By Ana Badour, D.J. Lynde and Meghan Hillstrom
On 22 May 2017, the Financial Stability Board (FSB) and the Committee on the Global Financial System (CGFS) released a report entitled “FinTech credit: Market Structure, Business Models and Financial Stability Implications” (the “Report”). The Report aims to provide an accurate picture of the extent and nature of Fintech credit activity by analysing the functioning of Fintech credit markets, including the size, growth, and nature of such activities, and the benefits and risks of Fintech credit platforms.
The Report defines Fintech credit broadly as “all credit activity facilitated by electronic platforms whereby borrowers are matched directly with lenders”. Common terminology includes P2P lenders and marketplace lenders.
The Report reviewed the Fintech credit industries in a number of jurisdictions including China, the US and the UK (the three largest markets) and Canada. The nature of Fintech credit activity varies significantly across jurisdictions. On the whole, although Fintech credit markets have expanded at a fast pace over recent years, they still remain small in size relative to credit extended by traditional intermediaries.
Fintech Credit Platform Models
The Report outlines the following types of models for Fintech credit platforms:
- Traditional P2P lending model – The Fintech credit platform acts as the agent matching borrowers with investors, by providing investors with a credit risk assessment of the applicable borrower to allow investors to select which prospective loans to fund.
- Notary model – The Fintech credit platform acts as the agent between investors and borrowers, with the partner bank originating all loans and then transferring the loans to the Fintech credit platform. The Fintech credit platform then sells interests in the loans to investors by issuing a note as a security.
- Guaranteed return model – The Fintech credit platform guarantees the investors’ principal and/or interest on the loans.
- Balance sheet model – The Fintech credit platform originates and retains the loans on its own balance sheet, similar to traditional business models of a non-bank lender.
- Invoice trading (or factoring) model – The Fintech credit platform provides recourse invoice financing (or factoring) services to businesses by providing more flexible services than traditional factors.
The Report includes certain findings specific to Canada. In particular, the Report states that the size of the Fintech credit platform market in Canada went from US$8 million in 2013 to US$71 million in 2015. There were 23 Fintech credit platforms in Canada in 2015, with the top five such platforms having a 60% market share. In contrast, the US is listed as having 67 platforms and China 356 platforms, in each case, in 2015.
Institutional funding was found to be the primary source of funding for Fintech platforms in Canada. According to the Report, the balance sheet model is more popular in Canada than in other jurisdictions, with approximately 60% of platforms using this model, in contrast to the US, where less than 20% of platforms use this model. The Report indicates that balance sheet lenders rely on traditional corporate finance sources of capital such as debt, equity and securitizations to fund originations of loans. P2P platforms were less popular – the Report cited a survey of individual bank customers which found them to be far less likely to either borrow or lend using P2P platforms in Canada, compared to other jurisdictions.
The Report also found a higher volume of consumer lending vs. business lending in 2015 by Fintech credit platforms in Canada. However, most balance sheet lending in Canada was business lending rather than consumer lending. The Report did not identify any invoice trading lending or real estate lending by way of Fintech credit platform in Canada in 2015.
The Report outlines the following as some key risks relating to Fintech credit platforms:
- Leverage and Liquidity Risks – Most lending platforms are not leveraged like banks, but rather operate as agents that match borrowers and investors. As such, there may be some question as to availability of capital resources.
- Operational Risk – Fintech platforms may be more vulnerable than banks to some operational risks, such as cyber-risks, due to their reliance on the new, evolving digital age. The extent of such risks is likely to depend on the degree of sophistication of platforms, mechanisms used for the storage of client information and the robustness of the platform’s cyber-security programs.
- Quality of Credit Risk Assessment – A crucial element of success of the Fintech lending business model, as with any lending business, is their ability to accurately price credit risk and deliver acceptable risk-adjusted returns.
- Business Model Incentives – The quality of credit risk assessment on Fintech loans might be adversely affected by misaligned incentives by Fintech credit platforms acting as the agent between investors and borrowers.
- Reliance on Investor Confidence for new Business – Fintech credit platforms are continuously required to attract borrowers and investors in order to generate fee-based lending revenue. As a result, maintaining investor interest and confidence is crucial to platform business viability.
- Low Barriers to Entry – Barriers to entry are not high, as the industry is generally less regulated than other financial services, product distribution is online and data sources used are widely accessible. Banks, which have access to significantly more resources, could launch their own credit platforms.
- Platform Profitability Risks – Fintech credit platforms must be able to consistently deliver sufficient returns to their shareholders. As some of the largest platforms have continued to report losses in recent years, this raises the issue of whether Fintech credit platforms will be able to consistently underwrite and competitively price loans at current volumes which may induce platforms to modify their business model.
Financial Stability Implications
The Report identifies both how Fintech credit can be beneficial to financial stability, and its risks. It can be beneficial in that it can provide better returns for investors and more diverse and less expensive sources of credit to borrowers, and it can create potentially higher resiliency of credit provision in the case of liquidity shocks, given the longer term maturity of funding sources used by Fintech credit compared to banks (which generally fund their loans by way of on demand deposits).
Fintech credit however also creates additional risks to financial stability, as it may result in procyclical credit provision (i.e. less lending in times of stress and more lending coupled with a reduction in lending standards in times of growth). In addition, Fintech credit platforms often fall outside the current prudential regulatory perimeter (resulting in regulators not having access to pertinent information on lending standards) and do not have access to public emergency funding in the case of liquidity or other stresses.
The securitization of Fintech credit obligations provides the potential to make funding available to borrowers from different classes of institutional investors and allows Fintech investments to be actively traded. However, depending on its nature, the increased use of securitization as a funding source may lead to some financial stability risks distinct from other Fintech platform funding avenues.
The Report identifies three potential risks associated with the increased use of securitization as a funding source:
- Interconnectedness – The securitization process increases interconnectedness between Fintech platforms, banks and capital markets. A continued expansion of the Fintech market could result in new transmissions channels where risks generated in the Fintech credit industry are spread to the wider financial system because of the interconnected nature of securitization and vice versa.
- Misaligned Incentives – Without “skin in the game” retention requirements for securitizations of Fintech credit obligations, the Report indicates that the potential for misaligned incentives between originators and investors may be increased than if such Fintech credit obligations are not securitized. There may be additional incentives for originators to originate high-risk debt obligations when a Fintech credit platform charges higher fees to higher-risk borrowers or to investors upon loan collection.
- Lack of transparency – The bundling and tranching of Fintech credit obligations may create increased issues with transparency in the overall market for both investors and regulators.
The Report also addresses the regulation of Fintech credit in the jurisdictions surveyed, including whether it is regulated within existing frameworks or subject to dedicated regulation. Given the novelty of Fintech credit, such regulation is very much in flux and a number of countries were identified as undergoing consultation processes to determine whether additional regulation should be implemented. Certain jurisdictions have in place specific risk management requirements that would apply to Fintech credit, including in respect of systems and controls, disclosure requirements, lending restrictions (such as concentration rules and conflict of interest rules), dispute resolution and capital and liquidity requirements. In addition, certain jurisdictions (China, France, UK and Japan) are identified in the Report as having tax incentives in place for investors in Fintech platforms.
In Canada, online loans may be classified as securities and therefore subject to applicable Canadian securities laws, depending on how they are structured. In June 2015, the Ontario Securities Commission (OSC) published a notice on peer-to-peer lending, inviting those operating in this sector to discuss their operations with OSC Staff and reminding Fintech credit platforms that if offering securities to the public in Ontario, that certain prospectus and registration requirements may be applicable to them, depending on their business model.
Although Fintech credit markets have expanded at a fast pace over recent years, the long-term growth and evolution of Fintech credit activity will depend to some extent on such lenders being able to attract and retain borrowers and investors. As discussed above, the growth of Fintech credit presents both opportunities and challenges to financial stability and regulators going forward. Fintech credit platforms and investors will want to continue to monitor both international and Canadian developments in this evolving area.
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