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CFPB's Buy Now, Pay Later Report Dropped. Now What?
Also: Five Key Take Aways from *that* OCC Speech, CommonBond Calls It Quits
Hey all, Jason here.
When this email hits your inbox, I’ll be somewhere in between Mexico City and Amsterdam (I can feel the jet lag already…). Friday, Mexico celebrated its independence day. Each year, on the evening before, the occasion is marked by “El Grito de Independencia” (the cry of independence), which commemorates when Roman Catholic priest Miguel Hidalgo y Costilla rang his church bell 212 years ago as a call to take up arms against the Spanish.
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The CFPB's Long-Awaited Buy Now, Pay Later Report Dropped. What Happens Next?
Last December, the CFPB announced it would conduct a market review of the fast-growing buy now, pay later sector. The bureau issued orders to gather information from five major companies offering “split pay” financing products: Affirm, Afterpay, Klarna, PayPal, and Zip. At the time, the bureau highlighted three key potential areas of concern: debt accumulation, regulatory arbitrage, and ‘data harvesting.’
Nine months later, the output of that market monitoring exercise is here.
While the report doesn’t really break new ground, it does provide some concrete data on an industry that some critics argue has operated in the shadows. It’s worth repeating that the data gathered and the report cover only “pay in four”-style products and do not include larger installment loans repaid over longer time frames.
Explosive Growth — And More Repeat Users
Given the speed with which the BNPL industry has grown, it shouldn’t be a surprise it has caught the attention of regulators.
The CFPB’s report, which only reflects data from five leading BNPL providers, puts specific numbers to the astronomical growth of the product category, revealing an over-11x growth in dollars originated from 2019 to 2021:
Despite diversifying into product categories beyond beauty and apparel, which propelled early adoption of BNPL, average loan size has barely budged in the period examined, increasing from $121 in 2019 to $135 in 2021.
Looking at loan and dollar volume of originations by quarter, the pace of growth began increasing substantially around Q3/Q4 2020 — after the worst of the pandemic uncertainty was in the rearview mirror, but with government support for consumers still going strong. The VC spigot was open wide, too: in September 2020, Klarna raised $650 million to power its international expansion in an environment that had become an increasingly competitive land grab.
However, as is often the case with small dollar, short duration products, it appears this growth was powered, in part, by a small proportion of frequent users.
CFPB analysis shows that an increasing share of borrowers used five or more loans per quarter, with 15.5% of users doing so in Q4 2021; 4% of borrowers used 10 or more loans that quarter. This is likely an undercount, given the CFPB examined aggregated data and thus couldn’t examine a single borrower’s behavior across multiple BNPL providers.
Margins Compressed as Competition Intensified
When BNPL first began breaking out, it was as a merchant-integrated offering. Merchants agreed to a higher merchant discount rate, with the trade-off being lower rates of cart abandonment, higher average order value, and more repeat customers. Back in November 2020, BNPL providers charged merchants as much as 6-7% of each transaction.
But with booming ecommerce activity driven by the pandemic, a glut of venture capital, and relatively low barriers to entry, BNPL companies proliferated and competition intensified.
The result? A compression in providers’ take rate. Despite efforts to develop additional sources of monetization, notably affiliate commissions, overall take rate as a percent of GMV has declined from 4.29% in 2019 to 4.02% in 2021.
Meanwhile, expenses are beginning to tick up. Two key expenses — cost of funds and provisions for loan loss — didn’t begin to accelerate until 2022 and thus aren’t fully captured in the CFPB’s data:
While credit loss provisions ticked up only 13.5% from 2020 to 2021, signs of increasing borrower stress are emerging. Overall, 3.79% of borrowers had debt that was ultimately charged off in 2021, an increase of 29.1% from the year prior:
Increasing competition is only part of the reason for declining merchant fees. In an effort to grow more quickly and ‘own’ the customer relationship, major BNPL providers have supplemented distribution through merchant-partners with direct-to-consumer channels: BNPL companies’ own websites and apps, browser extensions, and physical and virtual cards.
These efforts aim to turn BNPL services into shopping destinations in their own right, rather than being relegated to one of many payment buttons at checkout.
Direct-to-consumer distribution also enables consumers to use BNPL at any merchant — whether or not the merchant has a partnership with the provider. This can increase the frequency with which consumers use BNPL services, but means lower take rates for BNPL providers.
According to the CFPB’s report (emphasis added):
“The share of the five surveyed lenders’ GMV from non-partnered merchants (who make up a large share of the app-driven model originations) has increased from 11 percent in 2019 to 16 percent in 2020 to 19 percent in 2021 (and 22 percent when exempting the one lender who did not originate any non-partnered loans in 2021). Meanwhile, the share of lenders’ revenues derived from partnered merchants’ discount fees declined from 78.9 percent in 2019 to 61.9 percent in 2021.”
The upshot from increasing margin pressure? Again, according to the report (emphasis added):
“Different lenders are responding to these pressures with a combination of the following actions: tightening underwriting standards, increasing consumer fee revenues, and/or shifting toward acquiring borrowers via their proprietary apps rather than on the websites of retail partners.”
Other Noteworthy Stats
Approval rates hit 73% in 2021, up from 69% in 2020. Last year was likely a high water mark. With lower income consumers coming under greater strain as COVID stimulus is long gone and rising inflation hits household budgets, and charge offs ticking up, BNPL providers are likely to tighten credit policy.
10.5% of borrowers incurred at least one late fee, up from 7.8% in 2020.
BNPL providers’ share of revenue from fees (late fees and other fees) was 13.4% in 2021 — up from 11.7% in 2020. Late fees accounted for 6.9% of revenue in 2021, up from 4.8% in 2020 (despite some lenders changing late fee policies to make them more favorable to borrowers.)
Loans were primarily repaid via debit card, with 89% of repayments made this way, a rate which was virtually unchanged from prior years.
The bureau report acknowledged some positive attributes of BNPL for consumers: that it can be a low-cost alternative to other credit products and the products’ broad availability, ease of use, and simple repayment structures.
However, the report also reiterated concerns the bureau, legislators, and consumer advocates have previously expressed, which are likely to be the focus of any interpretative guidance or rulemaking:
lower consumer protections vs. those for debit/credit cards (returns, disputes, chargebacks)
lack of consistent consumer disclosures
‘data harvesting,’ specifically how BNPL providers use customer data outside of lending transactions, including for advertising, sharing with merchants, or discounting strategies
furnishing data to the bureaus, particularly to mitigate risks from ‘loan stacking’ and to better monitor sustained use across multiple BNPL providers
consumer repayment options, specifically whether or not users are required to use automatic repayments
BNPL providers’ re-presentment practices, particularly when these cause borrowers to incur overdraft or NSF fees
As a market monitoring exercise, this report itself doesn’t mandate any changes to industry practices.
However, together with Director Chopra’s previous statements, it quite clearly highlights the areas the bureau is likely to continue focusing on. The report is likely to serve as a justification for future interpretative guidance or rulemaking addressing some or all of the above mentioned concerns.
Five Key Take Aways From THAT OCC Speech
The Banking-as-a-Service speech heard ‘round the world? Fresh on the heels of the OCC’s agreement with Blue Ridge Bank regarding its third-party fintech partnerships becoming public, Acting Comptroller Michael Hsu gave remarks at the The Clearing House/Bank Policy Institute conference titled “Safeguarding Trust in Banking: An Update.”
As this speech has already been endlessly parsed, I’ll be brief and highlight my top five take aways:
1. Yes, Crypto, But…
Hsu began his remarks by acknowledging the rapid “digitalization” of banking, including extensive “hype” surrounding crypto.
The OCC, along with other federal regulators, have already adopted a “careful and cautious” approach, requiring supervised banks seeking to engage in certain crypto activities to demonstrate they can do so in a “safe, sound, and fair manner.”
Hsu argues that, while crypto has garnered a lot of attention, particularly with various meltdowns this year, fintech and Big Tech may pose a bigger risk. According to his remarks (emphasis added):
“While crypto has grabbed the headlines for most of the past year, I believe fintechs and big techs are having a large impact and warrant much more of our attention.”
2. Bank-Fintech Partnerships Will Get More Scrutiny
For many in the industry, it’s been clear for some time that regulators have been taking a closer look at banks engaged in “banking-as-a-service” business models. Those rumors were validated with the OCC/Blue Ridge agreement.
In his remarks, Hsu states (emphasis added):
“These developments are creating an increasingly varied and complex set of arrangements, which are significantly more intricate than the standard bank outsourcing relationships of yesteryear. The growth of the fintech industry, of banking-as-a-service (BaaS), and of big tech forays into payments and lending is changing banking, and its risk profile, in profound ways.”
Hsu compares the disaggregation and increasing complexity of fintech-bank partnerships to the 2008 global financial crisis and goes on to say (emphasis added):
“My strong sense is that this process, if left to its own devices, is likely to accelerate and expand until there is a severe problem or even a crisis. Like the globalization of manufacturing and the disintermediation of credit, the efficiency gains of these changes can be enjoyed immediately, while the most material risks do not manifest for some time.”
While I agree with Hsu there are risks in the increasing complexity, much of which is quite opaque to outside observers, I’m less convinced the comparison to 2008 is an apt one. At the moment, most fintech-bank partnerships focus on deposit/spending account products, rather than credit. Those that are focused on credit are likely to be smaller dollar amounts and unsecured.
To my eyes, the greater risks in these operating models are around IT/business continuity, consumer protection (including UDAAP), and financial crime risk, including AML.
Still, Hsu acknowledges it’s early days, and much work remains to be done, saying:
“My sense is that we are still in the early stages of a significant shift in how banking services are going to be provided in the future. By expanding our aperture, engaging more substantively with nonbank technology firms, and mapping out bank-fintech relationships and risks, we can help ensure that banking remains trusted and safe, sound, and fair as the system evolves.”
3. Climate Risk
This is perhaps not a very “fintech” part of the speech, but it is a policy area that is likely to have increasingly significant impact on banks’ risk management frameworks.
Hsu advocates taking a fresh approach to thinking about climate risk and avoid merely adapting existing stress test frameworks, saying:
“With climate-related risks, I believe we are much more exposed to failures of imagination—not asking enough “what if?” questions—than we are to failures of stringency or consistency.
Given the uncertain nature of climate-related risks today, probing for vulnerabilities under different scenarios will be more impactful to climate-related risk management than generating comparable, but overly stylized, loss estimates.
In short, I am concerned that the muscle memory of capital stress testing is more likely to handicap climate scenario analysis than to help it. I believe a clean sheet of paper and an open mind to considering a wide range of risks and scenarios will yield richer and more actionable information than an approach that borrows heavily from capital stress testing.”
4. Inequality’s Relationship to Trust in Banks
Under the Biden administration, regulators have worked to incorporate broader themes of racial and economic inequality in their work. That theme came through in Hsu speech (emphasis added):
“Persistent economic inequality can erode trust in banking because those who feel stuck or lack access to traditional financial products and services may conclude that the system is working against them, rather than for them. The OCC has been very active in taking steps to address inequality over the past year.”
Hsu highlighted ongoing efforts to modernize the Community Reinvestment Act (CRA) and successes in encouraging banks to reform overdraft and NSF policies.
He also highlighted the OCC’s Project REACh, which has notched some recent wins, including two just-announced initiatives at Citibank; one to underwrite credit card applicants that lack traditional credit scores, and another to boost credit access for small businesses owned by women, minorities, and veterans.
5. Bank Mergers & Acquisitions
The current administration has repeatedly made clear its desire to promote competition — including by taking a more active antitrust posture than the prior administration. One area that policy priority is likely to impact is merger and acquisition activity, including in the banking sector.
Updating the Bank Merger Act guidelines became an early flashpoint when an FDIC board power struggle over fielding a request for information spilled into public view. Ultimately, Trump-appointed chair Jelena McWilliams resigned as a result.
In his speech, Hsu makes clear he supports updating the guidelines, saying:
“Finally, let me say a quick word on bank mergers. I believe that the Bank Merger Act guidelines are ripe for updating. The OCC is working with our federal banking agency peers and the Department of Justice to review our bank merger frameworks consistent with President Biden’s Executive Order on promoting competition, as well as my own concerns about bank merger impacts on communities, the potential for institutions to become too-big-to-manage, and financial stability. As banks get larger, I am particularly focused on financial stability risks, given my experience in the 2008 financial crisis with too-big-to-fail firms.”
CommonBond Calls It Quits
Student loan refinance company CommonBond is calling it quits, company co-founder and CEO David Klein revealed via a LinkedIn post last week. He noted the challenges the refi business faced once federal student loan payments were paused during the pandemic — ultimately resulting in the company pivoting to a new sector altogether: financing solar installation.
And, although Klein says that business was going well, the company was unable to raise additional capital and ultimately had to shut down:
Still, multiple industry sources expressed surprise at the seemingly abrupt shutdown, particularly given that the company claimed to be profitable as recently as the first half of 2020. Sources pointed out that the student loan payment pause was a time-limited problem, with payments seemingly finally set to resume at the beginning of next year.
With the potential to resume student loan refi and the new solar business, it seems odd the company wasn’t able to raise fresh capital. If experienced industry vets with an operating business aren’t able to raise, there may be a lot more pain and failure in the fintech world yet to come.
Other Good Reads
Web3 Has An Identity Problem: Building Decentralized Identity (Jelena Hoffart)
Embedded Finance: What It Takes to Prosper in the New Value Chain (Bain)
Goldman Sachs: The Quest for Eternal Youth (The Generalist)
The New Inclusive Future of Fintech (WTFintech?)
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