Insights.

Are there too many intermediaries around?  ·  Sumit Kanthed  ·  31 May 2020

Have you ever wondered what is common among an all-you-can-eat buffet, life insurance, and payday loans?

All three are versions of the same problem — adverse selection.

What is adverse selection?

Information asymmetry between buyers and sellers, which results in good buyers being crowded out and only the bad ones remaining — further deteriorating the assumptions on which sellers set their price. In non-technical terms: the whole bears the cost of a few. The problem of adverse selection has always existed and is one of the factors creating underwriting cycles and credit cycles.

Historically, this was mitigated largely by risk remaining with the underwriter of the risk. Over time a restaurant learns and prices itself to recover its costs; insurers consider historical underwriting performance and tailor premiums; lenders avoid huge origination costs and know the borrower's history to make an informed credit decision. In traditional lending this is addressed by lending against security, by increasing the haircut on LTV and the cost of default disproportionately, and by the principal bearing the loss of default risk because decision-making stays with them.

The current scenario

Before we understand how this asymmetry can be addressed today, we need another problem that runs in parallel — the principal-agent problem. With the advent of search engines and aggregators paid to send leads to lenders, adverse selection has been given a multiplier effect. The lender pays for leads without any conversion and must recover the cost from those who do convert. With ultra-low interest rates and the hunt for yield pushing private equity into private credit, the problems of adverse selection and principal-agent are magnified manyfold.

Take a lender who has been in the industry for decades and knows their market and borrowers well. This reduces adverse selection but limits growth, because knowing the customer is time-consuming. Now a new PE house acquires this decades-old business, having raised billions from the fiduciary agents of capital — pension funds and insurers. The PE house grows aggressively, onboarding online channels and advertising heavily. This is the beginning of adverse selection. The mission shifts from risk-versus-return to short-term returns. The aim was once a sustained return on capital for stakeholders; now the mandate is to deploy the fund and sell the loan book to a follow-on fund. The portfolio manager also looks to move to a bigger, better-paid job in a few years. This is the principal-agent problem. Who really is the principal — the original owner, the private equity, the insurance company, or the ultimate retail investor whose savings sit in low-yielding deposits or a pension fund?

Limited agents, decision-making with the principal

A customer borrows from a lender who has substantial equity in the loan book, and the customer owns the security they have pledged.

Many agents, no decision-making with the principal

A customer searches online, is directed to an aggregator, enters their details, and is shown a suite of lenders ranked by the brokerage each lender paid for the lead. The lender goes to private equity, who go to the bank for cheap funding — subsidised by near-zero deposit rates — and private equity invests the margin taken from pension funds, which are themselves trustees of capital from policyholders and pensioners. At no point in the chain does the underwriter of the risk bear the first loss.

The lender wants credit-worthy borrowers who will pay more than their probability of default. The problem is how to originate those loans. The current model is flooded with intermediaries, aggregators and search engines paid to bring "leads" — with no idea of the underlying credit quality of those leads, by design or by ignorance. Lenders sometimes pay a fortune for leads, which hurts their ability to charge a fair interest rate to those who accept, complicating adverse selection further.

What can be done?

Reward should be tied to risk for everyone in the chain.

• Aggregators: tie commissions to realised defaults.
• Borrowers: the fallacy of choice is real — be careful where you share your data.
• Regulators: individual data should not be freely available; entities that use customer data should pay for it, with the benefit going to consumers, not to aggregators holding the data. Data-protection law must evolve with commercial reality.
• Lenders: use non-traditional sources of information to underwrite credit more effectively — this is where the area of growth lies. Data analytics, combined with heuristics and an in-depth knowledge of creditor behaviour, can help devise filters that reduce adverse selection.

So, to answer the original question: there are indeed too many intermediaries in the chain, and we need a better allocation of risk and reward throughout it.