There has been a dramatic increase in online alternative lending during the past several years, which has impacted how credit can be secured by consumers and small businesses. In early July, the Federal Reserve Bank of Philadelphia issued a working research paper providing some early signs of the role and impact fintech lending could have on consumers and the broader banking landscape, including financial inclusion and the use of alternative data sources. Specifically, the researchers used unique account-level data to explore the advantages and disadvantages of loans made by a large fintech lender, Lending Club, and similar loans that were originated through traditional banking channels.
While acknowledging that nonbank lending raises some regulatory concerns because fintech lenders are not subject to the same level of oversight as depository institutions, the paper highlights how fintech lenders’ technology platforms and their ability to use nontraditional alternative data sources to collect soft information about creditworthiness “may provide significant value to consumers and small business owners, especially for those with little or no credit history.” These findings, even if preliminary, also underscore the value of and benefit to depository institutions seeking to establish or maintain relationships and partnerships with fintech lenders.
By using loan-level data (rather than survey data) to explore the relationship between the amount of loans made by a fintech lender and the banking environment (e.g., the amount of banking competition, the decline in bank branches in that zip code and whether it is a low-to-moderate income area), the study assessed whether fintech loans increased access to credit in those areas where traditional banks have pulled back. The results from the study provide evidence that lending activities by fintech lenders appear to have played a role in filling the credit gap in areas that could benefit from additional credit supply, such as areas that have lost traditional bank branches and those in highly concentrated banking markets.
The study also found that the use of additional data sources and other soft information, including consumer payment history (such as utility and phone bills, and PayPal and Amazon transaction history), their medical and insurance claims, and their social network, which are not factors that are fully reflected in traditional credit scores, could improve credit access for some borrowers with few or inaccurate credit records (based on FICO scores).
With respect to credit pricing, Lending Club’s use of additional data sources appears to allow some subprime borrowers to receive a “better” loan grade, which in turn means lower-priced credit. Furthermore, it does not appear from the loan data that this credit is “mispriced” in terms of default risk. The study’s findings also imply that fintech lending has provided consumers with access to credit at a lower cost, based on a comparison of credit spreads, which are priced based on the expected delinquency of the loans.
The use of alternative data sources is an area that needs additional exploration and scrutiny. While the use of alternative data sources and algorithms by fintech lenders has allowed for faster and lower-cost credit assessments than traditional bank loans, which could mean reduced borrowing costs for consumers, it carries increased risk of disparate treatment and fair lending violations, and also raises consumer privacy concerns. In February 2017, the Consumer Financial Protection Bureau issued a request for information concerning the use of alternative data and modeling techniques in the credit process.
Although the number of nonbank lenders has increased, their long-term impact on the consumer lending industry remains unclear. Traditional bank lending continues to dominate the market. Yet this study and its findings underscore the value and importance of some adaptation in the traditional banking industry as well, or else banks could place themselves at a competitive disadvantage. Traditional banks should seek to forge and maintain partnerships with fintech lenders. These relationships could include providing origination services and funding to customer referrals. Ideally, such relationships would function so that the customer’s relationship with the bank is maintained. Some banks have also made equity investments in fintech lenders as a means to defray the cost of in-house development, and others have purchased loans from these fintech lenders to add to their balance sheets. These partnerships could provide fruitful benefits and serve as a means for depository institutions to remain competitive and make inroads into the unbanked and underbanked communities. At the same time, they also would allow banks to better serve the needs of millennials and small-business owners who are more comfortable with technology and not as reliant as past generations were on having a brick and mortar local bank branch. In this age, the “fittest” may be those institutions that can best adapt and take advantage of such opportunities.