The concept of Buy Now Pay Later, or BNPL was first created ages ago, probably when buying from a local shopkeeper. The idea of consuming first and paying afterwards, sometimes many days later, isn’t new to society – in fact, it tends to be the default, even for eating food at restaurants.
Shopkeepers would keep a “khata” (a ledger entry) for each person that would buy things and collect the money at the end of the month. This resulted in some goodwill because you could just pick up what you wanted and then pay later. The shopkeeper would diligently record all the purchases and send the details over. You could tally them, return what you didn’t want, and pay for the rest.
How would this work? Doesn’t the shopkeeper lose money on the interest lost by not getting money immediately?
First, The margins on these products were enough to pay for about a month of interest – roughly 2% in India – and leave enough for the shopkeeper to profit. This is also why paying upfront on an e-commerce site is cheaper – no one has a “credit period”.
Second, the wholesalers (who sell items to the shopkeepers) would provide some items on credit just so that shops could sell them and build demand. All was good until certain bad things started to happen. People stopped paying back. This was a social nightmare since it was a small community, but to many people, it was just that they’d spent too much and didn’t have the cash flow to pay. They’d either defer paying up until they got some money (harvests, etc.) or just carry the debt forever.
The issue was then that the shopkeepers themselves would have to pay their vendors when their credit periods expired. And hope they would get paid later. The big problem was that the shopkeeper’s job was to sell goods, not to underwrite credit. Fed up with this, some shopkeepers would post things like this: (this is what was posted in my grandfather’s shop in a village at the western ghats)
This posed a problem because credit is, to a large extent, required.
Why do people need credit to buy?
There are several reasons people take credit, even if they have the money to pay.
- In the olden days, people may not have had money immediately with them. You’ve got a customer who wants to buy something but doesn’t have cash. Maybe it’s at home. Perhaps it’s going to come in the monthly salary. If you let him go, he might not come back. So, let him buy now, but pay later. (Credit risk for the shopkeeper is a mess, but we’ll come to that)
- It feels better. You don’t have to pay it all at once. Even though you know you must pay it, your bank balance remains healthy enough right now. You can feel poorer later – which satisfies human emotion.
- It’s less friction. Cash, change etc., is messy if you’re doing transactions regularly.
- People think paying in instalments at zero per cent interest is like getting money for free since even in a savings account, your money earns some interest.
In general, if you offer credit, the chances that a customer decides to transact are much higher. For a large value transaction, it’s almost essential because people have sticker shock (large amounts are a no-no, but a monthly EMI is fine). For smaller value transactions, it might push them to buy more.
None of these reasons is bad. They are just what they are. So BNPL is real and must stay. But what is the problem with it?
The problem with BNPL
People don’t pay you back.
That’s about it. The rest of the problems in the BNPL space are much smaller, and we’ll go through every aspect of it. But the core problem is: I’d give you credit, but if you don’t pay me back, it’s a pain in the neck for me. So I won’t give you credit.
Obviously, this is not optimal. Because a) most people pay you back and b) credit creates more transactions, so you can’t refuse to have it.
In most cases, the credit from the shopkeeper or seller comes at a usurious cost if you don’t pay it back. The shopkeepers, who double up as money lenders, often charge very high rates and can deny you further supplies (usually if they’re the only shop in town) if you don’t pay. This is prevalent even now, at rates like 2% to 5% a month.
The answer, therefore, is to shift the onus of credit repayment collections to someone else. Who? A finance company or a bank. These finance companies have the ability to:
- pay the seller an upfront amount of money
- collect from the buyer over a period of time (“Later”)
- handle all the credit issues like what if a person doesn’t pay
So the idea of a “BNPL company” is born. This is the old-fashioned money-lender with a new name: A “bank” or an “NBFC”.
How does BNPL work for the lender or financing company?
Effectively, the financier gives credit for a transaction between a buyer and a seller. The seller gets paid directly by the financier, and the buyer pays back “later”. Even if the buyer cannot or will not pay, the seller doesn’t care – he’s sold his goods, received his money, and bears no further responsibility.
The financier makes money through multiple mechanisms:
- The buyer pays interest on the money borrowed for the period of the borrowing (just like any other loan)
- The buyer pays “fees” on the transaction – this might be a one-time “processing fee” that covers the interest cost. Or late fees in case they forget to pay. Or pre-closure fees if they have to close the loan early.
- The seller might pay a fee to get a customer, which can also reduce the effective cost for the buyer.
This could be done in many ways:
The Consumer durable finance model
An agent in a shop makes you fill out a form, gets your credit history and gets you an instant term loan to buy the product. Like that Lego set, but 40,000 rupees is too much? Pay Rs. 4000 for ten months instead! At Zero per cent interest!
This was the model used by players like Bajaj Finance even to do zero-percent EMI purchases. (See this: how do no-cost EMIs work?)
The seller usually finances this. The person who sells you the goods offers a discount to the finance company (not the buyer). The finance company then allows the buyer to pay the full price, but over time. The discount acts as the interest.
For example, if you wanted to buy a new phone for Rs. 45,000. You can pay the 45,000 upfront or get a six-month “interest-free” EMI at Rs. 7,500 per month. You’d think this is such an excellent deal – why not pay a little every month instead, especially when you aren’t paying more?
Who finances this deal? The seller. The phone seller tells the finance company – you guys give Deepak a loan for Rs. 45,000. And Deepak will pay you back. Instead, you pay me a 5% lower amount – Rs. 42,750. The difference is your interest.
You’re now thinking – wait, the finance company makes just 5% for six months? That’s like 10% per year? That’s not enough since a typical loan will come at much higher rates!
Well, no one’s doing a favour to anyone here. The finance company earns a very decent 18% per annum. Because it gets paid a little each month, the 5% discount translates to 18% a year for the finance company. The buyer pays a little more of the principal back every month, so what you see as a 5% rate is much higher since the capital deployed reduces every month.
18% is not something to scoff at, and in all likelihood, you don’t want your CIBIL credit score ruined for something as small as Rs. 45,000, so you pay up. If the credit underwriting model is good, defaults will be minimal. The point here is that.
- Financier gets to pay the seller a discounted rate
- And the buyer pays the full price over the time period
- Effectively, this is a high enough interest rate to make up for defaults
Take the same 18% return for the financier, and look at the discount the seller needs to offer for a “zero cost” EMI:
Think of it another way. You might not think getting a 5% discount is a big deal, but you will love the idea of paying in six months, interest-free. The seller gets a sale, and you go back happy. The financier gets to make 18% on the lending. Everyone thinks they win!
Why doesn’t the buyer get to take a discount instead?
This is also interesting because the buyer might choose the discount if given an option (pay upfront and get a discount). This screws up the economics for the seller, who typically sells the model through retail stores or online platforms. If the discount is offered to customers, then it’s quite likely that they still have the sticker shock and don’t buy. The monthly-payment model just works better for customers mentally, so it’s financed through BNPL.
The Expensive Car Finance Model
Car financing is another example of where the car manufacturer finances the model. A Volvo XC40 Electric that costs 55 lakh is provided with a financing rate of just 7.5%. This is cheap indeed.
Only 7.5% interest rate? That’s nearly impossible, considering that the loan is for an expensive car, which is not “subsidized” by RBI like housing. And then, it’s not a bank financing this; it’s an NBFC, whose cost of capital is higher. So it should come at 15%+ rates, for the most part. (Also, consider that a car depreciates upwards of 20% the minute you drive it out of the showroom, so it’s not like the collateral is secure either)
How can this work? A little help from the manufacturer in terms of a discount gives the financier a return of 15% to 18% on the loan.
Here the difference is that the EMI isn’t zero cost to the buyer, which is usually because the discount doesn’t give enough room for the lenders – they do want a higher return, so the buyer of the car still pays some interest.
The Credit Card model
Credit cards are the first digital version of BNPL. The bank gives you a card. You use it at a swipe machine at a merchant. The merchant pays about 2% of the transaction as a fee and gets only 98% of the bill.
The customer gets to pay after about 45 days on a monthly bill that bunches up all the transactions for a single payment. The customer pays no extra fees. Unless, of course, he misses paying the bill or pays less than the amount in full. Then all hell breaks loose, and bankers go and open champagne bottles. Because you’re going to be paying as much as 40% interest per year on the “balance” and on every new transaction that you do. Plus, you pay late fees if you don’t pay on time. This is effectively fee paradise.
Read: How credit cards sucker you with fees.
The fees are insane:
- The Issuing bank: This is the bank that gives you a card. You get a ‘credit limit’, which tells you how much you can spend. The issuing bank gets so many fees that even schools learn from them. Like card issuance fees, annual fees, late fees (if you don’t pay on time), cash transaction fees (if you have to pay cash) or fees because you weren’t looking. And they get a big portion of the 2% that merchants pay. (But then, they also pay the remaining 98% to the merchant and have to recover it from the customer after 45 days, so it’s effectively like an interest charge for that time)
- The acquiring bank: This is the bank that acquires the merchant, so they’re the ones whose name is printed on the swipe machine. They work with the merchant and get a portion of the charge that the merchants pay (the Merchant Discount Rate)
- Visa and Mastercard: These are card payment networks that basically reduce the fear that if you carry a card, it won’t be accepted at your favourite coffee shop. They charge a fee and ensure that if you are frauded by a dirty merchant, you can dispute it and get your money back.
We looked deeper into the Card business in our analysis of the SBI Cards IPO. Card companies/banks make a lot of money from the fees of both people who use the card and repay in time (“transactors”) and those who roll over the credit and pay interest (“revolvers”). It’s a fascinating BNPL business that has built scale.
The difference in a credit card model is that any merchant who accepts a specific type of card (Visa/Master/Rupay etc.) will automatically allow any card user to pay for anything. No deal needs to be made with the manufacturer of any item, just with the card network.
Effectively, the seller pays for the first month of credit in a credit card. And after that, the buyer pays usurious rates if he doesn’t pay back.
The Fintech BNPL model
Engineers (I’m also one) always think they’ve invented the next big thing, so obviously, BNPL became associated with fintech as a fantastic new thingy. It’s not. It’s the same thingy with different lipstick. Put loosely, assume I’m this fintech app that’s decided that “BNPL” is a cool-axe buzzword:
Me(Thinking): Oh, I can lend you money to buy stuff, because of things like you get zero cost EMI etc. But I’m not a bank, NBFC or whatnot, and I can’t be one. So I make an app that says you can buy this, and voila, you have bought it
Who pays? I have to find some NBFC or bank and say, dude, give them money.
NBFC: Why would we give some random fellow using some app all this valuable money?
I tell them: Because dude, I’m a fintech app and all, and I know all their relatives’ phone numbers and what crazy SMSes they get, so I have leverage. They’ll pay back. Or I’ll call up their relatives and tell them they know a disgusting defaulter.
NBFC: hello, uncle, please go home and put head under cold shower. This shit doesn’t work. We’ve even sent goons.
Me: Okay, I say. I’ll pay, dammit. If they default, I’ll pay. Interest also.
NBFC: Guaranteed? How?
Me: Okay, I’ll give you money upfront. Use that if they default. I raised THIS much money from investors; I can’t take a cold shower and all.
And that’s what is called a “First Loss Default Guarantee” or FLDG (another acronym that we engineers seem to love). The idea is: that if there’s a customer default, the NBFC will ask the fintech app to pay up. This ensures they don’t have NPAs, and the fintech app gets to go find customers for the relatively small cost of guaranteeing bad debt. Enforcement comes via a fixed deposit or such that is given to the NBFC.
The fintech app might work with popular other apps (Zomato/Swiggy/Amazon etc.) and says pay me later if you buy on these sites. They work with the sites to get a small discount, which these sites anyhow give for credit cards. The discounting of say 2% allows them to earn interest for the “getting paid later”. The buyer will be sent emails saying, please pay, and if they don’t pay, there are late charges, interest, etc.
The actual credit could be given through an FLDG arrangement with an NBFC. This usually means that for each sign-up, you must touch their credit score and assign a small credit limit to them. T
The fintech app has to make a deal with each popular app and be on board with its payment services. For instance, it won’t work with a regular offline shop until you’ve found the shop and made a deal with them.
Or, even better, the fintech app could work with a bank that issues a card with a network on it already (Visa/Master). This allows a customer to use the card anywhere that accepts Visa/Master, so you don’t have to onboard each merchant separately. But banks won’t just offer credit mindlessly. So you might ask them to offer a “prepaid” card, which an NBFC then finances on demand, backed by an FLDG by the fintech app.
The concept is: to create a prepaid card with a bank which has zero balance. When the customer uses the card, fill the balance in from an “immediate” loan given by the NBFC on demand. The loan is pre-authorized using Aadhaar and OTP and all that and available at the point of spending. When the customer pays back, the NBFC gets the money. The fintech app pays a portion of the merchant discount rate earned (roughly 1% to 1.5%) to the NBFC and some to the bank that issues the prepaid card.
Phew, that’s a lot of hoops. But it was the only real way to make it work.
Any NBFC in the picture will demand a pound of flesh, so the bulk of the effective interest earned would go to the NBFC. Some fintech apps chose to get an NBFC license themselves so that they could lend on their own. But for the rest, FLDG arrangements were the only way they could lend.
RBI Doesn’t Like FLDGs: Say hello to regulatory risk
FLDGs are a problem. The reason RBI controls lenders is to ensure they are well capitalized to deal with the risk of defaults. They can do that for NBFCs, but not for “fintech apps”. An FLDG means the NBFC isn’t actually taking the risk; it’s the fintech app instead. Are they well capitalized? Will they continue to be as they grow? The answer could quite easily be no, and very quickly so.
RBI has now banned FLDG arrangements from April 2022. Recently, they even banned the concept of using NBFCs to finance pre-paid cards. That’s also because the pre-paid card or wallet was supposed to be a non-credit instrument (people would fund the account from their money). Instead, a workaround has made them equivalent to credit cards, which are again a more regulated instrument. The ban has surprised and infuriated many startups in the space. Some of it is justified because overregulation is a problem in the country, but there’s more to it:
- It isn’t apparent that certain cards or wallets are actually credit – a pre-paid card is supposed to be a pre-funded card, so it doesn’t sound like credit.
- Since such apps give tiny credit limits which end up getting nearly fully used, people’s credit scores get impacted heavily (credit scores are negatively impacted when you use a credit limit to its full or nearly so)
- Fintech companies are not regulated in terms of capital adequacy. If they go gangbuster crazy on such lending, directly as NBFCs or through an FLDG, they could significantly impact the system, and we’ve seen this play out before.
We need to understand that BNPL has a history.
The Problem With BNPL in 2009
Credit cards were given outpost 2005 in a cavalier manner, with applications being approved no matter what. And the financial crisis hit hard in 2009. Defaults went up heavily. At one point in 2009, they were as high as 15% to 20%! From Livemint:
The percentage of non-performing assets, or NPAs, in the credit card portfolio of the Indian banking industry has almost tripled—from 5-8% in fiscal 2008 to 15-20% in 2009.
This is impossible to maintain. 15% default is wild – it can seriously hurt any bank’s capital. Apparently, we’re seeing that, or more, in many fintech NBFCs now. Look at Slice – it owns an NBFC called Quadrillion. Quadrillion’s last year’s (2021) bond memorandum (link) where they show loans of 149 crores, and write-offs+provisions of 12.5 cr.!
The gross NPA shown is just 1.1%, but the write-off number is 12.5 cr, around 8% of AUM. It means they’ve written off 12.5 cr. When they were managing 150 cr. 8% of loans went so bad they had to be provisioned for or written off. If this number goes up to 15% or 20% now, this could quite easily mirror the past experience.
Why would people not pay? For one, in 2009, credit bureau checks and reporting were weak. So if you defaulted, you didn’t face too many consequences. Second, lenders had given too much credit – so people borrowed too much, spent it and couldn’t pay it back. This is the equivalent of subprime in India, and it’s happened too often that the subprime gets impacted.
Now, while credit reporting has improved, there is still fear that the subprime part of the population has over-borrowed.
Any buy-now-pay-later approach requires trust that the borrower will repay. And borrowers, who aren’t usually financially savvy, tend to over-borrow when credit is readily available. They could, for instance pay one loan by taking another or just take enough loans on a “pay later” concept that eventually ensures they can’t pay back.
Overleverage, abuse of trust and easy credit – are not something we’ve seen just now in the fintech world. It’s happened earlier, many, many times. Using an app just makes it digital subprime, but all too many times, subprime is what it is because people can’t easily pay it back.
So BNPL is dead?
Moneylending is the oldest profession in the world so that all such concepts will survive. Yet, the way it’s being done will change, to some extent.
Entities like Bajaj Finance, which lend against consumer durable purchases, will probably continue to thrive as they are a registered NBFC. They onboard each merchant and are aware of the credit’s end-use. This is something RBI likes – you have better control of the process.
Banks that lend using credit cards will keep doing well, although they have stiff competition in the payment space through UPI. The only problem with UPI is that there isn’t a credit element in it just yet – it’s “buy-now-pay-now”. But if you attached an overdraft account to a UPI app, then on-demand credit can be made available even through UPI. Banks are likely to explore this model too, where they see UPI as a threat.
(Note: In UPI, merchants pay nothing at all. A zero Merchant Discount Rate means that if you buy now and pay later, you have to pay the interest, whereas, in a traditional card, the merchant would pay the first month. If merchants decide to pay that 2% on UPI, you will see a significant threat to credit cards)
Startup apps will be more regulated by RBI. They won’t be allowed to provide for credit losses (no FLDGs), but they might be allowed to become “agents” for banks/NBFCs and, thus, originate loans. However, some apps might get themselves an NBFC license and lend on their own. RBI will eventually let NBFCs issue credit cards as well. NBFCs need substantially higher regulatory standards, so there will be control over how crazy their lending becomes.
What about the rest of us? The borrowers in the ecosystem are likely to sell a cycle where lenders go bust and apps shut down. Either because there are too many defaults (the P2P space is one such) or because RBI’s regulations don’t allow them the freedom to lend. This means the cost of credit and its availability of it comes down. Only the best will be able to borrow, and the best don’t need much credit. The bankers love to give you an umbrella only when it’s not raining; that concept hasn’t changed for centuries.
For merchants, the ability to tie up with new payment mechanisms that use BNPL will be exciting, but most now accept UPI as a mechanism to pay. We could very quickly see a lending ecosystem that allows merchants to provide that 2% discount on UPI so that the buyer can spread a purchase over three months rather than all at once. This model will threaten credit card penetration.
UPI has already beaten the daylights out of credit cards in terms of growth, but even credit cards are growing reasonably. I’d bet on a UPI-based system to win the credit race, eventually.
Our take
The concept of BNPL mixes two things well: Credit and payment. Credit is that you want money when you don’t have it. Payment is that you can give money to someone else who is assured that they’ll get it reliably, quickly and at a cost that they’re willing to pay. Every move to ensure that a credit-based payment is more reliable, quick and at a low cost will only help the trade ecosystem.
UPI-based BNPL, where the seller pays a small fee, is likely to be the BNPL of the future in India. How this actually ends up happening is a question for regulation, technology and acceptance. But it is quite likely to beat plastic very soon.
The winners in this space are likely to be large NBFCs and bank networks, but startups have gone where banks could not, using a digital reach through impressive social media campaigns and networks. Expect that some of them will become NBFCs (or banks) and challenge the domination of the current bigwigs. Expect that some of these players are far more tech than ‘fin’ and will perish in the wake of regulation and mistrust.
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