Banks have been lending money to people and businesses for a long, long time. A lot of the incumbent banks can trace their roots back to the 19th century. Banca Monte dei Paschi di Siena, which is the oldest bank in existence, was founded in 1472. Although they often rely on cranky processes and old systems, these guys know how to lend money. It might be quite narrow, within a very finite set of parameters, but they know what they are doing in that space. Hate them or love them, that’s a fact. When fintech lenders emerged with their slick user experience and nimble operating model, it was widely assumed that lending would change for the better. It is true that one of the assumption was that fintechs would rely on newer technology, like machine learning, and thus completely revolutionise lending. But, are fintechs better at lending than banks?
Not really, it seems
According to a few researchers, fintechs are not so much better at lending than banks. Quite worse actually. Marco Di Maggio and colleagues recently published a very interesting article, “The Dark Side of Fintech Borrowing“, outlining a summary of their research. It is an extract of a longer study “Fintech Borrowers: Lax-Screening or Cream-Skimming?” (you have to love the name) from Di Maggio from Harvard Business School, and Vincent Yao from Georgia State University.
The findings debunk the myth that fintech lenders are better at lending. Even though they have more insight into their customers by using, for example, alternative data. Let’s also put things back in their context, Di Maggio and Yao looked at the personal loan industry in the US. Therefore, we cannot generalise to all lending segments globally. But there are some interesting takeaways nonetheless.
What is happening then?
First off, this is not a technology problem. It seems that fintech lenders are falling prey to irrational consumer behaviour. Well, maybe someone should have told them that customers are far from economically rational. Personal loans sold to consolidate credit card debts are useless if a few months down the line, you max out your credit card again. That’s a general problem with fintech providers: instead of replacing incumbents, they facilitate a fragmentation of financial relationships. Customers keep their accounts or credit cards with the established financial provider, and open an additional one with a fintech. In theory, more choices is a good thing. In that case, that ends up being an issue because you are not reducing the overall personal debt. Customers have more credit available – and so spend more.
What really happened is that customers indeed improved their credit scores. But that did not last. After a few months they ended up spending more than they should. More available credit ended up being more money being spent. What’s quite fascinating is that the researchers concluded that the type of borrowers is very different between fintechs and banks. More in debt on average and more prone to overspending. It is interesting at a time when buy-now-pay-later (BNPL) companies like Klarna are getting a bad reputation because it is seen as pushing people to spend beyond their means. And getting them into debt a bit too easily.
Is it really a problem?
From the fintech lender point of view, it will eventually be. We have been in a benign credit cycle for over 10 years. Which means that default rates on any types of loans including consumer ones were historically low. But unsurprisingly so, it is not going to be the case for very long. It can be a problem if as a lender you are taking low provisions for loans that are actually risky. Fintechs have seen on average higher delinquency rates than incumbent banks. But that was a walk in the park compared to what is coming up in 2021 when the music stops with all the government-backed schemes.
Many banks have been through the ups and downs of the credit cycles over the decades, fintechs have not. It will be interesting to see how all lenders are faring in a clearly adverse economic scenario. Time will tell, but it will clearly be survival of the fittest.
Beyond that, it seems that fintech lenders assumed that financial literacy was a given and missed on the opportunity to change minds on finance. Technology does not solve everything, it does not magically improve people’s financial situation. That’s a tough gig, for sure, but financial education is key here. Otherwise, inadvertently or not, you are pushing customers into being in a worse financial situation than before. That does not seem aligned to the purpose of many of the fintechs out there. Of course, these companies are not charities and need to make money. That’s fine. However, they portray themselves more often than not as changing finance for the better. So now is time to walk the walk.