2020 was an insanely crazy year for, well, just about everyone in the entire world? As a finance professional, I thought the crash of 2008 was a once-in-a-lifetime event in terms of unprecedented uncertainty, but even that pales in comparison to 2020. In 2020, in addition to disruption in financial markets, we’ve had to deal with abject fear for the health of our loved ones and an economic shutdown that has crippled our small businesses.
And it’s not over yet. As I write this on January 11, 2021, we seem to be at an inflection point. On one hand, COVID cases are still peaking at record highs – but on the brighter side, vaccines have started to roll out. However, it is expected that the majority won’t receive vaccinations until at least the summer, so we are bracing for 2021 to be another year heavily defined by the course of this global pandemic.
As I consult with financial services companies across the globe, I get asked a lot where I think we are heading from a credit perspective, and how lenders should be approaching their planning for 2021. Against this backdrop of COVID, the future is more uncertain than ever before, so the short answer is, of course, “I don’t know.” But I do see some very interesting trends in the market, and so without further ado, here are my bold predictions for 2021.
1. Favourable credit conditions will persist well into 2021
Ok, I know what some of you are thinking… isn’t this the same guy that’s been preaching forever that “now is the time to prepare for the downturn?” In fact, I wrote a Blog about it back in August 2019 - which seems like an eternity ago now.
And then, of course, COVID-19 hit, and the world changed overnight.
It’s hard to believe that a global pandemic and economic shutdown would lead to improved credit performance, but that is exactly what has happened. And not just by a little bit – by a whole lot. Apart from the initial shock and chaos in the first weeks after March 2020, when banks and governments were scrambling to deal with the crisis, credit performance has improved dramatically. Per TransUnion, credit card delinquencies were down 36% year over year in the third quarter of 2020.
Credit card delinquencies were down 36% year over year in the third quarter
The primary driver behind this immediate and sharp improvement in credit performance has been the unprecedented government stimulus. In Canada, disposable income actually increased by 11% in the second quarter of 2020, as government transfers more than outweighed the loss of income from unemployment. Rather than stockpiling it, consumers have used this extra cashflow to pay down outstanding bills or debt.
In a way, this global experiment has proved a testament to the strength of the human condition. In lending, we often talk about “willingness to pay” versus “ability to pay”. This experiment has permanently shifted my belief more to the end that debt problems are vastly a function of ability, rather than willingness, to pay. If given the chance, people genuinely want to pay back their debts.
Two data points lead me to believe this effect is going to last for quite some time. The first is that stimulus payments have been extended, at least here in Canada and in the US. The second is that the combination of stimulus and a decrease in consumer spending has created a massive spike in savings. A recent report from BMO Economics found that household savings was at 27.5% in the second quarter of 2020, compared with 1.4% in 2019. This translates to an additional $150 billion in savings – a whopping 7% of GDP.
A word of caution: these are still temporary effects that are masking the underlying fundamentals of higher unemployment, which sits at 8.5% versus 5.6% a year ago and is traditionally the data point most correlated with credit delinquency. I still think we will see a major correction, perhaps sometime in 2022, and thus would be cautious when underwriting revolving debt or longer-duration installment loans. But for vertical loan performance, I expect 2021 to be another very strong year with low charge-off rates.
2. Digital transformation will continue to accelerate
In business, nothing accelerates change like a burning platform. All incumbent financial services organizations have been on a journey of digital transformation for years, but most have been moving at a snail’s pace that lags both customer expectations and new fintech challengers. And then COVID hit, and overnight their entire organization had to shift to online, as their offices, branches, and retail locations were shuttered. If there ever was a bigger burning platform for digital adoption, I can’t think of it.
A new survey by McKinsey finds that responses to COVID have speeded the adoption of digital technologies by several years – and that many of these changes could be here for the long haul. I completely agree with this; in particular, I think the success of Work-from-Home (WFH) has emboldened many organizations to accelerate their rollout plans for digital technologies, both for their internal operations, as well as their customer and supply chain interactions.
The success of Work-from-Home has emboldened many organizations to accelerate their rollout plans for digital technologies.
One of the long-term effects of this should be significant cost savings, although the bulk of these will not hit the books in 2021. Reducing office space or retail footprints, exiting data centres and migrating to the Cloud, and shrinking operations centres through automation will all improve operating efficiency, not to mention enabling a lot of the real-time digital experiences that customers want.
The shift to digital channels for new customer acquisition will also continue in 2021. Banks have struggled to cross the chasm from a branch or retail sales model to online acquisition, but this has forced their hand to finally make a serious investment in the capabilities required to compete. I anticipate a higher level of investment from lenders in 2021 in data-driven decisioning models for ad placement and digital tools for improving conversion in order to reduce cost-to-acquire (CAC) and scale their online acquisition businesses.
3. Ecommerce lending will remain white-hot
One of the most successful product innovations of the past few years in consumer lending has been the “Pay in 4” model, pioneered by fintech behemoths like Afterpay, Klarna, and Affirm. These buy now, pay later (BNPL) financing offers are appearing in more and more online checkout flows, disrupting the ecommerce space and taking share from credit cards. Many of these offers are no-fee, 0% APR and entirely funded by the merchant, making them an attractive offer for consumers.
The growth in these BNPL loans has only been accelerated with the COVID pandemic. One of the direct implications of government-led shutdowns has been an explosion in ecommerce: online sales in the US were up 43% year over year in September. To see the impact this has had for ecommerce lenders, one needs to only look at Affirm’s recent IPO filing: its revenue was up a staggering 98% year over year in the third quarter of 2020.
Affirm's revenue was up a staggering 98% year over year in the third quarter
The big question is, “how much of this momentum is temporary due to COVID lockdowns?” I believe that although COVID is a temporary effect, the shift to merchant-funded loans online is hitting an inflection point and is very likely here to stay. In 2020, retailers were in reactive mode as they dealt with physical store closures; now, they are proactively planning for more online traffic and a more seamless online shopping experience in 2021. The popularity of these loans with consumers will convince many retailers that offering them will increase purchases and basket sizes, which in their minds will more than offset the difference between the merchant discount fee and what they are paying in interchange for credit card purchases. With modern technology, the barriers to entry are also quite low, as new merchants can be onboarded quickly with custom application processes that are fairly frictionless. I anticipate another very strong year for ecommerce lenders in 2021, as they will continue to steal share from other payment forms, while also benefiting from sustained levels of ecommerce spend.
4. The shakeout will finally begin in the fintech space
It’s been an incredible run for fintechs the past seven or eight years. After a period coming out of the Great Recession when deals were pretty much non-existent, there has been a steady flow of investment dollars since 2014, peaking in 2019 at over $130 Billion worldwide.
Like everything else, this was disrupted in the second quarter of 2020 by COVID, but rebounded strongly in the second half of the year. However, at a closer glance, while dollar volume was back up, the number of deals was actually down 24% from 2019 in the third quarter. Investments have been getting bigger and later, as evidenced by some of the eye-popping valuations of megadeals such as Robinhood and Chime. But for earlier-stage fintechs, could this be the first sign that the days of easy money are numbered?
People always ask me, "how are these companies making money?" The answer is simple: they're not.
One of the consequences of this easy access to funding is there are a bunch of fintech lending plays that have sprung up in the market that just don’t make sense to me. I see start-ups offering loans and credit cards with marketing claims of “no fees” and “no credit history required”. People always ask me, “how are these companies making money?” The answer is simple: they’re not. They are burning through cash from their latest round to grow their customer base with giveaways and freebies, while deferring on how to make these customer relationships profitable. In a frothy market, investors are willing to take a bet on these pre-profit start-ups in hopes of picking the next unicorn… but will this sentiment continue into 2021?
I think 2021 will be the year where the shakeout starts, and funding further rounds will become much more difficult for earlier stage fintechs with unproven business models. One thing all of these companies share in common is that they have not survived a recession before. Investors are forward-looking, and as their focus shifts to when the credit downturn is finally going to arrive and which lending plays are best positioned to weather the storm, many of these companies will find themselves frozen out. I see many fintech lenders that tout their use of alternative data and machine learning models to serve those borrowers who are not approved for loans through traditional banks. That sounds great in an investor presentation, but it is my experience that the success of alternative credit scoring has been limited and is often masked by higher APR and conservative loan amounts, or additional verification steps in the process. As investors start to tighten their purse strings, they will want more surety and will look more favourably on those who have a track record of good underwriting through actual performance on loan tranches. This inevitable retreat to quality and fundamentals will spell the end for many fintechs – and I think we could see that start to play out in 2021.
What are your thoughts?
What are your predictions for 2021? Which of mine do you agree with… and which do you not? Leave your thoughts in the comments, I’d love to hear from you!
Here’s hoping for a safe and happy New Year, with a return to normalcy as soon as possible!