The real business of banking is lending

If you set aside investment banking or trading in securities and derivatives – businesses that many say have little or nothing to do with banking – the primary services that a bank offers (taking customer deposits, facilitating payments within a country or internationally, managing investments etc.) all support or reinforce in some way, the real business of banking which is lending.

The basic economic principle of lending is simple: a loan like any other asset in a business, must contribute to its profitability. Its contribution to profits and the risk of its loss (if not repaid), represent forces that tug in opposite directions which must be kept in balance if a lender is to survive and succeed.

The higher the probability of default, the more the asset must earn to cover that loss.

Traditional underwriting

The brain of a lending business is its credit underwriting process – the analysis required to assess the probability of default of a particular loan. This remains essentially an art (of future divination) but one that is built on analytical and technical foundations. Credit bureaus and lenders use mathematical models and standardised credit scoring techniques that reflect a person’s profile, status, and past payment behaviour such as how promptly they settled their debts and if they ever missed any bill payments.

These models assemble available data from several sources to draw out cause-and-effect relationships that assess the returnability of a loan and offer a picture of a customer’s ability to repay in full and on time.

Online credit websites that digital lenders deploy are quite sophisticated with intuitive user interfaces so that borrowers fully understand the financial commitment they are entering into.

Even so, macro-economic conditions can deteriorate and negatively impact the quality of the loan portfolio especially where the lender is exposed to more risky sub-prime loans . People laid off from work, who have taken on too much debt can find themselves unable to repay. Lenders must find ways to recover the loss which they do by raising interest rates or charging additional fees or simply calling in the loan. Where there is a collateral pledged as in the case of mortgages, the lender’s exposure is reduced to the value of the collateral less disposal costs. Riskier still is open ended unsecured credit – credit card type of revolving credit – where the amount borrowed varies continuously and the risk faced by the lender also varies accordingly.

The new lenders

Non-bank lenders have been playing in this market for sometime now but new players are emerging regularly. These include most prominently companies such as Zopa in the UK, Lending Club, Prosper, SoFi, PayPal, and Affirm in the US, Klarna in Sweden and Europe – to name a few – that focus on lending to individuals and others such as OnDeck for loans to businesses.

On the burgeoning promise of big data, an army of new person-to-person lending “platforms” are waiting to get approval for online lending. In the UK alone, the Financial Conduct Authority (FCA) says that while only 8 firms are currently authorised, there are 86 awaiting a decision to be approved.

Some of the new lenders have developed their own risk assessment techniques which they claim more accurately reflect a borrower’s future ability to repay a loan rather than their situation at present and past payment profile which the traditional scoring techniques leverage. They claim to collect and include in their risk assessment tens of thousands of variables including data points from a customer’s digital footprint which is getting bigger and bigger by the day. This sounds a bit hyped and over-blown but digital footprint / social media presence can reveal a lot about a person’s lifestyle, needs, and financial stability.

But the conclusions drawn from digital media are as likely to be misleading as useful. New credit scoring techniques attempt to quantify certain non-quantifiable elements such as number of connection on Linkedin, places travelled on Trip Advisor or Facebook. Social media, useful as it may be for sleuthing around to get information on someone, is no indicator of one’s credit worthiness or their propensity to pay what they have borrowed.

But the new lenders are right about making certain assumptions when they look at someone’s future credit worthiness. It does not matter if a young graduate from a top class university has missed a few loan payments and is already laden with student debt, what matters is that his or her professional degree from a top class university is likely to lead to substantial income in the future.

Where the social media trail and data from digital media can help is in validating basic information about a person where none exists from the usual sources. Information provided by individuals with “thin files” – young people or those with insufficient records can be corroborated by what is available on social media.

Think different

Some of the new lenders are so devoted to be different that they do not use traditional tools at all. SoFi, a new lender privately valued at $4.5 billion have done away with traditional credit scores and now undertake the entire credit assessment process using their proprietary approaches. It is a unicorn valued privately at $4.5 billion and targets mainly students and young professionals in the United States differentiating itself by going the extra mile to meet the needs of this segment such as a friendly, efficient, and sympathetic approach to lending, suspending loan repayments, for example, if the borrower finds him or herself without a job and even help them find a new job. It considers lending as just one step in their grand plan of offering everything financial to their customers as well as other services which, they believe, have more to do with one’s financial status than we think: even online dating by matching SoFi customers with similar financial profiles. No joke.

Critics are sceptical here too. Alternative approaches to credit assessment do not lead to accuracy but have, in the past, been used to justify aggressive and even reckless lending to sub-prime consumer segments. This is the riskiest end of the market where it is easy to lend and recognise revenues in the books (and for lending managers to claim their performance bonuses). But the slightest economic downturn or rise in interest rates can trigger a delinquencies and loan portfolio deterioration as has happened in the past a number of times.

Analysts point to the worsening situation of some new lenders though at this stage these are just indications and not hard facts. Prosper and Lending Club – the original new lenders which began as person-to-person lenders but are now are also “marketplace” lenders – have raised their interest rates – which could be an indication something is perhaps awry or they expect delinquencies to come. But equally, it may just be that the cost of capital has gone up. These companies lend to individuals and then sell the loans on the market to institutional investors, who now account for nearly half of all loans made by Lending Club, who would otherwise take their business elsewhere in search for better returns. This leads to another point of significance. Marketplace lenders are becoming partners with banks rather than trying to replace them.

Actual delinquencies for Lending Club and Prosper have gone up in 2015 but only slightly. Industry observers such as Monja say that while there are no issues with these lenders’ “high grade” loans, investors should closely monitor their lower grade loans.

Checkout credit

Checkout credit in shops is common in many countries where retailers offer customers the option to purchase something outright or to pay at a later stage (deferred payment), or pay slightly more to spread the purchase amount in affordable instalments over an agreed period of time.

In the digital domain, Klarna, a Swedish firm, has been successful in its home market and selected other European markets and is now making designs on the biggest credit market of them all, the United States. It started out by offering deferred payment or “invoicing” – the option to pay later (certain number of days after receiving goods ordered online). For peace of mind and in a market like Sweden where invoicing is common, Klarna has achieved remarkable success. When the due date for paying the invoice arrives, the customer can be further offered the option to pay in easy instalments.

Companies such as PayPal and the start-up founded by a PayPal veteran, Max Levchen, called Affirm offer checkout credit to assess the buyer’s credit worthiness online in near real time. 40% of Millennials in America do not have credit cards, says Levchen. These are the customers Affirm plans to target in order to offer digital checkout lending.

As I mentioned above, the business of instalment lending is nothing new. In Turkey banks offer instalment loans when customers use their credit cards to buy stuff in shops. In Brazil, instalment loans are very popular though the loans are offered by retailers not banks. But in the digital world, surprisingly, there are not many competitors.

Where to?

The market is massive and the incumbents today who stand to be “disrupted” are not just credit card firms but also retailers who offer credit on things they sell. But the biggest challenge the digital disruptors face today is their own over confidence in their new underwriting techniques. Too much automation in the underwriting process, which should take into account hard data elements but also subjective factors which are difficult to quantify, may lead to odd and unfavourable results.

Interestingly also, these new lenders don’t want only to lend. They want to offer everything that a bank offers in the long term because, according to the, everything that a bank offers is sub-standard. “We’re going to build a bank that doesn’t suck,” says Max Levchin. Or here’s one from Mike Cagney, CEO of SoFi, “We actually are trying to change banking entirely.  We are trying to displace what we think is a fundamentally broken system.” Marketing speak again? Or a common delusion of entrepreneurs successful in one area labouring under the misconception that their secret magic can make anything come alive.

It is possible that marketplace lenders like Lending Club may have found a more sustainable model than the likes of SoFi as they are open to all types of investors for sourcing funds they lend. But all are vulnerable to restricting regulatory events such as those in America where new lenders may have to comply with more onerous and restrictive state lending laws than federal laws under which they have so far operated. China has already seen a crisis in the person-to-person lending industry recently mainly because it was allowed to operate under the regulatory radar. This year Chinese authorities released regulations to curtail some of the dodgy practices of the new industry which has grown exponentially from 253 billion yuan in 2014 to 982 billion yuan in 2015.

Ultimately, however, many in the banking industry see clearly where all this is leading to. Whether pure disrupters such as SoFi or marketplace lenders such as Lending Club succeed, the new lenders will always be between the end customer and the supplier of funds. Does that mean banks will ultimately become invisible relegated to suppliers of funds and digital players will cover the all important connection with consumers remains to be seen.