"Silicon Valley is coming," JPMorgan Chase chief Jamie Dimon warned in his annual letter to shareholders in April. As head of the largest bank in the U.S., Dimon clearly meant to instill a sense of urgency amongst financial institutions.
The growth of the financial technology industry has so far been rampant, with investments in fintech startups tripling just last year. Much of this growth is due to new and innovative underwriting models that are quickly expanding the borrower pool, allowing startups to serve those who were previously underbanked. As fintech increases the number of customers who can gain access to credit and other services, banks must update their traditional approaches to keep pace.
A borrower's creditworthiness has traditionally been based largely on a strict set of requirements, including their FICO score, debt-to-income ratio and salary. This system has left many potential borrowers unable to get the funds they need.
The situation worsened in the aftermath of the market crash of 2008. During the recession, Americans saw their net worth drop 39% and credit scores plunge, with 8.7 million jobs lost in the fallout from the financial crisis. Many Americans found themselves in newly vulnerable financial situations. Meanwhile banks, already suffering in the aftermath of the crash, were encumbered with additional regulations that hindered their ability to evolve with the times. These circumstances created the opportunity for a new breed of financial company that could increase the number of potential borrowers who never or no longer fit the traditional creditworthy profile.
Companies like LendingClub and Prosper forged the path for fintech firms. Since their rise, even more startups are finding innovative ways to assess a borrower's creditworthiness. Instead of relying only on information about applicants' past financial and credit circumstances, these lenders focus on the current state of their finances and their future potential to be a good borrower. In order to assess this, they analyze data including what colleges the applicants graduated from, their GPAs and even their LinkedIn connections. By increasing the number of lenses through which an applicant is analyzed, the pool of responsible borrowers has also increased.
As Dimon made clear, traditional lenders are becoming acutely aware of the groundswell of competition disrupting their once largely stagnant space. Startups are both dipping into banks' market and growing it.
Banks will be unable to drastically change their longstanding structure in the short term. But certain traditional lenders have begun to explore ways to use their inherent differences to beat out agile fintech startups. For example, some banks will refinance borrowers with much lower credit scores than leading alternative lenders, which typically require credit scores upward of 740.
Over time, startups with more innovative underwriting models will be able to prove the validity of their approaches with strong track records. At this point, larger institutions are likely to partner with them as loan originators. Meanwhile, as additional lenders enter the space, it will continue to grow into new and ambitious verticals. Starting just seven years ago in personal loans, the sector has grown to encompass student loans, mortgages, and business loans, increasing the borrowing pool not just by expanding the number of people who can be deemed creditworthy but by enlarging the types of loans that can be taken out.
No matter how the competition between banks and lending startups shakes out, it will greatly benefit the consumer. With both groups working hard to grow their addressable markets, consumers will be provided more choices that are more closely aligned with their needs.
Stephen Dash is founder and chief executive of the student loan marketplace Credible. Follow him on Twitter @stephenjdash.