There are three main ways in which a tech enabled business can provide/drive the provision of credit. These are: Pure Loan Origination, Off-Balance Sheet Lending and On-Balance Sheet Lending. We’ll now take a deeper look into the nuances, pros & cons of each one.
Pure Loan Origination
Loan origination is the process of sourcing loans and earning revenue from origination fees paid by the end financiers of these loans. This business model can take many forms, from traditional banks and credit unions to online lenders and peer-to-peer platforms. Loan origination businesses can offer a wide range of loan types, including personal loans, mortgages, auto loans, and business loans.
There are several pros and cons to loan origination. Some of the benefits include:
- Revenue generation: Loan origination businesses generate revenue upfront at the point of origination. This revenue can be significant, especially if the business is able to originate a high volume of loans.
- No balance sheet risk: By only origination loans these players pass on the risk to the end financier typically a bank or credit fund.
However, there are also some drawbacks, including:
- Don't own interest returns: Loan origination businesses only charge a one-off fee for originating a loan, meaning they do not own the interest returns generated by the loan. This means that they may miss out on a significant source of recurring revenue that could help to sustain the business over time. In addition, loan origination businesses that do not own interest returns may have less incentive to ensure that the loans they originate are of high quality and are repaid on time.
- Not in charge of underwriting: When loan origination businesses are not in charge of the underwriting process, they may have less control over the quality of loans they originate. This can lead to a higher risk of loan defaults and loan origination businesses may have to rely on third-party underwriters.
On Balance Sheet Lending
Balance sheet lending refers to a type of lending where a financial institution, uses its own balance sheet capital to make loans and holds those loans on its balance sheet rather than selling them to other investors.
Pros of Balance Sheet Lending:
- Flexibility: Balance sheet lending provides greater flexibility to the lender as they have control over the loan terms, including interest rates, repayment schedules, and collateral requirements. This flexibility enables the lender to customize loans to meet the specific needs of borrowers – the facility is typically a 3 year interest only facility
- Net interest margin: Financial institutions that engage in balance sheet lending can earn significant Net Interest Margin from the interest charged on loans, and also benefit from other fees and charges associated with the loans.
- Relationship-building: By retaining loans on their balance sheet, lenders can build long-term relationships with their borrowers, which can lead to repeat business and more opportunities to offer additional financial products and services.
Cons of Balance Sheet Lending:
- Risk: The lender is exposed to the credit risk associated with the loans they make, which can lead to losses if borrowers’ default on their loans. This risk can be especially significant in the case of unsecured loans, where there is no collateral to secure the loan.
- Capital requirements: Regulated entities engaging in balance sheet lending need to maintain adequate capital reserves to cover potential loan losses. This requirement can limit their ability to lend to riskier borrowers or to expand their lending activities – typically in the form of covenants and can be a 1:1 ratio of cash to the loan size
- Liquidity: Holding loans on the balance sheet can also reduce liquidity, making it more difficult for the Financial Institution to meet its obligations if there is a sudden need for cash.
- Corporate Guarantee: if the balance sheet is financed by external investors this will come with a corporate guarantee and default could lead to an external business takeover.
Off Balance Sheet Lending
Off-balance sheet lending refers to a financing strategy where a company can obtain funds through structures that through the purchase of the loan assets allow them to sit outside of the balance sheet. Off-balance sheet lending is typically used to drive scale and allow an alternative type of investor to fund new loans. This can create a lower cost of capital and overtime could allow further structures such as securitisation.
Pros of Off-Balance Sheet Lending:
- Enhanced borrowing capacity: There is a much larger pool of Asset Backed Security financiers who can provide capital for this sort of structure, improving lending capacity – Facilities typically start at $5m and can scale to $100’s of millions.
- Risk management: Off-balance sheet lending can provide companies with a way to manage their risks, such as by hedging against interest rate fluctuations or exchange rate risks as well as using the asset as collateral rather than the corporate.
- Flexible growth: As a loan book grows there is the opportunity to create larger and larger structures, refinance, bring in a mezzanine fund etc… - Facilities typically come at 65-85% ADV and rise over time, which can be further supported by 10-20% of mezzanine at scale
Cons of Off-Balance Sheet Lending:
- Higher costs: Off-balance sheet financing can be more expensive in the structuring given the complexity it requires for setting up a new separate entity – these facilities can cost $50-250,000
- Time: Structures take time to setup and need to have a track record of lending to access to ABS financing – typically 3+ turns of the loan book (e.g if duration is 3 months, needs 9 months of data) and takes 6-12 months to negotiate and structure.
- Geographical Requirements: There needs to be “true sale” which is the ability for the full title of the loan to be sold to this off-balance sheet facility which is challenging in certain jurisdictions.
Key Parties for on & off-balance sheet lending across Emerging Markets: