What Happens When 1,500+ Startups Enable Frictionless Access to Credit
December 13, 2018
Removing restrictions does create markets, but more often than not, there is little to no consideration of the potential damage that frictionless access to markets and funds may cause – for consumers, in particular.
While numerous studies have demonstrated that simple access to funds does not necessarily always result in long-term qualitative prosperity for those previously excluded from the formal financial system, the startup ecosystem keeps on pushing the rhetoric of enabling even easier and more frictionless access to funds for a variety of purposes. The matter goes far beyond financial inclusion and into simplifying the business of lending for conspicuous consumption. In fact, the rise of POS financing led to a 32% increase in sales for companies that enabled online POS financing. Moreover, the companies that offer POS financing experience an average increase in order value of 75%.
For consumers, the convenience with POS financing comes at its unique cost: the increased average volume for merchants translates into easier spending for consumers. With the opportunity to shop more and exceptional UX, consumers don’t immediately feel the costs – a rather controversial benefit. One of the most important points for criticism over easier access to alternative financing for consumer goods is the promotion of unnecessary consumerism at a higher price than traditional methods would result in.
The ethics of lending to the subprime are not particularly clear either. The tech industry, however, will likely see a correction from a credit push approach to a responsible extension of funds – all based on the recovery rates and behavioral data. To demonstrate the difference in how much interest consumers end up paying on a 12-month loan for an $850 purchase, some use Affirm.
Image: This graph shows the interest paid over a period of 12 months for an $850 purchase between an Affirm product and a credit card. Source: The Problem with Affirm Loans, 2015
Affirm is just one of the established startups in this space. At MEDICI, as we track close to 1,700 lending startups, including 120+ credit scoring startups, the idea of extending easier access to funds has become ever-prevalent in the startup community.
Even significant problems with alternative credit scoring could not inhibit the force with which the startup community works to enable easier access to funds through a variety of schemes and models.
Source: Marketplace Lending: Fintech in Consumer and Small-Business Lending, Congressional Research Service, 2018
Researchers at the Georgia Institute of Technology recently published a paper on winners and losers of marketplace lending, explaining that the imperfections in the credit market led to a rise of FinTech startups entering the credit markets in the last decade, including marketplace lending (MPL) platforms that specialize in P2P lending. Through the use of non-traditional data and alternative algorithms, emerged players are engaging in different interest rate pricing schemes. These FinTech players, the researchers claim, while still a very small segment of the market, have grown rapidly in terms of lending volume.
Sudheer Chava and Nikhil Paradkar of Georgia Institute of Technology found that MPL borrowers are more financially constrained relative to the average adult in the US. These borrowers have 2X as many credit cards and 2X+ the average credit card debt relative to the national average.
Most tellingly, their credit utilization ratio is 69%, which is over twice the national average of 30%. Additionally, MPL borrowers have average credit scores that are more than 20 points below the national average and a striking 80 points below the US homeowners’ average.
Not surprisingly, MPL borrowers are likely to be representing a higher risk group that is either underserved or cannot find suitable credit products with traditional institutions at favorable rates.
With the rise of the marketplace lenders and, as a result, a greater availability of credit to wider groups, in 2017, TransUnion observed greater consumer access to credit, balanced with rising trends in delinquency for card and auto loans. The company shares that credit card delinquency rates are slowly rising, but many lenders have the confidence to take on some risk, and subprime card accounts are still well below the account levels observed during the recession.
Meanwhile, Chava and Paradkar found that among the loan applicants on MPL platforms in the US, for more than 70%, the primary reason for requesting funds was expensive debt consolidation to pay off more expensive debt and replace it with monthly amortized payments.
One would ask then – what could go wrong with the desire to repay/consolidate debt through MPL? Well, while the researchers found that the average credit score rises by nearly 3% in the\ quarter of MPL loan origination, the credit profile improvement doesn’t quite last. The study found that in the quarter after MPL loan origination, borrowers revert to racking up their credit\ card debt. Moreover, three quarters after loan origination, MPL borrowers carry as much credit\ card debt as they did before origination.
Source: Winners and losers of marketplace lending: Evidence from borrower credit dynamics, Georgia Institute of Technology, 2018
Chava and Paradkar explain that firstly, this indicates that MPL loans provide only temporary debt relief since those loans do not change the fundamental credit behavior of borrowers who are deeply indebted and financially constrained.
Additionally, these borrowers do not actually reduce their aggregate indebtedness through MPL-induced credit card debt consolidation; rather, expensive credit card debt is simply transferred to a separate installment account, which is charged a relatively lower rate. Thus the researchers state that when these borrowers resume their accumulation of credit card debt after consolidation, they, in fact, become more indebted (in an aggregate sense) since they are now faced with paying down both borrowed MPL funds and their newly accrued credit card debt.
TransUnion shares that credit card marketplaces offers a strong example of the risk-reward paradigm of lending in 2018, as lenders provide credit cards to both the least risky and higher risk consumers.
More strikingly, increased credit card consumption after MPL loan origination is aided by an increase in credit card limits from traditional banking intermediaries. It appears that, influenced by the temporary consolidation-induced drop in utilization ratios, some banks extend additional credit to these borrowers at a greater rate in the months following MPL loan origination. This allows MPL borrowers to consume on credit cards at pre-origination levels, while still maintaining utilization ratios below pre-origination levels. We find that the probability of credit card default is 10X – 13X higher one year after MPL loan origination relative to pre-origination levels. This is consistent with the idea that increased levels of debt positively correlate with the risk of default. – Winners and losers of marketplace lending: Evidence from borrower credit dynamics, Georgia Institute of Technology, 2018
Source: Winners and losers of marketplace lending: Evidence from borrower credit dynamics, Georgia Institute of Technology, 2018
The credit bureau anticipates about 1% yearly rise of the average credit card balance per consumer.
In fact, in 2015, more than half (52%) of all personal loans were issued to the nation’s 92 million near-prime consumers and prime consumers, and while all types of lenders have experienced increased originations to near prime and prime borrowers, FinTech lenders remained well above banks, credit unions, and financial institutions.
As of March 2018, the stock of personal loans outstanding has grown to about $120 billion, according to TransUnion data. About 17 million Americans have this type of debt which, unlike mortgages and automobile loans, isn’t collateralized by an asset.
Overall, in Q2 2018, outstanding credit card debt in the US hit $829 billion (+$14 billion of quarterly change and +$45 billion in annual change).
In conversations about frictionless access to credit and the use of alternative data sources to enable that access, the focus has to shift towards responsible lending and sustainable recovery of funds. Consumers in the US, for example, are heavy users of credit. Consumer debt – including personal loans, real-estate-secured loans, auto loans, credit cards, and student loans – total over $12 trillion. Q3 2018 delinquency rates for consumer loans is at 2.28% (for credit card loans – 2.49%). That is not the number lending startups should be using as a highlight to justify their existence. That number represents an opportunity for companies operating in the lending space to focus on practices ensuring sustainable and responsible recovery of funds. \ \ For ~4.5 billion people globally – a majority of them from low and middle income emerging countries – with no credit or repayment data available, alternative frameworks may become a way into the formal financial system. But those frameworks will need to continuously evolve to take into account the most important stage – repayment history.
A 2018 study suggests that the cascading of information from a marketplace platform to a banking intermediary results in potentially inefficient extension of credit and higher defaults among borrowers who are already financially weaker.
The results of an extensive study show that while marketplace borrowers do consolidate credit after marketplace loan origination, they tend to default at a higher rate later.
All in all, there is still a great deal of uncertainty that surrounds the potential downsides of a greater, more frictionless access to funds and international markets are yet to see the results at scale. Some argue that the industry is creating risks for borrowers, investors, and the financial system. The sources of potential risk listed by Congressional Research Service in 2018 include:
Underwriting accuracy and loan performance has not been tested by economic recession.
Some marketplace lenders – including a number of the largest – generate revenue\ from origination fees but do not hold the resultant loans and are not subject to risk-retention rules, possibly creating an incentive to make excessively risky loans.
Funding availability and demand for loans has been high during a period of economic expansion with low interest rates, but the ability to raise funds and attract borrowers in other economic conditions is unproven.
Servicing of loans in the event of a failure of a marketplace lender could be disrupted.
Moreover, these risks are believed to potentially threaten the borrowers of and investors in marketplace loans, marketplace lending companies themselves, and – if marketplace lending grows sufficiently in coming years – the financial system. The Congressional Research Service lists the following possible adverse outcomes:
Loan delinquency and default rates could grow to an unexpectedly high rate, harming borrowers’ future credit availability and inflicting large, unanticipated losses on investors.
Credit determinations by marketplace lenders could disparately impact minorities and other protected groups.
Loan demand or funding for marketplace loans could contract to the point that marketplace lenders fail, potentially stopping the flow of payments to loan investors.
If the industry grows sufficiently large in the future, bad underwriting, large losses on marketplace loans or marketplace lender failures could create systemic stress.
The failure of marketplace lending firms is not problematic per se. Uncompetitive or unsustainable business models failing and equity holders suffering losses after taking informed risks is a central dynamic to a market economy. However, widespread failure of marketplace lenders – especially if these lenders grow to the point that they provide a substantial amount of credit to consumers and small businesses – could lead to a sharp contraction in the availability of credit to the economy. Also, because marketplace lenders often service loans they make, marketplace lenders’ failure could disrupt payment to investors from performing loans.
Another potential future issue is a systemic risk from marketplace lenders. Currently, marketplace lending is likely too small relative to total credit outstanding to cause stress across the financial system if loan defaults were to rise or marketplace lenders were to fail. However, the industry is growing rapidly, and its investors include individual savers and large institutional investors. Banks buy marketplace loans and enter into a variety of agreements and arrangements with marketplace lenders. If the size and interconnectedness of marketplace lending continue to grow, the industry risks could threaten systemic stability in the coming years. – Marketplace Lending: Fintech in Consumer and Small-Business Lending, Congressional Research Service, 2018