Here are two important truths about the credit business. One is popular, the other unpopular, though which you think is which will reveal something about your biases:
- No innovation in the past decade – and indeed longer – fundamentally changes the lending business
- The past decade has seen a number of important innovations that no lender can afford to ignore
These seemingly contradictory assertions are actually complementary, and can be useful to frame a discussion about what has really changed and what has “stayed the same,” helping guard against complacency on the one hand and naive risk taking on the other.
This piece is the first in a series the LendingFront team will publish to help our colleagues in the business of providing credit to small businesses to understand the major technological and market developments affecting our industry, to put them in context without losing sight of fundamentals, and to position yourself and your company to thrive.
A right of passage for anyone who enters the world of finance is exposure to “The Five Cs of Credit.” Sometimes the number is different, but the “Cs” nearly always include character, capacity, collateral and conditions and may also include cash flow, capital, credit history and common sense.
With modifications, this framework can be used to evaluate the suitability of any type of credit product for any individual or business. When encountering a proposed new approach to lending, many veteran bankers will cite the enduring wisdom of the Five Cs. And nearly everyone who’s been on the wrong end of a default (that is, anyone who’s been in the business long enough to earn their stripes) will likely agree that the core elements of lending do not change no matter how much else does and no matter how much it may seem to the unseasoned eye that “this time it’s different.”
At the same time, anyone who’s paying attention has to acknowledge that technology is constantly evolving, and that customer needs and expectations never stand still for long. This means that every leader in the credit business who hopes to stay relevant needs to stay informed and to have a point of view about when to stick with the tried and true and when – and how – to adapt.
This LendingFront series takes a systematic approach to evaluating the major innovations that have appeared in the credit industry, and the claims made about them. This first installment gives an overview of the major categories of technology and their application. Subsequent installments will explore each of these categories in detail.
We will start by looking at the overall terrain.
Seeing past the hype cycle
The past decade saw a wave of online lenders emerge, often heralded with grand claims about how the innovations they had tapped into would transform the world of finance. This was driven partly by cyclical conditions and partly by technological and related cultural shifts. Banks and other traditional lenders retrenched in the wake of the 2008 credit crunch, leaving unmet market demand that drew in a variety of new entrants. Meanwhile, the maturation of smartphones and cloud-based web applications led consumers and then businesses to expect to be able to perform an ever increasing range of activities instantaneously online.
Taking advantage of this, pure online lenders – often dubbed “fintechs” in the banking world – brandished their technological sophistication and up-to-date approach to digital user experience (“UX”) to claim a respectable share in some markets and an outsized share of media attention and airtime at industry conferences.
Typically, the leaders of these fintechs and their advocates would tout their many alleged advantages over traditional financial firms, such as:
- Technology was in their DNA. They had no need to deal with legacy systems, so they could leapfrog the incumbents, attract the best technology talent, and set in motion a virtuous cycle that would keep them on top in a world increasingly driven by software.
- Digital focus. This often meant they were able to deliver a superior online user experience. It also generally meant the systems driving that online UX were highly automated and had far better economics than traditional institutions with their reliance on branch networks, staff, and manual customer service.
- Quick decisions and aggressive use of data. A key source of differentiation for many fintech lenders was the ability to make quick credit decisions. This was often attributed to an innovative and aggressive approach to gathering and using data, which could also be applied in targeting customers and selecting credit products to offer them.
- Online borrower acquisition. For many lenders this simply meant state-of-the-art online marketing, while for some it meant connecting with online marketplaces, lead generation sites, or other channels, which often require a degree of flexibility and technological sophistication beyond the reach many incumbents.
- New sources of capital. Some fintechs tapped into new sources of lending capital that seemed to promise advantages in terms of cost and duration matching (for example, “marketplace” or “peer-to-peer” lending models).
- Lower regulatory burden. Leaner structures (and not taking deposits) meant fintechs could avoid many of the rules and restrictions that banks were subject to, reducing costs and freeing them to serve customer segments regarded as uneconomical or too risky by incumbents (e.g. non-prime consumers and small business financing).
Some of this has proven to be more hype than substance, fitting into the narrative of the many skeptics who said they’d seen this movie before, for example with monoline lenders two decades earlier like Providian, Nextcard and Metris, or even in the credit-fueled real-estate bubble that unwound so disastrously in 2008.
But however you may feel about them, the fintechs did pioneer some genuine innovations, and we are now in the stage of the hype cycle[1] where we can see with some clarity which of these innovations truly generated value versus what was ephemeral or illusory.
Evaluating innovations along the value chain
To do a fair assessment of the purported innovations, let’s break down the lifecycle of a credit product and explore where legitimate value may lie at each stage – for fintechs as well as for banks or other financial institutions that might benefit.
Here is an outline of the key elements of a lending or credit business, with a brief description of the promised value from new financial technology at each stage. We’ll then consider how that value may or may not materialize or endure in more detail, and explore how a bank or other financial institution (such as a CDFI or alternative lender) might incorporate and benefit from the underlying innovations.
Acquiring borrowers
- More efficiently connecting borrowers & lenders
- Digital marketing
- Connecting with referral partners or networks
- More intelligently targeting prospective borrowers with appropriate credit products
Sources of value
- Lower borrower acquisition costs
- Access to new or higher value borrowers
Better customer experience
- Well designed online and mobile channels
- Faster decisions
- More efficient & effective channeling of applicants
Sources of value
- Higher conversion rate
- More satisfied customers
- More efficient application processing
Better underwriting
- New data sources
- More effective risk scoring
- Faster decisions
Sources of value
- Fewer bad loans
- Supports better customer experience
- Enables better product/prospect targeting
Originating
- Digitized process
- Better consistency and auditability
Sources of value
- More efficiency and scalability
- Supports better experience for users and lender staff
Servicing & monitoring
- Automated data gathering, analysis and triggers
Sources of value
- Efficiently and effectively manage loan portfolios at scale
- Proactively and efficiently deal with problem loans at the first sign of trouble
- Proactively offer renewals and other products to qualifying customers in a highly automated, targeted manner
Acquiring borrowers
- More efficiently connecting borrowers & lenders
- Digital marketing
- Connecting with referral partners or networks
- More intelligently targeting prospective borrowers with appropriate credit products
Sources of value
- Lower borrower acquisition costs
- Access to new or higher value borrowers
This series will explore each of these areas and the related technologies, evaluating what has worked, what hasn’t, and where we expect to see meaningful innovation in the near future.
We will publish new installments in the series every two weeks or so, and will cap it off by compiling the full series in an e-book.
You can sign up here to be notified when new installments are released, and can opt out at any time.
We are glad you share our interest and hope get good value from this material. We also welcome any feedback or suggestions. Reach us at info at lendingfront.com
