Musings of A FinTech: Lending on the Efficient Frontier

Motivation for this post comes from a number of sources, including a conversation with a close friend on auto-leases and how new lenders have historically entered the market.

Entering lending markets is never easy. Established players have data, can price loans and generally deliver a solution to a set of borrowers. At the prime end of the market, assets with low probability of default and high asset coverage or security, it is virtually impossible to come in and disrupt: the game is about capital and funding. Large banks have both a capital advantage (lower risk weights, higher amount) and funding (e.g. deposit funding). A FinTech cannot win.

Strong and established lenders will naturally land on the efficient frontier of lending: low risk (volatility, capital) and reasonable return to get an optimal return per unit of capital. This can be viewed as either a point in time (where regulatory capital is determined as a through the cycle forecast) or as a through-the-cycle prediction: pick the stable annuity like returns and stay clear of the cyclical stuff. In other words, lend prime, ignore the sub-prime.

If a new entrant cannot win in the prime space (insufficient capital and funding), then all it can do is lend to those who don’t normally get loans (if you play on the efficient frontier, the established banks will out-scale you). This means lending to high default probability, low asset security, highly cyclical borrowers and you hope the credit cycle is long enough that you can establish yourself and diversify before the usually default cycle begins.

This has been achieved by a few FinTechs and new lenders:

Funding Circle entered the lending space at a time where nobody lent to small businesses as it was in the depths of the financial crisis but also the opinion that SME lending didn’t really make money through-the-cycle. Funding Circle identified a number of established businesses where banks refused to lend to: they couldn’t refinance easily as banks didn’t have the capital to lend to the riskier subset but were used to managing debt and had a good chance of survival. Next thing you know, they’re the 5th largest business lender in the UK.

Bear Stearns, for all its failings, really grew strongly from sub-prime and near-prime mortgage lending to become the world’s 5th largest investment bank. Its final failings were that is didn’t diversify away before the credit cycle blew it up: it was able to enter prime lending markets but had its deep exposers to its humble beginnings.

Dozens of other examples exist – from payday lenders, most peer-to-peer platforms (consumer loans with high stressed probability of defaults for those with interest of regulatory capital) all the way through to private equity or hedge fund owned non-bank lending platforms

Peer-to-peer also gives an interesting take: the initial losses are not an impact to the P2P platform. However, people will stop using a platform with high loss rates, so the platform would collapse in any case. But is the real play to hope the business cycle is long enough going to work for them? A recession now might also be a great thing for FinTech lending: it would provide an estimated longer time before the next cycle ends and open up more areas of lending the incumbents don’t want to lend. Timing is everything.

One final twist is lending itself: if incumbents lend in higher amounts and/or at lower interest rates, the business cycle will be longer (greater investment) and there will be fewer gaps on the efficient frontier. This means fewer FinTech lenders able to launch

Is this a problem? No, the consumer wouldn’t mind: they would be getting lower interest rates and more loans.

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