Where do we go from here?
Fintech—a merger of finance and technology—is bringing revolutionary change to the banking and investment industry in the same way as how e-commerce is disrupting the retail industry. The adoption of artificial intelligence and data mining has been particularly prominent in the online market lending sector as developments have been transformational notably in the world’s two biggest economies – the US and China. FinEx Asia is honoured to have been invited to contribute a chapter on the online market lending sector, comparing the platforms and the environments of both regions in the book “Fintech: The New DNA of Financial Services.”
The book, authored by the leading players in fintech, introduces the evolution and offers an in-depth discussion of the rapidly evolving industry. It explains the different aspects such as AI, Blockchain, Big Data, Cryptocurrency, Robo-advisory, Cloud computing, InsureTech, and Crowdfunding, as well as how these areas affect the different disciplines within the financial services sectors, including banking, investment management and insurance.
As one of Asia’s leading and initial players in the industry, we also provided our insights into the challenging technological requirements for such platforms as well as the potential risks and opportunities for the sector. We highlight some of these below.
Essentially, online marketplace lending refers to loans originated from Internet-based businesses rather than traditional banks. The heart of the online marketplace lending business model is replacing human loan officers at physical bank branches with a centralized, programmatic approach to loan approval and rate setting. There are four essential requirements in the setup of such platforms. They are borrower data, historical default rates, the risk framework, and a machine-learning platform. Once these building blocks are established, the development stage consists primarily of three processes: transforming the business case into a data model; applying the algorithms to identify patterns in the data; deploying the platform and ongoing iteration.
Rapid growth in mid-2000
In the U.S., these lending platforms such as Prosper and LendingClub started to emerge in the middle of 2000s, offering an alternative source of loans by matching individual borrowers and lenders. They were briefly shut down in 2008 by the US Securities and Exchange Commission (SEC) because they were seen as “sellers of investments” instead of lenders. Following their registrations with the SEC, operations resumed in 2009.
In China, the first online marketplace lending platform called Pat Loan started in 2007.The sector expanded rapidly after the deployment of machine learning enabled borrower screening as deep learning algorithms resulted in lower default rates and the ability to identify fraud. This coupled with more stringent regulations that were initiated in 2015 allowed the Chinese marketplace lending sector to flourish.
Today, these lending platforms have become recognized as part of the smaller borrower’s lending options, and any default on the platforms will be reported to the credit bureau and officially recorded.
As the industry matured, it started to gain institutional recognition. Banks and institutional investors began funding the loans, in place of affluent individuals. In 2017, 65% of the more than US$3 billion worth of loans on Prosper and Lending Club came from investors who snatched up whole loans. Banks were enticed by the strong cash flows and the advantage of avoiding costs involved in underwriting and servicing these loans. Institutions were attracted to the idea of trading liquidity in exchange for a short duration portfolio and a healthy credit spread.
Diversified pool of clients
The interest in this asset class has intensified. Rating agencies recently gave their go-signal to these securities, and the securitization of these loans made them more accessible to a broader array of investors. Along with the change in lender profiles comes new borrowers including those who can get a loan from a traditional bank but prefer the convenience and efficiency of going to a marketplace lender. Additionally, with risk profiling and fraud prevention approaches, online marketplace lenders have the confidence to expand to new borrowers, who include SMEs and those in need of student loans.
While the US is where online marketplace lending grew on a large scale, China followed quickly due to the high number of personal bank accounts and mobile-first online services. The two countries have successfully developed the industry; however, there are differences in customer segmentation, customer acquisition, charge-offs, and cost of funding.
In the US, the targets of marketplace lenders are prime and sub-prime borrowers, while in China, the end-users are a more diverse range of clients. One of the significant platforms focuses on younger borrowers with limited or no credit history. Also, direct mailing is the greatest customer acquisition method in the US, while most of the customer acquisition for marketplace lenders in China occurs online.
In the US, the maturity of the financial services regulation, combined with the extensive reach of legal recourse means the majority of charge-offs come from credit losses, which are triggered after four months of consecutive missed payments. Fraud is a small portion of charge-offs for US marketplace lenders. Meanwhile, in China, fraud far outweighs credit loss, both in terms of notional value and overall volume.
Sector challenges and opportunities
Despite the recent strong growth, the sector has its challenges too. One of the primary risks is the limitation on data sources and usage. Scandals about misused data have heightened awareness, among both the public and politicians, about the problems with data privacy and use of data. This will limit the data available to marketplace lenders as they seek to build more accurate risk models for borrowers.
Another significant challenge is the economic cycle. The last time the global economy experienced a significant contraction in 2008, only a handful of marketplace lenders were operating, and even those that existed had different operating models than the ones we see today.
However, despite these headwinds, opportunities for scale will start to encourage competitors to establish alliances and merge; thereby reaching a bigger pool of borrowers.
Another major opportunity for growth will be in new borrower categories, especially SME lending. US$600 billion in SME loans were originated as of 2015, and that figure is rising as the US economy continues to grow. Trade financing also holds considerable promise, especially for Chinese marketplace lenders, as they can look to fund the capital needs for suppliers throughout China’s vast, layered network of supply chains.
So far, the development of online marketplace lending has been driven by commercial factors at the borrower level, burgeoning investor interest at the funding level and technological developments at the infrastructure level. Going forward, besides the established markets of the US and China, we expect to see phenomenal growth in other parts of developing Asia.
The book “Fintech: The New DNA of Financial Services” is available at major bookstores.