Interest rates, consumer balance sheets, and the future for financing companies

Following multiple years of extensive federal stimulus and relief measures taken to help mitigate the fallout of a deadly pandemic, the balance sheet of the U.S. consumer was stronger a year ago at this time than it had been in decades and there were companies launching new offerings seemingly every day to meet growing demand. The economy was officially humming.

Today, a lot’s changed. Inflation that was initially considered “transitory” has become part of daily life, and it’s eaten into the budgets of consumers and businesses alike while causing increased financial stress in a variety of ways. The Federal Reserve’s aggressive response – raising benchmark interest rates five times this year with more to come – has made borrowing more expensive, lightening demand and impacting the economics of all financing companies to varying degrees.

There’s been some shake-up already in the industry with more headwinds coming into focus. Stock prices and valuations of some of the biggest names in fintech have taken significant hits while credit boxes have tightened (and credit quality has worsened), leaving consumers with fewer options to borrow or finance purchases.

All told, the business of consumer credit is beginning to look somewhat different than it did a year ago as companies begin to grapple with how their models can be more agnostic to the ebbs and flows of the economic cycle. At the same time, the value proposition for consumers has fundamentally shifted, as their robust balance sheets a year ago were the exception rather than the rule.

What we saw during the boom times of recent years was a proliferation in various types of debt-based products that could be offered extremely affordably to consumers while companies still made money with interest rates being near zero. It was a win-win in its truest sense, with the Fed accomplishing its goal of supporting demand through easy monetary policy. But, when the Fed started to act on inflation and rates crept up to two percent, margins tightened and the first cracks began to show.

Today, rates are even higher (and projected to reach five percent by May), and no company that offers financing is fully immune. The playbook is changing to accommodate a new economic reality. Consumer financing solutions must be funded somehow, and that capital has a real economic cost; in a higher interest rate environment, consumers or merchants must foot at least some of that cost to keep credit flowing. Otherwise, credit will tighten as capital looks elsewhere for profit. The financing companies that are able to strike the right balance between providing a valuable service, increasing prices, and still creating demand for their products are the most ideally positioned looking forward.

The good news is that there are many financing companies that do provide real value for all their stakeholders at fair prices, while also managing credit risk.  Lease-to own, for example, is both convenient (think of your mobile phone bundle), and also flexible (in that consumers can cancel). Both benefits help retailers support demand at the point-of-sale, and both benefits drive value for consumers. In an economy facing headwinds, these types of benefits are crucial for all stakeholders.

Another common theme during low-interest rate environments that is now changing is the amount of leverage available. Financing companies whose economics depend on extensive leverage have been able to thrive, at least so far, despite not posting equity against their underwriting. In other words, some financing companies keep most of the upside while passing through most of the downside to capital partners hungry for yield.

Today, with consumer credit worsening as consumer balance sheet strength gets used up, financing companies will need to become more comfortable taking risk in terms of what they underwrite. There will likely be some deleveraging, with companies being forced to put more skin in the game – or eating more of their own cooking by navigating credit risk on their own balance sheets.

Consumer credit and financing has changed a lot since America’s last sustained downturn over a decade ago. Fintech as we know it today is a relatively new industry that’s made underwriting much more efficient. Most of the companies that offer financing today are pulling out the recession playbook for the very first time (excluding the short recession in 2020). Some business models that were specifically suited to grow quickly during boom times will be materially tested while others that were more cycle agnostic to begin with, may only be slowed down slightly.

The shake-up is poised to continue, especially if rates continue to rise. What I know is that if there is a downturn, it will force companies to become more comfortable with risk and in underwriting consumers whose conditions aren’t quite perfect. Ultimately that should result in long-term progress from a financial inclusion perspective that will make financing better for everyone.