Buy Now Pay Later: A Dark Horse

A Closer Look at a The Booming BNPL Sector

As Buy Now, Pay Later (BNPL) services continue to gain popularity, their impact on consumer behaviors and financial stability alike is becoming harder to ignore. While these services offer an easy way to spread out payments, they also introduce potential risks that could have far-reaching consequences. In this newsletter, we explore the rapid rise of BNPL, the hidden dangers it poses, and the regulatory challenges that lie ahead.

What’s in Today’s Email:

  • The BNPL Boom: Examining the rapid growth of Buy Now, Pay Later services and how they’ve become a popular delayed payment option for consumers, particularly those with limited access to traditional credit cards.

  • Risks of Phantom Debt: Understanding the hidden dangers of BNPL, including the accumulation of untracked debt and the potential for systemic risks as consumers take on more liabilities than they can manage (or know of).

  • Regulatory Challenges: Exploring the current regulatory landscape for BNPL services, the gaps in consumer protection, and what steps might be needed to ensure sustainable growth and prevent financial instability.

This is the first leg of our series on BNPL, which will include an in-depth analysis of the companies’ financials and our conclusions on what is in store for investors in the space.

Buy Now, Pay Later (BNPL) is a form of consumer credit that allows buyers to make purchases and defer payments over a period of time, usually in installments. 

BNPLs’ key features are, in a nutshell: 

  • Deferred Payments. Consumers can buy products or services immediately but pay for them over a specified period, typically four or six bi-weekly installments, with the first one made at the time of purchase

  • Interest-Free Periods. Most BNPL services do not charge interest if the payments are made on time within the agreed period. 

  • No Hard Credit Check. BNPL providers typically do not perform a hard credit check, making it accessible to - and at times the only deferred payment option for - those with weaker credit histories.

  • Merchant-Funded Fees. The fees associated with BNPL are generally paid by the merchants rather than the consumers, as merchants benefit from increased sales and higher average transaction values.

The loans are usually bundled into a pool of assets, securitized, and sold to investors in senior, mezzanine, and junior equity-equivalent tranches - depending on the investor’s risk appetite - offering returns of typically 3-400 basis points above SOFR. 

Statistics show that the number of loans issued by the five main US BNPL providers grew by close to 1,000% between 2019 and 2021, from 17 to 180 million. According to the Consumer Financial Protection Bureau, in 2021 the value of loans issued in the US was approximately 24 billion, while the global market is projected to reach 700 billion by 2028, with 3 in 10 US consumers considering applying for a loan in July 2024 alone.

While the sector grew exponentially during the pandemic due to monetary and fiscal expansion - aka “stimulus checks” - the post-COVID change in monetary policy stance and the end of subsidies only marginally slowed down consumer adoption of BNPLs. Even as the US Federal Reserve raised rates 11 times between mid-2022 and March 2024, the sector grew robustly and is projected - as we mentioned - to continue to expand. 

Surprisingly, given their staggering growth, BNPL loans have not yet raised concerns in the financial community despite their disruptive potential on both consumer balance sheets and - more indirectly but perhaps more dangerously - on securitized loans investors.

The State of Consumer Credit in the US: Phantom Debt and the Potential for Systemic Risk

The rise in BNPL adoption is currently happening in the context of an increase in consumer indebtedness, despite the fact that rate hikes are typically expected to push consumers to deleverage and reduce spending.

Instead, consumer spending has been consistently surprising investors, pushing aside talks of a recession for the first half of 2024. The flip side of the story is that debt has remained stubbornly high in the US. Credit card debt, for instance, according to Q1 2024 figures, has reached a whopping $1.15 trillion. 

Perhaps tellingly, BNPL loans - also dubbed “phantom debt” - are not included in this figure, which therefore underestimates the level of consumer stress. In addition, the lack of reliable default figures - most BNPL providers are private companies - are making it hard to gauge the extent of the problem for investors and regulators alike. 

This may potentially signal that consumers are building “off the book” debt they are scantily aware of.

But neither are investors. In fact, two of the largest BNPL players - Afterpay and Klarna - have long been considered highly successful companies by the investment community. Klarna has recently turned profitable and is preparing for a $20 billion IPO later this year. Afterpay was acquired by Block for $29 billion at the end of 2022

Instead, the lack of reliable data about losses and defaults, and the creditworthiness of the customers using BNPLs - mostly individuals with less than optimal FICO scores, with limited access to credit cards - may potentially constitute an unappreciated risk to the financial system, if they are added to a growing trend of credit cards and car loan payments delinquencies

And while BNPL data is fragmented and unreliable - and somewhat inconclusive - auto loan and credit card delinquency rates are definitely on the rise. Overall, delinquencies on credit card loans (defined as 90+ days in default) in the US have been steadily increasing since the fourth quarter of 2021. As the FRED data shown below suggests, delinquency rates bottomed at 1.54% and stood at 3.16% in the first quarter of 2024

A deeper dive - as per the recent figures from Apollo - shows an even more alarming picture. In March 2024, delinquency rates for the youngest demographic, 18 to 29 year-old, rose to 10%. Surprisingly, 30 to 39 year-old are closer to 10%, while older age groups averaged between 4 and 8%.

Similarly, auto loan delinquency rates have increased to levels last seen in ‘08. Here again, the younger demographics - 18 to 29 year olds and 30 to 39 year olds - are worse off.

These levels of delinquency are somewhat concerning in a low unemployment environment. If unemployment rises, and there is a reasonable expectation that it will, delinquencies could potentially increase further, and may end up becoming a concern for the broader US financial system.

In this context, BNPLs are a bit of a dark horse. For now, the relatively small market size and the - seemingly - low default levels appear to rule out systemic risk. However, in a deteriorating economy these loans can potentially become increasingly more appealing as more traditional forms of credit become unavailable to consumers with lower credit scores.

The heavy correlation between credit cards and BNPL can hardly be missed. According to a Bank of America study, while average credit card balances have been increasing between 2021 and 2024, they’ve been rising faster for medium and heavy-use BNPL households

Perhaps tellingly, there are no rules prohibiting consumers from accumulating multiple BNPL accounts, and due to the absence of “hard credit checks,” it is impossible to know for companies providing BNPL services how many accounts a single consumer has open with other providers. This, in turn, could lead to less than optimal underwriting and account management decisions.  

This is especially dangerous as BNPL services - we should once again stress this - tend to target customers with weaker credit profiles. Unlike traditional credit services, BNPL does not require a hard credit check, making it an attractive option for those who might otherwise be denied credit.

BNPL Regulation is Ineffective

The particular nature of BNPLs - somewhat similar to but not quite the same as credit cards - contributes to consumers’ lack of understanding about what they are signing up to. It also makes it unclear which agency, if any, should regulate the sector. 

So far, BNPL services have been regulated similarly to credit cards in terms of their obligations to disclose terms to consumers. However, fundamentally, BNPL arrangements are loans, not means of payment. The key difference lies in their structure: BNPL typically involves no interest payments, setting them apart from traditional credit card debt. In addition, late payments do usually entail a fee, but do not trigger a punitive interest as credit cards do. 

From the regulator’s perspective, one of the major challenges in assessing the BNPL landscape is the lack of published data. Unlike credit card companies, many BNPL lenders are privately held and therefore not obligated to disclose their financial information, and - most importantly - repayment behaviors. The competitive nature of the market also discourages the sharing of customer data, with each provider unlikely to offer insights on its customer acquisition success.

At this stage, however, there are no standardized disclosures that force lenders (but mostly merchants) to share information about late fees, loan and repayment terms. 

It has been suggested - and our view is that this could be an interesting avenue - that BNPL should instead be considered by the regulator as a marketing tool employed by merchants, since the latter pay the associated fees and benefit from increased sales as a result of offering BNPL options. Consequently, the disclosures related to BNPL should be closer to the ones attached to marketing messages presented at the point of sale, which would put the burden on the merchant to be more transparent with the customer.

Customers would also be better off if they were made aware of their other BNPL agreements before adding a new one. This would give them time to reflect and perhaps backtrack, rather than continue to accumulate future liabilities (what’s known as loan stacking). According to a Bank of America study, a small but growing percentage of BNPL users have more than 10 monthly payments.  

Given these considerations, the Consumer Financial Protection Bureau (CFPB) should leverage its rule-making authority to expand the definition of Unfair, Deceptive, or Abusive Acts or Practices (UDAAPs) to encompass specific actions by merchants that promote BNPL financing. This could include mandating that merchants implement safeguards to prevent overspending by limiting the availability of BNPL financing.

Conclusion

The rapid growth and widespread adoption of Buy Now, Pay Later (BNPL) services has transformed consumer credit by offering an attractive and accessible payment method, especially for buyers with limited access to credit cards due to lower credit scores. It also gave merchants a big boost in sales by making goods more affordable to customers. 

However, consumer over-indebtedness is potentially a serious concern. BNPL services, while providing an interest-free credit option with no hard credit checks and no limits on loan stacking, often lead consumers to accumulate multiple deferred payment agreements, resulting in unsustainable debt levels. 

The lack of comprehensive data on individual consumer obligations further exacerbates this issue. Introducing regulations to ensure consumers are informed about their total BNPL obligations before entering new agreements could potentially mitigate this risk, but there needs to be action as the sector is growing at a breakneck pace.

BNPLs are a peculiar form of credit - not a payment system - and should be treated as such by the regulator, who should also look at who reaps the benefits (spoiler alert: the vendor). In addition, their convenience for buyers and vendors alike comes with significant risks that require additional supervision and transparency. 

Indeed, unlike traditional credit products, BNPL services are currently not subject to stringent disclosure requirements, preventing consumers from fully understanding the terms and potential fees associated with their purchases. Enhanced disclosure regulations, similar to those applied to marketing messages at points of sale, could ensure consumers receive clear and comprehensive information about their BNPL commitments. This would help consumers - at the very least - make more informed decisions and potentially avoid loan stacking

But most importantly, the BNPL sector's rapid expansion, particularly among consumers with weaker credit profiles, may pose a potential systemic risk to the financial system.

As Nils Hertzner and Nikita Saygakov, CFA wrote in CFA’s "An Introduction to Alternative Credit,” “the primary characteristic of (marketplace lending) originated loans is the exposure to consumer credit risk rather than corporate credit risk.

The lack of hard credit checks and the potential for multiple BNPL accounts increase the likelihood of consumer defaults, which may be currently underreported due to a lack of publicly available data. 

That, in turn, could spell trouble for the owners of the securitized loans.

We will delve deep into the topic in our next BNPL piece. But first…

…A few useful links: