases billed.
The attendant on the terminal would be struggling between cash, card, redemption coupons and loyalty cards. These systems were difficult to operate in some of the operations like deleting an already-scanned item or reversing any purchases. In recent years, the POS systems have changed radically.
A substantial part of that has been made online as well, thus changing the experience for online customers as well. In some of the stores, a customer can select an item and then scan the same using his/her mobile phone and complete the billing and payment right on the spot. Therefore, he/she does not have to stand in checkout lines. Some of the e-commerce sites like Amazon now provide devices that monitor your washing powder level and reorders automatically after the stock levels have been depleted. There has been a major shift in terms of POS technology as well. Now the POS systems are movable, as they operate on SIM cards as opposed to the wired connec- tion they were earlier using. Some of the POS systems actually take in your mobile number and send bill and payment confirmation details directly to an individual’s mobile or email system.
The software also is usually hosted on the cloud, thus simplifying loading upgrades and infrastructure requirements by a retail mart. The systems are also directly connected to an e-commerce solution, thus enabling an individual to order through a website. The customer can then collect the purchases in-person and then pay for it at the POS terminal in the stores. Some of the large retailers and e-commerce giants are changing the experience by having no checkout lines. In this model a customer logs into the physical store by tapping his phone at a terminal and then picks up groceries from shelves and walks out. The store software based on sensors and machine learning is able to identify the items that the customer has picked up and lists them in his/her mobile application. Once the same has been done, customers can checkout and make payments from his/her mobile device without going through a physical checkout counter.