Lending has a cold-start problem.

Happy new year to all, and I hope everyone had a great break. I am looking forward to 2025, which is shaping up to be one heck of a ride, so buckle up!

The past few weeks have been incredible—a perfect time to unwind and reflect. As I sifted through a myriad of thoughts, both personal and professional, I found myself repeatedly drawn to one recurring question: why is it so challenging to build a lending business from the ground up? This reflection stems from my own journey over the past few years, spent scaling, starting, and launching new lending ventures. There’s an old saying: “In banking, credit is where the money is.” And it’s true. Margins in lending can soar as high as 10%, depending on the product and segment. For many in financial services, these margins make lending an irresistible opportunity. It’s no surprise, then, that everyone—and their grandmother—wants a piece of the action. But then comes the ominous follow-up: “Lending is easy; getting your money back is the hard part.”

So let's dive in-

You assemble a capable team, do your homework, and identify what you believe is your unique edge. You launch your shiny new lending product with great fanfare. The early days feel magical. Customers sign up in droves, key metrics exceed expectations, and there’s a sense of momentum. The office buzzes with optimism as you toast your success over catered lunches, team celebratory dinners, and bottles of Dom Perignon. But three to six months in, reality sets in. As you start looking at the metrics (assuming you have a culture of monitoring data ??), you are concerned—very concerned! Delinquency metrics start to look alarming. Your potential losses are 2-4x higher than initial projections. First-payment defaults are skyrocketing. Customers who don't make even a single payment—a sign of poor underwriting or fraud or both—pile up. Payment returns soar. Bounced payments clog your systems and signal deeper issues in portfolio quality. Some even 'double-dip'—make a bad payment, use the opened-up line again to max out, then charge off for twice (or more) the original line....Welcome to the world of starting a lending business. And if you don’t act swiftly and decisively, the consequences are dire:

• Operational costs skyrocket as you scramble to handle customer complaints.
• Customer experience suffers: Negative reviews and bad press erode trust in your brand as you take drastic steps to tighten the credit box.
• Good customers leave, while fraudsters and risky borrowers double down. Your customer mix looks awful.
• CECL accounting rules (which require you to reserve for lifetime losses upfront) turn your financials into a bloodbath: Investors and executives question your competence. The lending business, once the crown jewel of your strategy, risks becoming an embarrassing cautionary tale.

As the saying goes: “In lending, you go bankrupt first slowly, and then suddenly.”

Why Does This Happen?

Lending, unlike many other businesses, is profoundly counterintuitive. Growth early on, typically a sign of success in most if not all businesses, often spells disaster in this industry. Here’s why:

1. Adverse Selection -

When you’re new, trust is a luxury you don’t have—heck, most of the time, you don’t even have a recognizable brand. The best borrowers, those with solid credit histories, naturally gravitate toward established lenders. What’s left? A higher proportion of higher-risk borrowers, eager to knock on your door. And because your underwriting isn’t fully dialed in yet—or maybe you’re just hungry for growth (and let’s be honest, probably both)—you end up saying yes to them! Your fist mistake.

2. Fraud Magnets -

Fraudsters love targeting new players. They know your defenses are untested and will exploit every weakness with ruthless precision. Take, for example, a digital lender I know of that launched with minimal fraud controls—not out of negligence but in a rush to get their product to market and iterate quickly. Unfortunately, investing in robust fraud defenses often takes a backseat to meeting aggressive growth targets. Within weeks, waves of fake applications flooded their system, complete with synthetic IDs, resulting in millions of dollars in losses before the team could even mount a response. And fraudsters aren’t working in isolation—they share tactics in underground forums and sophisticated networks. Today’s fraudster is more likely a tech-savvy PhD wielding cutting-edge ML and AI techniques to stay ahead of your defenses. By the time you spot the problem, the damage is often done, leaving your business scrambling to recover.

3. Predictive Complexity -

Lending is about predicting behavior, and the challenge lies in the multitude of variables:

• Repayment Behavior: Will customers repay on time? Early repayment, partial payment, or no payment at all are possibilities.
• Economic Sensitivity: How will macroeconomic factors like unemployment rates or inflation impact default rates? Seasonality: Do repayment patterns shift during holidays, tax seasons, or other cyclical events?
• Customer Retention: What proportion of your customers will return for another loan, and how can you identify and incentivize these high-value borrowers?
• Fraud Evolution: Fraud patterns are dynamic. Can your models predict and adapt to new fraud tactics as they emerge?
• Collections: How likely will you be able to get your money back once someone does default. Building robust predictive models requires high-quality, relevant data.

This is where new lenders often face their greatest obstacle: a lack of historical data. Established lenders have years of customer payment histories, credit scores, transaction and behavioral insights to inform their algorithms. In contrast, new ventures start with a blank slate, relying on third-party data sources that may be incomplete or not fully aligned with their target audience - in short a biased data sample. Additionally, data quality issues—such as inaccurate credit profiles or outdated financial information—can further compromise model performance. Early models often involve more guesswork than precision, leading to higher rates of misclassification and defaults.

4. Hyper-Growth Pitfalls -

A significant challenge faced by startups in the credit industry, particularly those in the early stages, is the intense pressure to scale rapidly. Most of these startups are backed by venture capital (VC) or private equity (PE) funding, which typically prioritize growth at any cost in the race to capture market share and prove scalability. Moreover, the focus on growth can overshadow the importance of building a sustainable credit infrastructure, including robust fraud prevention mechanisms, compliance with regulatory standards, and maintaining a responsible lending philosophy. The pressure to rapidly increase the loan book or achieve sky-high growth metrics can encourage risky lending practices, which, while fueling short-term expansion - often known in the industry as 'speed-boating', can ultimately undermine the trust and long-term profitability of the business.

In lending, scaling amplifies your problems eventually. For every risky borrower you onboard, you reserve funds for potential losses. Overextend, and you risk depleting capital before you’ve figured out your processes. History is littered with failures—companies that scaled lending too quickly only to be blindsided by losses. Ask yourself: How many lenders successfully launched and scaled after the 2008 financial crisis? Not many.

So what should we do about it?

With years of experience building and scaling various lending businesses—and the scar tissues to prove it—I’ve had a front-row seat to the unique challenges of starting a lending business from scratch. And no, I don't have a magic formula. If I did, I’d probably be the highest-paid consultant in financial services right now! What I do have is a framework and a set of guiding principles to help navigate the complexities. It all starts with a simple yet profound question: Why do you think you’ll succeed where others haven’t? In other words, what’s your differentiation?

When you dig deeper into this question, it becomes clear that starting and scaling a successful lending business requires distinct advantages over the competition. Do you have access to new and proprietary data? A unique distribution channel? An innovative product offering? Have you achieved significant cost efficiencies in your operations.... and so on. These factors, while sometimes obvious—or even cliché—are critical. Lending is a business that doesn’t just reward creativity but demands patience and discipline. Without these, even the best ideas can falter.

So, where do you begin? Here’s a roadmap to navigate the cold start problem and build a lending business with staying power.

1. Build the Right Foundation

• Data: Your underwriting and fraud systems are only as good as your data. Early-stage lenders often struggle with incomplete or inaccurate data, leading to bad decisions. Invest in partnerships or proprietary sources that give you an edge. Example: A fintech partnered with payroll providers to access employment data, enabling more accurate income verification.
• Underwriting: Develop nimble models. Rapid testing and adjustment are critical. For instance, a lender targeting small businesses used cash-flow data to refine credit decisions in real-time, reducing losses by 15% within months. The best part - these models would be updated and put in production every 2-3 months. While that may seem like an eternity in some industries, updating, let alone operationalizing new models every 2-3 months is nothing short of revolutionary in our industry.
• Marketing and Distribution: Lower CAC through innovative strategies. Partnerships with trusted brands or referral programs can bring in better borrowers. Welcome embedded finance! Example: A startup offering small loans to veterans partnered with veteran organizations, creating a steady flow of high-quality applicants.
• Product: Find your sweet spot. Lending is definitely not a one-size-fits-all affair. Think about offering unique benefits or a unique experience and it doesn’t always have to be groundbreaking. Take this for example: installment loans for consumer products have been around since the dawn of time – but if you add a snazzy digital experience, squeeze it into the ever-expanding e-commerce checkout flow, throw in some fresh, cool data sources for underwriting, and voila... you've got yourself a brand-new product called BNPL!
• Technology: Build systems that can scale as fast as your growth ambitions. In the world of lending, speed is everything, because faster you learn about your mistakes (and mistakes you will make!) and quicker you fix them, the better off you are – so make sure your technology enables rapid experimentation without breaking a sweat. Automate the repetitive stuff like fraud checks, collections outreach, and even simple customer inquiries to free up your team to focus on more strategic tasks. The key is to create a tech stack that supports quick updates to product features, so you can pivot when necessary without being held back by clunky system. But that's not all – your tech should also facilitate real-time feedback loops with your customers. Whether it’s A/B testing new marketing offers, experimenting with customer engagement strategies, or tweaking product features based on user feedback, technology should make these processes seamless, fast and efficient.
• Operations: Strong operational support—from proactive collections to efficient customer service—reduces losses and enhances customer trust. Optimizing key processes like collections can have a direct impact on the bottom line by reducing costs and improving recovery rates. When collections are efficient, more loans are repaid on time, leading to healthier financials. Additionally, streamlining the customer experience process – from application to servicing – not only enhances customer satisfaction, reflected in high NPS scores, but can also foster positive selection, attracting borrowers who are more likely to repay. In short, efficient operations drive profitability, improve customer loyalty, and help build a more resilient business.

2. Start Slow

• Experiment with Pilots: A crucial requirement for a successful lending business is a culture of constant testing. Whether it’s experimenting with new product terms, refining underwriting policies, testing alternative credit models, testing new offers and promotions and on and on - ongoing experimentation allows you to identify what works and what doesn’t. By continuously testing different approaches, you can optimize your offerings, improve risk management, and adapt to market changes. Begin with small, controlled programs. Measure every variable, from default rates to customer satisfaction. Example: A lender targeting freelancers ran a six-month pilot with 1,000 users, adjusting criteria like loan size and repayment timelines based on early feedback.
• Expect Losses: Losses are a feature, not a bug, of early-stage lending - LOSSES WILL HAPPEN. The key lies in managing them effectively and setting the right expectations with your leadership and investors. The first step is to keep those losses contained, which is why starting slow is crucial. By cautiously scaling and testing, you can ensure that you don’t overextend before understanding your risk profile and the gaps in your risk management infrastructure. Equally important is learning quickly from those losses. Each setback provides valuable insights that can help refine your product, underwriting, and operations. By adapting swiftly and making the necessary adjustments, you minimize future risks and build a more resilient lending model, setting the stage for sustainable growth over time.

3. Scale Thoughtfully

• Tested and Ready: Before scaling, ensure your models, underwriting, and operations have been thoroughly tested and proven. This means having a robust understanding of your risk profile, customer behavior, and product performance at a smaller scale. For example, a fintech might first target niche segments—such as students or young professionals—where customer needs are more defined and manageable. This controlled growth allows the business to gather valuable insights, optimize processes, and fine-tune its offerings before expanding to broader markets. Only when the models are proven and the operational infrastructure is built (which can definitely happen in parallel) should you move forward with scaling.
• Manage Growth: Scaling too slowly can be just as detrimental as scaling too quickly. While it's important to expand cautiously, once you've identified the right product, target segment, marketing/distribution, you need to scale and scale fast. As lending businesses grow, the cost of meeting regulatory requirements becomes more significant. Small-scale operations will likely not generate enough revenue to offset these costs, which can strain financial resources. Conversely, scaling at the right pace and right time - fast enough to leverage economies of scale while maintaining control—ensures that regulatory compliance and operational costs are more easily absorbed, making growth more sustainable.

4. Consider Alternative Models

If building a lending business from scratch feels daunting, explore alternative paths - at least to get off the ground- that mitigate risk while allowing you to learn the ropes:

• White-Label Solutions: Partnering with established lenders who take on the credit risk can be a smart way to kickstart your lending journey. This approach allows you to offer branded lending products without the heavy lift of building underwriting or collections capabilities from scratch. It’s an effective way to break out of the "cold-start impasse"—launch a product, start generating revenue, and gain valuable learning while laying the groundwork for your own lending infrastructure.
• Referral Programs: Instead of managing the full lending lifecycle, refer customers to an established lender and earn a referral fee or commission. This model lets you test market demand with minimal exposure to credit risk.
• Co-Branded Partnerships: Combine the trust of your brand with the infrastructure of an experienced lender. This hybrid approach allows you to build customer relationships while outsourcing the complexities of underwriting and collections. Example: Airlines and hotels frequently partner with banks to offer co-branded credit cards. The bank manages credit risk, while the brand enhances customer loyalty through rewards programs.
• Revenue-Sharing Agreements: Work with a lending partner to share both risks and rewards. This approach is particularly useful if you want to gradually build expertise while participating in the financial upside of lending. Example: A startup partnered with a fintech lender on small business loans. The startup provided customer acquisition and analytics, while the lender handled funding and credit decisions. Profits were split based on performance.

By starting with these models, you can gain invaluable insights into customer behavior, market dynamics, and operational nuances without the immediate pressure of managing a full-scale lending operation. Once you’ve honed your strategy and built confidence, you can transition into managing credit risk directly.

So to wrap up ...

Lending is a marathon, not a sprint. The cold start problem is real but not insurmountable. It demands a meticulous approach—careful planning, deliberate pacing, and a commitment to continuous learning. The challenges are steep, but so are the rewards for those who persevere.

Success begins with building a robust foundation. Invest in strong data, flexible underwriting, and scalable technology. Start small, test rigorously, and be willing to iterate. When ready to scale, do so thoughtfully, ensuring your models and operations can handle the complexity.

For those hesitant to dive in fully, alternative models like white-label solutions or partnerships provide a valuable starting point. They offer the chance to learn, adapt, and grow with reduced risk, laying the groundwork for future expansion.

Ultimately, the key to thriving in lending is resilience. Every challenge is an opportunity to refine your approach and strengthen your strategy. With discipline, patience, and a long-term vision, you can turn the cold start problem into a powerful launchpad for sustainable growth and industry leadership.