Digital Lending Innovation

Fintech and Analytics for

Finance

Professor Rolando Gonzales

1
2
DIGITAL LENDING INNOVATION
By looking at innovations in money lending, we can see how far we've
come, starting with pawnbrokers (lenders) and evolving into internet-
only banks offering immediate loan approval.

The idea of digital lending has been around for many years, but it is
only now that innovations that allow for transformation are taking
place. Digital consumer lending, student loans, small business loans,
and mortgages have all seen unprecedented growth and undergone
radical changes in recent years.

The biggest change has probably been the introduction of peer-to-peer

lending.It appears that this type of lending is more than simply a trend.
The use of advanced analytics to inform credit scoring and eligibility
for lending is another significant innovation.

3
4
DIGITAL LENDING INNOVATION
A Short History of Lending
In 1950, businessman Frank X. McNamara invented the credit card and
was the first person to use a Diners Club Card to pay a restaurant bill.
In 1958, Bank of America followed suit by launching BankAmericard,
which later became Visa.

Lenders in the US started using FICO scores to make informed credit

decisions in 1959. The first reverse mortgage was granted in 1961
when Nelly Young of Portland, Maine, lost her husband. She needed to
keep her house and was helped by Deering Saving and Loan's Nelson
Hayes. In 1970, the US Congress chartered the Federal Home Loan
Mortgage Corporation (Freddie Mac), to create a secondary market for
traditional mortgages.
Online lending specialist grew up between 1980 and 2000. Quicken
Loans, a Detroit-based mortgage lender, launched its online
application and review process in 1985. First Internet Bank started its
online-only banking in 1999, offering banking services and home
mortgage loans.

5
6
DIGITAL LENDING INNOVATION
Peer-to-Peer Lending
Peer-to-peer is an interaction between two parties with no
intermediary. This was a term originally used in computer networking,
but it now has various uses, from peer to-peer file sharing to peer-to-
peer lending.

In finance, peer-to-peer lending started with the launch of Zopa in the

UK and Prosper in the US, which match borrowers and lenders in a
central marketplace.

In 2016, Prosper had at least two million members, and about $6 billion
in loans were taken out. Zopa, on the other hand, was used to make
roughly $ 1.4 billion in loans and had at least 114,000 members.

During recent years, peer-to-peer lending has grown rapidly, and some
believe that it will continue to do so. Peer-to-peer lending is more
profitable than keeping money in savings accounts, tthtough.it is
riskier. Peer -to-peer lending is perceived having better social value
and being more responsible than traditional banking.

7
8
DIGITAL LENDING INNOVATION

P2P Marketplace Lending Business Model

Peer-to-peer platforms take both the depositor and borrower
businesses away from traditional banks. They transfer income and the
associated credit risk to the loan investors at the point of origin and
earn nothing from loans held on their balance sheets. Most of their
revenue comes from fees charged when new loans are taken out, so
they need to be making sales continuously.

As a result, some believe a purely P2P market is unsustainable. Some

companies, like Ratesetter, have changed their model and now charge
fees throughout the life of the loan. This provides a more stable
business model.

Standard marketplace economics indicate that loans are normally

originated at a 5% premium. Assuming a loan length of four years, this
would mean a 1.25 % transaction fee. Platforms would also charge an
annual maintenance fee of around 0.8%, which would make them an
average of around 2% all inclusive. A bank would make a lot more than
this, as they generally have margins of around 7% net interest, after
deducting credit losses.
9
10
DIGITAL LENDING INNOVATION

P2P Marketplace Lending Business Model

So far, peer-to-peer lending has not been very profitable. The top
lenders in the UK, Zopa and Funding Circle, lost $ 50 million in their
first decade. Sales and marketing, and origination and servicing
expenses have taken up roughly 5O % of the operating revenue of
these companies. Referral schemes have been very generous.

There are different approaches to dealing with unpaid loans. Some

lenders spread their investment over many different loans so their
eggs are not in the same basket. In these cases, interest rates are
indicative and depend on the number of unpaid loans. Other firms set
up provision funds, which mean that they put money Aside to cover
potential default on loans.
P2P loans are still looking for an optimal business model to sustain
profitability. A path to stability could be to have P2P lending as just one
line of business and offer other banking services as well. This would
allow them to have loans on a balance sheet and earn a profit from
them. A hybrid model could help them navigate the difficult Iending
times in a better way. They would be required to get a banking license,
and some have already started to go in this direction.
11
12
DIGITAL LENDING INNOVATION

Key Players

LendingClub

Founded in 2005, Lending club raised $10.26 million from Canaan

partners and Norwest Venture Partners. It became a peer-to-peer
lending in 2007. In December 2014, after several rounds of investment,
Lending Club completed its initial public offering (IPO) at $ 900 million.

A borrower can obtain an instant quote without damaging their credit

score. If they agree to the offer, investors can start funding their loan. A
lend.er can create a portfolio of loans for quality borrowers. They can
open an account quickly and receive their repayrnents and interest
monthly, with the option of reinvesting or withdrawing them. A person
looking for medical financing can apply through Lending club,s
network of providers around the country or online. A bank facilitates
the loans so lending activities are subject to fair lending practices,
consumer protection and disclosure requirement.

Lending Club's fluctuations show how quickly successful businesses

in this area can fall from grace.
13
14
DIGITAL LENDING INNOVATION
Key Players

Zopa

Launched in 2005, Zopa is Britain's biggest peer-to-peer website. It

broke even in 2016 and has at least 50,000 lenders with $ 1.6 billion of
loans, at an average rate of 0.8%. Borrowers pay around 5% interest,
depending on the loan term, loan amount, and credit rating. Typical
borrowers include homeowners who want to consolidate their debts,
make home improvements, or buy a new car. Lenders earn an average
return of 5 % on a minimum investment of $10. However, Zopa
recommends that new investors invest $ 500. Lenders can receive
repayments monthly and have the option to reinvest them.

Zopa recently obtained a banking Iicense in the UK in June 2017

allowing a move toward bank launch. It raised $ 44 million in July 2018
to fund the creation of a traditional bank, which will initially have a
focus on saving products.

15
16
DIGITAL LENDING INNOVATION
Key Players

Prosper

Founded in San Francisco, Prosper is a marketplace for lending with at

least $7 billion in loans. It matches borrowers and lenders in a socially
and financially rewarding manner. Borrowers can apply for a loan of
up to $35,000, and lenders pool their funds to lend the money. Popular
investors in the company include Credit Suisse NEXT Fund,
Institutional Venture Partners, Francisco Partners, and Sequoia
Capital.

Prosper uses pre-set rates determined by a system that considers the

borrower's credit risk. Lenders have the option to invest or not at the
rate set by Prosper's algorithm. The company profits by charging a fee
per transaction, which can range from 1% to 5%, with an annual
servicing fee of 1 % charged to investors.

17
18
DIGITAL LENDING INNOVATION
Key Players

Rate % Setter

Established in London in October 2010, RateSetter has at least 33,000

active lenders who have Ient at least $ 2.7 billion. Their default rate,
quoted at 0.7% , is extremely low, and none of their lenders have lost
money. Lenders can earn as much as 4.56 %on a minimum investment
of $ 10.

19
20
DIGITAL LENDING INNOVATION
Consumer Lending
An unsecured loan is one that doesn't have any assets or securities
against it and so is riskier for lenders. However, it is less risky for the
borrower because they have no property that serves as a guarantee if
they fail to repay the loan. Because of this. The lender charges higher
interest rates to offset the risk.

An unsecured loan can be of many types: signature or personal, credit

card, student, or a peer-to-peer loan.

A credit card is another type of unsecured loan provided by credit card

companies. A credit card company may offer a 0% interest rate for a
time to encourage people to apply for its card.
They can use a mobile app anywhere and anytime to gain access to
credit.

21
22
DIGITAL LENDING INNOVATION

Consumer Lending
The system's algorithms will take care of the rest of the complex
process using a collection of past data.
In a study by SAP Value Management Center and Bain & Company,
only about 7% of traditional banks' products are compalible with digital
transactions, making them vulnerable to competition.
Banks need to invest in digital lending if they don't want to lose market
shares. They have to create better customer experiences, remove
avoidable and bad interactions, make the loan application process
easier, and create an agile operating model for a cheaper, better, and
faster lending process.

23
24
DIGITAL LENDING INNOVATION

Key Players
Affirm
PayPal's Max Levchin in 2012 unveiled another start-up, Affirm, an
online company offering credit with more transparency and lower fees.
Affirm is slowly making its way into physical retail stores, offering
loans with low payment installments, very much like traditional credit
cards.
Affirm does not charge late fees and offers low Annual Percentage
Rates (APR). It targets individuals such as millennials and immigrants
without credit cards to use its loan facilities.

Avant Credit
Avant received more than $325 million in equity funding in 2015, with a
valuation of about $2 billion. General Atlantic, Balyasny Asset
Management, JP Morgan, DFJ Growth, August Capital, Tiger Global
Management, and RRE Ventures led this round of investment.
According to Avant's CEO and Founder Al Goldstein, the company
wants to become a leading provider of loans to low- and middle-income
customers.

25
26
DIGITAL LENDING INNOVATION
Key Players

Kreditech
Established in Germany, it built a wide array of banking and credit
products for individuals with little or no credit history. PayPal's Peter
Thiel also invested $44 million with other investors like Amadeus
Capital Partners. Since its inception, the company has raised $492
million in equity.

Currently, Kreditech operates in Russia, the Czech Republic, Poland,

Mexico, and Spain. It ls using its platform to reach out to individuals
who lack credit history. Its algorithm consist of 20,000 various data
points that assess a single loan application. To date, about 850,000
customers have taken out loans with the company. Kreditech is
planning to launch in Brazil next year. Instead of offering loans in the
USA, it is focusing on developing economies. All products will be sold
under one brand, Mondeo. It is reaching a valuation between €300 and
€5OO million.
27
28
DIGITAL LENDING INNOVATION
Key Players

Zest Finance
ZestFinance has built algorithms to provide customers who cannot
acquire credit from banks with loans. It was formally known as
ZestCash.

The technology used by ZestFinance uses non-traditional factors to

determine whether to lend lo consumers who have no access to credit
provided by banks, In a study carried out by credit-scoring company
Credit Karma, it was estimated that Basix could serve at least
42.2million people who have FICO scores between 6OO and 580. In
February 2017, ZestFinance launched the Zest Automated Machine
Learning (ZAML) Platform to enable credit underwriting.

29
30
DIGITAL LENDING INNOVATION
Digital Lending for students
A category that stands on its own inside the consumer lending space
is student loans. Many students need loans to fund their university
studies. Some countries, such as the United Kingdom, have a good
support system for students, as governments can fund loans at
extremely low interest rates. This doesn't mean that student loans in
the UK earn a good return on investment, since student loans are
about $70 billion, or 16 percent of UK's GDP, and many of these loans
are never repaid.

However, rules are different around the world. For example, student
loans are big business in the US, with $1.5 trillion in loans outstanding
as of February 2018. After mortgages, student loans are the next
largest debt market. Taking advantage of this market, many companies
and start-ups have started lending to students online.

31
32
DIGITAL LENDING INNOVATION

Digital Lending for students

Peer-to-peer lending companies offer two types loans to students:
consolidated loans after graduation or traditional loans for qualified
graduate program students.
Peer-to-peer lending companies offer two types loans to students:
consolidated loans after graduation or traditional loans for qualified
graduate program students.

33
34
DIGITAL LENDING INNOVATION

Digital Lending for students - Key Players

Sofi
In 2011, |ames Finnigan, Mike Cagney, Ian Brady, and Dan Macklin
established Social Finance or SoFi. As Stanford Business graduates,
they used it to offer more affordable student loan options to fund a
student's education. With $2 million initial capital, they funded 100
students, with an average loan of $50,000.

Sofi aims to disrupt the financial services sector by providing

borrowers with more personalized financing options, mobile access,
and better service. Although the loan process is digital, it has
hundreds of employees who assist member-borrowers.

An innovative disruptor, SoFi targets high-end customers with specific

degrees from particular schools, offering them refinancing of student
loans. Social Finance or SoFi invites its borrowers to free parties at
cocktail lounges, attempting to build a community, and it thanks its
customers by throwing parties. SoFi has refinanced more than $ 9.76
billion in student loans.
35
36
DIGITAL LENDING INNOVATION

Digital Lending for students - Key Players

CommonBond
Established in 2011 by Jessup Shean, Mike Taormina, and David Klein,
CommonBond aims to solve frustrating problems in the student loan
industry by offering exceptional customer service, simple and tech-
enabled loan experiences, and competitive pricing. CommonBond
focuses on bringing together investors and student borrowers.
CommonBond's average borrower is 33 years old with an annual
income of $ 159,028 and $5,996 in monthly free cash flow.It has
refinaced more than $2 billion in loans.

Earnest
Earnest, a lending Company, has at least 80,000 data points to assess
prospective borrowers with little or no credit history. Based in San
Francisco, it offers personal loans to students and refinancing of
student loans for indebted graduates, with rates of 2.47 %. In October
2017 Earnest was acquired by student loan leader Navient for $155
million in cash, seeking to create and deliver customer-centric credit
products to educate consumers and offer them advanced digital
services.
37
38
DIGITAL LENDING INNOVATION
Digital Lending for SMEs
Since the 2008 recession, well-known banks have been awarding fewer
loans to small and medium-sized enterprises (SMEs), and other firms
have started appearing to fill the void. Three interesting business
models that are worth exploring are innovative short-term working
capital, peer-to-business lending, and invoice financing.

39
40
DIGITAL LENDING INNOVATION
Short-Term Working Capital
For companies looking for short-term loans with quick delivery fintech
is good news. Up until a few years ago, there were no suitable
alternatives to banks. Companies would end up having to request
merchant cash advances, receiving a lump sum in exchange for a
share of their daily credit card sales. Effective interest rates would be
over 100 percentage points, making them very expensive. Companies
such as Kabbage, OnDeck, and PayPal Working Capital have
introduced low-cost alternatives.

These companies require a certain number of months of credit history

a certain amount of credit turnover, and they will also look at the
personal credit score of the owners. The good thing is that there is
almost no paperwork, and everything is done online. PayPal is the
easiest company to qualify for and has good rates. However,
borrowers need to be selling through PayPal. Kabbage is the next
easiest, and OnDeck is the most restrictive of the three. OnDeck
requires personal guarantees, meaning that you are pledging your
personal finances to pay back the loan.

41
42
DIGITAL LENDING INNOVATION
Peer-to-Business Loans
Because of banks' restrictions on lending, some businesses do not
have access to credit. Peer-to-business structures offer an alternative
to this problem by providing an opportunity for investors to earn
money. At the same time, it allows for businesses to acquire much-
needed funding. Businesses get funds quickly and at a lower interest
rate, while lenders receive a higher profit from their investments.
Banks cannot offer rhe same high margin to depositors, because of
their costly structures.

In April 2014, the United Kingdom´s Financial Conduct Authority started

a regulating peer-to-peer lending, including business lending to
protect consumers and supervise and guide relating anti-money
laundering measures, promotions, and other activities.

Peer-to-peet lending firms have base capital requirements that have to

be reported monthly to the FCA.

43
44
DIGITAL LENDING INNOVATION
Peer-to-Business Loans
In an auction P2B lending model, a borrower can initiate a loan by
specifying the amount and the date of repayment desired. Then
lenders try to outbid each other, offering an interest rate they feel will
mitigate their risks. At the end of the auction period, the borrower can
decide whether or not to accept the loan, depending on the average
interest rate.

In the United Kingdom, Octopus Investments entered"the peer-to-peer

lending business in April 2015 with at least $ 5.5 billion in assets. It
offers investors a discretionary portfolio of asset-backed loans from
Octopus Property. Established in 2O09, Octopus Property (formerly
Dragonfly) had about 3,50O borrowers with a loss rate of 0.1 %.
Octopus's loan origination is of the highest quality, and it has a reliable
under writing process. Octopus views the peer-to-peer lending model
as having strategic value because of the innovative investment model.

45
46
DIGITAL LENDING INNOVATION
Invoice Financing
Invoice financing,that is, getting financing for as-yet-unpaid invoices,
can consist of Invoice factoring, invoice trading, or invoice
discounting.
With factoring, an invoice financier will manage the sales ledger to
collect money owed to a company. Factoring allows companies to
grow by generating funds to keep a business afloat while waiting for
customers' payments. Usually, a third party (a factor) pays between
70% to 90% of total accounts, and customers make their payments to
the factor. Then the factor remits the balance to the business less its
service fee.
Before technological disruption, banks were the only ones providing
factoring. However, the introduction of technology allows for a different
product, invoice trading. Instead of managing the entire sales book,
companies can select which invoices are sold to financiers. By placing
these invoices on a platform, individual investors can invest in a
similar fashion to peer-to-peer lending. Players such as Market Invoice
and Platform Black have entered the market, bringing in
crowdsourcing platforms to provide invoice factoring, invoice trading,
and invoice discounting services.
47
48
DIGITAL LENDING INNOVATION
Invoice Financing - Key Players

Kabbage

Founded in 2OO9 by Marc Gorlin, Rob Frohwein, and Kathryn Petralia,

Kabbage offers a technology and data platform for business loans. It
can connect directly to Quick-Books, PayPal, banks, and even social
media to assess the creditworthiness of a prospective borrower.

Kabbage can provide a borrower with a maximum of $100,000, payable

in six months. On average, a borrower might take out eight loans
yearly for a total of $50,000. Kabbage is one of the top alternative
lenders in the US. It attracts investors because ofits low loan default
rate. It offers loans to established businesses using an automated
model that assesses charaiter, capacity to repay, and business
stability and consistency. In 2012, Kabbage became part of Red
Herring's Top 100 North American private enterprises.

49
50
DIGITAL LENDING INNOVATION
Invoice Financing - Key Players
PayPal
PayPal Working Capital is for PayPal users who want a fixed and
affordable business loan. A borrower pays the fees and pays back the
loan through their PayPal sales. However, they do not pay any penalty
fees, pre-payment fees, late fees, monthly bills, or interest charges.
The maximum amount they can borrow depends on the sales history
of their PayPal account. Loan approval only takes minutes, and the
money goes to the PayPal account immediately.

PayPal ensures that the borrower repays at least 10% of their loan,
plus a fixed fee, every three months for the 18 months of the loan term,
or until the borrower has repaid the loan in full. Only one loan can be
taken out at a time. The borrower needs to pay their loan in full before
applying for another loan. In September 2017, PayPal acquired Swift
Financial, a company that provides cash advances and loans to small
U.S. businesses, to expand its credit business and be able to offer
small loans to merchants seeking working capital financing.

51
52
DIGITAL LENDING INNOVATION
Invoice Financing - Key Players

Ant Financial

Ant Financial is the consumer lending arm of Alibaba. In 2018 they

exceeded $95 billion in consumer lending. In just one year, it doubled
the amount of lending. Its inlerest rates can go as high as15 %, though
in general they are below those numbers. Ant Financial's valuation is
calculated in 2018 at $150 billion, after they raised $14 billion in
funding. These funds are destined for global expansion and
developing new technologies.

53
54
DIGITAL LENDING INNOVATION
Digital Mortgages
MortgageTech has not grown at the rate of other products, mostly
because mortgages are a very complicated and heavily regulated
product. However, this area represents one of the biggest
opportunities in fintech, as worldwide mortage debt is estimated at $
15 trillion.

The automation of validation and verification functions reduces

subjectivity and costs, and hastens decision making. The use of
various data points determines the value and quality of collateral
borrowing capacity, and cashflows, and performs analysis to identify
possible misrepresentations and fraud. Some newer models use new
technology that considers employment markets, household cash
flows, infrastructure investment, demographic trends, and personal
preferences.

55
56
DIGITAL LENDING INNOVATION
Digital Mortgages - Key Players

SoFi

SoFi, like the other marketplace lenders, is growing fast, but it will be a
very long time before it becomes a threat to present mortgage giants
like Bank of America, JP Morgan Chase, and Wells Fargo. In a 2nd-
quarter 2015 report by the Mortgage Bankers Association, il showed
that morlgage origination during the period was at $395 billion. And the
biggest lenders were these three banks.

However, according to the report by Inside Mortgage Finance, non-

banks closed 37.5 % of US mortgages in 2014. PwC believes that
marketplace lenders could grow at an annual rate of 33 %, to $ 150
billion by 2O25.This forecast could prove to be true because it is easier
for a prospective homebuyer to apply for an online mortgage from non-
banks.
SoFi entered the mortgage market with about $50 million worth of
mortgage originations monthly that it sells to Federal Home Loan
Mortgage Corporation (aka Freddie Mac) and the Federal National
Mortgage Association (Fannie Mae). Instead of using debt-to-income
ratio to determine how much money to lend, it looks at the free cash
flow of the borrower.
57
58
59
DIGITAL LENDING INNOVATION
The Future in a Flash
Lending is about temporarily giving money with the expectatiorithat it
will be repaid, and the key variables are risk and return. Technology
allows improvement in both areas.

On the risks side, technology allows to calculate risks more precisely.

This is really necessary especially in emerging markets, where people
and businesses typically have no credit history or traditional financial
documentation. By introducing new sources of data, people can be
assessed better and more people can assessed.

On the return side, new opportunities are generated by introduction of

new players: different types of lenders, and different types of
borrowers.

Even though we will never be able to deal fully with uncertainty, what
we are moving toward is a more efficient market in which there are
fewer losses during the lending process and more satisfaction with the
products on the market. Innovations such as better credit scoring
driven by big data, peer-to-peer marketplaces and blockchain will be
enablers of this move towards efficiency. By standardizing the way that
lenders and data providers connect, the process of lending will
become more efficient.
60