A Blog by Jonathan Low


Jan 2, 2019

My Banker Is An Algorithm

Tech firms have all the data they need from processing businesses' and individual's payments to assess which may need - and be good customers for - loans.

Traditional banks are right to be worried. JL

Peter Rudegair reports in the Wall Street Journal:

Technology firms challenge banks not just on payments or digital apps but on the banks’ core business of making loans. Tech firms’ customer data give them an advantage. PayPal. has extended $6 billion in loans, using data it collected processing payments for internet retailers. Merchants that sell goods on Amazon have borrowed  $3 billion from (it). Fintech firms (are) trying to offer banking services without triggering bank regulations. (But) “increasing dependence on the extension of credit to customers has made the business model vulnerable." (And) machine-driven lending can rankle borrowers who might be better served (by) a human.
Billy Joe Wilson was cooking up tater tots and chicken-fried-steak sandwiches in a food truck on the Texas Gulf Coast last fall when an app on his tablet asked if he wanted to borrow $5,000.
“It’s either one of those things that are too good to be true or it’s going to require a lot of time and effort where it’s not worth it for me,” Mr. Wilson said. Neither turned out to be the case.
The offer came from a unit of Square Inc., which made the devices Mr. Wilson uses to process customers’ card payments. For weeks, its algorithms had quietly observed Mr. Wilson’s sales and then decided he was creditworthy. With a few swipes, he accepted Square’s terms and got the money within days. He later borrowed more than $150,000 to open a gastropub nearby.
Square, best known for its white credit-card readers that plug into smartphones, is part of a wave of the tech giants making inroads into the banking business. The firm, run by Twitter Inc. co-founder Jack Dorsey, is already well-versed in financial services through its payments business.
Last week, the San Francisco company took another step towards banking: It filed paperwork to open its own bank in Utah that would make loans to small businesses and offer deposit accounts to both companies and the general public.
Few things terrify today’s bank CEOs more than the specter of a big technology company elbowing them aside. Square’s new push puts it at the forefront of technology firms aiming to challenge banks not just on payments or digital apps but on the banks’ core business of making loans. Tech firms’ vast troves of customer data can give them a built-in advantage. PayPal Holdings Inc. has extended more than $6 billion in small-business loans since 2013, using data it collected by processing payments for Internet retailers. Over the past seven years, independent merchants that sell goods on Amazon have borrowed more than $3 billion from the e-commerce giant, which approves loans based on sellers’ historical volumes, Amazon reviews and other factors.
Older tech companies and financial firms have recently jumped into the fray. Last year, Intuit Inc. started offering loans to businesses that use its Quickbooks software based in part on the data contained in their accounting statements. First Data Corp. now lets businesses that use payments devices from Clover, a Square competitor that it owns, take out loans based on their sales history.
A team of techies at Square dreamed up its lending program, now called Square Capital, in 2013 when Square was around four years old. Their cumulative work experience in the financial industry was little more than a single yearlong stint at Goldman Sachs Group Inc.
Customer feedback drove the idea. Small-business owners that used Square’s payments services complained they couldn’t get bank loans, either because their personal credit scores were too low or their businesses didn’t generate enough revenue. Square Capital has since extended more than $3.5 billion in loans and cash advances to small businesses.
The company is gearing up to expand into consumer lending next. Under a new program, individuals can now borrow up to $10,000 to finance a purchase made at a participating Square business. Executives are also exploring ways to provide personal loans or lines of credit to the more than seven million users of Cash App, Square’s digital money-transfer service that rivals Venmo.
Square is still a small player in the lending arena. It extended about 200,000 business loans in the 12 months ending Sept. 30—more than three times the number of loans banks provided through the entire Small Business Administration over the same period. But the average size of its business loans is about $6,500, much smaller than what banks typically offer. The $405 million in credit Square Capital provided in the third quarter was about one-quarter of the volume extended by JPMorgan Chase & Co.’s small-business division.
For Square, there are plenty of factors that could curb its potential growth. Square loans are funded by money managers, and if they decide to stop purchasing the credits, Square Capital would have to slow down its lending. To keep those investors happy, Square Capital also has to charge higher interest rates than banks, which are funded by low-cost deposits. And some customers just prefer to have a person - not an algorithm - as their banker.
Like other financial technology firms, Square is trying to achieve a delicate balance of offering banking services without triggering bank-level regulations. Currently, Square outsources to a small bank the more regulated parts of lending, such as the ability to offer loans at uniform rates and terms nationwide.
The bank that Square wants to open would be classified as an “industrial loan company,” a niche type of financial institution that can offer banking services without oversight from the Federal Reserve. This structure would give Square many of the privileges enjoyed by banks, such as providing deposit accounts insured by the federal government, while letting it stay in existing commercial ventures that regulated banks typically can’t offer
Square has also hired more veterans of traditional financial institutions, especially Morgan Stanley , to handle relationships with investors and manage funding. Many welcomed the move from Wall Street to tech: One Square executive who made the switch told colleagues it was like leaving a funeral and going to a wedding.
Square Capital is now run by Jacqueline Reses, a former Goldman Sachs dealmaker and private-equity executive who took over when the unit achieved a critical mass, but she said the unit is still more focused on engineering expertise than traditional finance expertise.
Square makes automated decisions about riskiness by leveraging its data trove of businesses’ credit-card transactions. Square also looks at more detailed information, like whether a business is attracting repeat customers.
“You’re not harassed and feeling like the bank man is going to come in any moment if you have a slow day,” Mr. Wilson, the food truck and gastropub owner, said of the process.
The company touts both the ease of getting a loan and paying it back: Most customers never have to fill out a formal application, and Square can deduct repayments from a company’s daily take.
To offload risk, Square sells the bulk of its loans to outside investment firms. Current investors include Stone Ridge Asset Management LLC, which runs a $3.5 billion fund devoted to alternative lending, as well as the Canada Pension Plan Investment Board.
Since its outset, people both within Square and outside have been skeptical of the lending push. Convincing David Viniar, a board member and former top Goldman Sachs executive, was a turning point, people close to the company said. At an investor event last year, Mr. Viniar described his initial reaction to Square Capital: “I’m actually a much bigger fan of us getting other people’s money, than of us giving them our money,” he said. Sarah Friar, Square’s then-finance chief and another Goldman alum, helped sway him about Square Capital’s competitive advantages.
In October, a research analyst’s critical report about the consumer lending program helped send Square’s stock down 9% in one day. Square’s “increasing dependence on the extension of credit to its customers to spur its growth has made its business model increasingly vulnerable,” since its earnings would be more tied to the fickle appetite of the money managers, wrote the analyst, BTIG’s Mark Palmer. A Square spokesman said its consumer-credit team is taking a diligent approach to risk.
Square’s machine-driven approach to lending can also rankle borrowers with idiosyncratic circumstances, who say they might be better served with a human touch. Hardcore Sweets Bakery in Oakville, Conn., borrowed more than $130,000 from Square Capital between 2014 and 2018 to buy more kitchen equipment and open a second location of its heavy metal themed cupcake shop.
Co-owner Nicole Braddock said Square stopped making new loan offers to the bakery earlier this year but never explained why. She said no one on Square’s customer-service team would call her back, and emails she sent to a corporate Square account were met with a “copy-and-paste generic message.”
Eventually, Ms. Braddock found out about an old tax lien against her business and paid it off, but no new loan offers came through. She sent more emails to Square, but no company representative could tell her when she would be able to borrow again. Square declined to comment on specific customers.
“It’s really impersonal,” Ms. Braddock said. “I can’t even go over the issue for why I didn’t get approved for the loan.”



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