Understanding lending: how fintechs are changing the game

February 13th, 2024

Traditional banks find themselves up against a significant challenge with the revolutionary changes introduced by fintechs in the lending landscape. These pioneering entities are transforming the lending experience, prioritising individual needs over a conventional one-size-fits-all approach.

This article delves into the factors driving the transition from traditional banks as the primary destination for loans to the rising influence of fintech lenders. We will explore the advantages they offer and the regulatory framework that governs their operations.

Customised solutions for borrowers

Traditional banks have long relied on standardised lending products that may not perfectly align with individual needs. For instance, a bank may offer a fixed-rate loan over a predetermined period, penalising borrowers who wish to repay their debt early.

Fintech lenders, in contrast, emphasise tailored lending solutions. By leveraging advanced algorithms and modern technology, they analyse borrower-specific data to offer flexible terms, rates, and.

For example, Wisetack offers a compelling alternative to traditional credit cards. Through their innovative platform, consumers can access embedded pay-over-time options, providing greater flexibility in managing their purchases. Individuals can easily apply for financing and explore a range of monthly payment plans, allowing them to spread out the cost of their purchase over a predetermined time frame.

Overcoming data limitations

Lending to emerging sectors is challenging when historical data is scarce. Fintech lenders have thrived in this arena by capitalising on their expertise in lending to lenders. These agile specialists, often non-bank entities such as hedge funds and private equity firms, possess the knowledge to assess creditworthiness even in nascent industries like cleantech. Their ability to identify relevant data points enables them to make informed lending decisions.

The ascendancy of cash flow underwriting

Cash Flow underwriting has become the new norm across the US lending market, propelled by regulatory pressure on banks to adopt this approach. Unlike the conventional reliance on credit history, this method evaluates an applicant's financial health based on their checking account data.

By assessing factors like consistent bill payment and responsible spending habits, fintech lenders can gauge credit risk accurately. Even the polarising "buy now, pay later" (BNPL) model heavily relies on cash flow underwriting.

Navigating regulatory constraints

It is essential to understand that the limitations faced by traditional banks are not solely their fault. Stringent regulations exist to prevent large banks from taking excessive risks, which could lead to catastrophic failures.

For instance, banks with assets exceeding $100 billion in the US or $50 billion in Europe must maintain "adequate" capital on their balance sheets. Key regulations include:

Capital requirements – These guidelines stipulate the minimum reserves banks must hold to absorb potential losses. While higher capital requirements enhance stability, they also increase the cost of lending for traditional banks.

Stress testing – to ensure resilience during financial crises, banks are required to undergo rigorously designed stress tests. These examinations assess a bank's ability to weather economic downturns and protect depositors' funds. Compliance with stress test requirements is necessary to maintain regulatory privileges.
Restrictions on proprietary trading – banks face limitations on engaging in high-risk trading activities for their own benefit. These restrictions aim to prevent banks from jeopardising their stability by pursuing speculative investments.
Volcker rule – in an effort to curb risky investments, the Volcker Rule prohibits banks from engaging in certain types of activities, such as investing in hedge funds and private equity funds. This measure seeks to protect both the financial system and bank customers from undue risks.

Implementing AI to refine lending

While AI has been a hot topic in 2023, with many an organisation hyping it up to castle-in-the-sky expectations, it is already being implemented into the lending industry.

"Here in the US, many people who are credit-worthy don't have access to fairly-priced credit." – Jeff Keltner, SVP at Upstart.

Upstart, an AI-based lending platform based in California, uses over 2000 data points on every loan application to not only assess the feasibility of the loan, but also how likely it will be to lend out a certain amount of money over a specific period.

"The credit score system worked reasonably well for the well-off. You had reasonably priced access to credit if you were making a good amount of money and had a decent credit history and wanted a mortgage, you got a pretty good loan."

That's why Upstart started to train its AI model on new and young applications to better understand the actual market, and not just rely on a borrower's occupation or income.

Though, they still scrutinise their datasets and data points to ensure that the information is accurate. For example, Keltner gives the example of COVID-19 stimulus cheques in the US. These lead to unemployed individuals paying off more of their loans, which is a counterintuitive result. To mitigate risk, AI-based lending platforms must be sensitive to external factors that could destabilise borrowers and require adjustments to lending practices.

The Upstart's AI is constantly learning so that it can identify patterns, and make predictions that were previously impossible.

The Emergence of Shadow Lenders

Shadow banks, including hedge funds, private equity firms, and fintech companies, have increasingly entered the lending arena, emulating traditional banking activities. From 2007 to 2015, the market share of shadow banks increased from 30% to 50%.

However, a significant distinction exists between shadow lenders and traditional banks. Shadow lenders rely more on short-term or wholesale funding rather than stable depositor funding. This approach allows them to be more agile, responsive, and innovative in the lending space.

Fintech lenders represent the most rapidly growing segment within the shadow banking realm. They encompass an array of lending services, ranging from buy-now-pay-later providers to charge cards from spend management companies and "revenue-based finance." Their ability to leverage technology, data-driven decision-making, and streamlined processes positions them at the forefront of the lending revolution.

As the Fintech industry gains momentum, traditional banks are faced with the transformative power of customisation, cutting-edge underwriting techniques, and the ability to navigate regulatory hurdles faced by their fintech counterparts. The rise of agile lenders ushers in a new era of lending, where borrower-centric solutions, data-driven insights, and agility lead the way.

By embracing these changes, the Fintech ecosystem continues to reshape and redefine the lending landscape, ensuring increased accessibility and efficiency for borrowers across various sectors.

In this article