How to Lending

What is FinTech Lending?

Original Idea: Peer-to-peer (P2P)

Original Idea/Pitch?

Good timing to pitch the "sharing"?

Borrowers would post
- financial information
- maybe a picture
- how much they want to borrow, maximum interest rate
- why they wish to borrow
- hope that their peers will loan at a better rate than the card issuer (why might they?)
Peers:
- review the loan requests
- can choose the loans & amounts to invest

Sidebar: on the usage of photos

From Ravina, Enricetta. 2018. “Love & Loans: The Effect of Beauty and Personal Characteristics in Credit Markets.” Working Paper

Borrowers whose beauty is rated above average
- are 1.41 percentage points more likely to get a loan and, given a loan,
- pay 81 basis points less than an average-looking borrower with the same credentials.
Black borrowers pay between 139 and 146 basis points more than otherwise similar White borrowers, although they are not more likely to become delinquent.
personal characteristics are not, all else equal, significantly related to subsequent delinquency rates -
- with the exception of beauty, which is associated with substantially higher delinquency probability

Original Idea: Peer-to-peer (P2P)

Over time ...

https://www.youtube.com/watch?v=48kFuTtXexk

Lending Club in 2013:

Over time ...

Lending platforms became more involved in the decisions
- Make a credit risk evaluation and set an interest rate
Investors: can only decide if they want to be a part of it or not
Over the years:
- information provided to lenders has gone down
- most "peer" lenders now are institutions (95%(?))

Over time ...

Institutional investors automatically buy loans based on the platform’s risk assessment and pricing
Loans are securitized
- Assemble a pool of loans, issue securities backed by that pool

Marketplace Lending (formerly P2P)

What do people use FinTech Lending for?

price for loan

effort required to get loan

What do people use the online lenders for?

Source: Jagtiani & Lemieux, 2017, Philly Fed Working Paper 17-17

https://www.lendingclub.com/info/statistics.action

Who uses FinTech lenders? (Canada)

https://www.transunion.ca/blog/fintechs-in-canada

compared to 53% for consumers with personal loans from traditional banks

Who uses FinTech lenders? (Canada)

https://www.transunion.ca/blog/fintechs-in-canada

Why does it matter?

Unsecured loans #1
$3.7 trillion purchase volume in 2018
Debt has fallen from 64.7 percent in 1996 to 26.5 percent in 2018
- $900 billion in balances at the end of 2018
$4.3 trillion total credit lines, APR >20%
Balance vs payment:
- ~60% pay balance in full
- ~40% do not pay in full and keep a balance
Interest rates: >20%

Existing Credit markets: Credit Cards

(U.S. Stats)

https://files.consumerfinance.gov/f/documents/cfpb_consumer-credit-card-market-report_2019.pdf

Existing Credit markets: Decreased use as "credit"

https://files.consumerfinance.gov/f/documents/cfpb_consumer-credit-card-market-report_2019.pdf

small caveat: high balances for "private label" cards (e.g., store cards)

Existing credit markets: who is "scored"?

https://files.consumerfinance.gov/f/documents/cfpb_consumer-credit-card-market-report_2019.pdf

Credit cards: who uses them?

https://files.consumerfinance.gov/f/documents/cfpb_consumer-credit-card-market-report_2019.pdf

Credit cards: how easy to get?

Credit cards: usage as "credit" (revolving) vs. "payments"

https://files.consumerfinance.gov/f/documents/cfpb_consumer-credit-card-market-report_2019.pdf

Credit cards as "credit": costs

https://files.consumerfinance.gov/f/documents/cfpb_consumer-credit-card-market-report_2019.pdf

Credit cards as "credit": delinquency losses

basic portfolio math

average rate earned per consumer: 13-15%
average losses on portfolio: 2-4%
=> average return on portfolio: 9-13%

Is this market ripe for disruption?

high returns on the portfolio
everyone offered the same APR => not a lot of risk-based differentiation
alternative loans (e.g., personal loans) are hard to get

Why is there an opportunity?

All types of consumer credit are ripe for disruption!

Example: student loans. Very low hanging fruit!

All students within a cohort get the same interest rate.

$\to$ Find the graduates that do well & "cream-skim"!

Example: home equity loans

*

*HELOC=home equity line of credit

Why do we see it?

425bps!

Costs: Lending Club vs. A Bank

G&A=general administrative expenses

McKinsey: 59% of the banks’ earnings flow from pure fee products as well as the origination, sales, and distribution

Costs aside, there is very limited differentiation among banks!

Renaud Laplanche (LendingClub CEO) 2014 Keynote at Lendit

Banks even look the same!

Lending Club filled a niche: went to ZIP codes where competition was low!

Source: Jagtiani & Lemieux, 2017, Philly Fed Working Paper 17-17

Critically: they did scale up!

Source: Jagtiani & Lemieux, 2017, Philly Fed Working Paper 17-17

FinTech lenders aim to find a niche ....

TransUnion study in Canada:

FinTech portfolios are comprised of riskier consumers
- significantly higher consumer base within the subprime space.
- higher delinquency rates across all risk tiers
- higher interest rates for personal loans
These lenders seek to satisfy market demand among consumers who may not have access to traditional lending sources.

Here's a view from Canada (less positive than for the U.S.)

FinTech lenders aim to find a niche ....

TransUnion study in Canada:

FinTechs are focused on technology over risk management
Limited evidence of a risk-based strategy for pricing risk or assigning loan size based on a consumer’s risk profile
A one-size-fits-all approach
- similar loan sizes and interest rates being issued regardless of a consumer’s credit score.

https://www.transunion.ca/blog/fintechs-in-canada

Word of caution: I haven't been able to find the study (released Feb 25, 2020). Take the TransUnion blog conclusion with a grain of salt.

(Many FinTechs do their own credit scoring!)

FinTech lenders aim to find a niche ....

[Lending Club's] model attempts to identify applicants with FICO scores that do not reflect their true credit quality, and thus the risk could have been mispriced based on FICO scores alone.

Source: Jagtiani & Lemieux, 2017, Philly Fed Working Paper 17-17

What is different
about FinTech Lending?

about 33% of borrowers with FICO scores below 620 default
$\to$ 67% do not default!

(Upstart’s Paul Gu)

Why are they better?
What do FinTech lenders do differently?

FinTech lenders: Better data and better techniques

Old days:

FICO/Vantage scores
work only with credit history
26 million people in the US have "thin" credit history
$\to$ ask Canadian immigrants if they can get a loan...

"FinTech lenders use technology to obtain new kinds of data that can make lending decisions more efficient and informed."

Goldstein, I., J. Jagtiani, and A. Klein. 2019. “Fintech and the New Financial Landscape.” Bank Policy Institute (BPI): Banking Perspectives, Q1:7, March 2019.

Sidebar: academic insights from how data can be used well

New Days: Alternative data and machine learning

Soft information (Iyer, R., A. Khwaja, E. Luttmer, and K. Shue. 2016. “Screening Peers Softly: Inferring the Quality of Small Borrowers.” Management Science 62(2): 1554‒1577)
- whether the borrower posts a picture
- the number of words used in the listing text descriptions,
- friend endorsements
- social networks

example 1

New Days: Alternative data and machine learning

Flavour of the month: text-based analysis

Gao, Q., M. Lin, and R. Sias. 2017. “Word Matters: The Role of Texts in Online Credit Markets.” Working Paper:
use natural language processing (NPL)
analyze textual information from borrowers’ writing on online lending platforms.
quantify the informational content of lengthy personal text descriptions, linguistic style
lenders tend to bid more aggressively, are more likely to grant credit, and charge lower interest rates to borrowers whose writing is more readable, more positive, and contains a lower level of deception cues.
Note: Lenders are required to demonstrate that the use of alternative data does not result in biased credit decisions against certain segment of the borrowers, such as race and gender.

example 2

New Days: Alternative data and machine learning

Berg, T., V. Burg, A. Gombovic, and M. Puri. Year? “On the Rise of Fintech — Credit Scoring Using Digital Footprints.” Working Paper:

email contains their real name
make purchases at night time
number of typing mistakes
even the simple, easily accessible digital footprint variables as good as the Equifax Risk Score in predicting loan outcomes.
together with the Equifax Risk Score $\nearrow$ model’s predictive power

example 3

How do better data and better data analysis help FinTech Lenders?

Lending Club: steady growth of loans!

https://www.lendingclub.com/info/statistics.action

What are key components to their success?

quick note: Lending Club posts a ton of data on its website $\to$ that's why there is a lot of research on it

Lending Club: better credit scoring and product differentiation!

Source: Jagtiani & Lemieux, 2017, Philly Fed Working Paper 17-17

$\Rightarrow$ They learn!

Better credit scoring and product differentiation!

Source: Jagtiani & Lemieux, 2017, Philly Fed Working Paper 17-17

Better credit scoring and product differentiation!

Source: Jagtiani & Lemieux, 2017, Philly Fed Working Paper 17-17

The results show that given the same credit risk (i.e., for borrowers with the same expected delinquency rate), consumers would be able to obtain credit at a lower rate through the Lending Club than through traditional credit card loans offered by banks.

Source: Jagtiani & Lemieux, 2017, Philly Fed Working Paper 17-17

https://www.upstart.com/about#credit-limits-2

Example: UpStart

Example: Upstart

Source: upstart.com

Upstart

Source: upstart.com

Other types FinTechs in the consumer lending space

Other Niches? (In consumer lending?)

leverage cryptocurrency for loans.
loans available for Bitcoin, Ether, Litecoin and Dogecoin.
smart contracts to ensure the crypto is safely transferred.
Available in most U.S. states for business and personal loans & internationally in New Zealand, Brazil, Switzerland and the U.K.

Other Niches? (In consumer lending?)

Next big gap: Small and Medium Enterprise Financing

Problem: starting with the 2008 financial crisis, difficult for SME to get loan
processing costs for $50K and $1M loan are the same!
Banks require collateral/securing
- most SME loans are secured by personal wealth!

Next big gap: Small and Medium Enterprise Financing

Approval percentages of small business loan requests made at big banks (defined as having assets of $10 billion+) dropped to the single digit range during the ensuing credit crunch.
In June 2011, small business financing approval rates at big banks was a paltry 8.9%.

https://www.forbes.com/sites/rohitarora/2018/06/13/loan-approvals-hit-new-heights-for-small-business-borrowers-with-good-credit/#6820d6132f17

Today, big banks are granting 25.9 percent of the funding requests

This means that they decline 74.1% of applications!

https://www.sba.gov/sites/default/files/Whats_New_With_Small_Business.pdf

Small Businesses in Canada (2018)

1.2 million employer businesses
- 1.18 million (97.9%) are small
- 22,266 (1.9%) are medium-sized
- 3,010 (0.2%) are large

http://www.ic.gc.ca/eic/site/061.nsf/eng/h_03114.html

SME: why do they need the money?

https://www.spglobal.com/marketintelligence/en/news-insights/research/payment-fintechs-leave-their-mark-on-small-business-lending

Types of SME loans? (Lending Club)

Market segment challenges?

Personal loans:
- homogenous
- $\Rightarrow$ lots of data
SME:
- highly heterogenous
- $\Rightarrow$ hard to learn (even with data!)

Payments and Lending

https://www.spglobal.com/marketintelligence/en/news-insights/research/payment-fintechs-leave-their-mark-on-small-business-lending

Payment Fintechs (PayPal and Square)
- use their access to clients' real-time cash flow data to provide them with financing.
Merchant cash advances (MCA)
- Establish a fixed total repayment amount
- The payment company deducts a percentage from every card transaction until the full amount is paid.

Payments and Lending

https://www.spglobal.com/marketintelligence/en/news-insights/research/payment-fintechs-leave-their-mark-on-small-business-lending

Alternative (?): look at customers' credit!

Invoices are bought by FundThrough, which advances funds directly into the client’s bank account.
The client’s customer in turn pays the original invoice when it’s due

The flip side of online lenders?

Lenders vary in the amount of information provided, especially on costs
- challenging to identify interest rates or estimate cost

Personal and business information
- policies permit user-provided data to be used by third parties
  - $\to$ bothersome sales calls

Personal and business information
- unclear whether these data are used to underwrite and price offers of credit

https://www.federalreserve.gov/publications/files/what-small-business-borrowers-find-when-browsing-online-lender-websites.pdf (Dec 2019 report)

https://prospect.org/economy/how-amazon-uses-lending-to-control-small-businesses/

Crucial component of SME traditional loans: asset-based.
- SME: leverage assets as collateral, incl. goods, equipment, etc.
- The lender: reserves the right to inspect the “asset” of the borrower (and also the right to seize that asset)

Goods in Amazon’s warehouses $\to$
- Mixed with other sellers'
- No access for anybody
Amazon lending
- secretive
- MCA, double-digit interest rates
- single purpose: build up/ restock inventory on products sold on Amazon!

https://prospect.org/economy/how-amazon-uses-lending-to-control-small-businesses/

Alternative sources of funding for SME?

Personal credit (owner)
own funds ($\to$ own equity)
external equity
- Angels, VC (later stage)
friends and family
$\ldots$

Traditional sources of private equity funding

Friends and Family
Angel Investors
Individuals; must be ”accredited investors” (income of at least $200K, and/or high wealth).
Venture Capital Firms
- A limited partnership that specializes in raising money to invest in the private equity of young firms
  - General Partners = Venture Capitalists
Private Equity Firms
- Invest in existing firms rather than start-ups. Often participate in LBOs.
  - Typically more mature; larger amounts than VCs.

Venture Funding in Canada

Private markets in Canada (Ontario investors)

https://www.osc.gov.on.ca/documents/en/Securities-Category4/rule_20181129_45-716_exempt-market-report.pdf

Private markets in Canada (Ontario investors)

https://www.osc.gov.on.ca/documents/en/Securities-Category4/ni_20160128_45-106_key-capital-prospectus-exemptions.pdf

Private markets in Canada (Ontario investors)

Data: coinschedule

$5B in 2017

$2.2B in 2018

$2.3B in 2019

For comparison: publics markets in Canada (IPO)

Data: coinschedule

IPOs: expensive, difficult, and also the # is declining

Data: coinschedule

Why decline in IPOs?

Various reasons
Expensive to go public => want to stay private for as log as possible
Became easier to stay private for longer
- More money in private markets
- Additionally: regulation change in 2012: The US Jumpstart our Business Startups (JOBS) Act
  - the maximum number of shareholders a company can have before it must disclose financial statements went from 500 to 2000 shareholders

Alternative Sources of Funding?

Recently permitted by the SEC in the US and the CSA in Canada (JOBS Act Title III in the U.S.; provincial regs in Canada)
Restrictions (among others):
- Must be done on a registered platform
- Limits for entrepreneurs ($1 million in a 12 month period in the U.S.)
- Limits for investors (per firm&total; income-dependent). U.S. numbers:
  - >$100K => 10%
  - <$100K => 5% or $2K

Crowdfunding

For Canada, visit: https://ncfacanada.org

Alternative Sources of Funding?

Crowdfunding: Canada

For Canada, visit: https://ncfacanada.org

Restrictions (Ontario)
- Must be done on a registered platform
- Limits for entrepreneurs ($1.5 million in a 12 month period (?)
- Limits for investors
  - $2,500 in any one deal, max $10K in total per year
  - $25,000 if accredited & $50K (per year) total
The CSA promises a new harmonized set of rules for Canada out for comment by May 27, 2020.

Global Volume of Crowdfunding (2015)

Log Volume Per Capita (Crowdfunding, 2015)

Crowdfunding in Canada (statistic.com projections)

https://www.statista.com/outlook/335/108/crowdfunding/canada#market-revenue

Average deal now is USD13.5-14K

https://www.statista.com/outlook/335/108/crowdfunding/canada#market-revenue

Future of crowdfunding?

Pros and Cons?

Costs of crowdfunding?

Professional time (Lawyers, accountants, etc.)
- $500/hour
- 100 hours? => $50K in costs?

Platform Fee
- SEC 2016 study: 5%
- Wefunder: 7%

U.S.: max allowable amount is $1 million
- 10% in costs?!
- Plus advertising, management time, promos, etc

Costs to investors?

If you are making $100K, then about $50 per hour.
- How many hours did you spend "researching" the companies for your $2,500K to invest?
- Opportunity cost ....