What FinTechs forget about Finance — lessons and opportunities in the Credit space

Starting a credit card business is the latest trend in the FinTech. A flurry of players — Petal, Deserve, Elevate, LendUp (now Mission Lane) — have entered this space to compete against large banks, with many more companies incubating. And why wouldn’t they? This is one of the largest consumer credit market, at $1 Trillion in balances in 2017.

I applaud the ambition of FinTech players in this space. More competition and differentiated products will ultimately help consumers and distribute the significant profit margins of national banks. Unfortunately, FinTech’s still have to prove themselves. National banks maintain the majority of the market share in this space and their growth is not subsiding.

This article is a follow up on an article discussing the Financial Health space. In this piece, I want to share some lessons I learned specific to the credit space so as to help the next entrepreneur. First, we will explore the common pitfalls of the fictional naive FinTech CEO. Next, we will discuss the real opportunities in this space.

The bad news: 12 things FinTechs will learn the hard way about credit

1. CEO: “We have 100,000 users on our waitlist”. Lesson: Lending money is easy, getting the money back is the hard part. Turns out people respond well to credit. You can put a waitlist on your site, run a few ads, and thousands of people will have signed up. The crux of the issue is figuring out how to balance the lifetime value of the consumer (which includes credit risk, utilization, etc.) and the cost to acquire that consumer. This requires data, testing, experience, and time. Don’t be fooled by your marketing department, and ensure they partner with credit teams.
2. CEO: “Competition charges too high interest rates”. Lesson: It takes 1 bad apple to ruin a batch. Here is a good article on this. 1 bad loan out of 10 will require you to charge high fees to just break even given your borrowing and operational costs. You may be quick to criticize lenders that are offering high APRs to certain groups — it may be because they are predators but it could just as well be because there is not enough predictive data on these consumers to avoid that bad apple.
3. CEO: “We can do it better”. Lesson: Banks are not stupid. The top players in this space have reached the top by testing their way into product market fit relentlessly. Don’t underestimate their knowledge and experience. Sure, they have lower risk appetites, but so will you when you get heavily regulated and have large shareholders to answer to. Learn what to copy vs. differentiate on and test — or risk re-inventing the wheel (and credit is full of big wheels).
4. CEO: “We will focus entirely on our customers”. Lesson: Your business model will make it hard to prioritize customer delights. Building a credit card business is hard and there will be no shortages of things to build to improve profitability. Every entrepreneur means well when they say “we are going to focus on the consumer”. But the reality with credit businesses is that you will want to prioritize features that help ensure you get your money back. You will need a strong consumer centric culture to prioritize features that reduce your consumer’s debt burden since this will negatively impact your bottom line in the near term.
5. CEO: “We have the best rated mobile app”. Lesson: Consumers care more about price than your mobile app. When it comes to lending, consumers care mostly about 2 things: how much money am I going to get, and how much do I have to pay for it. What matters most is your ability to give the consumer the best priced product. When you signed up for the Chase Sapphire Reserve, you didn’t care about the mobile app — it was the 100,000 points, be honest!
6. CEO: “Banks have low NPS scores, we can beat them”. Lesson: Consumers also care about brand, and brand takes time. This is money you are talking about, not SUPREME. People are highly emotional when it comes to money, and highly risk averse. Even during the financial crisis, most consumers kept their deposits at large banks that were deemed the bad guys. Yes, banks rate in low NPS scores, but you still have your money there, right? In every focus group I’ve been a part of, consumers pick the product with the brand name they know. They need to trust you are not a scam and rely on their knowledge of your brand to make decisions. Building a brand will take significant amount of time, and will be the consequence, not the cause, of success.
7. CEO: “We have lower rates”. Lesson: Banks can borrow at a fraction of your costs. You need money to lend money, and banks can get that money at significantly lower rates than you because they are banks (e.g. 2% vs. 8% is a big deal on billions of dollars). This means that holding everything else constant, they can price their products cheaper and still have large margins. Don’t dry your series A competing on price alone, you need another edge. Also, ensure you have enough capital markets experience to reduce your cost of funds in the long term.
8. CEO: “Banks are evil”. Lesson: You need a bank partner. You can’t lend without a bank license, and you can’t really get a bank license. So you need to work with a banking partner. This means you need to build relationships, follow bank-like processes, and adhere to your partner bank’s risk appetite and compliance programs. Your bank partner will make or break your company if it doesn’t let you innovate. Choose wisely.
9. CEO: “We will ensure every customer is better off with us”. Lesson: You will have to harm some people to help others. Because you will not be able to 100% accurately predict how people will use your product, some customers that you advertise will end of defaulting. Many will barely squeeze by, and in fact you can build a decent business just on that (many fee harvesting credit cards do). What you need to set are the boundaries you will never cross.
10. CEO: “We are growing exponentially”. Lesson: Credit takes time. Set the record straight with your teams and investors (hopefully they already know): credit card businesses take time. We’re not renting scooters here. You are lending. Unless your investors are willing to give you a big check, raising money will require demonstrating a track record. And demonstrating a track record will take time — a typical credit card cohort may take 18–24 months to demonstrate performance. Be patient, stay hungry.
11. CEO: “We can take risks banks can’t”. Lesson: Nobody escapes the law. The lending space is heavily regulated, and rightfully so. History is full of examples where unfair lending practices led to the exclusion of marginalized populations from financial progress. Banks know the law, have entire teams focused on the law, and pay lobbyists to change the law. Yes, take risks, but not with compliance. Ensure you have a strong compliance culture from the start, with proper controls, monitoring, testing and evidencing for your teams, your banking partner, and regulators.
12. CEO: “We are going to rebuild banking from the ground up”. Lesson: Banking enterprise software sucks, but building it yourself may be worse. I’m excited to learn and use the next generation banking platforms that are being built today. But right now, banking platforms are still mediocre at best. It will be frustrating. There are days where you will want to built an entire credit card servicing platform yourself. Don’t (or change your business model to be B2B) — it is complicated, risky, and takes significant expertise. Do your due diligence and critically think before you decide to build anything.

With that, let’s jump into the good news.

The good news: 11 things FinTechs should harness to truly disrupt this space.

1. Go after the niche customer segments. Banks see customers as a set of FICO bands. Don’t make that mistake. Focus on specific customer segments, and tailor the entire product experience around that segment. Foster a customer centric culture: deeply understand who they are, what makes them tick, what their fears and hopes are. Every design should have the customer in mind: marketing, product features, landing pages, application flows, customer support experience, etc. Win in niche customer segments, and expand.
2. Be excellent at user analytics. Banks struggle to leverage their own data effectively. Consumer data is siloed in different parts of the organization, preventing anyone to have a holistic view of the customer once they start using the product. You see this when you get these irrelevant “exclusive offer” emails from your bank — they don’t know you at all. By ensuring you can measure every engagement your customer has with your product, you can better react to your customer needs.
3. Move faster by creating cross functional teams. The speed at which a company can innovate is how quickly it can complete the build-measure-learn cycle. FinTechs have an advantage here if they structure themselves correctly. Banks are silo-ed and see technology teams as “resources” meant to execute the greater vision of the “business”. This culture prohibits creating thinking. Create cross functional teams and give them decision making power. Encourage them to take calculated risks, launch tests, learn and iterate quickly. Speed is critical.
4. Use alternative data to compete. Banks have more data than you can dream of on their existing customers, and use that data to better target new customers. You don’t have this privilege, so to beat them you need to get data they don’t have access to, either because they are not focusing on your niche segment, or don’t have the risk appetite or expertise to use this data. Build that expertise.
5. Take big bets, early. Banks have legacy inertia in terms of culture, brand positioning, shareholder pressure and regulatory oversight that prevents them from dramatically changing their value proposition. Take the big bets that banks cannot take. Take Robinhood for example — $0 trades. That is unheard of. That set them apart. In no world would E-Trade, the closest competitor targeting digital millennials, have launched that feature. Their shareholders would simply have laughed.
6. Leverage software to lower operational costs. Banks have high operational costs such as branch staffing and customer support. By having a strong software development culture, you can buy/build solutions that will help your team achieve 10x what a similar sized team would achieve at a bank. Software can empower teams to be self sufficient, which will lead to better outcomes faster. This will help your bottom line significantly as you scale.
7. Partner with other FinTechs. One of your biggest competitive advantage is the FinTech ecosystem you are part of. You can’t do everything yourself. Team up. The issue is every FinTech wants to own the entire space at some point and fail to partner. We need to stop that culture — the space is big enough and consumers need us. Share best practices and open source software, identify opportunities for partnership, and hold each other accountable.
8. Identify new growth channels. Banks have tremendous experience in classic growth channels such as branches and direct mail. Yet the landscape is changing, and your niche market is very different than the masses. Find new ways to drive quality traffic by leveraging new technologies or platforms. Consider partnering with organization where there are synergies. Consider even partnering with banks, a strategy used by Upstart successfully.
9. Leverage Machine Learning. This might sound cliche, but I’m ok with it. The fact is that most banks still use rudimentary modeling methodologies because they do not have the expertise, culture, and risk appetite. It’s complicated, don’t get me wrong — but as long as you can explain 1) explain to the consumer why a certain action took place (e.g. a decline) and 2) have a strong handle on what you are building and 3) ensure you don’t discriminate against protected classes, you are on the right track. That said, don’t underestimate experience, especially credit, fraud, and regulatory experience.
10. Focus on changing consumer behavior. Banks don’t believe you can change people. They spend most of their time focusing on underwriting because they believe that whether you get your money back as a lender has more to do with who you lend to, then how you help them repay. I believe that by deeply understanding your customers, you can identify what makes them tick, and test & learn your way into features that change their behavior, which will in turn reduce their credit risk and improve their lifetime value to your business.
11. Ensure your product grows with your users. If you believe in your customers and build a product that helps them grow, then consumers will grow out of the product that initial brought them to you, out of the segment they were in. Banks fail at engaging customers past promotional periods other than customers who are stuck in debt. Leverage the data that you have accumulated on the user which no one else has access to. Reward them with a better offering. Keep helping them grow to achieve maximum lifetime value.

I hope some of this resonated with some of you. If all else fails, don’t worry. You can still exist in this space. The market is so large, and banks by definition do not want to take up significant market share out of fear of credit and regulatory risks.

I believe that by focusing on the right aspects of the finance industry to disrupt, and being honest with themselves, FinTechs will achieve amazing things. Here’s to building better financial products focused on financial health.