21st Century Lending

The earliest known records of lending date back about 4,000 years to Mesopotamia where the Sumerians were borrowing and lending livestock and seeds that would later be repaid from the offspring and yields harvested from the original “capital”.

Shortly afterwards the Sumerians discovered that it was more convenient to use silver as a medium of exchange, and not too long after that the Code of Hammurabi defined the price of silver and how the interest charged on silver loans was to be regulated. It seems that Hammurabi was quite concerned about usury and preventing abusive payday loan practices. If he were alive today, he may be disappointed (but perhaps not too surprised) to see that the need to regulate overly greedy lenders has not gone away. Four millenniums may have passed, but human nature does not seem to have changed much!

On the other hand, what has changed is the technology available to borrowers and lenders, and the good news is that there is now a new breed of lender emerging that uses this new technology to drive better outcomes for all parties involved.

This new type of lending is characterized by five main features: It is embedded, it operates in real-time, it unlocks and underwrites with sources of data that were previously locked up or inaccessible, the collection mechanism is “default on”, and the use of proceeds are laser targeted.

The net result of these five features is that the losses for this type of lending is orders of magnitude lower, in some cases approaching zero. Coupled with operational cost efficiencies enabled by technology, this in turn enables the lender to charge the borrower rates that are dramatically lower than other lenders, creating a virtuous cycle. Let’s now quickly examine all of these five factors in some more detail.

The first factor, embedded lending, has been written about and discussed a lot in the fintech community, including in my previous blog on the topic. In summary, it refers to the lending itself being invisible to the borrower and moving in harmony with the needs of the customer. An example we used in the past is how mortgages can be embedded into the property purchase to make the whole process last hours not weeks (or months as is the case in the UK). Imagine being able to buy a house with a few clicks!

Secondly, these new lenders operate in real time. In practice this means that they in real time ingest not just the data from the borrower, but also the third-party sources of data about the borrower, and hence can also make and communicate their decisions in real time. To take small business loans as a case study, consider how those were made in the past. The business owner would have to print pages and pages of financial statements that were already out of date at the time of submission, the loan officer would review these, and make the loan some weeks later. The business might have ended up in a totally different state by then, but again the loan officer would only find out once the new set of financial statements were prepared, reviewed by an accountant, and submitted some months later. Now contrast that with having real-time access to not just the customer’s bank account but also their sales data. Quite a difference!

One can only hope for lower interest rates in the future!

Thirdly, yes, the data is in real time, but crucially it also contains new and relevant information that is usually locked up inside the business. This can include anything from recent bank account movements to real time sales data or data on how many shifts an employee has worked that week. This incremental data not only provides better performance from a credit underwriting perspective, but it also ensures way better customer outcomes by making sure calculations like affordability and the potential vulnerability of the borrower can be made with superior precision.

The fourth factor is a collection mechanism that is “default on”. In simple terms this means that in the ordinary course of business, the collection of the loan is automatic and does not require any extra effort. Following the insights of behavioral finance that have emerged over the last decade thanks to Professor Richard Thaler from the University of Chicago (where I had the good fortune to take his class) and his mentors Kahneman and Tversky, this actually makes the loans much easier and painless to collect, resulting in substantial costs savings that can in turn be passed onto the borrower. A good example of such a mechanism is collecting a portion of sales receipts at the point of sale to repay the loan, but there are many other examples.

Finally, the use of proceeds is targeted with laser precision. The loan is not made as a general disbursement for the borrower to spend as they wish, but rather for a specific purpose. Another way to look at this is that the lender understands very well why the borrower needs the funds, and how that fits into a sustainable pattern where the borrower can pay back the loan without falling into distress. This leads to a much more borrower friendly situation, where funds are only drawn down subject to affordability and a sensible use of proceeds.  

In closing, it is also very important that one does not lose sight of the most crucial element of the narrative: Done rightly, 21st century lending enables far superior borrower outcomes where consumers and small businesses can borrow money when it is most needed, at a fraction of the cost, with minimal disruption to their lives, knowing that affordability and sustainability has been embedded into the process.

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