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Lending Briefing: BNPL regulation and the growing digital lending market

  • The BNPL market needs more regulatory oversight in order for consumers to be protected, new research suggests.
  • The fast-growing BNPL industry exists in a legal gray space and mostly consists of subprime borrowing, and pure players are yet to demonstrate profitability.

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Lending Briefing: BNPL regulation and the growing digital lending market

Grow now, regulate later? Why BNPL needs more regulation

The Buy Now, Pay Later space is growing aggressively, on track to jump 5x in two years to $100 billion in retail purchases in 2021. But to ensure sustainable growth in the BNPL sector and protect consumers, regulation is urgently needed, a new research paper led by Marshall Lux at Harvard Kennedy School suggests. 

Lux is a thought leader in financial services, with over three decades of experience as a consultant and practitioner. He also served as JPMorgan Chase’s Chief Risk Officer of consumer products during the global financial crisis. 

In his research and our conversation, Lux expressed concern about how consumers could be affected by the mostly unregulated BNPL market. 

“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," he wrote.

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. 

BNPL exists in a legal gray space, making it difficult for regulators to intervene appropriately. It’s interesting that consumer protections, such as the U.S. Federal Truth in Lending Act, are triggered if payment occurs over more than four installments - exactly the cap on the most popular BNPL products in the market. 

And considering that 43% of BNPL applicants are subprime borrowers and younger than the general credit-active population, there is ample capacity for many consumers to get hurt at the end of the day. The product is so easy to use that it could drive some of the same negative consumer consequences of high interest products, said Lux.

He mentioned a conversation he had with a leading risk manager who 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 appeal of BNPL is hard to beat, though. 

“During the pandemic when gyms were largely unusable, the 8% of Peloton bike users who earned less than $50,000 annually could access bikes priced from $1,495 upward by using monthly Affirm payments that were more affordable than most monthly gym fees,” Lux wrote.

No one could argue that BNPL widened the general access to credit and gave people an opportunity to purchase goods that they might not otherwise afford - this is why consumers love it. But to what extent does this constitute healthy new access to credit? TBD.

In this whole equation, it’s important to remember BNPL is not a consumer product, it’s a merchant product. BNPL revenues mostly consist of merchant fees, and most BNPL companies are still unprofitable.The business model in and of itself hasn’t been proven to work yet. 

And at the low transaction value end of the BNPL market, Lux pointed out that the unit economics have a harder time demonstrating the potential for profitability as standalone products – BNPL companies struggle to charge fees high enough to cover the cost of services and customer acquisition costs. 

And low transaction values seem to dominate. The January 2022 sales data of a leading BNPL player shows 66% of purchases were in clothes, and 10% in beauty products, and the average order value was just $118, according to YippitData. 

“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 said.

So once the pedal-to-the-metal BNPL growth phase is over and investors demand profits, who’s going to bear the brunt?

“Even the leaders in BNPL will need to do some thinking about business models. Profitability may be hard because of prices being squeezed, and I suspect we will see attempts to change,” Lux told Tearsheet.

In the research paper, Lux outlined a few regulatory measures that could help BNPL products continue to create value for merchants, consumers, and the financial system while protecting those most vulnerable consumers. These include mandatory fees and rights disclosure at point-of-sale to help consumers understand the real cost of BNPL financing, credit bureau reporting standards, data privacy standards, and stress testing.

“I'm concerned about consumers. I'm not concerned about whether these companies make money or not. I think it's really important that we have responsible lending that doesn't hurt consumers, especially the ones that can't afford it like millennials or subprime borrowers,” Lux told Tearsheet.

Read the full paper here.

Chart of the week

The US digital lending market is poised for growth, with solutions in business process management, loan origination and management as the largest segments, according to new research.

Artificial Intelligence, machine learning, and advanced analytics, coupled with strategic deployment of the latest fraud mitigation techniques, such as biometric authentication and e-signatures, are expected to play a decisive role in driving the growth of the market, the report said. 

Digital lending platform providers are also looking to embed these technologies to enhance their offerings, helping financial institutions improve customer experience and cater to evolving consumer expectations.

What we’re reading 

  • The impact of fintech lending on credit access for U.S. small businesses (Fed)
  • Experian to debut Buy Now, Pay Later Bureau (Finextra)
  • A top Bored Ape holder embarks on NFT loan challenge (deCashed)
  • New bill would give CFPB regulatory authority over small business lenders (deBanked)

What we’re writing

  • The evolution of lending towards a digital ecosystem, in 4 charts
  • ‘Peloton and pizza balance out in my mind’: A day in the life of Lindsay Davis, head of markets at Atomic
  • Banking Briefing: A look into new challenger bank Zolve and a few thoughts on niche banking apps
  • Marketing Briefing: A bank rebrands into a fintech

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