Data and New Technologies are the Key to Unlocking Credit Globally
In the US, the ability to open a bank account, get a credit card, or obtain a loan to start building a life or business all hinge upon the approval of credit bureau data. Lending Club has built a multibillion-dollar business by accurately pricing the risk of borrowers that were overcharged by credit card operators. Emerging lending platforms are finding new ways to bypass and best FICO – the “gold standard” of credit bureaus. In the developed world, banks have been sitting on (and not utilizing) a wealth of available data that would improve their loan origination decisions. Banks need to become smarter just to catch up with the underwriting capabilities of new marketplace lending platforms. The very same data problem also hurts non-bank lenders. At the lower end of the spectrum, most payday lenders refuse to report the repayment history of their clients to bureaus, as they fear graduating them into lower interest loans.
Even when you have a privately owned repository of repayment data, as you do with credit bureaus in the US, it is incredibly expensive to access it. A hard pull from a single US credit bureau costs a lender between $1 and $2 at scale, depending on their size. While that works fine for an auto loan or mortgage where underwriting is done only a few times within a consumer’s lifetime, it is entirely uneconomical to do so on a regular basis – like an adjustable rate revolving loan or for small loan amounts (“Can you lend me a few dollars? This 6-month old printout shows I have a good FICO score!”).
Across the world, the challenge is that most countries have no credit bureaus, and of those who have them, they only tend to report negative payment behaviour (as opposed to positive and negative behaviour and a numerical score). Even then, coverage is patchy, as most of the population is not even listed in the credit bureau databases. Most utility and bill payments are not captured or reported. Many organizations still carry out a lot of the data collection by hand.
Underwriting based on behavioural data, using machine learning, neural networks, and other advanced statistical techniques, will provide the scalability required for financial institutions to offer more to those still without access. Mobile phones are making most of the world’s people electronically accessible for the first time, and are providing a wealth of data that a stale stack of stamped bill receipts simply cannot compare with. Unless banks and traditional lenders think of themselves primarily as data and technology companies, they will become increasingly irrelevant.
Non-credit bureau-based underwriting is an area that shows great promise in the developing world. Indeed, in China, Social Credit Scoring performed by Sesame Credit (part of Alibaba), is due to credit score 900 million people before 2020. In the US and a few other developing countries, fair lending laws limit the use of many pieces of behavioural and demographic data to make credit decisions. I believe the worldwide transition from feature phones to smartphones will mostly be completed within one or two replacement cycles (maximum 5–10 years), and at that point the comprehensive use of mobile phone data to make consumer underwriting decisions will be the norm.
There are great opportunities ahead, and a new notion of identity can emerge via new technologies. The bitcoin blockchain holds enormous potential here. I will not get into the weeds of bitcoin, but given the distributed nature of the blockchain, the emergence of a decentralized credit bureau with global reach is now a real possibility. Using the blockchain ledger to create a global repository of the world’s credit transactions will establish a new way to assess underwriting and risk with data that was previously unavailable. The notion of a thin-file or no-file borrower can become irrelevant – people and companies will have full, instant access to their complete credit history, and make use of it to access loans in any country, regardless of how long these potential borrowers have been there. The notion of data portability across credit bureaus has so far been unheard of. For consumers, the costs to switch financial institutions (monetary and convenience) will reduce drastically. To keep a client, banks will have to compete on service levels as well as on price.
Lowering Costs, Increasing Transaction Frequency
Every day most Americans swipe their credit cards for groceries, utility bills, or a night out on the town. Charges are applied – merchants pay roughly 30 cents plus 3 % of the value of the transaction – and while expensive, merchants oblige because of the convenience credit cards offer to their customers. Given that most retailers have 5–10 % net margins, taking credit card payments often wipes out half or more of their profits! Furthermore, imagine that you are a merchant who is also a part of the three billion people (50 % of the world’s population) living on less than $2.50 a day. The 30-cent credit card fixed fee just does not add up. Who would pay a third of their income (plus taxes, which often do not get collected on cash transactions) just to swipe a card?
In this case, bitcoin – the internet of money – holds promising potential to bring transaction costs down. Anyone can send thousands of bitcoins across the world just as easily as sending one hundredth of a bitcoin, without incurring transaction or remittance fees. Moreover, unlike cash, full information details on the transaction can be attached to it, and be programmed to disburse only after whatever condition has been agreed upon is met – all without any extra cost. Talk about reducing the costs of moving money around!
Most of the costs of holding and moving small balances will be stripped out of such a system (eventually including deposit insurance). Electronic delivery and instant disbursement of funds will take place via mobile phone. Daily amortization would be possible for microloans. Pay as you go financial services are on the horizon. As the frequency of transactions increases, across all financial services, the ability for all participants (both customers and lenders) to better react and prevent financial shocks will improve dramatically.
Non-banks, all while still turning a profit and serving more clients, will perform many of the banks’ functions better. It is natural that service providers that interact more frequently with clients (mobile phone, retailers, internet providers) perform many of the consumer relationship functions. In many scenarios, banks will need to partner with such lower cost providers in order to remain competitive and relevant to the consumers who are experiencing financial services for the first time. One really wonders what banks will use their branches for 20 years from now!
Change is Coming, Past a Bank Near You
The current banking system is not equipped to carry out the challenging task of adapting to the new digital landscape. Banks use mostly centralized legacy technology infrastructure, and rely heavily on expensive branches and manual processes. Moreover, given their role in the recent financial crisis, they will keep facing increasing capital and regulatory constraints. Banks will continue to pull away from lending to “risky” clients. Given their high cost base, banks cannot afford to underwrite and lend money in small amounts, as would be convenient for clients.
Under this cost structure, banks rely heavily on fees and tricky penalties to make money – no need to hold capital reserves to earn those. Take the overdraft, which generates $30bn+ in fees per year,32 on automatic overdraft loans of less than $30bn+ annually. One FDIC study found that the average consumer would pay an implied APR of 3520 % on a $24 ATM overdraft (at the median overdraft fee of $34) – if the overdraft loan were paid back in two weeks.33 By the way, in 2007, total overdraft charges were $17.5bn, so this line item has grown at a “healthy” 9 % CAGR since.
Marketplace lending platforms hold the key to making finance as significant and well-distributed as it should be. Embracing new data sources and underwriting techniques, as well as using cost-reducing and feature-enabling technologies like bitcoin and the blockchain, is where the next mass-scale opportunities will be unlocked. Lending in the 21st century comes with the promise of transforming the world. The addressable market is immense – five billion people strong. There are plenty of loans yet to be made, and one trillion of them might just be the beginning.
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