As a follow-up to our article, “A Business Case for Dynamic Pricing in Banking,” there is a great deal of discussion regarding the role of dynamic pricing in lending and how it may be applied in the alternative lending market. Lending is steeped in risk and every nuance of a lending product is crafted to mitigate that risk. Is dynamic pricing even possible in the alt-lending market?
With the obvious heavy hitters like Lending Club, Kabbage, Prosper, and OnDeck garnering the lion’s share of attention, there are still approximately 1,300 companies in the US offering services to about 1% of the overall market – one projected to be upwards of USD$350 million by 2025. That leaves the 6,500+ traditional American bank providers fighting for the remaining 99%. Where’s the competition, you ask?
In the banks’ view, that 1% constitutes the “unbankable” or “undesirable” loans. But there is strong evidence that it’s not the retail consumer with bad or no credit history that the alt lenders are going after, but the small/medium enterprise (SME) business customer pool that is the primary, and most profitable, target.
Be it consumer or SME, what makes alt lenders attractive to customers comes down to pricing.
In the consumer market, peer-to-peer lenders like European based Zopa and Funding Circle offer investors (depositors) interest rates typically between 5-6%, attractive to those offered 2-3% traditional bank returns. Granted, borrowers face much higher interest rates (6-33%) than traditional unsecured loan rates from traditional banks (average cap of 16%).
The market sets the price (as do the Central Banks). And no lender is in this for charity – they want a marginal return that covers operational costs, liquidity coverage requirements, and profit. How individual lenders, alt or not, manage their appetite for risk determines a portion of those margins. So, does risk lend itself to dynamic pricing?
Can We Dynamically Price a Single Product?
How elastic is single product price? We’ve asked this question in our previous post, and concluded that relationship pricing is difficult in singularity, but a competitive differentiator and a smart strategy when offerings are bundled. Questioning how the lending market may adapt to adopt dynamic pricing leads us to believe that alt-lenders will slowly start behaving more and more like traditional banks to take advantage of a pseudo-dynamic pricing strategy.
Before we rationalize this assumption, let’s look at two pricing strategies that we predict will play a role in the lending market.
Abandoning Strict Cohort Analysis Pricing: This method of pricing to market segmentation usually means lumping potential customers into a single risk assessment category based on FICO or credit scores. This is the primary factor that determines the price of unsecured risk. Including other factors like age, education, employment and salary history, geography, and potential lifetime earnings, as well as potential repeat lending business to assess risk is a nod to relationship pricing (and lifetime customer value to the lender) that paints a unique profile for each potential customer. With big data and behavioral analytics, the straight jacket of strict cohort pricing loosens up, and pricing inches closer to reflecting the lender/lendee relationship value.
Alt-Lending/Bank Partnerships: While not a pricing option per se, a partnership is a risk mitigation strategy and customer service tactic by banks. It is also a way for banks to bolster their offerings, but the end result is more pricing flexibility. A recent partnership announcement between Regions Bank and alt lender Fundation underscore the advantage to banks:
“This unique agreement….allows Regions Bank to expand loan-product offerings and method of delivery for small businesses while also cultivating long-term revenue and loan-growth opportunities.”
RBS and Funding Circle have a similar program, something that Santander and Funding Circle did first, back in 2014.
A referral requirement in the UK has pushed banks and alt lenders into partnership, but the US market could see a similar push towards alliances.
Relationship pricing in this partnership context is possible when the customer’s portfolio from both the bank and the alt lender is taken into consideration when the risk pricing/rate is offered. This is especially true if a current bank customer is referred to an alt lender – because the bank doesn’t have appetite for that risk that customer poses – but has some assets at the bank the alt lender could consider collateral. We don’t see it now, but we could.
If It Walks Like a Duck, and Talks Like a Duck …
Let’s return to our assumption that alt-lenders will start to resemble traditional banks by offering non-lending products. While they may not accept deposits in the same way as a traditional banks, there is still a strong resemblance.
SoFi, primarily known for its student loan refinancing, accepts cash “providers” and pays them a higher yield rate (up to 6.5% as opposed to the typical 0.03% banks pay out) for managing those loans to borrowers. It can be argued that “providers” are in fact depositors, just depositors who aren’t insured by the FDIC or subject to regulations imposed by the Federal Reserve or Office of the Comptroller of the Currency. They can call it one thing, but the subtext is “super risky deposit”.
Zopa calls their product “savings”, but it’s the same principle. Deposit money that is in turn loaned out, and get paid a higher rate on those “savings”. It’s essentially a higher risk deposit not backed by the UK government’s Financial Services Compensation Scheme.
Payments is a natural next step … isn’t a credit/debit type product issued by alt lenders just on the horizon? Alt lenders could easily provide a card or app that draws on those ‘savings’ or taps into the line of credit. This is because loans are not inherently sticky products, and “underbanked” and “undesirable” lending customers even less so. Because of the high risk, they’re not attractive to banks, so there’s no incentive to encourage loyalty, let alone cultivate customer lifetime value.
But when an alt lender can provide savings and payments, as well as credit, the stickiness factor increases, and individual customer profitability margins can increase. Relationship pricing for even a small bundle of products is now viable. Nuanced pricing of loan rates could easily be tied to volume of payment product transactions, add in periodic reviews of the volume of payments and make the interest rate adjustable, dependent upon payment volume. The more the customer uses the payment product to dip into “savings”, the better the loan or savings rate.
While this isn’t relationship pricing in strictest sense of the word, it can be dynamic.
Of course once multiple product offerings become the de facto norm (or there’s even a whiff of it becoming a trend), regulatory scrutiny follows. What a new regulatory framework looks like is anyone’s guess, and we’re not exactly clairvoyant. But we do like to read the tea leaves.
Alt-Lenders Expanding Their Reach
Risk priced products are nearly impossible to price dynamically or in context of the customer relationship when offered as a stand-alone product. The current alt-lending market can’t adopt this pricing strategy. However, it can inch closer to dynamic pricing by approaching cohort analysis differently. And new bank/alt-lender partnerships crack open the door to more nuanced risk pricing.
Our prediction is that alt lenders will start to offer new, non-lending products. If so, then the door to dynamic pricing swings ever wider and we will see bundled offerings that can be relationship priced.