Nonprime lending isn’t as risky as it’s made out to be, and fintech firms can help traditional banks.
This month the Consumer Financial Protection Bureau issued new rules likely to curtail payday and title loans. On the same day, the Office of the Comptroller of the Currency removed its ban on short-term subprime lending by banks. Now some banks are sorting through ways to help meet demand for these loans.
These changes come amid turbulent times for millions of Americans. Average savings have dropped to less than 5% of income today from around 13% in the 1970s, according to the U.S. Bureau of Economic Analysis. A 2016 Federal Reserve report estimates nearly half of Americans would not be able to muster $400 for an emergency. Making matters worse, according to the Brookings Institution, income volatility has risen 30% since 1971. Access to credit has become an essential tool for millions of people dealing with unexpected expenses and income shortfalls.
Banks have also undergone dramatic changes. Automated credit scoring systems have replaced local loan officers, who once made credit decisions based on bank statements, income assessments, community connections and character. These technologies penalize those without pristine credit histories. Regulatory pressures have made the situation worse, forcing banks to curtail lending to the people most in need of it while battling for the relatively small pool of affluent customers.
To regain the trust and business of working-class Americans, bankers and their regulators must encourage innovations that help the underserved. With new leadership coming to the federal banking agencies, we offer five important insights:
• America is a nonprime nation. An astounding two-thirds of Americans have a nonprime credit score (below 700) or no score at all, according to the Corporation for Enterprise Development and FICO. Due to high credit-score requirements, some 160 million Americans find it difficult or impossible to access traditional bank credit. The way for banks to grow and better serve their communities is to figure out how to lend again, safely and profitably, to a much broader range of customers. Banks need a new generation of nonprime credit products.
• Nonprime customer needs differ greatly from prime customers. Traditional bank credit products haven’t really changed much in recent decades. Banks assume a customer is willing to come to a branch, fill out an application, provide paperwork, and then wait for a decision.
Nonprime customers’ need for credit is far more urgent. The top five reasons for selecting a lender are “Solve Financial Need,” “Fast and Easy,” “Money Quick,” “No Hidden Fees” and “Few Documents,” according to the Center for the New Middle Class. “Lowest APR” was listed as a top three reason by less than 1 out of 5 non-prime customers.
It is not enough to provide credit for consumers’ immediate needs. Banks need to be fully committed to improving the financial wellness of their customers through credit building and personal-finance training.
• Traditional underwriting approaches don’t work. Although FICO scores do a good job of identifying the overall riskiness of customers within different bands of credit scores, they are only minimally predictive for underwriting nonprime consumers. Prime lenders look for customers with pristine credit and typically turn down anyone with a limited credit history or derogatory credit information.
Lending to nonprime customers requires new, targeted credit scores built around specific types of consumers, often using alternative data sources and machine learning techniques. Regulators should support technology-based innovation in underwriting.
• Nonprime lending can be less risky than prime lending. The real risk in consumer lending stems from changes in the economic environment. Perhaps surprisingly, this is where nonprime lending is actually less volatile. During the Great Recession, charge-off rates for personal loans to prime credit customers increased by a higher percentage than nonprime loans, according to data from the credit reporting firm TransUnion. Changes in the broader business cycle influence prime customers more than nonprime customers, who are used to dealing with financial pressures.
• Fintech innovators are not the enemy. Most banks outsource the technology used in branch systems and for support of their core products. Fintech innovators should be encouraged to work with banks, not compete against them.
Banks have funding and compliance advantages, and banks already have financial relationships with the majority of Americans. But most banks will have difficulty matching the agility and analytical savvy of the fintech industry. Regulators should be receptive to joint ventures between banks and technology firms.
An outdated regulatory environment, fueled by misperceptions about nonprime lending, has resulted in greater risks for banks and their customers. Loss of market share and profitable sources of income has weakened banks, and consumers are hurt by being driven to more expensive nonbank lenders. The incoming leadership at the federal banking agencies has an opportunity to help banks re-emerge as the lender of choice to tens of millions of working Americans.