With financial services providers making banking more accessible to companies, the industry eyes lending as the new frontier in financial technology (FinTech). Lending-as-a-Service (or LaaS) has taken a longer path to market due to the rigorous compliance requirements (from state-by-state AND federal regulators) and higher upfront cost (program fees, cost of capital for loans, reserve amount for defaults). Key trends in 2021 (from consumers/business users, service providers, non-bank entrants, data) are pushing for the growth of LaaS providers and offerings to take center stage.

THE NEW CUSTOMER PERSPECTIVE ON LENDING

The pandemic’s impact in the last year is still being felt — traditional institutions have had to embrace digital banking at a more rapid pace. Customers are comfortable transacting via their mobile device and not going into a bank branch to speak to banker about new products/services. This shift has opened up the path to discuss innovative lending offerings.

Many of today’s millennial and Gen Z population grew up in the aftermath of the Financial Crisis (2008 - 2009). Their parents and households may have struggled with debt, lost their home to foreclosure, or lived through unemployment. The hard-learned family lessons were to avoid debt (from credit cards or loans) and build a financial safety net (e.g.emergency fund). As a result, these user demographics predominantly use debit cards for purchases and have minimal credit profiles (due to lack of open trade lines or payment history reported to credit bureaus).

The new customer demand is for a suite of products that provides the benefits of lending (i.e increase purchasing power, establish/build a user’s credit rating) without incurring additional debt (from fees, penalties, or APR). The banks and fintech companies capable of providing these alternatives stand to gain the most in market share and user growth over the next year.

MEETING THE DEMAND for dynamic credit solutions

With a clear path forward to customer engagement, why aren’t financial service providers offering LaaS in addition to Banking-as-a-Service (BaaS)? Licensing, compliance, and increased cost (passed to platforms and their users). In BaaS, partner banks are willing to allow the use of their national charter for a narrow scope of use cases focused on payments and deposits.

The licensing needed for lending is much more stringent — each state in the US has it own guidelines for approving, issuing, and servicing loan products. Added to this are numerous federal regulations (such as Fair Lending, Equal Credit Opportunity Act) that protect consumers from being unfairly discriminated when receiving a loan decision. Consumer complaints of fairness can lead to regulatory inquiries and penalties (of fines or shutting down a platform).

With this increased regulatory scrutiny, compliance management and controls need to encompass banking risk and wider scopes of financial risk (losing money on providing credit). Monitoring and mitigating risk comes with a higher overhead cost to maintain an in-house legal and compliance team that stays updated on state and federal changes. Lending platforms must manage these aspects or partner with an experienced, licensed provider.

Lastly, additional funding is needed to provide loans or credit cards to users. The banks in BaaS partnerships aren’t structured as lending sources for newly launched programs. Companies must self-fund OR connect with a capital partner (private fund or another bank) for the necessary loan reserve. The dual challenge of gaining funds to launch a loan product AND cash to fund the loans is typically too much for emerging startups (without an existing product or users), or established platforms testing a minimal proof of concept.

EMERGING TRENDS fueling LENDING-AS-A-SERVICE in 2021

Despite the complexity and cost in offering credit to consumers and businesses, various factors are pushing the industry to provide more fintech lending options. Here are the top forces having an impact:

SMB-FOCUSED ENTERPRISEs entering the lending space

Business credit has remained a huge gap which traditional banks have allowed to widen. Financial institutions tend to stay away from lending to small businesses with less than 2 years of revenue. Well-established eCommerce and payment firms continue to bolster products and credit to existing business users. Working capital loans, equipment financing, and lines of credit are now readily available for this user segment through non-bank alternatives.

What companies are offering these lending programs? Amazon, PayPal, Apple, and Square. These industry giants base underwriting criteria on their user’s payment or revenue-generating history. With detailed insights in being a user’s platform, companies like PayPal make instant decisions and approvals backed by data. Business users already trust these firms which help them sell more products & receive payments rapidly. Disbursements from approved loans can be sent in minutes.

Many unemployed individuals who transformed hobbies into side hustles and gigs created a new income stream for managing monthly expenses. This user segment continues to grow from 2020 into a community of freelancers and creators transitioning away from traditional employment. Streamlining income into recurring intervals (through alternative lending products) has kept these small businesses moving forward. Independent contractors continue to demand credit to cover their cash flow needs.

Embedding credit into the mainstream

This particular movement is apparent in payroll API providers and advances programs. Employees seeking to get paid earlier than their two-week payroll cycle OR paid after a day’s work have multiple options now.

An early version was available to gig workers of Uber and Lyft — for a fee, a driver can receive earned wages instantly. Marketplace apps such as eBay and Mercari can offer similar benefits to sellers after they’ve confirmed shipment of their product and payment from a buyer.

Buy-Now-Pay-Later (BNPL) are a newly accepted, high-growth payout option featured on the majority of eCommerce sites. Multiple providers (such as Affirm, Klarna, Sezzle, AfterPay) enable no-interest installment options without credit decisioning (and monetizing off of merchant discounts). The button is available on the checkout page and seamlessly covers the total purchase amount. Consumers can choose to check their eligibility first prior to making a purchase. Even established credit card companies (such as JPMorgan Chase and American Express) offer similar installment plan options today (post-purchase).

TECH-SAVVY, DEBT-AVERSE BORROWERS

Taking advantage of mobile shopping apps and purchase options, both millennials and Gen Z users are actively transacting digitally through embedded payment and credit features. Both groups tend not to use traditional credit cards due to the potential for costly debt. This cautious credit approach resulted in this demographic lacking a strong credit profile (needed to finance large purchases such as buying a car or home).

For these younger generations that struggle with employment during the pandemic, bank accounts also became a costly relationship (due to monthly balance requirements). Users flocked to fintechs with no-fee restrictions and an enhanced user experience. The combination of new ‘debit-like’ credit cards and loyalty with digital banks represents a tremendous opportunity for fintechs to increase customer satisfaction through the latest credit offerings.

This digital lending shift has also mapped over to lending for auto and homes. Rocket Mortgage’s share of loan volume rivals that of top banks in the US with branch networks. Within minutes (and minimal documentation), prospective borrowers can receive a full quote and pre-approval letter (necessary for submitting bids on homes). This is an improvement from the traditional process of meeting a mortgage banker to fill out an application, provide supporting docs, and wait for a decision.

THE IMPACT of AI & ML ON LENDING

Volumes of data are readily available for developing better underwriting criteria in lending models. Through the use of artificial intelligence and machine learning, fintech lenders can deliver higher approval rates and lower the risk of defaults. Going beyond standard review of income and credit score, AI and ML systems provide insights unique to target users and specific product use cases.

Bank transaction data, education, work history, and other points have yielded a new lending landscape. This innovation has helped improve digital credit cards, business loans, home lending application and approval experiences. Companies are increasing their development of in-house data capabilities or working with data aggregators to invest in new AI models to reduce operating costs and boost growth. A better performing loan portfolio provides a sustainable long-term path for digital lenders.

WHAT’s NEEDED TO TURN THE CORNER IN LENDING-AS-A-SERVICE?

Regulatory changes at the state level would reduce the risk for new entrants in the market. With the amount of variance (by state) in allowed APR (annual percentage rate) and fees, national pricing models with profit potential are difficult to build. In certain states, the max rate isn’t enough for a viable product (after accounting for program fees and cost of capital). States can also have added restrictions (such as proof of income, spousal consent) that add friction in the application and approval process. A unified stance may not be a near-term possibility, but alignment on general guidelines would be a step in the right direction.

Connected to regulatory compliance, higher program costs of delivering a lending product into market are also a barrier. Companies must obtain their own lending licenses or work with a licensed partner willing to be lender-of-record. In certain jurisdictions, servicing licenses may be needed as well (which add time and cost in launching a product). The current LaaS providers enable the majority of product and compliance needs, but without debt facilities or capital partnerships. These companies have annual costs starting at $500K, which can be cost prohibitive for new startups or firms testing the market.

AN ENTRY POINT in LENDING for FOUNDERS & PRODUCT TEAMS

Instead of raising funds for the cost of a program AND capital for lending, companies are entering the lending sector with offerings collateralized by the borrowers themselves (through refundable security deposits). Secured credit cards and credit builder loans are designed for users with low (or no) credit profiles. The reduced underwriting requirements increase approval rates for this user segment. The deposit they provide at time of approval (or loan commitment) serves as their credit limit — monthly payment history is reported to the credit bureaus to help improve credit scores. After 6-12 months of on-time payments (or end of the loan term), these users can ‘graduate’ to an unsecured credit product and receive their initial deposit.

Companies would only need to cover program costs in secured credit products since the users provide the loan capital. The user growth and activity can provide market validation to potential capital partners willing to invest in an unsecured offer. As in other niches within the credit sector, secured credit cards and loans face fierce competition from financial institutions and large fintech players (such as Chime). Ultimately, differentiation in added services and user targeting (e.g. for immigrants, new businesses, older teens) can increase success in the initial months of launch.

Overall, the recommended path for companies starting out, lacking funding or capital partnerships, or without expertise in credit would be a secured path. The unsecured route poses multiple challenges (in funding, credit modeling, cost of capital, licensing) that easier to face after being in the market with an established customer base.

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