In consumer lending, capital efficiency is a major driver of success and growth. Companies that can convert originated loans and other forms of lending into returns faster can be more profitable, scale faster, and hold up resiliently in volatile markets. With current market pressures like higher interest rates, new competitors, and tighter regulations, lenders have to find better ways to deploy their capital as efficiently as possible.
Traditional Approach to Capital Efficiency
The traditional banking model centers on holding loans to maturity. This approach ties capital up for years, and it often ties the expected returns heavily to the risk profiles of the borrowers. Scaling is limited because deposit funding is the central model.
Manual underwriting creates further bottlenecks, and rigid credit criteria may limit the ability to bring in new and creditworthy borrowers. Banks lend less, and borrowers have less access than they would otherwise because risk management is slow, complex, and risky in its own right.
Historically, this approach has the virtue of predictability. However, it also leads to risk concentration and capital-intensive operations that can have terrible effects when the macroeconomy turns against a lender or the broader market. Balance sheets full of proven borrowers outweigh risk-offs in many cases because size and stability are the main strengths of the traditional approach.
Shifts in Consumer Lending Models
The rise of digital-first lenders and marketplaces is the main disruptor in the current environment. Securitization and whole-loan sales allow many of these lenders to recycle capital faster, leading to greater efficiency. Digital-first operations also trim overhead significantly, and the overall model connects lenders and borrowers directly. Businesses can achieve national reach quickly without the costly and lengthy buildout required by the traditional model of establishing branches in every region.
Private credit and institutional investors are becoming major players in funding consumer loans, too. Insurers, endowments, pension funds, and even foreign investors are rapidly entering the consumer market with capital to support growing lenders.
Technology’s RoleContaining risk has been the main impediment to lending and remains so in the modern market. However, AI-driven underwriting has radically accelerated the speed of assessing risk and making lending decisions. Alternative solutions for credit decisions have also fostered lending because banks don’t have to rely exclusively on a simple credit score. Machine learning allows lenders to quickly:
- Compute behavioral scores
- Automate income verification
- Recalibrate credit considerations
- Monitor delinquency risks
- Render decisions
Fraud prevention tools leverage AI to quickly scan social media accounts, too. With the ability to rapidly and accurately assess whether a borrower exists or is the claimed person, de-risking becomes simpler. Likewise, downstream buyers of originated loans can be more confident in what they’re acquiring.
Automation also reduces overhead. Data collection and contract generation are vastly simpler. This increases loan throughput, too. Smart contracts enabled on the blockchain also provide efficient and transparent ways to encourage greater capital flows through a digital lending platform.
Strategies for Greater Efficiency
Originate-to-Distribute
Originating loans for the purpose of distributing them allows a company to turn over capital much more quickly. It also enables diversification, reducing risk concentration. Forward flow agreements ensure that lenders have predictable exits from loans.
Dynamic Pricing Models
Real-time risk models shift faster than traditional lending practices can handle. Automation allows dynamic pricing models to become the norm. Market pricing, real-time risk scores, and individualized borrower profiles all make it easier for lenders to pair the borrower with the right terms.
Partnerships With Investors
Blending banking, fintech, and private capital pools creates joint ventures for technology and investment. Risk sharing becomes the norm, and co-lending agreements allow diversification in funding sources by working with partners.
Embedded Lending
Integration of lending at the point of sale gives borrowers faster access to credit. It also lowers acquisition costs for lenders and puts them right where the consumer borrowing action is. B2B marketplaces, employment-sponsored lending, and digital wallets all shorten the distance between borrower and lender. AI lending systems also make it easy to embed lending in third-party applications, opening up opportunities for businesses that might not see themselves fundamentally as lenders.
Challenges and Risks
Sustainable lending practices are key to capital efficiency. The expectation of investor returns needs to make sense within a regulatory environment that’s still fractious on a state-by-state basis in the U.S. The influx of investors also leads to new requirements for both due diligence and reporting.
Consumer protection and fair lending are also important. The optimal outcome is that each digital lending platform will be safer and more accessible for each borrower. However, risk profiling does carry the danger of dressing historical discriminatory practices in technological clothing.
Humans also still need to be in the loop to ensure oversight and manage liquidity risks during inevitable economic downturns. Otherwise, runaway automated processes have the potential to crash institutions at unparalleled rates. In the same way that steam engines improved productivity but could also explode without an attentive operator, automation requires human insight.
Future Outlook
You can expect significant increases in collaboration between banks, fintech companies, and institutional investors. Hybrid models of fintech distribution alongside traditional banking with balance sheets will become more normal. The investor appetite will grow, but demands for ESG-compliant strategies for responsible capital and transparency will grow, too. Increasingly, capital-efficient AI lending will become a distinct asset class in the economy, attracting investors who may not be happy with current growth and yields in other sectors.
Embracing Speed, Sustainability, and Risk Management
Capital efficiency is poised to become the defining advantage for consumer lending institutions. Operational speeds will be measured in seconds. Risk management and sustainability will also intertwine more than ever. Institutions and investors that are ready to rethink traditional consumer lending models in favor of AI lending will have the edge in a market that’s becoming more fiercely competitive.
