The Challenge of Fintech – Lending Against the Banks

Fintech companies challenge the status quo of established industries with fresh ideas and new technologies while offering better rates and better services to customers.

They face a tough challenge though. More than any other, the financial services industry is highly regulated. When things go wrong, the fallout is felt not only in the banking sector but in the entire economy. This was evident during the banking crisis of 2008/9 when banks and other lenders, bloated with bad loans, which they packaged and sold off to unsuspecting investors, had to be bailed out by governments in a state of panic, lest the loss of investments and deposits result in the loss of consumer confidence in the economy (and in turn the government).

That is a story we are all familiar with. The story of Fintech is new. But it is also untried and untested and not a few times in the history of finance have excited lenders suddenly found themselves – much to their surprise – unable to collect their debts.

If private investor confidence is any criteria, some of these companies with valuations in billions of dollars are already runaway successes but that a large part of this confidence stems from irrational optimism is borne out by the fact that post IPO these sky high valuations, when subjected to the reality of the stock market, almost always come crashing down.

Hyped as they may be, many Fintech companies are breaking new ground and one of the most active Fintech sectors relates to new approaches in consumer lending.

Fintech – Consumer Lending

Fintech lenders are re-writing the rules of lending by developing alternative risk management algorithms that help determine who to lend to and how much to lend.

Stuck in the past

The standard method to credit check someone, developed for the banking industry by Fair Isaac Corporation or FICO and in use for decades now, is the determination of an individual’s credit score which is a measure of the risk of default that takes into account the past payment record of a customer: did they miss to pay a bill (not good), do they have too much debt already – mortgage, consumer finance (not good), whether they have been seriously sniffing around for credit recently? (not good at all) and other things that point to a chequered past of bad borrowing. Once all this information is collected and a credit score churned out, the credit approval process is fairly mechanical and standard.

All or nothing

Since a credit score measures a person’s past and everyone broadly uses the same methodology, an individual is often able to secure a loan from any bank no matter how doubtful their future liquidity may be or from none no matter how good their future prospects may be.

Focusing on the future

A number of start-ups have taken a more shall we say “futuristic” approach. To ascertain a person’s future potential to make money and hence pay bills and make repayments on time, they look at a broader set of parameters covering their digital footprint, their social media presence such as say on Linkedin (the bigger the network the better), education (fresh out of Stanford University? likely to do well), current employment status (highly indebted junior doctor at a good hospital? likely to be going up in the world). The idea is not to rely just on your credit score – particularly for younger customers – but identify whether the applicant has future prospects and earning or start earning high levels of income even though much of that income will go towards paying for schooling, housing, and student loans – in other words is applicant a HENRY – High Earner Not Rich Yet.

Hunting HENRYS

SoFi is the most celebrated HENRY hunter.

SoFi or social financial is an online lending firm in the United States that provides personal loans as well as mortgages to younger digitally savvy students (or their parents) and has just been valued at a whopping $4.5 billion. Earlier this year it stopped using FICO scores all together turning into a “FICO free zone”. So high is investor confidence in its dark arts of risk management that Softbank a venerable Japanese investment bank recently invested $1 billion which makes it cash rich and not dependent on the stock market as it does not need to IPO for now. Its track record is good. It reached $7 billion in outstanding loans. The money it lends comes from investors, bank lines of credit, and individuals in peer-to-peer arrangements. SoFi also plans to go beyond loans and has already rolled out mortgages and intends to offer wealth management advice to its customers: a perfect HENRY strategy.

Many Start-ups

SoFi is already facing tough competition from other start-ups such as Earnest, Pave, Upstart, and Common Bond.

Earnest started out without the use of FICO scores that SoFi have now also fashionably abandoned. Earnest also claims to have better rates than SoFi and claims one of the most advanced risk management formulas in the world using – using “between 80,000 to 100,000 data points to loan to people with little to no credit history.”

Pave, which recently received $300 million from Seer Capital, plans to lend part of that money to millennials, a term referring to people born between 1980 and 2000, focusing on “stable” professions such as unionised teachers who don’t earn much but their income levels are more or less stable and they tend to be responsible with their money. They are thinking out of the box and collaborating for customer acquisition with relocating companies saying every year 47 millions people in the United States move and people tend to move earlier in life. Pave does not discount credit scores.

Holy Grail Hubris

Though SoFi works with banks, Mike Cagney, its CEO is scathing of banking in general, even promoting a Twitter hashtag #Dontbank. “We actually are trying to change a fundamentally broken

[banking] system,” he says.

While the logic of focusing on the future is right, to ignore the past history of a customer is not to learn from the past and potentially dangerous. Santayana may well have been referring to lenders when he said, “those who cannot remember the past are condemned to repeat it.”

SoFi’s original and core approach of lending to students (burdened with debt) in the United States with good future prospects, aggregating and refinancing their debts, without using traditional credit scores makes sense for now. It has now expanded to mortgages another relatively safe sector provided they don’t repeat the aggressive and costly mistakes of the past when banks and others lent way beyond the value of the collateral, which was already inflated in terms of high real estate prices.

A bit alarming is SoFi’s Mike Cagney’s boastful approach who claims to have found a new holy grail to lending, one worthy of the digital times we live in, while other companies are just old wine in new bottle:

“The problem with fintech is that it’s not ambitious enough in terms of its objectives. It’s not really transforming anything. The companies of old, like Simple, which was just an electronic interface bolted onto a bank … I put Lending Club into that bucket. It’s a great business model. But at the end of the day, they want to be an origination arm for a bank, and their bank alliance illustrates that …In 10 years instead of asking someone who they bank with, I want people to ask who do you SoFi with?”

There is a touch of hubris that has the same feel to it as the bad old days of debt securitisation when banks believed they had discovered an ingenious way to lend to anyone, mix up the loans, and securitise them.

Lending Club that Mr Cagney so derides is the previous holder of the Silicon Valley Fintch Magic Act. It was hyped up and valued at $8.5 billion on the day it IPO’d only to gradually sink down to $2.3 billion as the magic wore off – by now a familiar pattern with many big name start-ups. Contrary to Mr Cagney’s claims, its performance does not defy the rules of business and lending money, the numbers are improving and transparent.

Injecting credibility

Since start-ups are new and need credibility to be taken seriously by investors, one way to do that is to sign up heavy weights. Lending Club boasts John Mack (Mack the Knife – ex CEO Morgan Stanley), the legendary Mary Meeker (ex Morgan Stanley and the 1998 “Queen of the Net”), Larry Summers (71st Secretary of the Treasury) among others. SoFi recently signed up Arthur Levitt, the longest serving SEC Chief, who in an interview with Fortune did what heavy-weights on the payroll are paid to do, sing praises of the company, even more of the CEO, and how the company is radically different from others, and that it will be around for a very long time injecting trust but at the same time fuelling the hype.

Summary

Alternative lending companies, their innovations and strategies, with their emphasis on customer needs are changing the banking and payments industry. Even if they do not go mainstream and replace the big banks, they would contribute to re-shape the banking industry itself.

But lending has a lure that often gets out of hand as we have seen many times before. All lending risk formulas are vulnerable and their outcomes are uncertain and highly unreliable if economic conditions change. In China, the unregulated person-to-person lending industry, which was allowed to operate under the radar was estimated at $150 billion at the end of 2015. However, hundreds of such companies failed creating havoc in the marketplace and making the government release tight regulations.

In the US and other markets with alternative lenders – it will only take one high-profile casualty before laws and regulations are tightened and it will become more difficult for technology companies to underwrite loans and provide a profitable avenue for investor capital. But one thing is certain that the valuations placed on lending start-ups by private investors reflect the misplaced enthusiasm of investors and their advisors and not the realities of a market that is already becoming very congested.