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Embedded finance entered the imagination of the fintech space through A16Z’s blog (Every company will be FinTech company) published in January 2020. Throughout 2020, Embedded Finance was highlighted multiple times, for example Lending is a feature (Kunal Shah), and as the 4th platform layer by Bain Capital.
This article summarizes the history of digital lending, and shows how Embedded Finance is not just an incremental improvement on digital lending but in fact an evolutionary leap.
Digital Lending Partnerships
Digital lending is the digitization of the lending workflows, typically manifested as a digital lending platform or digital loan apps. Digitisation made the lending process more efficient and increased credit penetration. It made it easier and quicker for customers to acquire credit. NTC customers could access credit at market prices (as opposed to exorbitant prices set by informal lenders) by providing their alternative data for underwriting.
When it emerged, digital lending was a wave of disruption in the credit space. However, digital lenders had primarily built their technology platforms to acquire customers from the open market i.e a mobile app or website.
Digital lenders ran partnership based strategies with customer-facing digital platforms (Anchor platforms). However, they ran these partnerships in a limited way, primarily through a lead referral model. Anchor platforms running a non-finance business with an active customer base, passed off leads generated on their platform to a lender in order to assist their customers acquire credit.
However, there were substantial inefficiencies in this digital lending partnership model.
The following story illustrates what was the experience for the customer borrowing through the digital lending partnership model.
How Embedded Finance affects the end-customer?
Picture this. Amit is a small retail shop owner who generally sources stock from a B2B E-Commerce marketplace. During the diwali season, Amit wants to stock up 3 times his usual order value. He generally orders on Thursday night and expects the delivery on Friday night, so that he is prepared for the weekend. He is acclimatised to the platform and expects it to fulfill his various needs.
He sees an “Apply for Loan” option on the platform, and decides to try it. He is immediately thrown to a completely new webpage, of a bank, that he doesn’t recognize. He has to input a lot of information and upload documents to complete the loan application process. He had shared these with the E-Commerce platform already for some prior use-case.
The bank informs Amit that it will take 2 days to process the application. In the middle of the weekend, he gets a rejection from the bank. He isn’t informed of the reason, but he is rejected because he doesn’t have a formal bureau history. The bank can’t underwrite him.
Since there are still a few more days of heightened demand, Amit applies for a loan again. He is thrown to the website of the platform’s second lending partner. He has to refill the form details and reupload the documents that he has now shared not once, but twice. He is again informed that his application is being processed and he will hear soon. Next day, he receives a notification from the second lending partner informing him that there were some issues in his uploaded documents. He doesn’t understand the problem, and calls the customer support of the platform. Customer support isn’t able to help him since it has no information on what is happening with the lending partner. He is redirected to the customer support of the lending partner.
At this point, it doesn’t matter whether he is approved or rejected. His need is now expired. The festival is over, and he doesn’t need the credit anymore. Amit had come on the digital platform to place an order, but ended up having to take multiple detours and had nothing to show for it.
Now contrast this with if the platform had an embedded credit product onto itself. Amit had been granted a credit line despite being new to credit, thanks to data about his past orders that the platform had. The terms of the credit line were conceived by close consultation with the platform. Amit ran into a few hiccups in the application process, but the customer service could easily identify the roadblocks and help him move forward. The credit line enabled Amit to seamlessly make the purchase on credit. He had come on the platform to place the order, and that was all he had to spend time doing, as receiving the credit was completely seamless and frictionless. He was able to cater to the larger demand and capitalise on an opportunity to do more business.
For Amit, the experience of embedded finance was profoundly different as compared to Digital Lending partnerships. Embedded Finance simplified the process of borrowing to a seamless payment option.
Embedded Finance vs Digital Lending Partnerships
Embedded finance is the seamless integration of a financial service in an anchor platform in the non-finance space. It packages lending as a feature. For the end-user, the financial service and the core service of the anchor platform shouldn’t be differentiated. They are both enablers of the user’s final intent. So it makes sense for the anchor platform to serve both needs well, and get rewarded for it, especially if credit enablement is essential to enabling the core business of the anchor platform.
Embedded Finance is not merely an advancement of the digital lending tech stack. It embraces the need for customization and deep collaboration between anchor platform and lenders. It creates a business model that aligns interests of all stakeholders. Embedded finance infrastructure providers get paid on the shared success of the digital platform and the lender.
Since building a native experience in the app was intractable and expensive, Anchor platforms had no choice but to pass off a “lead” that they generated, to a digital lender. The customer expressed interest in a loan product on their platform, but had to be redirected to the unfamiliar ecosystem of the digital lender. This typically meant the customer had to download the digital lender’s app to apply for credit.
Thi led to suboptimal user experiences. The anchor platform had little to no transparency on the experience of the customer and very limited ability to help him/her. The user had to go through multiple non-uniform user experiences if he ever had to borrow from multiple lenders and repeat the same form-filling process. This resulted in a high drop-off rate.
High drop-off rates
Poor User Experience
Embedded Finance enables the digital platform to bring the entire lending lifecycle on its platform, customise it for their customer base and proactively assist their customers. User experience on the platform is arrived through deep collaboration with platforms. Customers can receive loan offers from multiple lenders with a single uniform journey.
An interesting way Embedded Finance ensures high customer satisfaction is prequalification. This enables very high approval rates (ratio of successful loans and number of applications) as only eligible borrowers are shown an offer for the credit products. This is done through leveraging the data available with the platform as well as by leveraging alternative data. Reducing overall rejections ensures high user satisfaction.
Digital Lending Partnerships traditionally connected the anchor platform with one lender. Integrating with one digital lender is an expensive and time-consuming process for a digital platform. Integrating with multiple digital lenders means n times the cost, developer hours, customer service, partnerships. Working with only one lending partner also means that the approval rates of the passed leads were low.
Lower Approval Rates
Suboptimal Terms of Credit
High integration overhead for the anchor platform
Suboptimal User Experience
Potential for disrepute to anchor platform
Embedded Finance connects anchor platforms with multiple lenders. Here are the key benefits of integrating with a network of lenders as opposed to partnering with one digital lender at a time
Credit coverage - If a digital platform has a diverse demographic varying in geography, sector of industry, size etc., then it needs to connect with multiple lenders to provide the best service for their customers. It ensures high approval rates and better than market rates for end customers.
Interest Rates - Different digital lenders have different costs of capital. Having a network ensures best interest rates for your customers.
Embedded finance also provides a uniform unified journey to customers and enables them to borrow from multiple lenders
NBFCs and digital lenders are specialised at underwriting a particular narrow segment of customers and rarely approve customers outside that demographic. Their end-to-end approval rates range between 5 – 12%.
Rejecting such a large proportion of borrowers risks bringing disrepute to the digital platform. Digital platforms want to approve as many customers as possible and smoothly enable credit on their platform.
Digital lenders and NBFCs rely on credit bureau data (and in rare cases, alternative data) to underwrite customers. They were not able to leverage platform data for underwriting, since digital lenders are only specialised to underwrite a narrow segment of customers.
Lower Approval Rates
Potential for disrepute to the anchor platform
Embedded Finance enables platform data underwriting. platform data requires specialized expertise in underwriting. Underwriting small electronics retailers based on cash flow will be different from underwriting FMCG retailers. Embedded Finance enables platform data underwriting. Anchor platforms have valuable data about the customer such as cash flow, accounts receivables, accounts payable, purchasing history etc. Embedded finance infrastructure companies can underwrite customers based on this data. This enables customers without a credit history to get credit. It also enables the approval of small ticket size short-period loans.
Digital Lenders rely on credit bureau data to underwrite, are heavily regulated, and are not close to the end consumer. Due to this, digital lenders offered rigid credit products that often didn’t suit the exact needs of the customer.
Borrowers tend to overborrow
Borrowers are strained in repaying
Higher drop-off rates
Higher delinquency rates
Embedded Finance enables platforms to innovate, evolve and tailor credit products to serve the use-cases of the customer in deep collaboration with the anchor platform. Customized credit products that suit the exact needs of the customer provided at the exact time of need work much better than one-size-fits-all products that digital lenders provide.
Credit is an enabler for all businesses. A deep integration between anchor platforms and lenders and availability of diverse functionality enables these platforms to leverage their unique position in assisting in loan servicing and acquisition. Such creative partnerships enable platforms to offer unbeatable and tailored products to their customers. They can improve loan approval rates by 2-3x, and offer best-in-market interest rates. Embracing Embedded Finance enables anchor platforms to run successful credit programs that effectively help their customers. The Anchor Platforms whose core business is enabled by credit must embed credit on their platform.