Big Tech, Fintech, and the Future of Credit

Lenders want to know that borrowers will pay them back. That means assessing creditworthiness before making a loan and then monitoring borrowers to ensure timely payment in full. Lenders have three principal tools for raising the likelihood of that firms will repay. First, they look for borrowers with a sufficiently large personal stake in their enterprise. Second, they look for firms with collateral that lenders can seize in the event of a default. Third, they obtain information on the firm’s current balance sheet, its historical revenue and profits, experience with past loans, and the like.

Unfortunately, this conventional approach to overcoming the challenges of asymmetric information is less effective for new firms that have both very short credit histories and very little in the way of physical collateral. As a result, these potential borrowers have trouble obtaining funds through standard channels. This is one reason that governments subsidize small business lending, and why entrepreneurs are forced to pledge their homes as collateral.

Well, new solutions have emerged to overcome this old problem. In this post we discuss how technology is increasing small firms’ access to credit. By using massive amounts of data to improve credit assessments, as well as real-time information and platform advantages to enforce repayment terms, technology companies appear to be doing what traditional lenders have not: making loans to millions of small businesses at attractive rates and experiencing remarkably low default rates.

The biggest advances are in places where financial systems are not meeting social needs….

Sources of Finance: Internal versus External

It ought not be surprising that borrowing can be difficult. In good times, households usually can obtain financing to purchase a house or car. But these loans are secured with collateral that is easy to resell. Even so, some measures suggest that it is currently more difficult than under “normal” conditions to obtain mortgage finance (see the Urban Institute’s Housing Credit Availability Index on page 16).

With firms, credit has been rising significantly in recent years—across advanced and emerging economies alike (see the BIS measures through 2017 here). Yet, commercial borrowers, especially small and medium sized enterprises, complain loudly when they feel that their ability to succeed is being hampered by overly cautious lenders. And, since lenders often find it difficult to both assess a business’s prospects and to monitor effort once a loan is made, aside from periods of euphoria borrowing can be quite difficult.

As we discuss in our primers on adverse selection and moral hazard, information asymmetries make external funding—either through equity or debt—expensive. And, while the entire financial system is designed to reduce these costs, they are still quite high….

Tougher capital regulation pays off

Banks continue to lobby for weaker financial regulation: capital requirements are excessive, liquidity requirements are overly restrictive, and stress tests are too burdensome. Yes, in the aftermath of the 2007-09 financial crisis, we needed reforms, they say, but Basel III and Dodd-Frank have gone too far.

Unfortunately, these complaints are finding sympathetic ears in a variety of places. U.S. authorities are considering changes that would water down existing standards. In Europe, news is not promising either. These developments are not only discouraging, but they are self-defeating. Higher capital clearly improves resilience. And, at current levels of capitalization, it does not limit banks’ ability to support economic activity.

As it turns out, on this particular subject, there may be less of a discrepancy between private and social interests than is commonly believed. The reason is that investors reward banks in jurisdictions where regulators and supervisors promote social welfare through tougher capital standards....

Truth or consequences: Ponzi schemes and other frauds

In the financial world, the real scandal is often what’s legal, but you still have to watch out for fraudsters. If you don’t pay the costs of screening and monitoring your financial counterparties, you may lose your house.

The never-ending need for financial vigilance came to mind recently when we noticed that the 1920 home of Charles Ponzi was for sale in Lexington Massachusetts. It’s a very large house – 7 bedrooms, 6 bathrooms, 7000 square feet of space (650 square meters) on nearly an acre of land (0.4 hectares).(You can see a picture here.) ...

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Money, Banking, and Financial Markets