Buy now pay later continues to intrigue but is the fuss and hype justified?

By Phillip Dransfield, Partner, at 4most

A different kind of lending

Buy now, pay later (BNPL) is generating a lot of attention that doesn’t seem to be dampening and there are many reasons why. At the moment, it feels like the option to BNPL is something consumers come face to face with almost every time they purchase something online. From a credit lending perspective, it is a stand-out amongst comparable consumer lending products – with rapid unparalleled growth in customer take up and exposure over the last several years. The Financial Conduct Authority (FCA) reported a tripling of lending to customers in 2020 alone. It is surely one of the notable positives out of restricted movements during the pandemic.

But it is not just about ubiquity and lending growth. It is also the posterchild for innovation in retail finance. BNPL shows us all what is possible when technology, e-commerce and consumer needs are matched well. It can produce all round wins for consumers, retailers and providers. What’s not to love about it?

Somewhat ironically too, it also demonstrates that old and innovative are not mutually exclusive. Something old can be a great success in the new, digital world but BNPL is not new, it has been around for a long time and can trace its roots to common financial arrangements between individuals and suppliers, like paying the annual membership for a fitness club, invoicing between firms, and even that arrangement in place to pay the orthodontist for your child’s braces. What is innovative, is blending this old idea seamlessly into the digital customer journey, tapping into the desire for flexibility that is so important for modern customers.

What may surprise some is that these arrangements sit outside the rules and laws governing credit lending

They are deliberately exempt from consumer credit laws and regulations. The decision to exempt them appeared sensible at the time (and has since for 50 years) as most of this type of arrangement poses little risk. But unlike most of those arrangements, BNPL is plain and simple, lending. It may appear to only separate the timing of purchasing goods or services from repayment, but it is a contractual agreement to make repayments, and it can lead to interest, and fees being charged.

BNPL has the potential to overcommit the customer and cause harm if not conducted well. Therefore, being unregulated seems a little at odds with what most people might expect today against a backdrop of increased consumer protections that focus on reducing detriment and harm from lending. Looking at where BNPL has reached in these last few years, it feels like a missed opportunity from oversight bodies to get to this place, accepting that only a few years ago BNPL still remained a relatively immaterial part of overall lending. It goes to show how quickly that can change, and here we see it has come from outside of the pool of current lenders, outside of the Fintechs and outside of the big tech firms. The one key learning in all of this is, we just don’t know where some of the future risks will come from.

Change is happening

However, this is all about to change. The industry is bracing itself, even pre-empting what might happen, in order to get in front of it. The FCA led a detailed review of practices in unsecured credit – the Woolard Review[1]. This review identified BNPL as being different from other forms of arrangements, exempt from consumer credit laws and regulated activity, and as presenting a high risk of consumer detriment. Key areas of concern are around how it is used, promoted, understood, and whether good practices are in place to manage the risks and harm to customers.

The FCA recommended it be brought within its perimeter of conduct rules, and the Treasury is consulting on making statutory changes that will remove current exemptions. This all seems sensible and there appears to be little dissent from providers.

In a sign of what is to come, the FCA has taken a pre-emptive strike to the main providers. Showing an intent to exercise their full powers, they recently issued publicly, the findings of a review of the four largest providers of BNPL loans covering compliance with consumer contract regulations and consumer rights. They raised concerns in respect of contractual terms that were considered unlikely to comply with the rules. According to the FCA, the four providers involved have been ‘fully cooperative’ and ‘agreed’ to changes, including for some, a voluntary refund of inappropriately charged fees. Welcome to first grade!

Providers are pretty savvy though. It seems clear to all where this will end up – not too different from other forms of lending. Many are revising terms, providing new options for payment at the point of sale and making more prominent messaging and options. Their internal practices are also sharpening up. Providers are strengthening their credit risk controls – adopting good practices in line with more traditional lending products (and providers) in assessing customer indebtedness and ability to afford repayments, as well as better overall management of their credit risks.

However, it is important to note the requirements are not certain. The questions, as the Treasury put it, are – what is to be included within the scope (that is, what is no longer to be exempt) and what controls need to be in place to manage this. Their conundrum, remembering that BNPL looks and feels a lot like other types of arrangements, is – cast the statutory net too wide and they risk including arrangements that do not require such attention and may have unintentional ramifications on a wide range of practices; cast it too narrowly, and it is easy for providers to avoid any requirements by slightly tweaking their products and practices.

Unregulated BNPL is becoming significant

As pointed out earlier, arrangements that spread payments over a period, the broadest class of BNPL, have been around for some time. They have been used by many households to support, amongst other things, moderately substantial home purchases such as white-goods, electrical items, furniture etc. Essentially, the things that tended to impact on the family budget if swallowed whole, but were much easier to manage if broken into more digestible pieces over a relatively short window. The items being purchased were important ones that provided a better quality of living for people, and BNPL-type arrangements allowed them to enjoy this benefit before they would otherwise be able to. That is a good thing. It provides a meaningful application and justification for credit.

However, this sort of short-term interest free credit (as labelled by the Treasury and FCA) is not what the law makers and regulators are concerned with – it is not what is growing rapidly or causing detriment to consumers. The focus of their attention is what they call unregulated BNPL agreements, which typically target lower value items, often non-essential and fast consumable items like clothing – not essential, long-lasting, household goods. BNPL decouples the buying steps of purchase and payment from the customer (replacing the latter with making a commitment to pay).

That distinction which previously might cause customers to think carefully, consider if they can afford the item right now, or if they needed to wait a little longer, save a little more, is removed.

Equally concerning is who is using the product. It has a high concentration amongst those consumers under 30 years of age, a potentially vulnerable group often with a thinner history of disciplined use of credit (and therefore less understanding of the consequence of borrowing) and tending to have reduced financial resilience. This is worrying as BNPL is potentially indoctrinating a generation into habitual use of credit on items that it is not appropriate for, and that may lead to indebtedness creating long term problems.

Even though the Treasury has said there is little evidence of harm being done, and that it is less likely than in other forms of lending as no interest is charged during the instalment/promotional period, they may be looking at an out-of-date picture.

The Woolard research pointed to exposure levels of £2.7b in 2020 and c5m customers. A more recent study points to nearly 8m people having used BNPL and over £4b in exposure. The Guardian cited an estimate of £40b by 2026 by Juniper Research. One of the problems is that it is hard to know, as providers are unregulated and do not supply official data for reporting.

What gives confidence that this is about to explode is that the leading fintechs and many mainstream lenders are now moving. Oscar Wilde’s quote on imitation being the sincerest form of flattery feels apt. Success for current providers is possibly best demonstrated by how the retail finance industry is responding. Fintech banks, being most agile and also most in need of adopting new ways to acquire customers and provide new and in-demand products and services are lining up their BNPL offerings. Large incumbent banks and payments providers are also introducing products, or new features to existing products, that provide similar flexibility and terms to BNPL – particularly adapting credit cards to enable the transfer of purchases into instalment payments, with no or reduced interest.

There is potential for BNPL to be much, much bigger

If the wider market foray into BNPL continues, it will likely cannibalise existing lending, particularly of credit cards, but it may also bolster spend levels overall. Should BNPL purchases shift upward in value, this will see total exposures grow quickly. Individual online retail shopping amounts for BNPL are relatively low. But aggregating spend over multiple purchases for a customer mounts up. If purchases shift to more substantive goods – the territory of short-term interest free items mentioned previously – it will account for a sizeable chunk of the quarter trillion-pound unsecured market.

And that’s why this really matters. It doesn’t take much to see that this could happen. Having the largest BNPL providers sit outside the regulatory perimeter, or inconsistent practices between lenders undermines the whole unsecured market.

Growth is not likely to stop until it hits or goes over an equilibrium point of what customers can bear, a balance of usefulness of the products and how customers feel about the outcome. Our history in unsecured lending shows that a number of people are not well disciplined with an in-built off-switch. Where credit has been offered more loosely, it is taken up, the customer sees it as safe and reasonable, they interpret that the provider thinks this is okay, they don’t second guess the retailer’s motivations, they even tell themselves they will budget, change spending habits and ensure they repay. But loose lending standard has previously grown to an unsustainable bubble of debt and harm.

The saving grace might be that with bank lenders and regulated entities moving into this space, offering products that mimic BNPL, these entities already have to adhere to conduct and credit rules.

It may be these that ensure good practices become the standard and customer inertia moves back to those bases? Maybe then, we should be less concerned?

The outlook for providers

Analysis by Redburn, as reported in the FT, suggests BNPL providers that only offer this product are unlikely to be sustainable in the long run. Whilst they look attractive today, they will soon be outgunned by incumbent lenders. However, those able to deepen their offerings and relationships with a broader suite of products and services will see sustainable value, leveraging BNPL as an effective acquisition generator for new business.

This reinforces a further point, that the type of customer who is attracted to and uses BNPL now is younger and without a credit history. Yes, BNPL may be a positive for greater financial inclusion, but it also points to a possible vulnerable customer group who are less aware, less financially astute, less resilient, and so more susceptible to harmful practices.

There is a role in influencing merchants’ actions too. Merchants have been quick on the up take. They can see this helps sell their goods. It is a short-term win for them. How it plays out for the customer is less clear. If it ends poorly, then the retailer has also lost that customer and that may also have a ripple effect more widely. If providers improve their practices to safeguard against poor outcomes, then this is mitigated.

Providers can and should be sharing their data with all lenders via credit bureaux. Offering BNPL that allows customers to purchase small items may appear insignificant, but customers may (and do) have many such agreements – and other credit besides. By sharing data with other lenders, a provider could see that a customer has many such purchases, and other commitments, and thus ensure a complete picture is formed. Understanding an aggregate position of the customer and whether they are within a safe tolerance goes a long way to using their competitive advantage for the good of the customer.

The BNPL product is clearly useful to many. That says there is a lot of good that can come from keeping this and ensuring a proportionate response is had.

Providers should therefore aim to build on that foundation with very clear long-term perspective. A view that covers decades not just the next few years, this is how BNPL can become the backbone of how people spend on low to moderate purchases when requiring credit.

To do so requires providers to change their mindset and view BNPL through the eyes of how it works for the consumer. The proposed consumer duty provides such a view and presents some very useful perspectives about projecting into the future the outcomes that are expected. In part this is having a clear basis of how the price and fair value are matched, but more so it is being able to identify the different segments of customers (who will change through time) and what experience and outcome they will receive. Careful analysis and monitoring over time will help providers to determine if this unfolds as expected, or if they need to take action.

No provider should think it is okay that in ten or twenty years a customer’s life has been adversely impacted through poor lending practices. It is incumbent upon providers to ensure that does not happen.

[1] The Woolard Review – A review of change and innovation in the unsecured credit market. Report to the FCA Board, published 2 February 2021