Balancing Risk: Modern Architecture & BNPL - A Guide

The Resurgence of "Buy Now, Pay Later" and Emerging Risks

The “buy now, pay later” (BNPL) payment method, while not new, is experiencing a significant revival in popularity. This rapid growth presents potential challenges for BNPL fintech companies, particularly as they navigate the complexities of lending and traditional banking systems.

BNPL's Rapid Growth and Market Size

Recent data indicates a substantial market for BNPL. FIS, a major payment processor, estimates the industry at $100 billion, representing 2.1% of all global e-commerce transactions. Marqeta, another processor, reports a 350% increase in BNPL transactions on its platform this year alone.

Drivers of BNPL's Success

The success of BNPL can be attributed to its benefits for both merchants and consumers. It boosts sales at checkout for businesses and offers consumers a convenient way to avoid interest charges and debit card fees. Notably, over 91% of consumer loans in California last year were categorized as BNPL.

Impact on Order Values and Consumer Debt

Klarna, a leading BNPL provider, suggests that offering four interest-free payments can increase average order values by as much as 45% at checkout. However, the ease of use associated with BNPL is raising concerns among consumer advocates, who fear it may encourage excessive debt accumulation.

Potential Risks During Economic Downturns

An economic downturn could significantly impact BNPL providers if consumers struggle to repay their debts. Fitch Ratings has described the performance of BNPL debt as “opaque,” citing a survey where 31% of respondents admitted to being late with a BNPL payment or incurring a late fee.

Dual Risks: Consumer Credit and Merchant Practices

Beyond consumer credit risk, which BNPL providers claim to manage through data-driven underwriting, they also face risks related to merchant practices. This presents a double challenge for these companies.

Regulatory Scrutiny of Three-Sided Loans

Loans involving three parties – a lender, a merchant acting as a reseller – have attracted regulatory attention since the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010.

The Role of the CFPB

A key provision of Dodd-Frank was the creation of the Consumer Financial Protection Bureau (CFPB), granting it authority to address “unfair, deceptive, or abusive acts or practices” within the consumer financial sector. The CFPB has recently taken enforcement actions against various lenders, including Nationwide Equities Corporation and Better Future Forward, focusing on the clarity of information provided to borrowers.

Risks Associated with Merchant Conduct

With three-sided loans, the lender has limited control over the information provided to borrowers, increasing the risk of accountability for merchant misconduct. In July, the CFPB acted against GreenSky following allegations that merchants used its platform to secure approximately $9 million in loans without customer authorization.

Regulatory Focus on BNPL Providers

While BNPL transactions often originate directly with consumers, regulators are identifying other grounds for scrutiny. Consumers typically initiate BNPL lending themselves and authorize account access.

Settlements with BNPL Companies in California

In 2020, the California Department of Business Oversight (DBO) reached a $300,000 settlement with Sezzle, concluding that its merchant partners’ credit sales were structured to circumvent consumer protections. Similar settlements were also reached with QuadPay, AfterPay, and Klarna for non-compliance with state lending regulations.

Class-Action Lawsuits and Allegations of Deceptive Practices

These settlements may be indicative of larger issues. In May, an AfterPay user filed a class-action lawsuit alleging deceptive practices regarding the risks of using the service. A similar suit was filed against Klarna shortly after.

The Challenge of Real-Time Account Information

Klarna, and other BNPL providers, have no control over bank overdraft fees. A significant obstacle is the outdated infrastructure of many American banks and credit unions, which prevents real-time reporting of account status.

Impact of Outdated Banking Architecture

This outdated “batch architecture” hinders accurate debt calculations and prevents debit card companies from proactively warning customers about potential overdrafts with BNPL payments. It also explains why obtaining a precise payoff amount for credit card debt can be difficult.

The Need for Modern Infrastructure

Modern architectures offering real-time calculations and reporting can resolve these issues. As the benefits of these systems become clearer, pressure will increase on both traditional financial institutions and fintechs to upgrade their infrastructure.

Minimizing Risk Through Modern Loan Management

Adopting modern loan management and servicing architecture can help BNPL providers minimize third-party merchant risk. Automation can flag compliance and security concerns, and providers can offer alternative financing options to borrowers at risk of overdrafting.

Leveraging Banking-as-a-Service APIs

BNPL providers can implement modern lending infrastructure even without direct integration with a consumer’s bank, thanks to new API-based banking-as-a-service stacks. This approach provides protection against unfair practices and promotes transparency in borrowing.

The Future of BNPL: Transparency and Responsible Lending

BNPL providers have demonstrated an ability to leverage technologies like cloud computing and mobile platforms to enhance user experience. By embracing infrastructure innovations, they can avoid accusations of unfair practices and foster responsible borrowing. This is a crucial step towards sustaining the growth and benefits of the BNPL model.