Digital lending faces the heat amid funding winter

Photo: Shutterstock
Photo: Shutterstock

Summary

Even a few years ago, digital lending was seen as a pathway to profitability for Indian fintech companies

Even a few years ago, digital lending was seen as a pathway to profitability for Indian fintech companies. Unlike digital payments, the most popular sub-segment in fintech in terms of venture funding, lending had a clear way to profitability—the spread between their cost of funding and the interest rates they charge their customers.

In a study published in 2018, the Boston Consulting Group projected that digital lending would account for 48% of all lending by 2023, driven by changing consumer behaviour, technological advances, favourable regulations and digital innovations. Last year, in another report, BCG said the share of valuation for lending startups will increase from 13% in 2020-21 to 35% in 2024-25. According to a report by Venture Intelligence, 29% of all venture funding that went into fintech between 2018-19 and 2022-23 went to lending, next only to payments.

However, in the past few quarters, growth in digital lending has slowed. According to Face, an association of digital lenders, the sequential growth in disbursements by its members fell from 82% in the June 2022 quarter to 23% in the September 2022 quarter to just 2% in the December 2022 quarter.

Average loan size, after growing in 2021-22, has been hovering at 8,000-8,300. There are concerns that the slowdown in growth might be reflective of broader issues facing the industry: higher cost of capital amid tightening regulations, made worse by the funding winter faced by startups in general. Contrary to earlier expectations, digital lending startups might be losing their edge to traditional players.

Cost Push

Central banks around the world are increasing interest rates in an attempt to control inflation, after a period of loose monetary policy during the covid-19 pandemic. The Reserve Bank of India is no exception, raising the key repo rate from 4% in May 2022 to 6.5% now. This increases the cost of capital for all lenders. However, fintech firms have traditionally faced a higher cost of capital, partly because, unlike traditional banks, they don’t have access to low-cost deposits.

Digital lenders have also been facing criticism over higher interest rates. 58% of borrowers took loans from lending apps at an annual interest rate of over 25%, according to a survey by Local Circles last year. Last year, the Delhi high court, after hearing a petition, asked RBI to submit a status report on high interest rates charged by digital lenders. All these constrain the ability of digital lending startups to maintain their net interest margins.

Regulatory Squeeze

Digital lending apps face even more intense scrutiny over potential frauds. Payment and loan frauds are common in the financial sector. According to RBI, in the six-month period to February, 1.1 million complaints totaling 1,442 crore were reported in the Central Payments Fraud Information Registry by various entities, including scheduled commercial banks. However, the scrutiny that digital lending apps have attracted is of a different order. For example, last year, an RBI working group on digital lending identified 600 illegal apps operating in India. Similarly, this February, the Ministry of Electronics and Information Technology (Meity) banned 94 lending apps due to their foreign links. It later revoked the ban on some of these apps and platforms, which also highlighted how deficiencies in some platforms can potentially undermine trust of the entire segment. Tighter regulations promise to improve trust, but they could potentially constrain innovation

Funding Winter

Central banks raising interest rates also impacted startup funding. Venture capital (VC) flow into digital lending startups in India dropped by over 80% to $170 million in the December 2022 quarter, from $887 million in the March 2022 quarter. This drop in funding also has implications for startups that raised funding when it was easier to come by.

The focus has shifted from growth to profitability, which is harder to pull off when the cost of funding has also risen. Earlier this month, VC firm Bessemer Venture Partners published a note saying that lending was not attractive as a venture-funded business. “Banks and NBFCs have an unfair advantage on cost of capital, India Stack has bridged the technology gap with the new-age lenders." It’s a view of one VC firm. Digital lending startups will hope it doesn’t become a more widely held view.

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