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ISSN: 1962-5361 Disclaimer: This Philadelphia Fed working paper represents preliminary research that is being circulated for discussion purposes. The views expressed in these papers are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System. Any errors or omissions are the responsibility of the authors. Philadelphia Fed working papers are free to download at: philadelphiafed/research-and-data/publications/working-papers. Working Papers Which Lenders Are More Likely to Reach Out to Underserved Consumers: Banks versus Fintechs versus Other Nonbanks? Erik Dolson Federal Reserve Bank of Philadelphia Supervision, Regulation, and Credit Department Julapa Jagtiani Federal Reserve Bank of Philadelphia Supervision, Regulation, and Credit Department WP 21-17 April 2021 doi/10.21799/frbp.wp.2021.171 Which Lenders Are More Likely to Reach Out to Underserved Consumers: Banks versus Fintechs versus Other Nonbanks? Erik Dolson* Federal Reserve Bank of Philadelphia Julapa Jagtiani* Federal Reserve Bank of Philadelphia April 19, 2021 Abstract There has been a great deal of interest recently in understanding the potential role of fintech firms in expanding credit access to the underbanked and credit-constrained consumers. We explore the supply side of fintech credit, focusing on unsecured personal loans and mortgage loans. We investigate whether fintech firms are more likely than other lenders to reach out to “underserved consumers,” such as minorities; those with low income, low credit scores, or thin credit histories; or those who have a history of being denied for credit. Using a rich data set of credit offers from Mintel, in conjunction with credit information from TransUnion and other consumer credit data from the FRBNY/Equifax Consumer Credit Panel, we compare similar credit offers that were made by banks, fintech firms, and other nonbank lenders. Fintech firms are more likely than banks to offer mortgage credit to consumers with lower income, lower-credit scores, and those who have been denied credit in the recent past. Fintechs are also more likely than banks to offer personal loans to consumers who had filed for bankruptcy (thus also more likely to receive credit card offers overall) and those who had recently been denied credit. For both personal loans and mortgage loans, fintech firms are more likely than other lenders to reach out and offer credit to nonprime consumers. Keywords: fintech, P2P lending, consumer credit access, personal lending, credit cards, mortgage lending, online lending, credit offers JEL Classifications: G21, G23, G28, G51 _ *Erik Dolson is a senior analyst in the Supervision, Regulation, and Credit Department at the Federal Reserve Bank of Philadelphia; email: erik.dolsonphil.frb. *Julapa Jagtiani is a senior economic advisor and economist in the Supervision, Regulation, and Credit Department at the Federal Reserve Bank of Philadelphia; email: julapa.jagtianiphil.frb. The authors thank Drew Taylor and Andes Lee for their research assistance. William W. Lang, Joseph Hughes, Christine Cumming, Brian Knight, Beau Brunson, Mitchell Berlin, Robert Hunt, and William Spaniel provided helpful comments and suggestions. The views expressed in this paper are solely those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.2 I. Introduction Fintech firms became a well-known and trusted supplier of a wide variety of financial services to consumers in the last decade, from payment services to personal loans and mortgage loans. By 2019, about 96 percent of global consumers became aware of at least one fintech money transfer and payment service, and over three-quarters had heard of a fintech in the consumer credit space. 1 Many fintech firms, such as LendingClub, SoFi, and Rocket Mortgage (owned by Quicken), have now become household names in the United States. One of the biggest shares of fintech expansion has been in consumer credit, especially unsecured personal installment loans, which have been typically used for paying off credit card balances, debt consolidation, or large household purchases. Fintech firms have exploded into this small but growing product line, undoubtedly contributing to the increase in personal loan usage in recent years. The average year-over-year growth for personal loan market has been more than 15 percent for the last several years (Beiseitov, 2019). According to TransUnion (2019), 38 percent of personal loans outstanding as of December 2018 were originated by fintech firms, compared with only 5 percent in 2013, a dramatic increase over the span of six years. This trend is borne out in credit mailing offers as well. Figure 1 presents the total volume of personal loan (offer) mailings sent to consumers, broken down by lender types (banks, traditional nonbanks, and fintech lenders). Starting from almost zero credit offers in 2010, fintech credit offers started growing rapidly and surpassed credit offers by both banks and traditional nonbanks in 2014 to peak at about $1.2 billion in 2016. Recall that this is the volume of credit offers (not loan originations) by various lenders, based on a survey of credit offers received by random households (assuming these sampled households in the survey are good representations of the general consumer population). In addition to establishing footprints in the personal lending space, fintech firms have also established a significant presence in mortgage lending. We observe increasing mortgage credit offers by fintech firms in recent years. Indeed, one of the fintech mortgage lenders, Quicken, and its subsidiary Rocket Mortgage, have become the largest mortgage originator in the United States. Along with the growth in fintech credit offers in recent years, the volume of fintech loan originations has also seen explosive growth, especially among personal loans and mortgage loans. Most of the literature posits two potential explanations. On the one hand, fintech firms may be reaching out to consumers with little access to formal financial markets filling a gap in the credit market. On the other hand, fintech lenders may simply be attempting to poach the highest-quality 1 See EY Global Financial Services (2019) Global Fintech Adoption Index. fintech-adoption-index.pdf.3 borrowers from traditional banks, wooing consumers with faster and superior service and potentially a price advantage over banks. This is what is often referred to as fintech firms “cream skimming” the best borrowers who may already have access to credit and are not underserved in the traditional sense. The goal of this paper is to explore the role of fintech lenders in expanding credit access to underserved consumers in the personal lending and mortgage lending space. We focus on lenders willingness to lend (as measured by their credit offers) to underserved consumers, using a unique data set containing consumer risk characteristics, the financial products offered, and the lenders characteristics that allow us to examine details about the financial product offered to different types of consumers (with varying credit scores, income, etc.). Specifically, we ask these questions. First, are fintech lenders targeting underserved consumers in the personal loan and /or mortgage markets? Second, are consumers paying a higher or lower interest rate (measured in annual percentage rate (APR) to fintech firms compared with banks and traditional nonbank lenders, controlling for consumers risk characteristics and general economic factors? Our study is unique in several ways. First, we focus solely on the supply side of credit (mortgages and personal loans) to explore fintech lenders willingness to offer credit to those who would not have been able to access credit otherwise. It would be then up to the consumers to choose whether to take up the offer from fintech lenders or traditional lenders. Most research studies so far have focused on loan origination, which is determined by both supply and demand. We fill the literature gap by providing additional insights into fintech firms commitment and lending behavior. Second, we compare fintech lenders with both traditional banks and traditional nonbanks (also called other nonbank lenders) to also control for the regulatory environment to which lenders are subject. All lenders, whether banks or nonbanks, are subject to regulations, including fair lending, consumer protection, and other state regulations. 2 Banks, with access to deposit insurance, are subject to more stringent capital and liquidity regulations, and they are subject to periodic onsite examination by the banking regulators (the Federal Reserve, the Office of the Comptroller of the Currency, state banking regulators, and the Federal Deposit Insurance Corporation). Shadow banks are not subject to periodic onsite examination, and they operate in a more similar environment, regardless of whether they are fintech lenders or traditional nonbank lenders. The only difference is that fintech lenders use more data (including alternative data) and more complex artificial intelligence/machine learning (AI/ML) modeling in their risk evaluation and pricing and in their fully digitized credit-decisioning process. Lastly, we use a diverse and 2 Some states, such as California, require greater transparency and more stringent interest rate ceilings, not only for consumer loans but also for small business loans.4 extensive set of measures of access to credit at both the individual consumer level and the geographic (zip code) level to gain a robust understanding of the potential roles of fintech lenders in filling the credit gaps and enhancing consumer credit access overall. The remainder of the paper proceeds as follows. Section II provides a brief review of the literature, highlighting recent research on fintech lending and focusing on mortgages and personal loans. Section III discusses the data used in this paper. The empirical approach is presented in Section IV. Section V presents our results for both the mortgages and personal loans. Section VI discusses limitations, and finally, Section VII provides implications and concludes. II. Related Literature and Our Contribution Along with the growth in fintech credit offers (as shown in Figure 1), the volume of fintech loan originations has also experienced explosive growth, especially among personal loans and mortgage loans. The current literature posits two potential explanations, with mixed empirical results. On the one hand, fintech firms may be reaching out to consumers with little access to formal financial markets, thus filling the credit gap. Specifically, fintech lenders may be able to identify good borrowers of the subprime pool, using more complex, proprietary algorithms, and alternative data. These “hidden prime” consumers may appear high risk using traditional metrics (such as credit scores) but who have a high likelihood of repayment, especially those with a short credit history whose credit score may not reflect their creditworthiness. On the contrary, as mentioned earlier, fintech firms may simply be “skimming the cream” and serving the same market segments as banks, wooing well-served consumers with faster service and potentially lower rates. Jagtiani and Lemieux (2018) find evidence supporting the hypothesis that fintech (personal loan) lenders penetrate areas that are underserved. In addition, Jagtiani, Lambie-Hanson, and Lambie-Hanson (2021) find similar evidence for fintech mortgage lenders; that is, mortgage loans are more likely to be a fintech loan in a zip code that experienced higher mortgage denial rates by traditional lenders. 3 Several other previous studies explore the roles of fintech in expanding credit access and the price they offer, using different data sets and different methodologies, and they arrive at different results. Cornaggia et al. (2018) show that the expansion of fintech firms in the unsecured loan market leads to declining loan volumes for traditional banks, driven largely by declines in the higher-risk segment. This implies that fintech firms compete for bank customers (especially those higher-risk borrowers), probably because some of those borrowers being considered high risk by 3 See Allen, Gu, and Jagtiani (2021) for an overview of fintech growth, potential disruption, literature review, and policy discussion. For more background on important factors that drive fintech lending growth and loan performance, see Jagtiani and Lemieux (2019); Goldstein, Jagtiani, and Klein (2019); Jagtiani and John (2018); and Croux, Korivi, Jagtiani, and Vulanovic (2020).5 traditional banks could get lower-cost credit from fintech lenders. The authors also find that fintech firms offer lower interest rates than traditional banks for high-quality (less risky) borrowers (they only have data for this group of borrowers). The fact that riskier borrowers leave their banks for fintech lenders would imply that the lower interest rate may have been offered to higher-risk borrowers as well. Despite higher-funding cost at fintech firms, Cornaggia et al. (2018) conclude that fintech lenders are able to offer a lower rate of interest than banks because of their cost advantage driven by smaller overheads and other operational costs. Similarly, Di Maggio and Yao (2019) ask whether fintech firms are expanding access to credit for the underserved or simply capturing the most creditworthy borrowers from banks. Using account-level consumer credit panel data, focusing on unsecured installment personal loans, they find that, in a longer term, fintech borrowers are more likely to be more indebted (overleveraged) than traditional bank customers. Based on this, they posit that fintech borrowers are likely to be consumers with a preference for immediate consumption who overborrow and use the loans to finance increased expenditure. In addition, they find that consumers who receive fintech personal loans tend to, on average, have a higher income, have a better credit history, live in more affluent neighborhoods, and have significantly more credit accounts, but they tend to have higher credit- utilization ratios than a matched sample of bank borrowers. These borrowers might have already maxed out their ability to get credit from traditional lenders, given their large credit lines and high utilization ratios. In a similar vein, Tang (2019) examines whether fintech and traditional bank loans are substitutes or complements. The author notes that if they are complements, fintech lenders and banks would be serving different segments of customers, with fintech firms serving the lower- quality (lower-score) segment. Any negative exogenous change in bank credit
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