Why Does Disruption in Financial Services Come from Below?
I recently did a guest post on PandoDaily about how big data and machine learning is creating disruptive financial services companies. Although there are some notable exception, it is interesting to note that most of these companies are playing in the bottom end of the market.
This is not true just for lending businesses like Zestcash*, Wonga, Progreso Financiero and Lendingstream, who are all targeting subprime customers. In payments, Paypal initially targeted Ebay sellers when traditional credit card processors were focused on much bigger merchants. Today, Square targets individual proprietors, most of whom considered themselves too small to take credit cards before Square. In international money transfer, Xoom targets immigrants remitting home to their families, not big dollar corporate transfers. Prepaid debit cards like Netspend, Greendot and AccountNow all target the underbanked.
The bottom end of all these markets are underserved. At current market price points, demand outstrips supply. If you can lower the price point, you can unlock additional demand, and you can offer lower prices that allow you to take share from incumbents. In stable situations, competition is driven by brand, or by economies of scale, and in both cases this advantages incumbents. But if startups can innovate to meaningfully reduce costs, they have an opportunity to disrupt from below and grow fast.
In most cases, the incumbents built their systems aimed to serve the core of the market i.e., prime customers. These systems often struggle to scale down to the low end. This creates a pricing umbrella which is more forgiving to a startup targeting the low end. Contrast this to the prime segment of the market, where there is little room for error because the market is already very efficient.
So how can a lending startup lower costs? The two biggest drivers of costs are (1) Loan loss and (2) Customer Acquisition cost.
In the prime part of the market, FICO is actually a pretty good predictor of credit quality. As a result, loan losses are predictable and relatively low, competition is fierce, and there is little room for an innovator to upend the market. There isn't enough margin for improvement to allow a startup, with all of its inefficiencies and missteps, to survive.
But in subprime and below, when loss rates get high and interest rates even higher, there is an opportunity for a startup to innovate. A company like Zestcash* that has built a proprietary underwriting algorithm that produces meaningfully lower loss rates than the market norms can create a real cost advantage over incumbents. This is why big data + machine learning can create such disruption, by lowering the key driver of cost in subprime, the loan loss rate. It is precisely because loan loss rates are high, that so much improvement is possible. If they were low, there would, by definition, be less room for improvement.
Incumbents have stronger brands than startups. Startups are also typically sub scale in their marketing spend, a further disadvantage for customer acquisition.
But one thing that startups can do to win share is to lower rates. In a lending business, a lower rate is always compelling to a customer. Winning in underwriting, and being able to pass some of the reduced loan loss in the form of lower rates is one way that a startup can compete.
The other way that a startup can win in customer acquisiton is to think entirely orthogonally about a market. Wonga has done this in the UK. Payday lending has traditionally been a business conducted in the shadows, in storefronts in lower income neighborhoods, without much glitz. Wonga upended that by pursuing an all out branding campaign. They buy TV ads, buy billboards in the London Underground and in other outdoor locations, they even sponsor a premier league soccer team.
This elevated their brand and makes them top of mind for many borrowers. It even expands the market to attract many who would never have considered a payday loan before, as they would never have stepped into a payday storefront in a bad part of town. But from the privacy of their own homes, with the warm brand associations created through top notch ad campaigns, a customer might consider taking out a payday loan for the first time. And if they have a good experience, then perhaps a second, and a third, and pretty soon they are loyal customers.
Better underwriting is a double whammy because it allows a startup to compete on either lower loan loss rates, or on lower acquisition costs (by advertising lower rates). I am highly interested in meeting companies who are taking new approaches to improving underwriting in various lending markets.
* Zestcash is a Lightspeed portfolio company. Image courtesy of ShutterStock.