PUB#01 Product Teardown Of Fintech Micro Lending

1st September 2019 in The PUB Series

PUB is a series of product teardowns focused on the product, user experience, and business elements of an industry or company. If you're curious to know its principles, read the first post here or check out the whole series.

After almost a year in the Fintech micro lending space, I've learnt enough to share about the industry. In this teardown, I've taken a newcomers approach and start from the top instead of analyzing a specific company.

Fintech as a Whole

If you haven't yet heard, Fintech is the coolest kid on the tech block. Investment in the industry jumped 120% from 2017 to hit a record $39 billion in 2018.

But what exactly counts as Fintech? For the most part, companies can be divvied into 2 categories:

  • Fin - Consumer facing financial services such as loans, deposits, or remittance.
  • Tech - Business facing technologies which enable these consumer services such as payment gateways or fraud detection.

Within 'Fin', lending attracted the highest global investment in 2017 and was 3rd in 2018 behind payments and wealth management.

Why lending? Two reasons.

1) Profit - It's what commercial banks already do to make all that money.
2) Opportunity - Massive untapped market in economies with a newly emerging middle-class.

Fintech lenders, like banks, use what capital they have to make more capital. This is called leveraging and it's been around for centuries.

In fact, with some innovation and a hunger to expand in new markets, these firms are even starting to beat banks at the game.

From this data on US unsecured consumer loans, the banks 40% share has been declining since 2013. By 2017, Fintech took over and hit 38% in 2018 while banks are at 28%.

CNBC unsecured consumer loan market share

That's something I didn't expect to happen in such a short time span!

Before diving into the innovations that aided this flip, we'll first cover the core problem that financing solves.

Micro Lending As A Product

One of the biggest problems with banks is that too many people don't have one. In South East Asia, 53% of adults are unbanked.

Even when they do own an account, the majority are still underbanked since they lack the collateral or deposit history to qualify for any financial services at their banks.

The Job To Be Done
Just because you are unbanked doesn't mean that your need for credit goes away. Unforeseen circumstances or opportunities do come up.

You may need a little extra cash to buy supplies for your store, get medicine for a sick family member, or repair your motorbike. The core problem faced is:

Provide access to extra cash when I need it.

When banks try to solve this problem, a 'chicken or the egg' dilemma arises (it's the egg by the way). Let's take the scenario of repairing a motorbike as an example.

Deposit, credit card, scooter, payment icons from Flaticon

While banks do use more than deposit history alone, the point is when information is insufficient to anticipate the outcome of extending credit, banks take the safe road and avoid starting a relationship with 'risky' customers in the first place.

Rejected by traditional credit institutions, these individuals turn to family members, neighbors, or money lenders for financing. Amongst these informal options, Fintech lenders have recently emerged as another formal alternative.

Better Credit Decisions
A critical advantage these firms have is using unconventional sources of data to forecast the outcome of a loan and replace collateral. It's that simple (well, not really) but banks merely have not built the capacity to collect or process it yet.

Risk teams, made up of data scientists, rely on these data signals to build machine learning models which can root out fraud and predict loan nonperformance while maximizing interest revenue by offering larger loans.

xkcd on machine learning

This is the Fintech lenders secret sauce. It's not who you say you are, but what you do that truly matters and it's all written in the data.

By employing technology to streamline data collection, improve credit decision-making, and rapidly experiment with credit products, these firms can target the 53% of people that banks ignore.

They are also more reliable than the informal choices mentioned above which means unbanked families now have broader financial tools at their disposal.

Unsuitable Credit Products
Tech is only one side of the coin though, and designing the types of credit available is key to supporting the underserved effectively.

Here is where things can start to go awry. In pursuit of quick scalability, some lenders prioritize one month payday loans or push borrowers to take up too much commitment over financial literacy and progressive creditworthiness.

Ultimately, this leads to unsustainable debt with the possibility of destroying lives as opposed to working on longer timelines where economic changes have the space to actually settle.

An Optimized User Experience

Aside from having a product that serves a bigger consumer market, the second strength of Fintech lenders is in friction removal.

Information Collection
The first place this shines through is in smartphone data collection. These devices are smokestacks of personal information; your contacts, call logs, SMS's, emails, online purchases, and even your GPS coordinates are vacuumed up in seconds.

With your permission of course.

For the borrower, this means not having to fill long forms or spend half a day at the bank with a loan officer. Its available 24/7; you can start applying anytime, continue your application from where you left off, and get cash in your bank within hours.

Providing such convenience is easily overlooked by the incumbents that previously enjoyed their monopoly. However, when it comes to fickle consumers, this amount of friction has been discouraging enough to flip the market share.

Habit Forming Games
An additional tool in the Fintech lenders kit is games. Like all 'sticky' digital products, the apps of these companies compel users to perform certain actions by associating specific tasks with routines and emotions.

Though the example below is in Bahasa, it's a direct case of incentive theory where a user's effort acquires points that can be swapped for rewards or other discounts.

The most points are given for challenging activities such as repaying on time (Mengembalikan Pinjaman Tepat Waktu) or successful loan approval (Sukses Mengajukan Pinjaman) which encourages users to complete these actions.

The next example is a little more involved. In the 'Lucky Egg' game below, actions earn points too. You can then choose to boost your egg level or smash it to redeem your prize.

So what's the catch? There's a chance that upgrading your egg fails and the success rate drops at each rank!

A game designed this way plays on loss aversion theory where humans are about 2.25x more likely to choose the option that avoids failure over an equivalent gain.

Users are then nudged towards incrementally moving up the reward steps rather than gunning straight for the top egg. This helps improve engagement and allows the lenders to incentivize behaviors they desire.

These are a few instances of the engagement hooks Fintech lenders build into their applications to cultivate behaviors and create an 'addiction' to their product. It also raises questions about how ethical it really is.

There are those that concentrate on using these techniques to get customers to repeat loans or coax others in their circle to take up debt, regardless of whether they need one. This is manipulative and reveals a purely for profit motive.

Granted, persuasive products can fall at different ends of the spectrum. When the habits being created are focused on developing financial literacy and responsible credit, these firms may truly be a force for good.

The Business Balancing Act

Same product, larger market, and a better experience. The next section is on answering 'how do Fintech lenders make money?' As mentioned, it's akin to a bank.

Revenue of First Loan
Every business needs to be profitable to survive and the first part of this equation is revenue. Instead of earning income by selling stuff like commerce companies do, the income of lenders comes from interest payments on each loan.

Since they are lending to riskier consumers, many Fintech lenders levy higher interest rates to offset the greater proportion of bad debt in their loan portfolio.

Typically, they make more per customer than the bank does and depending on the regulations, some can even go up to 24% monthly interest. This is roughly 12x the average bank charge and is predatory in nature.

Expenses of First Loan
Expenses are things 'consumed' to run the business and reduce revenue; what's left over is profit.

Compared to traditional institutions, Fintech lenders probably spend more. A slew of services such as criminal database checks, ID card image recognition, along with expensive data scientists all serve to separate quality customers from the risky ones.

There is a reason for this expense. Remember that 53% of the world is unserved? These firms employ automated technologies to significantly lower their unit costs at scale by spreading it over a bigger audience.

Balancing For Profit
Higher revenue, lower expenses; it seems like Fintech lenders could be generating excellent margins provided their portfolio is correctly balanced. Why?

It's simple to open the floodgates, bring in a lot of potential revenue by approving any loan, and reduce unit costs but this also exposes the company to defaults.

To make money, businesses constantly tread carefully between approval rates and nonperformance, then gain the bulk of profit through recurring loans from their creditworthy users.

The End of Credit?

If part of this has begun smelling funky, you're right. While there is a huge opportunity to deliver value for underserved populations and improve financial independence, the right product can easily go astray with the wrong intentions.

In poorly regulated markets like Africa, Indonesia, and Vietnam, hundreds of companies attracted by profit have popped up. Many get away with ridiculous interest rates and questionable collection practices comparable to loansharks.

Personally, I believe that it takes a strong ethos from the founding team to stick with the right values and figure a way to run the business without trading off the well-being of customers.

Despite this (and this is the scary bit), the demand for credit in SEA is still strong which could eventually lead to a China-style P2P collapse, if the proper controls are not put in place soon.

Disclaimer: This is a personal blog. All statements in this article are solely my own and are not endorsed by people, institutions, or organizations that I may or may not be associated with unless explicitly stated.