The retail and small business credit market is currently undergoing a major transformation.
Up until a few years ago, credit was typically extended by established and regulated financial services providers such as banks, credit unions and, in many emerging markets, microfinance institutions.
In recent years, alternative lenders have emerged and are now extending credit to unserved or under served market segments such as SMEs, the unbanked or "thin file" borrowers. These alternative lenders utilize state-of-the-art lending platforms coupled with advanced algorithms to extend credit at a lower cost (to the lender) and with very fast turnaround times. Alternative lenders tend to vary in accordance with the market in which they operate.
For example, in the USA and in the UK, both advanced credit markets, peer-to-peer lenders have successfully gained market traction by operating via a business model that is not subject to the same regulatory framework that applies to banks and which facilitates reducing the interest margins between borrowers and lenders, benefiting lower risk borrowers with favorable borrowing terms. As another example, some alternative lenders are able to outperform banks in assessing the risk of SMEs by tapping into these businesses' accounting software to glean updated financial information automatically and in real-time.
In emerging economies such as Kenya, mobile lending solutions such as M-Shwari and M-Benki (which both utilize the M-Pesa mobile money service) allow borrowers to apply for short-term loans through their mobile phones and receive an approval and disbursement immediately. The popularity of these solutions is growing rapidly, taking away market share from the majority of banks that are currently unable to offer similar services.
The advantage of all of these alternative lending solutions to borrowers is clear - a simple process for applying for a loan via a direct channel (mobile, web, etc.), real-time approval and immediate availability of funds.
Traditional lenders such as banks, credit unions and microfinance institutions that want to offer real-time lending solutions in order to effectively compete with these alternative lenders may be tempted to view online lending as a "channel" play, which simply takes the financial institution's existing lending process and extends it to the web or to a mobile device via automation.
We believe that viewing online lending strictly through this channel approach misses the point and could actually pose a high risk to the lender. Indeed, in our experience, financial institutions that had attempted to grow their credit portfolio through online lending by taking a channel-only approach had typically failed due to two factors:
- Growth did not meet the lender's goals.
- Loan losses were exceptionally high, primarily due to the high proportion of high risk borrowers in the online lending portfolio.
We believe that successful online and mobile lenders typically leverage their existing assets and data to gain a competitive edge. M-Shwari provides an interesting case in point:
- M-Shwari leverages the M-Pesa brand name and its existing direct marketing channels to effectively target existing M-Pesa customers.
- M-Shwari uses advanced algorithms to assess the credit risk of an existing M-Pesa customer by analyzing that customer's M-Pesa payment history.
We would recommend that traditional lenders shall introduce online and mobile lending while taking into account all three of the following considerations:
- Invest in the required "agile" channel and automation technology - financial institutions must extend their existing channel solutions to support online and mobile lending. The technology must facilitate a means to enable an applicant to submit an application via a direct channel or a mobile device, to receive a response in real-time and to enable the financial institution's internal system to facilitate immediate booking and disbursement of the loan. Many financial institutions still rely on a manual process for loan disbursement and this limitation must be overcome.
- Leverage your existing customer data to automate lending decisions - existing financial institutions must leverage information about their historical customer base to make better informed and automated online lending decisions. By analyzing historical customer behavior, it is possible to develop advanced algorithms that assess the credit risk of each customer as well as identify the most appropriate credit product for that particular customer. For example, an existing customer that had successfully repaid a large loan that was extended through a traditional relationship-based approval process is most likely a relatively low risk customer and could therefore qualify for an automated online loan. In a similar manner, an existing customer that has been depositing some money on a monthly basis into a savings account has a dependent income source and would therefore be of relatively low risk as well.
- Put in place controls that allow the financial institution to monitor credit quality and enhance underwriting policies - when developing an online lending portfolio from scratch, financial institutions must have the monitoring tools that allow the quality of the credit portfolio to be monitored pretty much in real-time. Consequently, business rules that drive automated decisions and pricing policies will need to be enhanced quite frequently shortly after launching online lending.
To summarize, our recommendation to existing financial institutions that expand into online lending is to define a phased credit growth strategy, whereby the financial institution will initially lend online to relatively low risk segments and, as experience is gained, gradually expand into higher risk segments or segments that are more challenging to target.
For example, financial institutions would benefit from initially targeting its online lending offering to existing customers for which sufficient historical information is available to suggest that they pose low credit risk. Over time and once the performance of this initial low risk segment has been substantiated, the financial institution may expand into higher risk segments such as reaching out to employees of the financial institution's corporate clients.
Alternatively, financial institutions may further grow their online lending offering by developing alliances with external service providers such as utility companies in order to target their customers with online lending services while leveraging the customer history that is available to these utility companies to assess their risk. Extending credit online to applicants for which no history is available should not be introduced until online lending has been "tried and tested" on lower risk segments and sufficient controls are in place. We believe that a credit strategy which targets applicants with no history is extremely risk and may fail.