Fintechs Gain an Edge Against Banks: An FRB Fintech Recap
Last week, at Philadelphia Federal Reserve Bank’s Fintech and the New Financial Landscape (FRB Fintech), leading research experts and industry innovators came together to share their insights on the future of fintechs. Across some of financial services’ most traditional providers to the newest fintech players, one consensus was surprisingly clear: banks have something to learn from fintechs when it comes to understanding their consumers.
Are Banks and Fintechs So Different?
Before we can discuss how banks can learn from fintechs, we have to clarify the common misunderstanding that they lend to very different borrowers. John Wirth, VP of Consumer Lending and Fintech at TransUnion, focused most of his presentation on debunking this myth.
For example, many assume that fintechs cater to a much younger audience than traditional lenders (i.e. millennials). But in reality, the age distribution of fintech borrowers is similar across fintechs, banks, credit unions, and traditional finance companies. In fact, fintechs lend to the lowest proportion of consumers aged 18-29 and the highest proportion of those aged 30-49.
According to Wirth’s research, the borrower profiles of fintechs and banks also show similar proportions of thin-file consumers: 14 percent of fintech borrowers are thin-file, compared to 13 percent of bank borrowers and 32 percent of traditional finance company borrowers. Interestingly, compared to other lender types, fintechs also exhibit the most linear relationship between credit risk and price — subprime consumers consistently receive higher interest rates than prime consumers, and vice versa.
Perhaps that’s why fintechs are generating effective risk-return ratios that outperform banks and credit unions (in spite of higher delinquencies among subprime consumers for fintechs than for other lenders). At FRB Fintech, Wirth suggested that fintechs’ insight into consumers, through the use of advanced analytics and FCRA-compliant alternative data, is what enables them to compete effectively across the credit spectrum.
Fintechs are generating effective risk-return ratios that outperform banks and credit unions.
What Drives Fintech Success?
Researchers from FRB Philadelphia, Rutgers University, and Hanyang University investigated the factors that might be driving this effective competition in their paper, Consumer Lending Efficiency: Commercial Banks versus Fintech Lenders. They looked at two primary factors in loan performance: inherent credit risk and lending efficiency.
As TransUnion’s research demonstrated, inherent credit risk is fairly similar across commercial banks and fintech lenders. At FRB Fintech, these researchers compared the largest commercial lenders to LendingClub, as an example of a fintech leader. Their findings aligned with those of TransUnion; LendingClub’s inherent credit risk is similar to that of the largest lenders — both take on high credit risk.
It’s important to note that high credit risk isn’t necessarily indicative of risky behavior on behalf of lenders. The biggest banks maximize their market value by increasing risk. So, both for commercial banks and fintechs like LendingClub, taking on riskier borrowers is a rational business decision, even when it increases the volume of nonperforming loans.
As expected, the researchers found that the largest commercial lenders have higher lending efficiency than smaller traditional lenders. What was less expected: LendingClub’s lending efficiency hovers around equal to the largest lenders and greater than other banks. They speculated that LendingClub’s efficiency results from “a greater capacity to accurately evaluate credit risk using more advanced technology, more complex algorithms, and alternative data sources that might be less accessible by small traditional lenders.”
How Can Banks Learn from Fintechs?
Through the lens of various findings and perspectives at FRB Fintech, a common thread emerged: fintechs have an edge over banks when it comes to analyzing and evaluating consumer credit risk. In other words, fintechs can operate at high efficiency and high risk even without the scale and resources of large banks because of the way they leverage analytics and alternative data.
Fintechs can operate at high efficiency and high risk because of the way they leverage analytics and alternative data.
Local credit unions often emphasize their intimate customer relationships as an advantage in the lending space. Fintechs do the same; because they invest in predictive, innovative data sources, they’re able to better understand their consumers and lend more effectively. As Ken Rees, CEO of Elevate, said at FRB Fintech: “In the non-prime space, you need insights into customers. I think these insights will help banks develop better products to serve customers’ needs and to develop the kinds of analytics and tools needed to serve them.”
To learn more about how lenders can access new alternative data sources to drive granular consumer insights, check out our recent eBook.
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About Amy Hou
Amy Hou is a Marketing Associate at Urjanet, writing about emerging topics in sustainability, energy management, and data innovation.