In 2017, alternative lending was at a crossroads.
On the one hand, companies introduced important technological advancements. Investors remained optimistic, funneling significant money into payment and credit innovations. Traditional banks rolled out new digital products, capitalizing on the fact that growing numbers of consumers expect their relationships and interactions with financial institutions to occur exclusively online. By the end of 2017, demand for alternative lending products was stronger than ever.
But the picture wasn’t all roses. Some of the biggest names in P2P and marketplace (non-balance sheet) lending reported losses and write-offs, and struggled to find a clear path to profitability. Attempting to remedy those shortfalls, some platforms became much more selective with their lending. They pulled back on loans for consumers whose credit scores fall below 700 FICO.
Skeptics weighed in. They questioned if FinTech could truly deliver on the potential from its early days, when it promised that it would blow open access to money giving many more people a better way to achieve their financial goals while delivering healthy returns to investors.
I think those skeptics are missing the point. Yes, FinTech needs to recalibrate in the coming year. But a small shift in focus can rebalance the scales for all parties involved. When the industry prioritizes profitability — and that’s not out of reach — it’ll naturally lead to sustainability. That creates a win-win-win environment for all parties: consumers, businesses, and investors. The alternative lending promise is still very much alive and attainable.
So the 2017 crossroads was actually a turning point. As an industry, we’re experiencing a time of critical category creation.
But before we look ahead, it’s worth taking a look back. Let’s see how we arrived here in the first place.
A Look Back at Alternative Lending
From 1999 until about 2007, the U.S. economy experienced significant growth. That came to a screeching halt in 2007 when the bottom fell out of the subprime mortgage market threatening to collapse the entire global financial system. Banks that were “too big to fail” accepted government bail-outs in exchange for stringent regulation. Credit dried up for below-prime borrowers. Those individuals found themselves caught between a financial rock and a hard place: bank declines on the one side and risky, expensive payday loans on the other.
Beginning around 2007, savvy tech entrepreneurs recognized this unmet need. They restarted consumer lending with an eye towards those borrowers left behind in the new, more restrictive banking environment. They introduced online platforms that leveraged technological innovations to connect borrowers and lenders, eliminating the middleman and taking advantage of smartphones whose eventual ubiquity was just getting underway.
These early alternative lending companies needed aggressive customer acquisition to succeed, however, so they favored credit-last, capital-light solutions. They were originating platforms, so they were compensated with origination fees instead of through repayment of loans. There was little to no incentive to develop lasting relationships with borrowers for the life of their loans. While this acquisition-at-all-costs strategy provided rocket fuel to some alternative lending companies at the start, it ultimately didn’t align the interests of lenders, investors, and borrowers.
But this isn’t to say that peer-to-peer and marketplace lending hasn’t made made significant contributions: they made shopping for credit much easier and user-friendly. They pioneered a frictionless online experience between borrowers and lenders that is better for consumers. But the model needs to be profitable to have longevity.
How to Fix the Alternative Lending Model
When the skeptics question FinTech’s ability to deliver on its promise, they’re really asking if it can actually create an environment of financial inclusion, one that provides access for borrowers and that satisfies the expectations and interests of consumers, lenders, and investors. I believe this is imminently possible.
In the coming year, I suggest the industry focus on the ABC’s of alternative lending:
Access. People with FICO scores above 700 are typically well-served by credit solutions. FinTech makes their lives easier and broadens their options, but it doesn’t necessarily give them access to credit they wouldn’t have had otherwise. But the band just below that — what we call NearPrime, people with scores about 600 to 700 — are the ones worth the industry’s attention. Traditional FICO models do a poor job differentiating creditworthiness among this group, cutting off credit access even to those among them who are deserving borrowers.
No one is born with a 700+ FICO score. Alternative lenders should invest in the data and technology to understand the unique credit stories of people that FICO overlooks. Focusing on this group means FinTech lending can revolutionize access to credit for worthy people who need it most.
Balance Sheet. Balance sheet lending aligns the interests of all parties — the lender, the borrower, and the investor — because the lender earns its yield as the borrower repays. Unlike P2P and marketplace models, the balance sheet lender maintains both the credit risk and the relationship with the borrower. They have “skin in the game,” so to speak, unlike a lender whose interest naturally dissolves once it gives up the loan to the party that buys it. Balance-sheet lending ensures more accountability to lend responsibly, offer better products, and develop stronger long-term relationships with consumers. It’s a model primed for stability and longevity.
Credit First. Demand is not the problem. Lots of people want credit. In fact, demand outpaces supply. So it’s important that the industry can wade through all that demand and pinpoint those who are good risks — people poised to be 700+ FICO scorers one day but aren’t quite there yet — and zero in on them. A lending platform should seek to say “yes” until it’s presented reasons to say “no.” This is the only path to profitability and sustainability. A credit-first approach focuses on a customer’s potential and aligns that customer with a product that sets him or her up for a better, more responsible financial life.
FinTech is at an important point in its maturation. It is positioned to continue to serve the worthy borrowers who deserve access to credit and who have been overlooked too often. And it’s also ready to demonstrate it can do that with business model that also delivers for lenders, and for investors, over the long run. That will make 2018 a healthy year, for all the parties with a stake in alterntive lending.
Written by Juan E. Tavares, co-founder and chief strategy officer, LendingPoint