Research Finds Fintech Enhances Financial Inclusion at Lower Cost

by Manatt, Phelps & Phillips, LLP
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In a new research paper, the Federal Reserve Bank of Philadelphia concluded that fintech lending has enhanced financial inclusion, often at lower cost to consumers.

What happened

As financial technology plays an increasing role in shaping financial and banking landscapes, “Fintech Lending: Financial Inclusion, Risk Pricing, and Alternative Information” explored the advantages and disadvantages of loans made by fintech lenders, the use of alternative data sources and the impact on financial inclusion.

The report concluded that fintech lending has “penetrated areas that could benefit from additional credit supply, such as areas that lose bank branches and those in highly concentrated banking markets,” and that the use of alternative information sources has allowed some borrowers who would be classified as subprime by traditional criteria to be slotted into “better” loan grades and therefore receive lower-priced credit.

Fintech companies—which have experienced “explosive growth” since 2010—are increasingly affiliating themselves with traditional banks, the Federal Reserve Bank of Philadelphia noted, and federal regulators are responding to the changes in a variety of ways, including the Office of the Comptroller of the Currency’s controversial proposal to issue charters to fintechs.

The report relied upon five sources of information for its analysis: data on loans that were originated through an online alternative channel (specifically, loan-level data from the Lending Club platform), data on loans that were originated from traditional banking channels, consumer credit panel data, banking market concentration data and bank branch information, and economic factors.

Analyzing the data, the Federal Reserve Bank of Philadelphia found that Lending Club initially concentrated its efforts in the Northeast and on the West Coast but today has loans in every state. About half of the loans are in areas where a few banks dominate the market and there is less banking competition, as over the years, “an increasing percentage of Lending Club loans are originated in markets that had a declining number of bank branches.”

To date, the empirical evidence “is consistent with an argument that fintech lenders such as Lending Club have played a role in filling the credit gap,” the report found, penetrating underserved areas and making loans more accessible to consumers.

The Federal Reserve Bank of Philadelphia noted an increasing disparity between the rating grades of Lending Club and FICO scores. While the lender’s rating grades initially tracked the FICO scores of borrowers (with roughly 80 percent correlation in 2007), the similarities have dropped to only 35 percent in 2016, seeming to indicate that Lending Club is relying more on other information.

Focusing on loans with the identified purposes of credit card or other debt consolidation, the study compared the pricing of Lending Club loans with those from traditional lenders. The report found that the use of additional information by the fintech lender “allows some borrowers who would be classified as subprime by traditional criteria to be slotted into ‘better’ loan grades and therefore obtain lower priced credit. And, it does not appear that this credit is ‘mispriced’ in terms of default risk.”

Overall, the study found that Lending Club’s rating grades have served as a good predictor for the borrowers’ probability of becoming at least 60 days past due within the 12-month period following the loan origination date, “despite the fact that the rating grades have a low correlation with the FICO scores.”

In addition, as compared with loans from traditional lenders, “given the same credit risk … consumers would be able to obtain credit at a lower rate through the Lending Club than through traditional credit card loans offered by banks,” the report said.

“The declining correlation between traditional risk scores and Lending Club’s rating grades suggests that the traditional credit scores may have been discriminatory since the models were built based on experience from those consumers who already had access to credit,” the Federal Reserve Bank of Philadelphia added. “There is additional (soft) information in the Lending Club’s own internal rating grades that is not already incorporated in the obvious traditional risk factors. This has enhanced financial inclusion and allowed some borrowers to be assigned better loan ratings and receive lower priced credit.”

To read the working paper, click here.

Why it matters

Although the report noted concerns about the potential risks of disparate treatment, fair lending violations and privacy abuses with regard to the use of alternative information sources, it presented a positive picture of fintech lending. “While the growth of nonbank lending may raise some regulatory concerns, the firms’ technology platforms and their ability to use nontraditional alternative information 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,” the Federal Reserve Bank of Philadelphia wrote. “In addition, as more millennials make up the pool of small business owners and the consumer population, they are more comfortable with technology and therefore, may be more comfortable dealing with an online lender than in dealing with a traditional bank.” How traditional financial institutions learn to successfully collaborate with online lenders will be the next large test to determine the overall growth and success of this online lending industry.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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