How Lending Will Change After COVID

As far as financial crises go, I thought I had seen it all when I sat on a mortgage trading desk through the US housing crisis/ Great Recession of 2008 and then the European sovereign debt crisis of 2012-2014. Alas, life had other plans. The impact of the COVID induced recession is far deeper, more widespread, and likely more impactful than these earlier episodes in the way the lending business will operate in future. 

I’ve been thinking about the various ways that consumer lending will change in India will change as a result of COVID. Putting these thoughts on paper is something I’ve found helpful in synthesising the various streams running through my mind; it forces me to crystallise the ideas into something tangible.

With these ideas then, I was going to make a listicle: “10 ways lending will change after COVID”. I found however that the numbers were pretty meaningless, there was no real ranking that made sense. I thought instead that it’s more useful to break down the idea of lending into its constituent parts to give a more intuitive assessment of COVID’s impact:

PROCESS 

COVID will accelerate the secular trend towards digitisation of financial services. The lockdown has exposed glaring vulnerabilities in banks’ processes. Many saw their operations grind to a halt during the lockdown due to the inability to complete processes without physical interaction, or for staff to work from home since they couldn’t log in to the company systems. With losses mounting and pressure to figure out a way to make money again, they’ll need to transform how they do business.

Onboarding

Banks often still rely on arcane processes which require a customer to visit a branch, wet sign documents, and move physical documents between departments internally to complete a loan process. Customers today will be far more cautious towards visiting bank branches, they will want to complete a loan application from the comfort and safety of their own home. To stay competitive therefore, it’s essential that banks migrate to a more digital process not only to serve the needs of customers, but to mitigate the risks of disruptions to operations resulting from further lockdowns.

We may also see RBI relax eKYC norms to include NBFCs to facilitate credit supply into the economy (see point on credit supply).

Underwriting

Traditional lenders for the most part rely on a relatively narrow set of metrics when making credit assessments: credit score, debt/income ratio, and employer rating. These will continue to have merit, but we could see some other considerations receive greater prominence:

• Cash flow analysis.  Credit scores are a backward looking view of how borrowers have met their obligations in the past. In the face of an economic shock like COVID, they’ve proved impotent it determining the credit worthiness of an applicant. Lenders would want to understand the cashflow and therefore solvency of a borrower today. In this respect, cash is king.
• Income level. The crisis has shown an inverse relation between income level and credit distress. Those with more savings capacity/ ability to withstand shocks will have been better able to absorb the impact of the downturn. Expect minimum income thresholds to increase. Interest rates therefore may also become more sensitive to income level.
• Self-employed sector may suffer in the near term as lenders opt for borrowers with a more stable income profile.

Collections

With restrictions around mobility, and borrowers less willing to have strangers come to their homes, we should see less reliance on collections agents. Instead a more centralised, data driven approach is best suited for maximum collections efficiency.

SUPPLY OF CREDIT

In aggregate there will likely be a contraction in the supply of credit to the economy. The economic shock from the countrywide lockdown and associated moratorium has impacted lenders across the board. They’ll first focus on repairing their balance sheets and be more cautious towards new lending in the near term.

• Less supply from banks: they’ll prioritise dealing with their existing books & be cautious on risk. New origination will be mostly to existing clients where they have better visibility of past performance/ trust has been established.
• NBFCs have been hurt by crisis. They will get smaller debt lines from banks, which again means less supply to the real economy.
• NFBC liquidity impaired due to moratorium (had negative carry with banks). They will first focus on rebuilding reserves before resuming new lending.

DEMAND FOR CREDIT

• Discretionary demand will decrease as consumers reduce their leverage with the weaker economic environment. Consumers will focus on paying down their existing debts and reduce the rate at which they purchase “nice to have” consumer goods.
• Needs based credit demand will remain robust since these use-cases are less cyclical. People will still need to pay for medical expenses, school fees, and weddings. As much as I think people spend too much on weddings, I’m not counting on a change in behaviour.

MARKET LANDSCAPE

The market will be less competitive in the next 12-18 months:

• Banks will be inward looking (see above)
• A number of fintechs will go out of business. Some will run out of money. Others will not be able to stomach the losses and the messiness of collecting.
• Fewer Chinese players due to new restrictions on Chinese capital coming into India. They had been particularly active in the payday loan space.
• Fewer part-time players. Companies who think they can monetise their user base by tagging on “lending as a feature” will also have second thoughts. While lending is a way to make money, it’s also a way to lose a LOT of money. Maybe picking up pennies in front of the steamroller isn’t such an attractive proposition after all.

Outside the prime personal loan market, interest rates will be higher:

• Reduced competition.
• NBFCs facing higher funding costs will pass this on to the borrower
• Lenders increasing margin to rebuild their capital base.

Lenders who are still in the market will have a greater ability to attract higher quality borrowers and still make good margins.

?CONCLUSION 

It goes without saying that we’re in the midst of a very tough environment for lenders. However, those lenders that can navigate through this crisis, and make it to the other side will see a tremendous opportunity ahead of them. 

India remains a large economy with pent up demand for credit to fuel its growth. This lack of credit supply, particularly to the masses, will only become more acute as a result of the COVID crisis.

The ability of lenders to take advantage of this opportunity will be a function of the health of their balance sheet, their ability to evaluate credit and collect in this new environment, and the (tech) scalability of their operations. A very compelling opportunity awaits those that can execute across these parameters.