Fintech: How Technology Is Changing Consumer and Small Business Lending

This blog post is the third in a series about fintech and how it is affecting the banking industry. Last month, we looked at artificial intelligence and machine learning. This month, we examine what we are terming “technology-enabled lending.”

Technology-enabled lending—frequently dubbed marketplace lending—has branched far beyond its initial beginnings as person-to-person (or P2P) lending. Whereas P2P lending featured individual investors financing loans to consumers, marketplace lending is much broader. It includes multiple types of financial, nonfinancial and institutional lenders and also investors such as hedge funds.

These lenders leverage data analytic techniques (such as machine learning) and mine massive amounts of data (so-called “big data”) to underwrite loans.The emergence of both cloud and high-speed computing has also been a boon to technology-enabled lending. According to data cited by the Treasury Department, this sector has grown from infancy in 2006 to $26 billion in loan originations in 2017. One analyst has predicted loan origination volume will hit $90 billion by 2020. “Marketplace Lending: Fintech in Consumer and Small-Business Lending (PDF)”. Congressional Research Service, Sept. 4, 2018. Despite growth in this market, it’s important to note that marketplace loans outstanding represent less than 1% of the total consumer and small business loan market.

Marketplace Lending Models

There are two common models for marketplace lenders: direct lenders and platform lenders.

Direct lenders—which are also known as balance sheet lenders—use funds (capital) generated from outside sources to originate loans. Most of these loans are kept on the lender’s books after origination. Some of the more well-known direct lenders include CAN Capital, Kabbage and SoFi.

Platform lenders, on the other hand, partner with depository institutions to originate loans that are then purchased by the lender or by an investor using the platform. LendingClub, Prosper and Upstart are prominent examples of platform lenders.

Some lenders cater to one type of borrower (such as small businesses), while others provide a variety of products such as small personal loans and mortgages to consumers, as well as lines of credit, fixed-term loans and cash advances to businesses.

Marketplace loans start with an online application filled out by a prospective borrower. While underwriting may consist of conventional checks such as credit scores, income and debt repayment history, it might also be based on less traditional data such as monthly cash flow and expenses, educational history, payment and sales history, and online customer reviews.

Where Banks Come In

Banks—while competitors with some marketplace lenders—have played an important role in the growth of this market by:

• Purchasing loans originated by marketplace lenders
• Using marketplace lending platforms to originate loans using the bank’s name
• Providing operating loans to marketplace lenders
• Underwriting the securitization of marketplace loans
• Clearing and settling marketplace lending transaction proceeds

Whether acting as a partner or a facilitator, banks benefit from the technology-enabled lending. Properly conducted, consumers and small business borrowers benefit from the ease and convenience of technology.

Knowing the Risks

Bank participation in this area carries a number of risks, some of which are inherent to banking and thus familiar, and some that are new. These risks include:

• Traditional credit risks
• Risk that the underlying technology model might not work as expected, also called “model risk”
• Outsourcing and vendor management risks, when depending on a model developed by third parties
• Consumer compliance risks arising from the use of nontraditional data, including fair lending risk, unfair and deceptive acts and practices, and fair credit reporting
• State law issues, such as caps on interest rates (usury laws)
• Uncertain performance of the models in provisioning of credit during economic downturns
• Cyber risks resulting from an extended technology footprint

What's Next?

Technology-enabled lending is growing. The pace of future growth will depend on the demands of consumers and small businesses for convenience and speed. While technology-enabled lending is promising, its risks to the consumer and small business must be properly managed.

Notes and References

¹ The emergence of both cloud and high-speed computing has also been a boon to technology-enabled lending.

² “Marketplace Lending: Fintech in Consumer and Small-Business Lending (PDF)”. Congressional Research Service, Sept. 4, 2018. Despite growth in this market, it’s important to note that marketplace loans outstanding represent less than 1% of the total consumer and small business loan market.

Additional Resources

• On the Economy: The Basics of Fintech
• On the Economy: Fintech: Understanding AI Use in Financial Services
• On the Economy: Fintech Interest in Industrial Loan Company Charters: Spurring the Growth of a New Shadow Banking System