Imagine a subprime consumer who wants to settle their credit card bills because their interest rates fluctuate between 15% and 21%. They want a personal loan with better amortization plans to pay off their existing debts.
Are people more likely to go to a bank or credit union researching their options, or will they be more intrigued by fintechs that offer credit entirely online?
The latter looks like a nicer option. And what happened. Fintechs have wrested market share left and right from traditional banks and credit unions. Fintechs claimed 49.4% of the unsecured personal loan market in March 2019, up from 22.4% four years earlier, according to Experian.
However, the level of defaults is much higher on these nontraditional loans, with fintechs reporting a default rate of 3.53% 15 months after lending, almost double the traditional provider rate of 1.77%, according to a recent study by two Company school professors.
( dig deeper: Fintech Lenders Will Come Back When The Economy Reopens)
The study – “Fintech Borrowers: Lax Screening or Cream Skimming“- conducted by Marco Di Maggio from Harvard Business School and Vincent Yao from Georgia State University, was first published in 2018 and updated in late 2020. What they found isn’t a pretty sight for fintech lenders.
For one thing, the co-authors found that borrowers with high interest rates on their fintech loans are nearly 40% more likely to be overdue and have a greater drop in credit than a bank or credit union loan – an average drop of 12 points instead of 0.9 points – and their total debt increases by over 8,000 US dollars after a single year.
According to Di Maggio and Yao, fintechs could target audiences with subprime credit scores and poor credit histories by realizing that these consumers cannot get comparable credit from a traditional banking provider. However, there isn’t enough data to support the theory that these non-bank lenders are actively marketing to subprime consumers.
This is not an exclusively US problem. Leading fintechs in India reported a doubling Failure rates between August 2019 and 2020 according to a TransUnion CIBIL report.
“The picture of default is complex and will take some time due to the delayed impact of financial conditions, lender-backed aid programs and the shift in payment priorities of Indian consumers,” added the TransUnion report.
Di Maggio and Yao obtained their information from a credit bureau, which gave them information about unsecured personal loans – a fintech favorite. The two examined a sample of the more than 200 million consumer credit files and rated borrowers based on gender, age, marital status and college degree, and whether consumers took out loans from a traditional provider or a fintech.
Di Maggio says he can’t reveal which credit bureau he worked with to pull data on fintech default rates. The data provided to Di Maggio as anonymous consumers enabled the authors to match people with different types of credit and to determine which loans were issued by which type of lender.
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The data that made waves
To delve deeper into the paper The financial brand spoke to Di Maggio, who says he decided to pursue the matter further when he realized there was a lack of information on fintech failure rates.
“I researched the scientific literature, looked at it [and found] it was a tough question, ”he explains, adding that it is not common or easy to find the data to support his and his co-author’s hypotheses. It’s still quite a new conversation and the data is still not in abundance, even though fintech lending is gaining exponential growth in the credit market.
Most of Di Maggio’s main focus is on private fintech loans, which are primarily used to consolidate existing debt. He considers it to be the “most risky segment”, because even if borrowers can use parts of the personal loans to settle their outstanding bills, not all funds are always earmarked.
The vicious circle:
People only use a portion of the debt consolidation loan that they took out to pay off their debts. Instead, they use significant portions of the loan on new purchases.
And the problem has grown dramatically, he says, because card debtors often keep the cards after paying and then top up the balance.
“The worst result happens because if $ 40,000 wasn’t sustainable before, you end up at $ 80,000 six months later,” says Di Maggio. “Also, borrowers’ results deteriorate in the months following fintech loans compared to similar individuals who borrow from non-fintech lenders.” It is a classic vulnerability of debt consolidation loans. Fintechs have just made the process a lot easier.
Di Maggio’s insights are still making waves in the financial industry. When he first presented his research to a fintech audience at a conference, people were angry.
“We had people from LendingClub, people from TransUnion, who were very upset,” he says, joking that he asked them to find data that would prove him wrong. Two years later, he says they haven’t come to him with alternative dates yet.
It’s not all sunshine and roses
Fintech lending has its advantages, of course, which is why so many consumers are turning away from traditional providers. People will find it easier to get loans if they have a sub-prime credit rating, and the fintech lenders will review other forms of personal information to meet creditworthiness requirements.
( Continue reading: Banks are playing with dumping credit scores from credit decisions)
There is also a lot less supervision. While banking regulators are threatening to denounce banks and credit unions for compliance violations, fintechs have no federal oversight, although the Consumer Financial Protection Bureau oversees some practices.
“Some observers argue that fintech lenders may be able to operate where banks find it unprofitable,” wrote Di Maggio and his co-author in the paper, noting that fintech lenders also have lower fixed costs have as traditional lenders because the non-banks have no branches.
And traditional bank providers do not miss these advantages either. Banks and credit unions, even if they refuse to admit it publicly, are increasingly concerned about the growing swarm of competitors.
You could win you:
Almost nine out of ten financial institutions also fear that fintech lending will overtake their own lending, according to PWC.
Existing vendors may find it a relief to know that they may not need to worry as much as they think they are. According to Di Maggio and Yao, fintech lending may not be all it could be, and traditional banking providers still have an edge over challengers. They have a better track record in attracting consumers who are able to repay their debts. And the regulations that were once believed to hamper traditional banking providers can save them.
“I think lending and digital banks are less dangerous than, for example, the payment system,” says Di Maggio, quoting Stripe and similar specialists in digital payments who, in his opinion, pose a significantly higher risk for banks than LendingClub.