FinTechs in the Lending Industry

Lending has been one of the most primary functions of money markets and banks. Investment firms and private lenders are the lenders in the financial services industry. A prospect typically approaches these lenders when he/she needs a considerable amount of money to be borrowed for a longer term and is often referred to as a formal lending. There is another form of lending that is common between friends and family for small amounts of money and usually over a short duration. This lending happens in the case of an emergency, crisis and in situations where the borrower knows he/she cannot reach out to established lenders for multiple reasons. The reason can be the lack of documentation, lack of borrowing capacity or any other reasons. This kind of P2P lending between family and friends is the most frequently done and is referred to as informal way of lending. On the basis of this, the entire lending industry can be categorized into formal and informal lending. Formal and informal lending can be further categorized as found beloww.

Formal Lending

This is the type of lending where the lender and borrower enters into a formal agree-ment to lend a certain amount for a specified duration. The borrower guarantees that the initial amount will be returned to lender along with a specified interest at the end of the agreed duration. The lending could be done either against a lien of moveable or immovable property or just based on a commitment from the borrower to return the loan without any lien on any property. In some of the Third World countries, lending is prevalent against livestock, and in extreme cases it could be even against a lien on a person. The formal lending in a more-organized market can be further categorized as below:

  • Lending to an individual customer
  • Lending to business corporations
  • Lending to government
  • Lending to FIs

There are other complex lending mechanisms including the lending by a consor-tium of lenders to a business group; but to keep the case simple, we will restrict the lending discussion to the above-mentioned four types.

The processes and software systems for formal lending have evolved over time. Every improvement in the software systems for lending has ensured there are less chances of committing fraud on an individual level. Additionally, there has been a radical transformation in software systems to carry out the due-diligence process regarding creditworthiness. This has helped to better predict nonperforming assets (NPA), i.e., the aggregate amount to which the borrowers will default on. In turn, lesser provisioning for NPAs has helped bring down the interest rates. The interest rates are typically calculated by estimating the cost that a lender incurs including the cost of funds. Lesser NPA amounts mean less provisioning for defaults which in turn means less cost of funds, thus ultimately bringing down the interest rate. To explain this further, let us take a hypothetical case in which 10 borrowers collectively borrow $100. Let us assume that the lender incurs a cost of about $7 and makes a profit of $3 for every $100 borrowed. Therefore, the net interest rate charged by the lender would be $10 for every $100 borrowed collectively from all the borrowers or $1 from each of the borrower. The basic assumption behind this calculation is that all the lenders will return the capital borrowed on time and in the agreed-upon installments. Now let us assume if two of the borrowers default on the loan taken out from the financial institution, then the next time the bank will end up charging $20 not paid plus $10 in expenses in total to all 10 customers. This would increase the interest paid by each individual borrower from $1– $3. Thus, the more borrowers default on their payments, the interest rates charged next time by the lender would be higher.

One of the advantages the formal lending process brings in is reduced default at the individual level. The financial crisis of 2008 has shown that it is the large corporations rather than the retail borrowers who have defaulted for huge amounts of money, consequently raising the cost of managing funds for lenders in the for-mal economy. The defaults have also brought in regulator and paperwork require-ments for both the borrowers and lenders, further increasing the time to market and increasing the overall cost of funds.

In some countries, the state subsidies and writing-off of loan defaults have increased fund costs for lenders in the formal economy. The situation is ironical from an honest customer perspective, as after going through a tiring process of lending, they are not getting the benefit of a lower interest rate. Instead, they are getting penalized for somebody else’s wrong-doing despite they themselves are being honest. Lenders rely on the credit scores by credit bureaus and credit rating agencies to determine the creditworthiness of retail and corporate customers respectively. Interestingly enough, the credit ratings improve if an individual borrows more and repays the same in time. Unfortunately, this system has a number of drawbacks:

  1. It indicates how the customer has repaid in the past and is not predictive enough to determine the future paying capacity of an individual.
  2. The system ignores people who might be paying by using their savings or cash and thereby having better creditworthiness.
  3. This reliance from lenders on credit scores eliminates first-time borrowers with good creditworthiness.

Owing to regulatory processes and huge costs and time involved in transform-ing their monolithic systems, established and large lenders have stayed away from changing any process involved in determining creditworthiness. FinTechs, being agile and building their systems from scratch, have been able to define the disrup-tion of determining the true creditworthiness of the individuals.

Informal Lending

This type of lending exists from a time before formal lending started. Informal lending typically involves low value transactions, but the frequency or number of times this type of transaction is conducted, is far higher than any other form of lending. This type of lending is also known as P2P lending. Lending between friends, family, acquaintances, etc. can be considered as this type of lending. Lending through quasi-governmental bodies, nongovernmental organizations (NGOs) and religious institutions can sometimes also be categorized as informal lending. Community lending amongst business communities to provide working capital assistance to one of their members can also be called informal lending. Additionally, lending to a fellow businessman to overcome difficult business con-ditions can also be termed as informal lending. Shopkeepers enabling customers to purchase items on the credit, to be paid back at end of a specified duration like month, is also a type of informal lending. This is one of the most common forms of lending in emerging nations. FinTechs through platforms like P2P lending, community lending and multiple other types of lending, have been very active in transforming the informal lending. Through their platforms, FinTechs are now able to provide a more organized mechanism to borrow, thus building transpar-ency in the informal lending space. Additionally, FinTechs have also ventured into the areas of POS lending. This type of lending again is more prominent in the informal lending markets

Post Author: newfintech

Leave a Reply

Your email address will not be published. Required fields are marked *