Why Buy-Now Pay-Later is Growing so Quickly

Over several years there has been much interest and discussion around Buy Now Pay Later (“BNPL”) and its role within consumer credit.  The concept of paying for a purchase in installments is not a new concept at all—in the distant past however, it was incredibly inefficient compared to electronic ways to pay and finance at the point of sale, like credit cards. The use of technology to streamline the customer experience at the point of sale has brought the product back in popularity. While we are several years into its resurgence, there are still developments and shifts in the market that make it important to watch if not participate in.   

A BNPL product facilitates a purchase whereby the purchase amount is split into generally four payments over a six-week timeframe without an interest cost during the payment period.[1] The product was already on a growth trajectory, and then COVID propelled its growth as online purchases became more of the norm. The current BNPL market is sizable and will continue to grow significantly. BNPL purchases in the United States totaled nearly $100 billion in 2021, up from $24 billion the prior year.[2]  Worldwide BNPL volume in 2021 was $680 billion and is expected to grow to $1.1 trillion in 2025.[3] 

Benefits for both sellers and buyers help to drive the strong growth in the market:

• Benefits to Sellers: The strongest benefit is incremental sales. With advanced technology and data, BNPL providers can underwrite and approve more customers. Potential buyers complete their purchases through a compelling user experience along their purchasing journey. Sellers also benefit from fraud protection.

• Benefits to Buyers:  BNPL is an economically rational product compared to other forms of financing like credit cards. For users who do not own credit cards, the product enables users to access financing. BNPL financing is more economical compared to higher-cost credit cards[4] since financing is cost-free if all payments are made on time. BNPL has more transparency and predictability with its installments, helping consumers work with their budgets and manage their spending since they have known installment obligations.  Perhaps most compelling is that BNPL provides the benefit of credit while using money that consumers have on hand—in fact, many BNPL products in the market have been structured so users cannot go into perpetual debt.[5]  Further, BNPL appeals to Gen Z that has fully embraced the smartphone and generally has a lukewarm attitude towards credit.

While pure-play BNPL providers have suffered lower valuations recently (as with many fintech players), their recent top-line performance illustrates the relevance of the BNPL benefits to the market:

Risks, Resiliency, and Regulation

Given the exponential growth in BNPL and the emergence of new entrants, there has been much attention in the market, including that from regulators. The CFPB put forth an inquiry and obtained data from BNPL firms including Affirm, Klarna, and AfterPay, and through their research published a report in September 2022[6] voicing concerns around debt accumulation and overextension, data harvesting and monetization, and inconsistent consumer disclosures and protections (e.g., disclosed fees, dispute protections, customer service for handling returns and refunds, etc.).[7]  This investigation was justified since regulators need to understand significant market developments, potential risks created in the market, and their impact on consumers. 

Since BNPL transactions and their payments are currently not reported to the credit reporting agencies, there is limited visibility to the true volume of BNPL transactions, the overall market performance of these loans, impacts on consumer debt burden, shift in usage from credit cards to BNPL, and other analytics. This poses a great risk to lenders since they do not have full visibility into a consumer’s financial picture. Each of the credit rating agencies has put initiatives in place to begin the capture of these transactions,[8] and these efforts are still underway. 

The rising interest rate environment is also a risk in the industry for pure-play monoline BNPL providers; however, their earnings releases and the growth in volumes will represent growth in top-line revenue.  The profitability of these players and their sustainability are significant concerns.

The nature of BNPL requires instant underwriting decisions with the goal of high approval rates. These requirements seem in conflict and could lead to a misperception that the underwriting for risk is not robust. This is an incorrect generalization—many providers, lenders, and banks are using credit information, other sources of data, and proprietary risk models to assess the customer’s ability to pay—the same approach as with other unsecured credit products, except that BNPL typically has smaller sizes. 

How the Industry Structure is Changing

Traditional suppliers of consumer credit and other industry leaders have responded to the opportunity (and threat) of installment lending and BNPL:

• Credit card issuers have developed hybrid functionality. Programs like Amex Pay Later, Citi Flex Pay, and Chase My Plan enable cardholders to select specific purchases and pay overtime in fixed installments. 

• Banks are introducing BNPL quickly with technology partnerships. While banks have a long history of underwriting, they traditionally have lacked the ability to leverage technology to provide products to consumers that are accessible when it matters the most. Technology providers such as Jifiti, LiftForward, and others provide the technology infrastructure linking banks to merchants and enabling embedded finance solutions including BNPL. 

• MasterCard and Visa have each launched their own programs that enable lenders the ability to offer BNPL at checkout across their merchant networks.

• Big Tech is getting into the game in a big way. Apple Pay Later was launched in March 2023^[9] to select users.  The service will enable users to split purchases into four installments, and users can manage these loans in their Apple Wallet. This is particularly interesting in that Apple already has a wide reach into the iPhone customer base and is integrated into Apple Wallet—customer acquisition will be inherently easier for them compared to other providers, and authentication of the borrower is already built into the device.

A big question remains about the quantified impact of BNPL on other consumer credit products.  Consumer attitude is compelling towards BNPL in that the product is more flexible and better aligned with the customer’s financial needs and interests compared to credit cards.  

The growth of the market and the economic benefit of BNPL does indicate there this likely some displacement of credit card volumes to that of BNPL. This could be better quantified once BNPL transaction activity is fully reported to the credit rating agencies.

Looking Ahead and Implications

BNPL is young in its life stage and the market has been evolving rapidly.  This is what we can expect to see going forward:

1. There will be more regulation with clearer requirements for treating BNPL as credit—the industry will need to work with regulators during this journey. The regulators need to spend time having conversations and working with data so they can figure out how the industry works and where the true risks lie. It is imperative for the industry to work with the regulators during this journey. Expect more regulation, guidance, and rules for BNPL like that of credit cards (note:  a similar move was just enacted in Australia[10]).  This will include consumer protections, bureau reporting, supervisory examinations, disclosures, data privacy, etc. Regulatory pressure will create a rougher period in the near term, but the industry will be stronger on the back end.

2. BNPL will be included within credit bureau reporting—providing more visibility into BNPL and adding information to borrower credit reports. Each of the credit rating agencies is building infrastructure for BNPL reporting, which will take time for completion and use by lenders and furnishers. In the interim, some lenders will use alternative sources of data (e.g., cash flow data) to provide a clearer picture of the credit risk of their customers/applicants.  Once BNPL is fully integrated into the reporting, there will be more transparency on the BNPL performance, impact on other credit products (e.g., credit cards), and quantified impact on consumer debt burdens. From a borrower’s perspective, BNPL could be a path to establish a credit file, and these tradelines will add more information to existing credit files.

3. Consumer adoption will surge—keep your eyes on Apple Pay Later. JD Powers estimates that the percentage of U.S. consumers with a BNPL account was 22% in January 2023, up from 18% in October 2022 and 14% in July 2021.[11]  Strong adoption will continue as more users become familiar with the economic benefits of the product. Apple Pay Later will help to raise awareness of BNPL with its iPhone users, who will likely have delightful user experiences with the product. 

4. Additional use cases and merchant categories will expand.  BNPL will continue to go upscale with larger purchases such as travel. We will likely see BNPL that combines multiple purchases into an “experience” bundle—such as trip expenses (airfare, hotel, car, meals, event ticketing), back-to-school shopping across several retailers, holiday shopping, etc. BNPL products will be developed for B2B purchases, freeing up the cost of financings and improving cash flow for suppliers. B2B BNPL is already happening in international markets and is estimated to be a $200B opportunity in Europe and the U.S.[12]

5. BNPL providers will diversify or be acquired. BNPL as a stand-alone product is not a sustainable model since it is difficult to own a customer relationship or address their broader financial service needs. Pureplay BNPL providers will need to diversify their product offerings to enhance their revenue streams and build customer loyalty.  They need to drive to become profitable or will continue to suffer from low valuations and represent bargains for potential acquirers.

6. There will be more BNPL participation coming from traditional banks, including incumbents with existing merchant relationships.  Technology providers are building programs and solutions to make it easier for banks of all sizes to participate.  Larger institutions with existing merchant relationships (e.g., issuers with retail relationships for private label and/or cobrand portfolios), banks with merchant acquiring services) are likely to capitalize on these relationships and find more opportunities to serve them with their credit capabilities including BNPL.

7. Meet your customers where they are – evolve from product-centric strategies to customer-centric strategies based on customer needs.  Think about customer needs and their journey along the purchase process and how they prefer to pay.  If you are not already offering BNPL, you should research what your customers need to determine if you should participate.  Determine how important the Gen Z customer base is for your business and understand their payment preferences.  Offering more choices to customers can support their acquisition, loyalty, and retention.

8. Lenders, tech providers, and sellers will need to increase their focus on implementing strong risk management and compliance programs over their partner relationships.  On June 9, 2023, the Fed, OCC, and FDIC issued inter-agency guidance on the risk management of third-party relationships and includes discussions on governance, oversight, accountability, independent reviews, documentation, and reporting[13].  BNPL depends on connections between lenders, sellers, and in many cases technology providers.  Expect heightened focus from regulators in the risk management program, governance, and monitoring of these relationships.

Continuing the Conversation

BNPL is an economically rational product that provides many benefits to buyers and sellers.  BNPL is in a resurgence and is young in its life stage compared to other more mature credit products such as credit cards. Governance over BNPL—such as credit bureau reporting and regulation of BNPL as a form of credit—has not caught up to the popularity of the product. This will happen in the near term. 

Despite the regulatory uncertainty as the product matures, the supplier landscape is responding rapidly, including traditional banks which are able to participate quickly by partnering. Consumer adoption will accelerate, and Gen Z will represent a key market segment. While BNPL is relatively new in its evolution and guardrails still need to be put in place, current data does not clearly indicate that the product is inherently bad for the industry or for consumers. More will be proven over time, but in the meantime, we can fully expect the market to continue to grow and represent great opportunities to meet customers where they are.

Please contact me if you found this of interest and would like to continue the discussion!

[1] Other payment and financing mechanisms at the point of sale include installment loan financing (at an interest rate over a term), private label credit cards, other credit cards, etc., and are excluded from the definition of BNPL.

[2] Source:  Cornerstone Advisors, https://www.forbes.com/sites/ronshevlin/2021/09/07/buy-now-pay-later-the-new-payments-trend-generating-100-billion-in-sales/?sh=7f96781e2ffe

[3] Source:  CB Insights, https://www.cbinsights.com/research/report/buy-now-pay-later-outlook/

[4] A recent CFPB study estimates that a majority of BNPL borrowers would face credit card interest rates between 19 and 23 percent annually if they had chosen to make their purchase using a credit card.  Source:  Consumer Use of Buy Now, Pay Later: Insights from the CFPB Making Ends Meet Survey | Consumer Financial Protection Bureau (consumerfinance.gov)

[5] For example, the AfterPay product has been structured with responsible spending rules and consumer protections built into the service (e.g., payments via debit, late payment fees fixed/capped and suspended service, rewards for responsible spending).

[6] CFPB Study Details the Rapid Growth of “Buy Now, Pay Later” Lending | Consumer Financial Protection Bureau (consumerfinance.gov)

[7] Director Chopra’s prepared remarks on the release of the CFPB’s Buy Now, Pay Later report | Consumer Financial Protection Bureau (consumerfinance.gov)

[8] Everything You Need to Know about BNPL Credit Reporting (jifiti.com)

[9] https://www.apple.com/newsroom/2023/03/apple-introduces-apple-pay-later/

[10] https://amp-abc-net-au.cdn.ampproject.org/c/s/amp.abc.net.au/article/102368810

[11] https://www.jdpower.com/business/resources/battle-buy-now-pay-later-customers-being-won-point-sale#:~:text=According%20to%20our%20data%2C%20the%20total%20percentage%20of,in%20October%202022%20and%2014%25%20in%20July%202021.

[12] https://www.pymnts.com/bnpl/2023/demand-for-flexible-b2b-payments-fuels-eu-bnpl-growth/

[13] https://www.federalregister.gov/documents/2023/06/09/2023-12340/interagency-guidance-on-third-party-relationships-risk-management

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The Importance of Small Business Lending in the United States

Small businesses across our nation play a crucial role in the health of our economy. As of 2019, small businesses employed 46.4% of total employees in the United States and paid 39.4% of the nation’s wages.[1] Women and racial minorities own 43.2% and 19.4% of small businesses, respectively. 

Despite their significant contributions to the U.S. economy, many small business owners have difficulty accessing credit to launch and/or grow their businesses. Small businesses may not have sufficient revenue history or other information to qualify for credit, their financing needs may not fit within the credit box of banks, or other factors. Access to credit is particularly difficult for women and minority small business owners if their business and/or personal credit histories are not well-represented in traditional credit reporting datasets.

When it comes to small business lending, community banks have an advantage over large national banks given their deep understanding of the communities they serve. As such, community banks have played a key role in small business lending. Fintech lenders also are filling the gap, leveraging alternative data, predictive algorithms, and other technologies to not only provide a more detailed picture of the financial health of a small business but also to streamline the customer experience and lower operational costs.

The Consumer Financial Protection Bureau (CFPB) has recognized the need to support equitable access to credit for small businesses, and on March 30, 2023, issued its Final Rule under Section 1071 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Rule 1071”), which modified the Equal Credit Opportunity Act (ECOA) to include data collection and reporting requirements on small business lenders—including large banks, community banks, credit unions, and fintech lenders alike.

Access to credit and small business ownership are levers to build wealth. Fairer small business lending practices can enable more businesses to launch and grow, drive economic prosperity for our communities and the families of small business owners, and support greater equity within our nation.  Alternatively, the lack of fair small business lending can hamper potential growth and further create inequity for small business owners in marginalized segments of the population. 

Final Rule 1071

Final Rule 1071 was issued on March 30, 2023, with ~900 pages outlining data collection and reporting requirements for small business lenders to provide transparency into small business lending practices.  While the CFPB anticipates that it will initially release aggregate-level data, application-level data will eventually be released. The reported data will ultimately be used to enforce fair lending laws and identify business and community development needs for women and minority-owned small businesses. 

Rule 1071 applies to:

The data elements required for collection and ultimate reporting under Rule 1071 include:   

For data collected directly from an applicant, procedures must ensure that: 1) The initial request for applicant-provided data occurs prior to notifying an applicant of the final action taken on an application; 2) The request for applicant-provided data is prominently displayed and presented; 3) Applicants are not discouraged from responding to such requests; and 4) Applicants can easily respond to such requests.  Further, lenders are required to maintain procedures to identify and respond to indications of potential discouragement (e.g., low response rates for applicant-provided data).

The final rule has recordkeeping requirements, including a requirement to retain copies of small business lending application registers and evidence of compliance for three years.  

Rule 1071 also includes a requirement to maintain an applicant’s responses surrounding the applicant’s minority-owned, women-owned, and LGBTQI+-owned business statuses and regarding principal owners’ ethnicity, race, and sex separate from the rest of the application and accompanying information.

Timing of rollout varies depending on the volume of covered originations:[3]

Implications for Small Business Lenders

Small business lenders should assess Rule 1071 and the implications for their business given the risk of regulators and other entities using the publicly available data to raise fair-lending concerns. The implementation of Rule 1071 will require small business lenders to make substantial operational changes across their lending workflow and significantly increase their overall cost of compliance.[4] The effort required for data gathering, storage, analytics, reporting, and ongoing monitoring and testing will be more significant for lenders that are not accustomed to such requirements (e.g., those that do not offer consumer mortgages) and/or have manual small business lending processes with little automation. 

Here are some recommendations for you to consider as your organization gets ready for Rule 1071:

1. Don’t underestimate the level of effort required to be compliant.  Even if your organization has experience with the data gathering and reporting required for consumer mortgages, the nuances of small business lending are significant and the data supporting lending decisions can be more complex. It is likely that you will need cooperation and collaboration across various business groups and stakeholders unaccustomed to such data collection and reporting requirements. This complexity increases if your organization provides multiple credit products to your small business customers. 
2. Dedicate resources, develop processes, and leverage technology to capture, clean, and store accurate data. Some considerations:
   • Ensure data is complete and correct.  Modify your applications and other forms where necessary.  Limit applicant-provided “open text” data and consider the use of defined choices that the applicant can select where possible.
   • Craft demographic-data questions carefully and monitor response rates by division, location, loan officer, etc.
   • Establish and maintain strict firewall procedures to restrict access to certain data from employees involved in the credit decision. Maintain data records for at least three years, allowing for audits and regulatory reviews.
   • Update your internal policies and procedures to reflect the new data collection, reporting, and retention requirements.
3. Once you have the data collected in usable form, conduct preliminary testing to see if there are any potential fair lending concerns so you can remediate them in advance of public disclosure. This analysis should be conducted by product, division, industry vertical, location, loan officer, etc. as appropriate. Remediation of potential fair lending concerns could involve testing the specific variables used in the lending decision, automating more of the lending process, analyzing previously declined applications to determine if other models and/or information could have been used to approve the applicants at the same risk, and other strategies. 
4. Establish a robust compliance management system to oversee the implementation of Rule 1071 and monitor ongoing adherence to its requirements. This may include appointing a fair lending officer, conducting regular fair lending analysis, and remediating any identified issues on an ongoing basis. Ensure your existing reporting systems can accommodate the new data and reporting formats that will be necessary to support compliance. Automate and build the compliance process and supporting infrastructure the right way from the start, to allow your team to focus on what it does best—cultivating relationships and serving the financial service needs of small business owners.
5. Consider the development and/or extension of automated processes and models aligning with your credit strategy. Any part of the process or decision involving human intervention increases the risk of error or bias. Conduct fair lending testing during model development and iterate/refine before the models are put into production.  
6. Consider the use of new data and/or scores to allow for a more holistic view of the health of a small business since credit-worthy small businesses may not be adequately represented within traditional data sources/scores.  If you are considering the use of new data, leverage automated fair lending testing tools to understand the fairness of the data and its impact on women and minority business owners.
7. Develop strategies and documentation of your fair lending compliance approach (data evaluation, model development, testing, monitoring) that will stand up to regulator inquiries.
8. Develop training for staff who touch on any of the new processes related to 1071 compliance.  Communicate that fair small business lending practices help to support small business growth, community economic prosperity, and potential new business/ lending opportunities for your organization. 

Continuing the Conversation

Rule 1071 is important to help support fair access to credit for women and minority-owned businesses— creating more opportunities for business and economic growth and narrowing of the wealth gap. By strengthening small business lending practices as an industry, we can support access to credit and influence the success of small business owners, improve relationships and loyalty with these customers, and create incremental capital flow and new lending opportunities. 

However, the implementation of and ongoing compliance with Rule 1071 will require significant efforts from small business lenders. Rest assured that small business lenders do not have to navigate this journey on their own and there are industry resources to help along the way. As an industry, we will need to orchestrate the right people, data, processes, and technology to help manage the cost of compliance with Rule 1071. The effort we make in the near term is justified to support new opportunities for lenders and economic prosperity for all small business owners, regardless of their race, ethnicity, gender, or sexual orientation.

Please contact me if you found this of interest and would like to continue the discussion!

[1] https://advocacy.sba.gov/wp-content/uploads/2022/08/Small-Business-Economic-Profile-US.pdf

[2] https://www.consumerfinance.gov/about-us/newsroom/cfpb-proposes-rule-to-shine-new-light-on-small-businesses-access-to-credit/#:~:text=%E2%80%9CSmall%20businesses%20are%20the%20primary%20job%20creators%20and,means%20by%20which%20families%20and%20communities%20build%20wealth.

[3] https://files.consumerfinance.gov/f/documents/cfpb_sbl_info-sheet-regarding-compliance-dates.pdf

[4] A lawsuit has been brought forth by Texas-based Rio Bank and Texas Bankers Association asserting that the new reporting requirements will drive away smaller lenders in the space and therefore eliminate available products for small businesses, including those owned by women and minorities.  https://www.bankingdive.com/news/texas-bank-trade-group-rio-lawsuit-cfpb-small-business-data-collection-rule/648831/

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November 5, 2022

Money 20/20 is one of the biggest events in financial services, blending all things digital across banking and FinTech. Despite economic and market uncertainty, this year’s event held last week in Las Vegas, brought energy and optimism that could only be described as infectious.  

Over 11,500 registered attendees convened at the Venetian to explore new developments in the industry and challenge the status quo.  A major theme of the conference was the need for the industry to strengthen and prove the governance function between FinTechs and their Bank partners, coupled with the availability of automated tools and techniques to support these relationships and their overall risk management functions that benefit FinTechs and Bank partners alike.

Here are some takeaways related to this theme from Money 20/20 this year: 

1. FinTechs continue to need access to a Bank’s charter to move money and/or provide financial services under the watchful eyes of regulators who monitor compliance with KYC, AML, BSA, fraud monitoring, OFAC screening, UDAAP, fair lending, and other requirements.  While some FinTechs obtain their Charters through their own applications (Varo Bank) or through bank acquisition (Lending Club, SoFi), a more common approach is to form a relationship with a Bank that has experience in partnering with FinTech providers. 
   
2. There was an increased focus and discussion on the governance between FinTechs and their Partner Banks, and the coordinated compliance programs that need to be in place to protect industry stakeholders including FinTechs, Partner Banks, investors, and consumers.  The growth of BaaS and the number of FinTech partnerships has increased regulatory scrutiny in this sector, as evidenced by the recent order by the OCC against Blue Ridge Bank relating to third-party risk management, BSA/AML risk management, suspicious activity reporting, and information technology control and risk governance.
   
3. Given a backdrop of economic uncertainty and rising interest rates, FinTechs must now justify their business models and business practices, including complying with numerous regulations.
   
4. Partner Banks must demonstrate to regulators that they are monitoring FinTech activities and the overall relationship. FinTechs, meanwhile, need to stand up their practices to many constituents – to regulators, their Partner Banks, and investors.  Money 20/20’s agenda included panels where banks, FinTechs, and industry experts discussed the requirements for successful partnerships. These include strategic and product alignment, organizational resources and commitment, technology integration and formalized governance programs and frameworks to ensure ongoing regulatory compliance and consumer protection. Such programs are crucial since FinTechs are an extension of the Banks that they partner with, and introduce financial and reputational risk to Bank partners.
   
5. Kareem Saleh, CEO of FairPlay, took the stage to discuss how FairPlay works with its bank and FinTech customers to debias data and automate fairness testing and compliance (back-end reporting as well as front-end model development) of algorithmic models used across the customer lifecycle (e.g., marketing, credit decisioning, pricing, fraud screening, servicing).  FairPlay also optimizes decisioning systems for fairness and creates Second Look programs.  Through these analytics, FairPlay has been able to help its customers reduce their cost of compliance, increase confidence when dealing with regulators by evidencing commitment to fairness, increase application approvals, and ultimately provide fairer products and solutions to their customers.

Over time we expect to see governance models between FinTechs and Partner Banks continue to evolve and strengthen.  Forward-looking Partner Banks and FinTechs will invest in automated tools and in their compliance, legal, and oversight functions to support this evolution and create a competitive advantage.

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