The Seesawing Journey of Fintechs During COVID
By: Tanvi Anand
The coronavirus pandemic has impacted lives and livelihoods worldwide. Along with the unprecedented human toll, it has triggered an economic crisis, with severe contractions in global GDPs. This crisis has heavily impacted Small Medium Enterprises (SMEs) /Small Medium Businesses (SMBs), suffering one of their worst financial hits in several decades. Over the second quarter of 2020, small businesses experienced at least a 50% reduction in year-over-year revenues . Additionally, the latest Yelp Economic Average report  shows a surge in permanent and temporary closures across the USA, with a possibility that 60% of those closed businesses will not reopen. All in all, SMEs are in dire need of external financial help to survive.
By drawing on learnings from the 2008 crisis in conjunction with new insights from the ongoing pandemic, banks have further toughened their lending criteria for SMEs, as also reflected in the falling approval rates of commercial loans by banks . As a result, the chances of subprime borrowers getting loans from banks (prime lenders) are on a downfall. This results in a golden opportunity for fintechs to offer much-needed commercial financing to SMEs, but not without some creative thinking. To truly seize this opportunity, Commercial Fintech lenders must rethink their existing strategies to make inroads with a new customer segment while battling the numerous challenges triggered by the pandemic. In this article, we explore how the US alternative lending landscape has changed and how we can understand the resulting opportunities.
Fintech lenders have been witnessing a significant increase in their share within the small business lending marketplace. Federal Reserve Banks of New York’s 2019 Small Business Credit Survey  showed that roughly one third of small businesses applying for credit in 2019 chose alternative lenders over banks. With banks continuing tightening their credit guidelines – fueled by COVID, this trend is expected to grow manifold in years to come. Unfortunately, the past seven months have been a roller coaster ride for alternative lenders, and while things have become better in fall than spring of 2020, not many lenders have recovered from the crisis, with only half of the pre-existing players originating loans in today’s marketplace (2020 Q3) (Figure 1).
Fig. 1 – COVID Shock on Alternative Commercial Lenders
As the COVID-19 pandemic continues to cause uncertainty, fintechs are still under stress on every aspect of their business: Financing, Acquisition, Underwriting, Portfolio Management and Collections (see Figure 2). Consequently, COVID has forced all types of alternative lenders to readjust their strategies to not only survive but also capitalize on growth opportunities provided by this crisis. Let’s take a look at how fintechs have gone about their business to tackle this crisis and what could be way forward for them.
Alternative lenders fund their loans from several sources, the most lucrative of which is Asset Based Security (ABS) or Securitization as it is a low cost capital source. ABS is secured after meeting different levels of performance metrics and lenders that utilize this funding source are legally obliged to maintain those performance levels to keep the ABS in active mode. Due to COVID-19 concerns, the ratings of 29 securitizations representing $2.1 billion across different alternative lenders were placed on “Watch Downgrade” by Kroll Bond Rating Agency (KBRA) after seeing early delinquencies. Since most borrowers failed to pay their debts on time, numerous lenders including Kabbage, Fora Financial, and Rapid Finance  could not avoid defaulting – also known as Rapid Amortization Event (RAE – a call to liquefy the bonds and give back investors money) – on their ABS, losing the ability to fund new loans through Securitization. This resulted in many lenders losing capital and lending potential.
Many lenders avoided going into RAE by formulating an effective approach in a timely manner. For example, as part of their approach, Credibly (Previously known as Retail Capital)  reached out to their securitization bondholders and acquired a crisis-demanded amendment(s), thereby allowing the Michigan-based lender to provide tailored reliefs to its merchants. As of August 30, Credibly successfully repealed the amendment and was also able to retain its bond ratings, which placed it in a prestigious list consisting of only two lenders (the other lender being Kapitus) whose ABS was not downgraded due to COVID. Overall, lenders had to think beyond established and proven strategies to save their financing through this crisis. Furthermore, as banks have again started seeing an increase in deposits, some banks might consider deploying their money into the market through fintechs. This will result in opening some new financing options for alternative lenders.
Stalled Sales & Marketing Attempts:
Traditionally, alternative lenders rely on two channels for their lead generation: (i) Internal (or Direct) Sales & Marketing Teams and (ii) External Sales Organizations/Partners (sometimes referred as Independent Sales Organizations [ISOs]). The ISOs act as a bridge between borrowers and alternative lenders in the acquisition of customers, as shown in Figure 3.
To reduce expenses, many lenders like Ondeck  halted ongoing expenditure that was directed to marketing, for both internal and external channels. Numerous lenders also furloughed a significant number of employees in the wake of drastically changing business conditions.
Fig. 3 – Customer Acquisition Channels for Alternative Lenders
Early in the crisis, demand for commercial loans dwindled with mounting business closures and many lenders halted new loan approvals. Many ISOs – especially the smaller ones could not bear the brunt of the ongoing crisis and stepped back from marketplace lending. Large ISOs like Lendio or Fundera had to resort to providing a platform for Paycheck Protection Programme (PPP) loans for survival. With demand for commercial loans on an upswing among alternative lenders as banks continue to employ more conservative credit guidelines , alternative lenders have refocused on Sales & Marketing, benefiting both internal and external sales teams. Moreover, lenders who are currently not able to originate loans have chosen to work as an ISO for other lenders in order to stay afloat.
Tightened Credit Guidelines:
Underwriting is the soul of commercial lending. In the past seven months, financial institutions have adjusted to the changing dynamics of borrowers’ credit levels by introducing more rigorous underwriting procedures and changing the minimum qualifications for securing an advance. BlueVine exemplifies this approach, increasing its minimum monthly average revenue requirement for commercial borrowers to $40,000 from its pre-pandemic range of just $10-15,000, as per BlueVine customer service.
Since Probability of Default (PD) models employed in underwriting were developed prior to COVID, these models were/would be unable to measure the risk accurately during/post COVID crisis. Accordingly, lenders had to adjust their PD models by tuning the model inputs such as the industry type. The creditworthiness of borrowers differs enormously by sector. For example, sectors like Ed-Tech and pharmaceuticals have fared better due to higher demand of their products. On the other hand, industries like Airlines, Leisure Facilities, Restaurants, Oil & Gas Drilling, and Hotels/Resorts/Cruise Lines  have been struggling to cope with side effects of the pandemic, hence showcasing higher PDs, as shown in Figure 4. This resulted in lenders pausing lending in these adversely impacted industries.
Moreover, the CARES Act  passed by the U.S. government amended the Fair Credit Reporting Act (FCRA) to stop adverse credit reporting during the COVID-19 crisis under specific circumstances. According to the amendment, if a creditor/lender makes an accommodation because the borrower was affected by COVID-19 during the covered period, that lender must report the account as current to the credit reporting agencies, so long as the borrower wasn’t already delinquent on payments. This change renders usual credit scores a less reliable metric for a borrower’s credit worthiness and paves the way for alternate creditworthiness criteria.
As commercial delinquencies continue to increase and credit bureau data is expected to be lagged and inflated to some extent, alternative data can help lenders with making a more accurate decision by gaining a holistic view of borrowers’ credit history. For example, social media and macro event data are proven to enhance the core lending decision-making process .
Fig. 4 – Sectors Showing Higher Probability of Default (PD) due to COVID (Source: S&P Global )
Inadequate Focus on Portfolio Management
Portfolio Management is a key element to a lender’s success, along with focusing on individual borrowers and their underwriting process. Strong and Effective portfolio management enables lenders to identify and promptly counteract early signs of frauds to minimize final losses. While banks are known to give an equal weightage to their Portfolio Management as part of their lending business, it turned out that many fintech lenders failed to realise its gravity. As the pandemic set off, not many lenders were prepared to fight it off due to lack of a strong portfolio management team, but the ones that were, attribute part of their success to it.
Historically also, lenders have been seen to emphasize this segment especially in times of a crisis. Current examples of which are Credibly  and Kapitus , two of the alternative lenders that stayed afloat during the pandemic. These alternative lenders realized the importance of portfolio management early on and moved over a significant percentage of their staff to the Portfolio Management team as the pandemic worsened. Furthermore, lenders with a strong Portfolio Management team could service distressed portfolio(s) for extra revenue.
Increase in Losses
COVID-19 has halted the record-length period of economic expansion. With the threat still unresolved, economic disruptions from pandemic containment measures will keep affecting lending. With lenders’ capital, profit-and-loss, and liquidity positions being hit hard, most of them have seen a huge increase in their losses due to COVID. Recently published surveillance reports by KBRA show Cumulative Net Losses (CNL) have increased by as much as double pre-COVID loss levels (Figure 5). Kapitus emerged as the only lender whose CNL remained the same, while Credibly saw a difference of only 0.96%, which is testament to their innovative strategies and strong Portfolio Management teams .
Fig. 5 – COVID Impact on Cumulative Net Loss (CNL) for Alternative Lenders (Source – Kroll Bond Rating Agency )
THE WAY FORWARD
Not only this crisis has adversely impacted lenders, but also has opened new avenues for growth. Some of those opportunities are listed below:
Strategic Partnership(s) in Demand
Now that major leaders like Ondeck and Kabbage have been acquired by Enova  and American Express , respectively and the gap between prime lenders and subprime borrowers further widens , we are likely to see new players entering the market. These could either be newcomers or pre-existing companies from other sectors expanding into the space.
We have also witnessed partnerships between leading banks and retailers to help out small businesses; Goldman Sachs’ Marcus, Amazon , and Walmart  partnered to provide Line of Credit to their respective sellers. Biz2Credit  and Lendio , two market-leading ISOs, partnered with different firms supporting SMEs, to help their SME clients attain easy credit. With 60% of credit unions and 49% of banks in the US expressing interest in forging partnerships with fintechs, more partnerships are expected, and the anticipations are now further fueled by the ongoing crisis .
Distressed Portfolios Available for Servicing
This crisis has also opened doors for companies in the portfolio servicing industry, especially for the distressed ones. Many lenders went out of business or were acquired, and their portfolios were left without a servicing platform. For example, American Express acquired Kabbage’s technology and human resources but left out the portfolio. Distressed portfolio servicing is an attractive market for enterprising players looking to capture a new market.
Quicker Decision-making Through Digital Accounting System
With the world shifting online, digital payments are increasingly favored over cash transactions, with an accompanying increase in innovative partnerships. In September, Paypal and VISA  partnered to facilitate quick and easy payments for SMEs and consumers. Not only digital payments will make access to capital easier, but also will help lenders with solving one of their long-standing problems – how to have direct and easy access to cash flow information of a SME, which will, in turn, help lenders expedite their decision-making on credit. Online platforms like Quickbooks  are already and will continue to play an important role on this front.
SBA-approved Lending in Limelight
Paycheck Protection Program (PPP) loans from the Small Business Administration (SBA) under the CARES Act were more than just a lifeline to struggling SMEs/SMBs. They also presented an opportunity to alternative lenders to grow their customer base and portfolios. For example, Kabbage deprioritized its usual lending practices and focused on issuing PPP loans, augmenting their portfolio with over 200,000 approved PPP loans . Through the PPP program, more lenders as well as borrowers became educated about SBA loans. Consequently, an increase in the volume of SBA loans is expected, especially 7a loans meant for small businesses, along with an anticipated increase in the number of SBA approved lenders.
COVID has severely impacted Small and Medium-sized Businesses. Economists  predicted the shutting down of over 100,000 small businesses by May 2020, with more to follow. This may also cause a ripple effect in communities, especially in smaller towns with economies heavily dependent on small shops and businesses. Many businesses depend on other businesses, and as some pull the shutters down forever, more will follow.
In summary, many SME owners are still uncertain of their business future. Thus, SMEs are looking up to lenders for extra capital in order to survive. However, banks continue to tighten their credit guidelines for commercial loans, thereby making it harder for SMEs to acquire a loan from prime lenders. This opens a door for alternative lenders to capture a new market segment, but not without some out-of-the-box thinking. Many lenders are already breaking barriers, adjusting their functioning and operations to meet the needs of small and medium businesses that are suffering. What remains to be seen is that in this saw-toothed economy, with business revenues more variable than ever and with the coming of winter, have lenders weathered the full storm or just the first wave?
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