How regulation will change the ‘buy now, pay later’ business model: could banks one-up fintechs?

Posted September 6, 2021

Forthcoming European regulation of ‘buy now, pay later’ (BNPL) products is certain to change the operating model of the firms that offer them. Until now, BNPL providers have successfully taken market share from banks, but regulation may tilt the playing field in a way that makes this harder to sustain. Below I explain how this could happen and why banks, BNPL providers and policymakers should take notice.

The hot new payment method

BNPL has rapidly become the preferred payment method for millions of consumers. In 2020, BNPL - offered by providers such as Klarna, Clearpay, Laybuy and PayPal - accounted for 5% (over £40 billion) of e-commerce transactions in the UK, and around 20% in European countries such as Germany and Sweden. FIS Worldpay estimates that, in four years’ time, 13.6% of all e-commerce payments in Europe will be made using this option.

BNPL typically allows consumers to spread payments into three or four interest-free monthly installments. It has given consumers a way to manage their cash flow without using credit cards, which some (particularly younger) consumers regard as expensive and opaque. The number of credit cards in issue has declined since the onset of the pandemic, though it is early to tell if this is a structural trend.

In contrast to credit cards, which start charging interest on unpaid balances at the end of their monthly cycle, BNPL is free to consumers who pay the monthly installments on time. Providers typically charge fees for late payment (and may pass unpaid balances on to debt collection agencies), although PayPal has announced it will cancel late fees on its UK BNPL offering from October, which may see some of its competitors following suit. Unlike consumers, merchants pay a fee to BNPL providers (4-6% of gross merchandise value), but with an expectation of significant sales increases in return.

Fairer credit?

Electronic payments often involve an element of cross-subsidy. Merchants pay a fee for accepting card payments, allowing consumers to use them at no additional cost, but if merchants pass on these card fees to all consumers in the form of higher prices, then those who pay cash are effectively subsidising card payers. For deferred payment methods, there may also be a cross-subsidy within the group of consumers who use them. For example, people who revolve their credit card balances, accruing interest, may subsidise those who pay on time. Policymakers are concerned that any cross-subsidy should not unfairly penalise those who are already vulnerable.

It is possible to make the case that BNPL is a comparably fair payment method, because the consumers who pay late or are unable to repay at all face lower charges from doing so than they would with credit cards. Whereas credit card interest might compound indefinitely, BNPL providers usually cap the fees charged to late payers. And while non-BNPL users are likely to subsidise BNPL users by paying more for the same products, non-BNPL users tend to be older and pay upfront using debit cards. If they can better afford the higher prices than BNPL users, one could even argue that the cross-subsidy is ‘progressive’.

What’s changing?

Until now, the typical BNPL offering has been exempt from the UK Consumer Credit Act (CCA) and the EU’s Consumer Credit Directive (CCD) owing to the product’s short term and the fact that consumers do not pay interest for using it. But this will soon change in the UK, with the Treasury due to consult on regulation following the Woolard Review’s recommendation to bring standard BNPL products into the Financial Conduct Authority’s perimeter. Meanwhile, the European Commission is reviewing the CCD and may soon remove the exemptions that BNPL providers currently enjoy.

Regulation will likely involve tougher credit assessments, mandating that providers look at whether consumers can afford to repay in addition to their credit risk. It will also allow consumers to make claims against providers to the Financial Ombudsman Service (FOS). FOS claims can be costly to financial firms, as they must pay £650 for every complaint made against them, regardless of the outcome. While some BNPL firms are already familiar with the FOS because they also offer longer-term credit, BNPL regulation will expand this oversight to cover a much higher number of mostly lower-value loans.

A spoke in the wheel of BNPL firms?

Consumer-focused regulation could disrupt the business model of BNPL providers and give banks a leg up. 

BNPL firms have a close relationship with merchants, but not with consumers. Gaining good visibility over consumers’ overall financial position could therefore be a challenge, and it is not clear that the current credit reporting infrastructure is set up to help them. And yet, failing to adequately protect consumers would leave BNPL firms vulnerable to FOS claims, given the proportionately large fee (£650) they would face per claim relative to the size of the typical BNPL loan (in the low £100s). The fatal impact of FOS claims on other small lenders in the past is a cautionary tale.

Banks, on the other hand, have longstanding relationships with consumers, hold large and diversified loan portfolios, and already supply and use credit reference agency (CRA) data. Banks are signatories of data reciprocity agreements with CRAs and other institutions, helping to strengthen their position (and that of the largest CRAs) in the face of challengers in the credit market. Although BNPL performance data currently falls outside these reciprocity agreements, banks and CRAs could update them to incorporate such data for their customers, since BNPL payments are ultimately deducted from bank accounts. 

Banks also have the experience and human resources to cope relatively easily with additional regulation. And while they have struggled to make their credit card offerings attractive to Millennial and Gen Z consumers, many are alive to the threat BNPL providers pose and are starting to come up with alternatives. For example, Visa recently launched a facility to allow banks to offer interest-free installment loans (a BNPL substitute) to their customers.

How regulation may change BNPL firms and their offerings

Some BNPL firms are already gearing up for the commercial challenges that regulation will pose. Square’s recent purchase of Australian BNPL provider Afterpay (which operates as Clearpay in the UK), while undoubtedly motivated by other factors, will allow Afterpay to increase its focus on consumers’ financial health. Square will be able to link its digital wallet, CashApp, with the Afterpay BNPL product, giving Afterpay visibility over a consumer’s cash flow position and highlighting potential troublespots.

Some providers, such as Zilch, have partnered with card schemes (Mastercard in Zilch’s case) to offer a card that gives consumers the option to pay in installments. This is a departure from the standard BNPL model, which involves enlisting merchants rather than consumers, but it might just balance scalability (given Mastercard’s broad acceptance among UK retailers) with policymakers’ push for BNPL firms to make sure consumers can afford to use their products.

More competition on the horizon

Many BNPL firms have welcomed regulation. Any other stance in the face of mounting high-profile (if anecdotal) reports of consumer harm would probably have been counterproductive. But the prospect of consumer-oriented regulation is a threat to their highly successful merchant-focused business model. Depending on the requirements that the FCA puts in place for affordability assessments, regulation could even put an end to BNPL as we know it today. 

For banks, BNPL regulation stands to be a boon. It will not only (like most regulation) raise the operating costs of BNPL firms but will also push the product into familiar two-sided-market territory (with a formal link between merchants and consumers) - a market that banks, as card issuers, have historically dominated.

The upshot is that regulation is likely to introduce more competitive pressure into the burgeoning BNPL market. BNPL firms need to engage with regulators to make sure that affordability checks and other new requirements do not drive them out. It will also be important for regulators to create a level playing field in access to (and provision of) repayment performance data, perhaps using open banking tools. Banks, on the other hand, can use the advent of regulation as an opportunity to upgrade their products aimed at the people who have so far opted for alternatives. Those who stand to benefit the most? Consumers.