The 5 Crucial Steps to Building a Lending Product
Remember when you had to be a bank to build financial products?
How quickly times have changed! In the not-so-distant past, large retailers like Canadian Tire, Walmart, and Rogers had to go through the lengthy process of becoming a Schedule I Bank in Canada in order to build a credit card program. Now, with the explosion in API-driven technology and the increasing appetite of banks to partner with fintechs, any company can build and launch a financial product.
But while there are many Banking as a Service (BaaS) providers who claim to be able to build your product in a matter of weeks, the reality is that the path to a successful launch is still a challenging one. Especially if your product has a lending component. There is a good reason why so many looking to branch into financial products start with a debit or pre-paid card – it is way less complex than a lending product and can be brought to market much faster. Simply put, lending is a tough business to crack.
Step #1 – The Idea
In broad strokes, non-banks looking to launch a lending product typically fall into two categories:
Adjacent: These are large companies with an established customer base that are seeking to expand their offerings to include lending products. Apple Card and Shopify Capital exemplify this model:
- Even behemoths like Apple realize that you don’t need to become a bank to build a financial product – you just need to partner with Goldman Sachs if you want to launch your own Apple Card.
- Realizing how many of its merchant base were taking out loans to fund their marketing and inventory, it was a natural extension for Shopify to launch Shopify Capital, whose loans are issued by WebBank.
Start-ups: These are innovative companies, often VC-backed fintechs, that spot unmet needs in the market and address them with unique offerings. Consider Brex, a company aiming to revolutionize small business lending, or Neo, a company which proffers the premise that everyone deserves rewards. These fintech lenders tend to go after niches that are underserved by the incumbent banks. For instance:
- Anyone who owns a small business and has applied for a loan through their bank, including myself, knows how inadequate large corporate credit models are for meeting their needs. By designing a company around the unique needs of startups, Brex has built financial products that business owners love and translated that success into unicorn status.
- Access to credit and rewards in Canada is offered very selectively by the Big 6 banks. Neo is reinventing banking in Canada by offering merchant-funded rewards to all its customers – and with a digital experience that its customers truly love.
There are three important questions to ask yourself to validate if you have a winning idea:
- What is the Customer Need or problem you are filling? How acute is this problem – would customers be willing to pay for your solution?
- What is the Total Addressable Market (TAM) for your product? If you are using the product as an entry point, what is your product roadmap and path to scale?
- What is your Unfair Advantage? What unique capabilities do you have that can create moats for potential competitors?
Step #2 – The Licenses
Lending is a highly regulated business, which means you’ll need to navigate complex legal waters to launch your product. While you may not need to become a bank per se, at the end of the day, you’ll still need to interact with one to get your product to market.
In recent years, the BaaS market has grown exponentially, with many regional banks eager to partner with companies looking to launch lending products. Sponsor banks such as Peoples Group provide banking licenses, BIN sponsorship for Visa & Mastercard, white-label services, and built-in compliance infrastructure for their B2B partners. Some sponsor banks, including Peoples, will also offer a portion of their balance sheet as a debt facility for their partners.
When picking a Sponsor Bank, consider these factors:
- Speed to Market – Does their process meet your timelines? Do they have a track record of launching within their promised schedule?
- Credit Control – How tight is their credit box? How arduous is their credit governance process? As the true lender, they will need to ultimately approve your credit policy, and as a fintech or digital lender, you want to have as much control and flexibility as possible to iterate on your policy as you scale.
- Cost – What is the revenue share agreement? Are there guaranteed minimums or other commitments?
- Geographic Coverage – Do they have federal licenses or are they only licensed in certain states or provinces?
Step #3 – The Build
Once you’ve sorted out the legal and licensing hurdles, it’s time to focus on the product. The buzz about fintechs today is their ability to disrupt traditional financial products and revolutionize customer experiences. A big part of this lies in their ability to deliver tech in a manner that is not feasible at legacy institutions. The single biggest advantage that fintechs have over incumbent banks is that they are built from the ground up on modern tech stacks, rather than legacy mainframe systems.
Build vs. Buy?
Just as there has been tremendous growth in sponsor banks, there have been a ton of companies springing up in the core banking and infrastructure space. Many of these providers offer end-to-end modernized services via API integration with partner companies. Companies like Alloy offer complete identity decisioning platforms for fintechs that automate their onboarding process. Deserve offers “card-in-a-box” solutions with its digital-first, mobile-centric, and API-driven Credit Card as a Service.
When planning your product launch, one of your first decisions will be how much do you build in-house, versus how much do you want to buy from Platform as a Service providers? With API’s powering plug-and-play architecture, the solution doesn’t have to be one or the other; many companies will choose to outsource certain services, while building others with their own engineering teams.
For triaging which to build vs. buy, ask yourself the following questions:
- What are your existing capabilities? Established companies with existing development teams may be able to build a good portion of the features in-house, and thus have more control over the experience and avoid monthly subscription costs. Although rare, even some startups have demonstrated the ability to build their own core systems – I have been amazed at how much of a difference a star tech or product lead can make in the early phases of building out financial products.
- How fast do you want to get to market? How critical is customization to your customer experience? These two questions go hand in hand. Leveraging a solution like Deserve will likely get you to market faster, but you will have to accept a more white-label solution.
- How much are you willing to spend? Similar to choosing a sponsor bank, cost is a big determinant in choosing a platform partner for key services such as payment processing and core systems. Many of the established providers such as Marqeta will have tiered pricing based on minimum thresholds for volumes that will make them prohibitively expensive during the early years for startups. But be cautious of going with the lowest-cost provider – these are often startups themselves that are still building out their solutions and are hungry for business partners to serve as their guinea pigs.
Your choices will ultimately balance speed to market against cost and long-term control.
Step #4 – The Credit Policy
You would be shocked at how many companies start a fintech without anyone on the founding team having credit experience! Perhaps this isn’t totally surprising – the people setting out to reimagine banking aren’t likely to be bankers themselves. But this can pose a dilemma for these new lending companies as their launch date nears and they need to develop their credit policy, monitoring plan, controls, and governance.
When I first talk to a founding team about their credit policy, I cover 5 areas:
- Risk Appetite – Underwriting to zero-risk is never optimal, but there is asymmetric downside from having policies and procedures that are too lax. Startups need to head to market with a clear articulation of how far down the credit spectrum they are willing to go, and how their pricing model will support this.
- Data Sources – Banks have a distinct advantage with existing loan data to model from, whereas startups have to look elsewhere. Leveraging an open banking solution like Plaid or Flinks can provide an additional view into your applicant’s cash flow, in addition to their credit report.
- Customer Experience – For startup lenders, there is always a tension between adding additional risk criteria (or “friction”, as product would call it), versus growing and scaling a new business. It’s crucial to make the right tradeoffs here – we are now seeing some fintech lenders imploding because they made the wrong decision to not require personal credit checks.
- Structural De-risking – There are key choices in product design that can reduce the risk of default. For example, requiring customers to sign up for pre-authorized debit as a condition of the loan can put you first in the customer’s payment hierarchy.
- Testing – Although it is tempting to keep out of scope for MVP launch, I always encourage startups to start testing as soon as possible. The only path to being an end-game player in lending is to build proprietary risk models on well-designed test data. While that may seem like the distant future, you need to drop tests early to allow them to season.
Step #5 – Launch & Scale
You’ve launched your product and worked through the initial bugs to get your beta version working. At MVP stage, you’ve undoubtedly had to make some tough decisions, cut a bunch of corners, drop a number of “nice-to-haves”, and sacrifice on customer experience. It’s inevitable.
But once you’re past the point of survival, it’s time to focus on, “What are you going to be when you grow up?” Now, you need to turn your attention to scaling.
The Funding to Scale
If you’re like most startups, you’ve got to MVP by funding off your own equity and balance sheet. This is expensive, as you want to be using your hard-earned equity for operating runway, not tied up against loan assets. You’ll quickly want to raise your first debt facility, likely in the $100 million dollar range. Here are a few things to know:
- Some Sponsor Banks will also provide a debt facility, so this is the first place to look. If they don’t, you can secure one yourself through private lenders like Victory Park.
- You can expect to pay a high premium for your first facility (10-15% APR) until you have a year or two of loan performance data. There also may be additional fees and minimum guarantees attached as part of the commercial terms.
- The advance rate is the maximum loan amount that the facility will provide, expressed as a percentage of the total collateral. The higher you can negotiate, the more capital you will be able to preserve.
- Watch out for restrictive loan covenants that would hinder your control over key lending decisions.
A big part of the move from startup to scaleup is planning which capabilities you now need to bring in house to reduce tech debt and vendor dependency. Aim for a target architecture that’s platform agnostic, highly interoperable, with maximum flexibility built in. All too often, I see companies being restricted by their data structure and interpretability. This will give you the best chance of maintaining your speed and nimbleness as you grow from a scrappy startup to a bigger organization.
Monitoring & Controls
What separates lending from other financial products is your exposure to fraud and credit losses. As a new entrant in the market, you will attract fraudsters looking to exploit weaknesses in your system and credit-hungry customers looking for new access to credit. Depending on the structure of your product, it can take months to years to truly understand the risk of your portfolio. Monitoring early risk indicators, such as delinquencies, is critical. A solid suite of monitoring views lets you understand the health of your portfolio and allows you to update your credit policy before things take a turn for the worse.
By carefully considering the factors in these 5 steps, you can successfully launch a financial lending product, even if you’re not a bank. In a world where finance and technology intertwine more each day, there’s plenty of room for innovation, growth, and profit.
About the Author:
Brent Reynolds, has over 20 years of experience in the financial services industry, with deep expertise across the entire customer lifecycle, spanning product, marketing, credit, customer experience, fraud, and loss mitigation.
Prior to Payson, Brent served in multiple senior executive roles at Capital One Canada, including Chief Credit Officer, Head of Capital One-Branded Cards, and Chief Customer Experience Officer.
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Engaging with the organizations leading and innovating within the sector and beyond makes the upcoming 2023 Lenders Summit a must attend event. Taking place on November 1st at the MaRS Discovery District in downtown Toronto, the focus of the event will be on networking, partnerships, and driving innovation in the lending sector.
From Banks and Credit Unions to best-of-breed vendors from the fintech ecosystem, the 2023 Lenders Summit is the hub for networking and business partnerships across all consumer and commercial sectors. Main themes include fraud technology, Identity Verification (IDV), financial data solutioning and supporting new-to-Canada and new-to-Credit.