Silver Lining In Covid Storm Clouds For Banking & Lending Fintechs
There Are Reasons For Optimism For The High-Yield Lending Fintechs Which Weather The Storm
Across the world, the last decade has seen a proliferation of well-funded banking and lending fintechs. Built as a response to a perceived dissatisfaction with existing bank services, neobanks and specialty lending fintechs have gained increasing traction among consumers and SMEs. Challengers such as N26 (Germany), Revolut (England), Nubank (Brazil), and Xinja (Australia) have been at the vanguard for retail bank disruption. At the same time, innovative lenders such as Kabbage (US), OnDeck Capital (US), Funding Circle (UK), and Judo Bank (Australia) have focused on SME lending while taking advantage of a lean cost structure and innovative underwriting processes. These challengers have built businesses on the promise of profitably providing credit at scale to customers who had historically been ignored or underserved by banks.
The question hanging in the air as these fintechs swallowed venture funds and grew was: how would they survive their first economic downturn? The answer so far has been mixed. Many have seen default rates soar just as their funding sources dried up. However, there is also reason to believe that this could be a significant growth opportunity for the sector.
Intuitively, it seems that fintechs catering to higher risk and unsecured borrowers would be the first to feel the impacts of an economic slowdown. Unlike well capitalized incumbent banks with access to cheap long-term deposit based capital, fintechs have funded their lending with higher cost capital, which is often more sensitive to short-term market fluctuations. While this formula works during economic expansion, it would seem to make banking and lending fintechs more vulnerable during economic contraction, and also seem to lead to the consequent drying up of funding and increased borrower default. Indeed, this pressure is already starting to show. New York based OnDeck Capital reported a Q1 loss of US$59 million due largely to Covid-19 related loan delinquencies. In response, it boosted capital reserves and put down almost a billion dollars in credit to ensure ongoing liquidity. The SME lending fintech Kabbage was reported to have furloughed hundreds of employees in early March as it turned off the credit tap to SMEs, citing Covid-19. The situation was even worse for the European challenger bank Moven, which announced in March that it was shutting down due to funding challenges related to the Coronavirus outbreak.
In addition to funding issues, these fintechs have even greater existential risk due to their client base. Most serve customers with thin margin or credit files, and it is fair to expect higher than average defaults. US based retail neobank MoneyLion has reported that its delinquencies on personal loan repayments have nearly doubled. During good times, this risk was rewarded with APRs that could reach 70-80%. However, there is reason to believe that in a normal world, they would likely be the first to feel the market turn.
Nonetheless, we aren’t living in a normal world. We are living in a world where many 70-80% APR loans are being backstopped by the full weight of government monetary and fiscal policy; whether this is a smart thing for society is yet to be seen. In many countries however, government support is enduring worse Covid impacts than anyone else and this will create significant short and medium-term opportunities for fintechs which can pivot and weather the storm.
In the near future, fintechs that can act quickly to leverage their digital capabilities and build their customer base will position themselves well for recovery and growth. Fintechs have always focused on servicing the long tail of customers, unlike traditional lenders who have had the luxury of focusing on a more narrow segment of the market. This crisis is now forcing governments to also focus on quickly serving the financial needs of an extremely long tail of customers, and this is what fintechs were built for.
Fintechs’ agility and digital reach will allow them to quickly develop products in response to emerging market demands.
Kabbage is providing funding for small businesses and delivering smaller than average size PPP loans to the long tail of SMEs.
(Source: US Small Business Administration, IBSintelligence.com)
These platforms have grown to provide the exact functions that are needed now: quick onboarding, easy KYC, product agility, efficient disbursement of funds, and post-loan account management across the long tail of users. Not surprisingly, fintechs will adjust much faster than banks to achieve product-market fit in a Covid and post-Covid world. For example, at the same time Kabbage was shutting down SME lending, it was repurposing its platform to administer and provide the US Small Business Administration’s Paycheck Protection Program (PPP) loans. The crisis is proving to be a catalyzing event for Kabbage, which reported over 37,000 paycheck loan applications representing more than $3.5 billion in just the first four days of the program. For context, Kabbage has issued 225,000 small business loans for $9.5 billion since it was founded 11 years ago.
In addition to increasing their user base by quickly pivoting to act as a distribution channel for government programs, this crisis has created new business opportunities for lending and banking fintechs. Once they are satisfied that the borrowers have been qualified, they can issue loans immediately against the credit of the government lender and ultimately sell the debt. In the US, for example, the SBA loans pay a handsome origination fee (ranging between 5% for loans <$350,000 to 1% for loans >$2,000,000). While these loans only pay 1% interest on the principal, they should nonetheless be attractive to fixed income funds as they are basically risk-free loans and are superior to other options in an extremely low yield environment. This creates a lucrative business opportunity for fintechs that lack the balance sheet—or desire—to hold debt, but have a comparative advantage in origination, onboarding, and KYC. This is in contrast with slow moving incumbent banks, many of whom insisted on pre-existing banking relationships with prospective SBA funding program borrowers.
Covid is also emerging as a milestone event for the regulatory acceptance of fintechs: no longer are they just fringe players in the financial ecosystem, they are now being recognized by policy makers as having unique capabilities and fulfilling an important role in the financial services world. The increasing importance of fintechs as an integral part of the financial services ecosystem became a political issue in the US and was recognized by Treasury Secretary Steven Mnuchin who promised that “Any fintech lender will be authorized to make [PPP] loans.” While regulatory approvals may have been slower than desired, a number of fintechs including Square, PayPal, and Intuit have been authorized to issue loans, while others (including Kabbage) have partnered with banks, further accelerating the trend towards open banking and the separation of regulated and non-regulated banking services. Outside of the US, their ability to quickly implement government stabilization policies and get money to the long tail of citizens and SMEs most in need is also being recognized. In early April, for example, the government of Australia provided AUD$500 million to the digital bank Judo to provide SME loans. Interestingly, that funding comes from both specialty funds for Coronavirus relief and from normal operations.
Taking a longer term perspective, the lending and banking fintechs that survive the crisis will likely be very well positioned for longer term success. In addition to enjoying a survivorship bias and larger user databases, they will emerge into a world of low fixed income yield which will create a positive environment for equity funding and debt facilities.
Whenever and however the world normalizes, it is likely that interest rates will be lower than they were when the crisis started. This low yield environment will have two re-enforcing benefits for lending and banking fintechs. First, as yield hungry institutions search for risk, it will likely compound the rush of capital into higher risk investment opportunities such as venture capital investment. While this will obviously benefit all startups, it will have a doubly beneficial impact on those which were able to leverage the crisis to scale. Second, there will likely be an excess of debt made available to lending and banking fintechs, as investors search for the type of high yield fixed income opportunities enabled by these business models. This will provide the liquidity needed for these fintechs to scale their businesses quickly—either on their own balance sheets or with their willing partners.
Despite legitimate reasons for scepticism about the prospects of lending and banking fintechs, some of these businesses will enjoy significant gains over the coming months and beyond. This will create high impact opportunities for both financial and strategic investors looking to invest or acquire. However, distinguishing successful from unsuccessful businesses will take a deep understanding of business models, market conditions, and policy and regulatory dynamics across different geographies.