As Feds increase fintech scrutiny, experts outline a BNPL regulatory framework
- After experiencing a meteoric rise in recent years, the BNPL industry is bracing itself for increased regulation in the US as government agencies are looking to widen their oversight into the fintech sector.
- With concerning signs regarding credit quality, risk intake and its effects on consumers, industry experts are advocating for more regulations and offer recommendations of what these could look like.
While BNPL brought access to affordable credit and a new opportunity to purchase goods one might not otherwise afford, the lack of regulatory oversight in the space remains a cause of concern.
The ease of use of BNPL products has been associated with increased spending and could drive negative consumer consequences, prompting US regulatory agencies to look deeper at this rapidly growing space.
Last December, the CFPB launched an investigation into the business practices in the buy now, pay later (BNPL) sector due to mounting concerns about “accumulating debt, regulatory arbitrage, and data harvesting in a consumer credit market already quickly changing with technology.”
As a result, the agency asked the five biggest players in the space - Affirm, Afterpay, Klarna, PayPal and Zip – to submit information in order to report industry practices and risks to the public.
“Buy now, pay later is the new version of the old layaway plan, but with modern, faster twists where the consumer gets the product immediately but gets the debt immediately too,” said CFPB Director Rohit Chopra.
And just last week, the CFPB went a step further and invoked a "dormant authority" to examine nonbank financial companies that could pose risks to consumers. The agency noted that nonbanks “do not have a bank, thrift, or credit union charter; many today operate nationally and brand themselves as ‘fintechs’.”
“Given the rapid growth of consumer offerings by nonbanks, the CFPB is now utilizing a dormant authority to hold nonbanks to the same standards that banks are held to. This authority gives us critical agility to move as quickly as the market, allowing us to conduct examinations of financial companies posing risks to consumers and stop harm before it spreads,” said Rohit Chopra, the bureau’s director.
Other voices in the industry are also supporting more government oversight in the BNPL sector:
“Without precedent, regulation, or oversight, consumers, investors, and leading credit risk managers cannot evaluate the risks of significant subprime borrowing in an unregulated industry with revenues approaching $1 trillion,” said Marshall Lux in a recent research paper.
With a credit risk experience spanning over three decades, including serving as JPMorgan Chase’s Chief Risk Officer of consumer products during the global financial crisis, Lux argued for enhanced regulatory oversight in the BNPL space.
And the industry is also taking note of this trend – banks could take advantage of increasing regulation and compressed margins in the BNPL sector to strengthen merchant relationships in order to keep up with competition, according to a Deloitte report.
“Banks are well positioned against fintechs in a market facing more regulation, lower margins, and potential market consolidation. By adopting a startup mindset and assuming some level of risk, banks can leverage their existing compliant operating models, large individual and merchant customer bases, and lower funding costs to succeed in this market,” it said.
Forbes also reported that banks could be successful in the BNPL space, and regulation will only strengthen their competitive advantage in the market.
“Regulation will raise the barriers to entry, closing the doors to smaller BNPL providers. While the big fintechs won’t be shut out of the market, the industry will definitely have greater barriers to entry. With less competition in the market, there will be more opportunities for banks to succeed,” wrote Yaacov Martin, CEO of Jifiti, a fintech that provides white label BNPL solutions.
Credit impacts
More regulatory scrutiny is also needed in the light of major credit bureaus including BNPL data in credit reports. TransUnion and Experian will start to include BNPL data in credit reports, allowing consumers to generate credit scores without a credit history.
But the way BNPL affects credit scores is still relatively unknown. Credit scores could see damage especially if issuances of BNPL credit are considered single installment loan accounts that are quickly opened and closed, and if consumers aren’t informed over the impact of certain credit behaviors.
A leading risk manager he talked to expressed doubt about underwriting BNPL even with better inclusion of data by credit bureaus. “I don’t know how to evaluate the risk of consumers anymore. The presence of BNPL in a consumer’s portfolio isn’t clear to me, nor do I understand their total debt burden. I’m unsure how credit bureaus’ actions will improve this,” the risk manager said.
The issue becomes particularly worrisome looking at the demographics of BNPL users, which are heavily skewed towards high-risk, low income borrowers. Plus, 57% of BNPL consumers earn less than $50,000 annually, and half of them struggle to pay monthly bills.
In a 2021 Credit Karma survey, around one-third of BNPL consumers had fallen behind on at least one payment – of those, 72% of respondents said that their credit scores declined as a result of missing the payments. Delinquent credit repayment rates are also substantially higher for BNPL than for credit cards: three times higher at 30 days past due and two times higher at 90 days past due.
“The consumer base is now two-thirds subprime, and people are using it to buy sneakers, sweaters and shirts. I have a lot of risk management experience, and that's a sign of danger,” Lux told Tearsheet.
Recommendations for BNPL regulations
In our conversation, Lux expressed his concern about consumers - he stressed the importance of responsible lending and consumer protections, especially for the ones that can’t afford it like millennials or subprime borrowers.
Currently, US BNPL products have no set standards for disclosures, which have helped them grow so quickly – the market is on track to jump 5x in two years to $100 billion in retail purchases in 2021.
For example, while credit card companies have to maintain a robust customer support system to manage disputes, BNPL providers are not obliged to do that.
Moreover, the U.S. Federal Truth in Lending Act is triggered if payment occurs over more than four installments, but Pay-in-4 is among the most popular BNPL products available in the market, leaving consumers unprotected.
The industry would benefit from a framework that focuses on increasing transparency for consumers, investors, and merchants while potentially limiting the scope and scale of subprime lending.
“A pro-consumer and pro-business regulatory framework can retain the added convenience and structure of BNPL offerings while reducing the frequency of late payment fees, decline in credit scores, and defaults,” Lux said in the research paper, where he outlined five sets of interventions that could help resolve major consumer protection issues.
- Mandatory fees and rights disclosure at point-of-sale
While most BNPL products already have some sort of a fee disclosure, there should be a standardized presentation of the real implied cost of finance. This could help reduce overspending, credit defaults, and other types of financial stress.
Such a measure could also help fight against hidden late fees or any type of misleading user experiences, which in the case of BNPL have been associated with a false sense of security.
And last but not least, such a measure could also require BNPL companies to disclose at checkout how their products could affect one’s credit score.
- Credit bureau reporting standards
All three major credit bureaus have announced plans to integrate BNPL data into their credit systems, but this data is currently being given voluntarily by BNPL companies.
If BNPL firms were required to report repayment and defaults to bureaus, this would create a more cohesive feedback loop where in the end, consumers could be informed of best practices to build a good credit score.
- Data privacy standards
As data privacy in general gains more interest from regulatory agencies, there are implications for BNPL as well, as it collects payment history data from each use of the product.
The CFPB voiced its concerns regarding this use of data and the potential implications for the business model to evolve towards data monetization. The Bureau said it wants to better understand practices around data collection, behavioral targeting, data monetization and the risks they may create for consumers.
- Services and/or charge dispute settlement procedures
Currently, disputes for consumers with open end credit accounts are facilitated by the Fair Credit Billing Act (FCBA), developed to solve issues consumers face when incorrectly charged for goods and services.
However, this law does not apply to installment contracts, such as BNPL. If BNPL were to be classified as a loan instead of direct debit, consumers could receive the same protections as with credit cards.
- Stress testing protocols
Like in every other area of finance, stress testing can help companies understand where their major vulnerabilities are, preventing future consumer and economic risks.
Currently, only certain financial institutions are required to implement stress testing, while many also do this voluntarily. But as the BNPL is young and hasn’t been through a credit cycle, mandatory stress testing might be advantageous, Lux argued.
BNPL companies could partner with the FDIC and CFPB to develop stress test scenarios, tailored to each product they offer.