Embedded lending is the future of lending in emerging markets

 Samora Kariuki photo
Samora Kariuki Director of Fintech, Sote
3min read

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One of the most exciting areas of fintech at the moment is embedded finance, and particularly embedded lending. With the right maturity and scale, it can drive big, big value and unlock vital financial access in emerging markets. It’s the future of lending in these regions.

Financial exclusion is a massive problem. For SMEs involved in areas like retail trade, logistics, farming and mining, having access to capital that can grow your top line is so important. It can help to fund your fixed costs and reach profitability. In the long term, this profitability becomes retained earnings or dividends which are reinvested into the economy to drive further growth.

In most emerging markets, the lending markets don't paint a pretty picture

They’re defined by a lack of sufficient, scalable credit scoring infrastructure. When this infrastructure does exist, it’s poorly designed and leads to perverse incentives. Look at Nubank. Their massive growth in Brazil shows that alternative approaches to credit scoring are needed even when infrastructure exists. A lack of infrastructure creates a situation where banks fall back on two outdated models of underwriting risk - requiring businesses to have collateral in the form of landed property or defaulting to name-based lending.

By definition, these two lending formats create exclusion. People without access to property or reputation are left high and dry. The stats bear witness to this. In Africa, it’s estimated that the SME funding gap is worth $330bn. To make matters worse, only 40% of Africa’s trade finance is intermediated compared to areas like Asia, where this figure stands at 80-90%. The $5.2tn+ SME funding gap is largely concentrated in Asia, South America and Africa.

The $5.2tn+ SME funding gap is largely concentrated in Asia, South America and Africa.

What does this mean? That companies fail to grow, and in turn economic outcomes don’t develop. If a company can’t grow then it can’t hire new staff or expand into new markets. So in many emerging markets, wealth creation is focused on incumbent family-based business groups with both assets and a reputation within the banking system.

Embedded lending is the key to bridging the gap

For this to happen, you need key vectors like B2B e-commerce, logistics, and payroll management software which lend themselves to digitisation at scale. And to work, these platforms need at least three of the following:

  1. Access to customers and scalable and low-cost customer acquisition

  2. Access to data that give an advantage in credit underwriting

  3. Collection capabilities, or at least the ability to drive repayment behaviour through ‘skin in the game’ mechanisms

  4. Low cost of funds

Most platforms should have the first three and partner with financial institutions for the cost of funds element where possible. A good example is Shopify’s partnership with Stripe and Goldman Sachs for Shopify Capital.

These four elements are critical to the success of embedded lending, and you see this every time a financial institution successfully partners with a platform. Like Flexport Capital underwriting credit risk with its access to clients’ import data. It has collection capabilities through control of cargo as well as customer origination from its existing freight forwarding business. Alipay is the ultimate example of how embedded lending can create opportunities for previously marginalised borrowers. Through the integration of data between Taobao, T-Mall and Alibaba, Alipay was able to originate facilities for its clients while banks funded the loans. Alipay checked all four elements required to lend at scale with a well-designed and structured solution.

Alipay is the ultimate example of how embedded lending can create opportunities for previously marginalised borrowers.

My unfiltered opinion

Building out the infrastructure and partnerships required for embedded lending won’t be easy. Different stakeholders have different requirements from a regulatory and risk point of view. But once all the boxes are ticked, embedded lending will be the future of lending in emerging markets. It’ll create a new infrastructure that can channel huge amounts of capital to businesses and individuals who have previously been excluded, and I’m keeping a keen eye on Rappi and Mercado Libre in South America, Twiga Foods and TradeDepot in Africa as well as players such as Udaan in India.