Investors love growth, and as we approach the longest sustained period of growth in the history of the United States, the business climate has been almost unprecedented. The Dow Jones Industrial Average is hovering around record highs and unemployment is at its lowest level in nearly two decades.
These robust economic conditions have supported and stimulated lending activity as well as an explosion of interest in the financial technology arena. Venture capital-backed financial technology companies disrupting traditional banking by effectively unbundling products and services have raised a record $40 billion from investors globally in 2018, up 120% from the previous year, according to research by data provider CB Insights.
However, as we enter the last six months of 2019, signals suggest that economic and regulatory changes could expose the fundamental weaknesses of many consumer lenders. This is exacerbated by growing fears of a prediction recession arriving before 2021; concerns compounded by the most recent trade war with China and slow wage growth that has been largely offset by inflation.
In addition, major new accounting standards are set to be imposed on all financial institutions which could challenge the way investors assess lenders’ financial health. Set to go into effect at the end of 2019, the Current Expected Credit Loss Model (CECL) utilizes a life of loan concept to establish loan loss allowances and requires that lenders hold reserves that cover losses for the life of a loan. CECL is effectively converting a general reserve application to a rules-based application, bringing consistency to allowance methodology. This change stems from the 2008 global financial crisis, which amplified the need to improve existing financial reporting standards. In its October 2018 report on CECL impact, based upon its coverage of 43 banks and specialty finance companies, UBS estimates this change will lead to an average increase of 35% in allowance for loan losses for lenders.
Given the magnitude of the imminent change in the macroeconomic and regulatory environment, these five key fundamentals will define consumer lending models as sustainable, defensible, and in turn, profitable over the long term.
Sustainability cannot depend on growth. Growth can conceal weaknesses. Lending constitutes a meaningful segment of the financial technology industry, and the unsecured personal loan market, which hit an all-time high last year surged 17% year over year to $138 billion. According to TransUnion, was most of this growth occurred in the subprime tier. In order to effectively remove the impact of growth when measuring performance, sustainable consumer lending models must incorporate a rigorous approach to static pool analysis. In periods of rapid growth, key metrics such as delinquency and default can appear low, because the overall portfolio growth may be accelerating — this is a phenomenon known as “speedboating.”
Differentiation matters. While disruption has been the most prominent buzzword used to describe the dramatic rise of fintech, differentiation may be more impactful. As it relates to lending, differentiation is commonly achieved by targeting a specific borrower profile, particularly one which is underserved or possesses a unique set of attributes which potentially correlate to better than average loan performance. In the case of Tricolor, our focus on low-income Hispanic auto buyers with little or no credit history clearly differentiates us from other lenders in the space. That differentiation results in defensibility. Smart data science alone will not sustain disruption in the financial services industry; this essential non-technological factor plays a significant role in determining success.
Take the long view. For a lender, cash flow ultimately drives value creation, and successful lenders will pivot to focus on maximizing the present value of future cash flow streams originated through loans. This can be managed by embracing vintage analysis, which informs the most precise view possible on how a lender can expect originations from a certain period (or vintage) to perform over the life of that vintage. A vintage strategy involves an ongoing cycle of testing, learning and pivoting to optimize the key inputs that drive loan performance: credit grade (which in turn, provides expected lifetime credit losses and average life) and deal terms (which consist of loan to value, origination APR, down payment, term, and payment amount).
Recognize the elephant in the room. For many businesses, CECL will expose the vulnerability in their lending model. On average, specialty finance companies are worse positioned than banks given their high loss content and so have the largest estimated reserve increases. According to Moody’s, CECL changes could cause loss allowances for U.S. auto lenders to increase by as much as 1.5 to 2.5 times the current allowances. The impact on unsecured lending will likely be even more dramatic. Overall, UBS estimates that the specialty finance companies in its survey will require an average 64% increase in their allowance.
The test of time is the real test. Technology is creating disruption across industries faster than ever. Since 2000, 52% of companies in the Fortune 500 have either gone bankrupt, been acquired, or ceased to exist as a result of digital disruption. The collision between the physical and digital worlds has become increasingly profound in financial services. There are many elements to a sustainable and successful business model—a great culture, great customer experience, great quality, great processes—but for a consumer lending business, a defensible model requires a strategic approach which must be continually measured and optimized. For many lenders which have increased market share and capitalized on a robust economic environment, 2020 may provide formidable headwinds with the combined impact of a potential recession and regulatory change in the form of CECL implementation.
Daniel Chu currently serves as founder and chief executive of Tricolor Auto Group and Ganas Holdings. Chu has distinguished himself as a successful entrepreneur, having founded six companies over the past 25 years, including two which became public. Chu currently serves as the founder and chief executive of Ganas Holdings, a national used vehicle retailer focusing on the integrated sale and financing of vehicles to Hispanic consumers. The branded chain of thirty dealerships across twelve metropolitan markets operates in Texas as Tricolor Auto Group, and in California as Ganas Auto Group.
