Buy Now Pay Later and the impact on incumbent banks

As consumer habits have adapted to an increasingly digital world, credit products are evolving alongside the digitization of payments. With the rise of POS-financing and so-called Buy now Pay later products, banks and credit institutions are being challenged by fintechs in what has been one of the most profitable verticals in the retail banking industry.

Although this should come as no surprise in the Nordics, the home of leading Buy Now Pay later behemoth Klarna, incumbents are late arrivals to the party, allowing Klarna and its peers to dominate the market for POS financing.

This week, it was known that Square has put USD 29 billion on the table to purchase buy now pay later company Afterpay in order to get in on the action and complement Square’s existing payment ecosystem. Square plans to integrate Afterpay into its existing Seller and Cash App business units, so that even “the smallest of merchants” can offer buy now, pay later at checkout. The integration will also give Afterpay consumers the ability to manage their installment payments directly in Cash App.

Another familiar player in the payments race with similar plans is Apple, which is developing their own buy now pay later solution that is allegedly named Apple Pay later.

Although Klarna and its peers are claiming to offer something completely different from traditional banking products, the principal difference between traditional unsecured credit facilities and buy now pay later is that unlike credit cards, on which a borrower paying a minimum could carry a balance indefinitely, each line of credit is tied directly to a single purchase and are often designed to be paid off in a set number of payments.

In its simplest form, consumers are granted a mini-loan at the point of sale, where you may choose between a variety of repayment terms. One of the potential challenges with this scenario is that each solution has its own set of rules on fees, number of installments, duration of schedules, interest rates, and credit reporting.

As Buy now Pay later options are designed to increase conversion rates in online checkout, such solutions are sometimes interest-free for consumers (at least for a given period), while recuperating those revenues through a significantly higher merchant fee than credit cards. For reference, a typical credit card interchange fee is often somewhere between 1% to 3%. The buy-now-pay-later companies usually take about 5% or 6% from the retailers.

As buy now pay later becomes the default way to pay for many, consumers habituate towards choosing to pay in installments for even the smallest of purchases. Over time this may prove to be challenging for consumers to keep track of their various lines of credit from a plethora of providers.

This has sparked a debate around regulations in the buy now pay later space. The meteoric growth of Buy now Pay later as the preferred payment option, especially among younger consumers are a cause for concern when it comes to unsecured debt. In the UK market, the Financial Conduct Authority issued the Woolard Review early this year, which concluded with an urgent need to regulate all buy now, pay later (BNPL) products.

Because the loans are not secured, just like a credit card, there’s nothing to stop a consumer from racking up balances with multiple services, apart from the limited credit underwriting that these services perform. And while there are no interest charges or service fees for most BNPL loans, there are frequently fees, steep charges for missing a payment, as well as a negative credit score impact on missed payments. While it is not technically defined as credit, I am taught that if it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck.

For incumbent providers of credit, this has several implications. McKinsey’s Consumer Lending Pools data estimate that in the US market alone, fintechs have diverted somewhere between $8 to $10 billion in annual revenues away from banks, and if the size of yesterday’s acquisitions tells us anything, we have only seen the start of this development. Buy now pay later providers are targeting a sweet spot in the payment value chain where they are able to disrupt both consumer and commercial banking.

Revenues at risk consist of revolving interest rates from credit cards and consumer loans as well as interchange fees on the consumer end on one side of the transaction. On the other side of the transaction, buy now pay later is disrupting card acquirers and providers of transaction banking products towards small, medium, and large enterprise clients.

While buy now pay later still represent only a small portion of the total payment market,  it is predicted that the global size of buy now pay later payments will reach a total spend close to 700 billion USD by 2025, doubling the total spend of just north of 350 billion USD in 2019.

To really understand the potential implications for banks, it is important to look beyond short-term revenues at risk and view payments as more than just stand-alone transactions or one-off financing offerings. The leading providers of buy now pay later are engaging in establishing a digital ecosystem, where the point of sale is the gateway to both user acquisition and long-term customer relationships through their entire purchase journey, from prepurchase to post-purchase. Klarna’s recent acquisition of APPRL, a platform that helps content creators and retailers cooperate shows how Klarna is building a digital ecosystem centered around eCommerce transactions.

In the time to come, we should expect to see buy now pay later transition from the checkout process at online retailers and become an integrated offering from digital wallets such as the announced Apple Pay Later, PayPal’s, Pay in Four, and the upcoming integration of Afterpay in the Cash app. For incumbent banks and credit institutions, this is bad news, as banks are not in the driver’s seat in the digital wallet department.

For incumbents, it is imperative to rethink how credit is offered. The lines across traditional credit products are already blurring, as banks offer loans against open credit card lines and fintechs offer installment-based credit cards or debit cards with pay later features. Loan origination, therefore, needs to be agnostic of the product through which credit is being delivered.

The key takeaway from all of this is that in a digital world, the customer is always right, and developing customer-centric offerings that reduce friction for both consumers as well as merchants is a critical factor.